M&A IV: Limits on Target Firm's Tax Attributes

Question 1

Whether or not a Target Co’s tax attributes c/o to the new owner depends on what?

Answer 1

• Acquisition structure

Question 2

For taxable asset acquisitions, with whom do the tax attributes stay?

Answer 2

• Target co. (which is still owned pre-liquidation by its S/Hs)

Question 3

For taxable stock acquisitions and nontaxable acquisitions, with whom do the tax attributes stay?

Answer 3

• Tax attributes of Target c/o to new owner

Question 4

What is the most important Target Co. tax attribute to a potential Acquirer?

Answer 4

Tax basis NOL

Question 5

What are the two restrictions affecting Acquiring Co. ability to use Target’s preexisting NOLs (in general)?

Answer 5

• First restriction limits sources of income that NOL can be used against
• Second restriction limits amount of pre-acquisition NOL that can be utilized in a given year
• Both restrictions apply annually

Question 6

Expand on Restriction One affecting Acquiring Co. ability to use Target’s preexisting NOLs.

Answer 6

• Target’s pre-acquisition NOLs can only offset post-acquisition income of Target Co. (or income generated from acquired assets)
• Pre-acquisition income NOLs cannot offset other income earned by Acquiring Co.
• This limit is referred to as the separate return limitation year (or SRLY)

Question 7

Expand on Restriction Two affecting Acquiring Co. ability to use Target’s preexisting NOLs.

Answer 7

• The amount of Target’s NOL c/f that can be utilized to offset post-acquisition TI of Target is subject to annual limit.
• The limit, referred to as the Sec. 382 limit is computed as:

Sec. 382 Limit =
FMV of Target’s stock before ownership exchange *
LT tax-exempt interest rate at the ownership change date

Question 8

What is the economic effect of the tax restrictions on acquired NOLs?

Answer 8

Spreads out NOL usage over more time

Question 9

In theory, why would Acquiring Co. be willing to pay more for a Target Co. with tax basis NOL c/f? What is the max additional amount Acquiring Co. would pay for a Target Co. with tax basis NOL c/f equal to?

Answer 9

• B/c it can utilize a portion of Target’s NOL

- Max additional amount Acquiring Co. should pay is PV of future tax savings generated by Target’s NOLs

Question 10

What are the two limits on the transferability of NOLs?

Answer 10

1) SRLY Limit

2) 382 Limit

Question 11

If the Target Co. generates an NOL post-acquisition, can it use its pre-acquisition NOLs?

Answer 11

• No, use the NOL from this year to offset any income (SRLY limit does not apply to post-acquisition losses)
• However, cannot use pre-acquisition NOLs (those get carried forward to be used in future years)

Question 12

Who is capturing most of the benefits associated with the future tax savings from Target’s NOLs if Acquiring Co. had to pay very little to buy the Target’s NOLs?

Answer 12

Acquiring Co. captures most of tax savings from NOLs

Question 13

Who is capturing most of the benefits associated with the future tax savings from Target’s NOLs if Acquiring Co. had to pay almost full price to buy Target’s NOLs?

Answer 13

Target S/Hs captures most of tax savings from NOLs

Question 14

What is the max additional amount Acquiring Co. should pay for a Target Co. with NOL c/f (Target B) compared to a Target Co. w/o NOL cf (Target A)?

Answer 14

• Max additional amount Acquiring Co. should pay for Target B = PV of future tax savings generated by Target B’s NOLs

Question 15

What five factors likely affect how much a Target’s NOLs will sell for?

Answer 15

1) Discount rate
2) Tax rates
3) Ability of Acquiring Co. to use Target’s NOLs
4) Ability of Target to use NOLs as a standalone co.
5) More bidders for Target Co. (increased competition)

Question 16

The more quickly the Acquiring Co. can use Target’s NOLs, the what the price Acquiring Co. is willing to pay?

Answer 16

• Higher

Question 17

If the Target Co. can use its NOLs without an acquisition, then it might demand what?

Answer 17

• Higher price for its tax NOLs

Question 18

The max amount Acquiring Co. would pay for Target’s NOLs is equal to what?

Answer 18

Present value of future tax savings from Target’s NOLs

Question 19

What does TNOL stand for?

Answer 19

• Expected amount of Target’s NOL that Acquiring Co. expects to be able to utilize (or deduct) for tax purposes

Question 20

What does nnol stand for?

Answer 20

Number of years which Acquiring Co. expects to use Target’s NOL

Question 21

What happens to the value of the NOL as n increases?

Answer 21

Value of NOL decreases as n increases

Question 22

What is the direct cost to make a 338 election?

Answer 22

The corporate level tax on the basis step up (which is due at time of election)

Question 23

Following a 338 election, how is the Target Co. treated for tax purposes?

Answer 23

• Target Co. treated as a new co. for tax purposes (i.e. pretend it is a new Target Co.)
• All prior tax attributes, including NOLs, are eliminated

Question 24

In most cases, why is it probably not (after-tax) value maximizing to make a 338 election?

Answer 24

• B/c it accelerates payment of the corporate-level tax

Question 25

In determining whether or not a 338 election is optimal, what do you need to compare?

Answer 25

The present value after-tax CFs of Target with and without the 338 election

Question 26

Regardless of the 338 election decision the same underlying assets are acquired, thus CF differences are strictly due to what?

Answer 26

• Tax related cash flows

Question 27

How do you calculated NET338?

Answer 27

NET338 =
Direct NPV tax benefit (cost) due to 338
Less PV of tax savings from Target’s NOLs if forego 338 election

Question 28

The direct NPV of making the 338 election is…

Answer 28

the actual tax liability associated with the 338 election less the PV of tax savings associated with basis step up (i.e. tax savings from increased depreciation deductions)

Question 29

What is TNOL338 limited to?

Answer 29

• Limited to Pricetaxstock less TASSETB

Question 30

What is TNOL338?

Answer 30

-Amount of Target’s NOL used to offset the 338 gain

Question 31

How is the tax liability due to the 338 election computed as?

Answer 31

TAX338 =

[(ADSP - TASSETB) - TNOL338] * tc

Question 32

If nstep < nnol, how does that affect the decision recommendation for a 338 election?

Answer 32

• If nstep < nnol, prefer 338 election

- B/c realize the tax benefits sooner with deducting the basis step-up compared to the timing of the NOL c/f

Question 33

If nnol < nstep, how does that affect the decision recommendation for a 338 election?

Answer 33

• If nnol < nstep, prefer NOT to make the election

- B/c can deduct the NOLs more quickly than the basis step-up