Taxable Versus Tax-Free Transactions

Mergers and acquisitions can be either tax-free or taxable events. The tax status of a transaction may affect its value from both the buyer's and the seller's viewpoints. In a taxable acquisition, the assets of the selling firm are revalued or "written up." Therefore, the depreciation deduction will rise (assets are not revalued in a tax-free acquisition). But the selling shareholders will have to pay capital gains taxes and thus will want more for their shares to compensate. This is known as the capital gains effect. The capital gains and write-up effects tend to cancel each other out.

Certain exchanges of stock are considered tax-free reorganizations, which permit the owners of one company to exchange their shares for the stock of the acquirer without paying taxes. There are three basic types of tax-free reorganizations. In order for a transaction to qualify as a type A tax-free reorganization, it must be structured in certain ways. In contrast to a type B reorganization, the type A transaction allows the buyer to use either voting or non voting stock. It also permits the buyer to use more cash in the total consideration since the law does not stipulate a maximum amount of cash that can be used. At least 50 percent of the consideration, however, must be stock in the acquiring corporation. In addition, in a type A reorganization, the acquiring corporation may choose not to purchase all the target's assets.

In instances where at least 50 percent of the bidder's stock is used as the consideration but other considerations such as cash, debt, or non equity securities are also used the transaction may be partially taxable. Capital gains taxes must be paid on those shares that were exchanged for no equity consideration.

A type B reorganization requires that the acquiring corporation use mainly its own voting common stock as the consideration for purchase of the target corporation's common stock. Cash must comprise no more than 20 percent of the total consideration, and at least 80 percent of the target's stock must be paid for by voting stock by the bidder.

Target stockholders who receive the stock of the acquiring corporation in exchange for their common stock are not immediately taxed on the consideration they receive. Taxes will have to be paid only if the stock is eventually sold. If cash is included in the transaction, this cash may be taxed to the extent that it represents a gain on the sale of stock.

In a type C reorganization, the acquiring corporation must purchase 80 percent of the fair market value of the target's assets. In this type of reorganization, a tax liability results when the acquiring corporation purchases the assets of the target using consideration other than stock in the acquiring corporation. The tax liability is measured by comparing the purchase price of the assets with the adjusted basis of these assets.

 

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