How section 338 election influence the deal structure in a M&A transaction?

Introduction

  1. In a M&A transaction, structuring a deal is as important as the strategic rationale behind the acquisition.There are two ways to structure a deal.A buyer can acquire the assets of the seller or the buyer can acquire the stock/equity of the seller shareholders thus retaining the control over the seller.
  2. In case of an asset acquisition, the buyer retains only the liabilities associated with the assets that it is acquiring.The remaining liabilities is not owned by the buyer.In this case, all the associated ownership of the assets including the ownership of the seller customer contracts, IP and licenses needs to be transferred to the buyer. This takes a lot of time and is an expensive process.In many cases, certain customer contracts or licenses cannot be transferred because the agreements are generally valid only till the seller legal entity is retained.Hence, in order to transfer such IP/contracts, the buyer is sometimes forced to acquire the assets the seller along with its other liabilities.
  3. In case of a stock transaction, the buyer acquires all the assets and liabilities of seller.The legal entity of the seller is retained and there are no issues related to the transfer of ownership.This transaction is fairly a straightforward process.The buyer in this transaction takes control of the ownership.

Taxation and Deal structuring

Structuring a deal has an important effect on the tax structure and liability for both buyer and seller.Taxation on Asset acquisition

  1. A buyer would prefer an asset acquisition because in this case, the seller assets are stepped up to Fair Market value.The purchase price is allocated to the fair market value of current assets of the seller.Any value over and above paid by the buyer post the fair market value of the seller assets is taken as a goodwill.The buyer can take advantages of the additional tax savings in future by higher depreciation/amortization of the seller assets.The goodwill can also be amortized for a period of 15 years in an asset acquisition and the buyer can get a higher tax savings on his future earnings.
  2. For the seller, this transaction will impose a double taxation.An asset acquisition is executed between the buyer and seller organization.Hence first round of taxation will be applied on the capital gains from asset sale on the seller organization.Post that, the proceeds from asset sale are distributed to the seller shareholders in the form of dividend which again attracts a withholding tax.Due to the double taxation involved, the seller would not prefer an asset acquisition unless the seller is part of the conglomerate and seller has high net operating losses that can be used to offset the taxable income.

Taxation on Stock Acquisition

  1. In case of a stock acquisition, the transaction is executed between the buyer and seller shareholders. Hence the gain or loss on stock sale is subjected to capital gains tax.In this acquisition, the stock price is stepped up where as asset value of the target is carried over. Hence the buyer does not get additional tax savings on the higher depreciation/amortization of the target assets.The buyer needs to follow the depreciation schedule of the seller and any goodwill allocation in the purchase price cannot be amortized in case of a stock acquisition.

Section 338 election

  • It is quite evident from the above that the buyer prefers an asset acquisition where as seller prefers a stock acquisition.
  • There are cases where buyer and seller can have the best of both.Section 338 election is where the stock acquisition is carried out through stepping up of seller assets at Fair Market value.

This elections can come under two different scenarios.Section 338g election

  • This election is generally preferred for a cross border acquisition where the target is a non US entity.In this case, the acquirer controls more than 80% of ownership in seller entity.The seller assets are stepped up to Fair Market value for tax savings on additional depreciation/amortization.
  • The acquirer makes an unilateral election on 338g.In case of acquisition, where the target is a US entity, the seller is subjected to double taxation: one at the corporate level and another at the capital gain proceeds from share sale at shareholders level.In this case, the buyer absorbs the tax cost from the capital gain in order to realize the projected tax savings on additional depreciation of seller assets in future.Hence the buyer needs to assess and proceed only if the present value of the future tax savings exceeds the tax cost of the asset sale.
  • In case of a cross border acquisition involving a non US target, the capital gain from the asset sale is not taxed on the seller.The buyer can depreciate the stepped up value of the seller assets in order to realize additional tax savings.

Section 338(H)(10) election

  1. In this case, the buyer and seller together announce the election on the proposed acquisition. This transaction has criteria:
  • The target should be a S Corp
  • The target should be a subsidiary of a parent company where parent controls 80% of the target stake
  • The target is affiliated to a parent but filings are done at a consolidated level.

As the target is a S Corp, any asset sale is generally passed through its shareholders and no corporate tax rate is levied.Hence there is only one level of taxation on capital gain of the asset sale on seller shareholders.The seller assets are liquidated to a new seller entity created fictionally and this entity is acquired through stock acquisition by the buyer.The gain from the asset sale of the old seller entity is distributed to the buyer shareholders but are not taxed. The new seller entity created is owned by the buyer as its subsidiary. Hence the seller legal entity is retained and the seller assets are stepped up at Fair market value for buyer to realize additional tax savings.The new sale price of the seller asset is priced using Aggregate Deemed Sale price approach where the stock ownership of the buyer on target is grossed up to 100%.After that the target liabilities are added to arrive at Fair market value of assets.This value is then subjected to depreciation/amortization for future by buyer to realize additional tax savings.These types of deal structures are more common and used in domestic acquisitions.

Fair Market value of the Assets

  1. When arriving at the Fair market value of the target assets, the purchase price is allocated between various assets in the target balance sheet.
  2. For current assets like Account Receivable and Inventory, the Fair market value is calculated by its selling price.Such income is recognized as Normal income and has higher tax rate than the capital gain tax.
  3. Self created intangibles like goodwill is taxed at capital gain tax on the seller.

Adjustments in Final Purchase price subjected to Section 338 election

  1. The seller compares the final proceeds that it might get on a Stock acquisition and compare the value with Section 338 election.If the seller is required to incur a higher tax cost on the asset sale on 338 election compared to a stock acquisition, then it request the buyer to increase the purchase price to compensate for the loss.

Conclusion

  1. Section 338 election is very critical when finalizing on the deal structure of an acquisition.
  2. The tax accounting and GAAP accounting norms for valuing an asset varies.In an asset acquisition, Goodwill is impaired on accounting terms but is amortized on taxation terms for up to 15 years to realize additional tax savings for the buyer.
  3. These things needs to be kept in mind during the valuation exercise of a target company during the acquisition.


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