The following article is reprinted from The M&A Tax Report, Vol. 13, No. 1, August 2004, Panel Publishers, New York, NY.


By Robert W. Wood

Taxes are complex and arcane, perhaps no where more so than in the world of corporate finance and M&A. As readers of The M&A Tax Report know, most merger or acquisition transactions have significant tax implications. The transaction may be structured as taxable sales, in which the target's stock is being purchased or the target is selling its assets and then being liquidated. Alternatively, the transaction may be structured as a nontaxable reorganization involving an exchange of stock. In the latter case, they may either be wholly tax-free or partially tax-free depending on the various types of consideration given to the target and/or its shareholders. The consideration can include cash, common or preferred stock, promissory notes, and even contractual earnout rights. The type and amount of tax will vary with the type and amount of these classes of consideration.

Given all these various permutations, it will be a rare transaction in which one or more tax lawyers have not been asked to examine the tax consequences for both the buyer and the seller. At the very least, this will come up at tax return time, the year after the deal closes (nothing worse than a nasty surprise after the deal is done). However, since it will almost always be too late then to do much more than write a check to the IRS or state taxing authorities. M&A tax work generally should begin much earlier in the process.

Typically, this kind of tax structuring should occur during the planning stages of the acquisition, certainly well before the closing occurs. Indeed, optimally these discussions take place before the letter of intent is even signed (that would be a nice change of pace). The appropriate record should start early on, before a trail of correspondence and documents may seal the fate of any kind of effective tax reduction techniques.

Competing Tax Considerations

From a buyer's tax viewpoint, the buyer will generally want to achieve a step-up in the tax basis of the assets, thus affording higher depreciation deductions in the future. The buyer will also want to have the benefit of any tax attributes of the target that the buyer thinks are attractive. Especially sought after tax benefits include net operating losses that may help shield future taxable income.

In many cases, these tax goals are mutually exclusive. The buyer may therefore have to decide which tax issues are most important to it (talk about a Hobson's choice). Then, the interaction with the seller must occur. In almost all cases the buyer and seller will have competing tax interests that can make for some heated negotiations. Whose tax interests are more important? Who will pay which tax liabilities? Which tax risks should be the subject of a tax indemnity obligation?

State and Local Taxes, Too

As if all of this did not make the tax issues in M&A deals interesting enough, there will often be state tax consequences, too. Sales and use taxes on assets sales, for example, can be costly. They can also dramatically impact reporting obligations after the transaction is complete.

Not only will these state tax issues need to be considered, but like federal income taxes, they will enter into the bargaining over the business terms. If state and local sales or use taxes are payable, either the buyer, the seller, or some combination thereof, will have to pay them. There may even be sales and use taxes paid in more than one state. Buyers and sellers often end up agreeing to split sales and use tax liabilities, but there is no absolute standard for this.

Apart from state and local sales taxes, other state taxes can prove nettlesome, too. These state tax issues don't necessarily follow the federal tax law treatment. The state tax issues can include state corporate income taxes or state franchise taxes. The more states in which the target company or the acquiring company does business, the more state tax issues there will be to negotiate.

Tax Rules and Judicial Doctrines

Most tax lawyers agree that the Internal Revenue Code and the Treasury Regulations contain a considerable volume of material that is nearly Herculean to try to master. Taking a more modest goal, even if one focuses only on one chapter of the dozens in the Internal Revenue Code-the rather lengthy provisions dealing with mergers and acquisitions-the task can be daunting. Yet, even this large amount of reading (and the accompanying expertise that will hopefully develop) will not be enough in many cases. A significant body of tax law has developed over the last fifty years that is actually not included in the Internal Revenue Code at all and, in large part, not even included in the IRS' own regulations. These nonstatutory doctrines (based on case law) serve as a general overlay to the tax treatment of mergers and acquisitions.

The most famous of these nonstatutory rules, one with which most corporate lawyers have at least passing familiarity, is the "step transaction doctrine." Under this self-descriptive moniker, the Internal Revenue Service (and state taxing agencies, too), may come along and seek to integrate portions of a transaction that may on the surface seem to be separate transactions with independent tax consequences. The IRS or other taxing authorities can assert that such separate deals must be all connected together, in effect being mere "steps." Since our Byzantine tax law often allows one to accomplish in several transactions what cannot be completed in a more direct and forthright manner, the result of treating several deals as one, making them only one transaction for tax purposes, is usually quite negative.

Many court cases discuss and refine this topic. Basically, though, if you start out with a series of binding steps that lead to one tax result, and if this result is different from the tax treatment that would apply had the transaction been accomplished directly, guess what? For tax purposes, the IRS can assert that the tax treatment that would normally accompany the direct transaction ought to control. In some cases, the tax liabilities from such a recharacterization can be truly terrible.

Tax lawyers spend countless hours thinking up creative techniques to avoid certain unfortunate results. The step transaction doctrine is one weapon the Internal Revenue Service can use to attempt to combat so-called "creative" transactions. (Sometimes "creative" is a tax lawyer's euphemism for "aggressive.") Other nonstatutory tax doctrines can also be a problem, too.

Other Case Law Doctrines

It is impossible to briefly catalogue all the nonstatutory doctrines that the IRS may seek to invoke in the context of a corporate merger or acquisition. However, one development of the last century that is of particular interest-particularly so that readers don't believe the IRS never changes its mind-is the Bausch & Lomb doctrine, named after the famed optical company.

In Bausch & Lomb Optical Co. v. Commissioner, 30 T.C. 602 (1958), aff'd, 267 F.2d 75 (2d Cir. 1959), the acquiring corporation had a pre-existing 79% stock interest in the target company, a stock interest Bausch & Lomb had possessed for quite some time. Because Bausch & Lomb held 79% of the target's stock before the acquisition, the transaction ended up failing compliance with one of the reorganization sections (I.R.C. §368(a)(1)(C)). Based on a technical reading of the statute, this seemingly straightforward transaction was held by the court to be fully taxable. Why?

The court concluded that the transaction violated the "solely for voting stock" requirement to this code provision. Because the acquiring company had received 100% of the target company's assets, and only transferred Bausch & Lomb stock to the 21% minority shareholders of the target, the court concluded that the balance of the assets must have been acquired on the liquidation of the target and the surrender back by the acquiring company of target stock.

Although this may sound somewhat technical, it actually wasn't terribly complex as these types of transactions go. This now well-known "Bausch & Lomb problem" only arises when a corporation attempts to acquire the assets of a partially owned subsidiary. In the Bausch & Lomb case, the acquiring company owned 79% of the subsidiary's stock. The court agreed with the IRS that the acquiring company had made a taxable transaction.

Never Too Late

For the next 44 years, people in a tax advisory role have watched out for the Bausch & Lomb doctrine, and have made sure that in these so-called "creeping" acquisitions, that another route to tax-free acquisition treatment is taken. There usually is more than one way to skin the proverbial tax cat.

Strangely enough, 45 years after their victory in the Bausch & Lomb case, the IRS reversed its own position and said that the Bausch & Lomb doctrine isn't a problem any longer. This IRS benevolence is worth noting for several reasons. First, it can represent a major change in the ease with which the tax treatment of a particular type of acquisition can be consummated. Second, it is just so darned rare for the IRS to back down on a position (and 45 years later!) that someone ought to write about it.

Treasury Regulation Section 1.368-2(d)(4)now embodies this IRS change in its long-standing position that the acquisition of a partially controlled subsidiary's assets does not qualify as a tax-free reorganization. Under the regulations, an acquiring corporation's pre-existing ownership of a portion of a target corporation's stock generally would not prevent the "solely for voting stock" requirement from being satisfied.

Hit the Showers

Even many sophisticated readers may think that any discussion of tax rules-even a positive IRS development-is complicated enough to push even more lawyers away from the tax law. After all, the United States indisputably has the most complex (and voluminous) tax system in the world. In fact, ours is the most complex tax system by a margin that is considerably wider than the Pacific. Still, the tax rules affecting mergers and acquisitions-stock sales, assets sales, earnouts, tax-free reorganizations-are critical in making the economics of any of these transactions hang together.

Tax Aspects of M&A Deals: A Pervasive and Intricate Part of Any Transaction, Vol. 13, No. 1, The M&A Tax Report (August 2004), p. 5.