STATEMENT OF RONALD A. PEARLMAN ASSISTANT SECRETARY (TAX POLICY) DEPARTMENT OF THE TREASURY BEFORE THE SUBCOMMITTEE ON OVERSIGHT AND THE SUBCOMMITTEE ON SELECT REVENUE MEASURES OF THE HOUSE WAYS AND MEANS COMMITTEE

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP87T00759R000100170004-5
• Release Decision: RIFPUB
• Original Classification: K
• Document Page Count: 46
• Document Creation Date: December 22, 2016
• Document Release Date: May 10, 2010
• Sequence Number: 4
• Publication Date: April 1, 1985
• Content Type: MISC

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:tachment A
TREASURY NEWS
Department of the Treasury ? Washington, D.C. ? Telephone [phone]
For Release U Ron Deliver
Expected at IU:UU A.M., E.S.T.
April 1, 1985
STATEMENT OF
RONALD A. PEARLMAN
ASSISTANT SECRETARY (TAX POLICY)
DEPARTMENT OF THE TREASURY
BEFORE TEE
SUBCOMMITTEE ON OVERSIGHT
AND THE
SUBCOMMITTEE ON SELECT REVENUE MEASURES
OF THE
HOUSE WAYS AND MEANS COMMITTEE
Mr. Chairmen and Members of the Subcommittees:
I an pleased to appear before you today to discuss some of
the more significant Federal income tax aspects of corporate
acquisitions. The recent surge in merger activity and the
publicity surrounding recent acquisitions (and attempted
takeovers) of large, publicly held corporations has renewed
concern that our tax laws inappropriately encourage these
transactions. We do not know all, of the economic and other
reasons behind the recent flurry of activity. However, we doubt
that tax considerations are the driving force. We suspect that
other market forces precipitate these transactions; forces that
reallocate resources to higher valued uses, promote economies of
scale, increase shareholders' return on investment, replace
inefficient management, and free up capital for new investment
opportunities. Only those persons responsible for the merger
activity know for certain the forces that drive their decisions;
I will not today speculate on their decision making process,
instead I will concentrate on the principal tax aspects of
mergers and acquisitions and defer to the expertise of others on
the effect of these corporate acquisitions on the economy as a
whole.
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While it is doubtful that our tax laws are primarily
responsible for the recent merger upswing, they play an important
role in these transactions, just as they do in virtually every
business transaction corporations conduct. The subject of the
hearing today concerns those aspects of our current tax laws that
exert the greatest influence on merger activity. The first part
of my testimony summarizes the different types of corporate
acquisitions and describes the divergent tax consequences that
may be obtained. The second part of my testimony discusses
certain structural features of our tax system that appear to
encourage corporate acquisitions and takeovers. The third part
of my testimony describes recent trends in merger activity that
raise significant tax policy issues. Included among these are
the use of ESOPs in leveraged buyouts, the use of asset
reversions from overfunded defined benefit plans to finance
mergers and acquisitions and the carryover of tax attributes in
mergers and acquisitions of thrift institutions. Finally, I will
discuss certain legislative proposals that are inspired by the
current wave of mergers and acquisitions.
I. Taxing Corporate Acquisitions - An overview
In general, for tax purposes, corporate acquisitions are
categorized into two basic forms -- taxable and tax-free. while
this categorization vastly oversimplifies how the tax law applies
to these transactions, it is useful in analyzing the important
tax policy questions in this area to think of the transactions as
coming within one of these two categories; for it is this
categorization that will trigger the most significant tax
consequences. This first part of my testimony summarizes the
types of mergers and acquisitions that come within each category
and their principal tax consequences.
A. Tax-Free Acquisitions
The distinctive characteristic of a wholly tax-free
acquisition is that no gain or loss is recognized by the target
corporation or its shareholders. The target shareholders are
permitted to roll over their investment position in the target
corporation for an investment position in the acquiring
corporation without paying current tax. This tax-free rollover,
however, is generally available only to the extent the target
shareholders receive stock of the acquiring corporation or
certain related corporations. Other consideration received by
the target shareholders is taxable either as dividend income or
capital gain, depending upon the application of a complicated set
of judicial and statutory rules that strive to make this over
difficult distinction.
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A tax-free acquisition generally will not generate taxable
income to the target corporation, even if that corporation has
appreciated assets. The corollary of this tax-free treatment is
that the target corporation's historic tax basis for its assets
"carry over' to the acquiring corporation and are not
'stepped-up" (or down) to fair market value. Moreover, with
certain limitations discussed below, tax attributes of the target
corporation, such as net operating losses and unused credits and
accumulated earnings and profits, will also carry over to the
acquiring corporation.
To qualify as a tax-free acquisition, the transaction
generally must qualify as a 'reorganization' as defined in
section 368 of the Code.!/ Although the statutory definition and
judicial interpretations place significant constraints on how a
reorganization can be structured, significant flexibility does
exist. Thus, a tax-free acquisition can take the form of a
direct acquisition of the target corporation's assets, the
acquisition of the target corporation's stock, or a combination
of the target and the acquiring corporation pursuant to statutory
merger or consolidation.
B. Taxable Acquisitions
The principal characteristic of a taxable acquisition that
sets it apart from a tax-free acquisition is that the seller in a
taxable acquisition cannot receive a tax-free rollover of his
investment. The seller in a taxable acquisition can be either
the target corporation (a taxable asset acquisition) or the
target shareholders (a taxable stock acquisition). The
collateral consequences of a taxable asset acquisition and a
taxable stock acquisition differ in so many respects that each
will be discussed separately.
*/ A 'reorganization' is defined in section 368(a) as including
four basic types of acquisitions: statutory mergers (type "A"
reorganizations), stock-for-stock exchanges (type "B"
reorganizations), asset-for-stock exchanges (type 'C"
reorganizations), and bankruptcy reorganizations (type 'G"
reorganizations). Tax-free acquisitions can also be effected
through compliance with section 351. In addition to
satisfying the statutory definition, a reorganization must
most certain other regulatory and common law tests (such as
the 'continuity of interest' and 'continuity of business
enterprise' tests) in order to qualify as a reorganizatiod.
Although there is some uncertainty regarding application of
these statutory and judicial tests to particular fact
patterns, there is a substantial body of case law and
Internal Revenue Service rulings and past history that
provide guidance to taxpayers.
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1. Taxable Asset Acquisitions
In a taxable asset acquisition, gain or loss is recognized by
the target corporation, unless, as discussed below, the target
corporation is completely liquidated within a statutorily
prescribed time. The sale may be reported on the installment
method, however, in which case any capital gain is deferred and
reported as the installment payments are received. In any case,
the tax basis of the assets acquired are adjusted to reflect the
purchase price paid for those assets. In a taxable asset
acquisition, the acquiring corporation does not succeed to any of
the target corporation's tax attributes, such as net operating
losses and unused credits and accumulated earnings and profits.
These tax attributes, however, will be available to offset the
target corporation's income and tax liability resulting from the
sale.
If a transaction is a taxable asset acquisition from a
corporation that has adopted a plan for complete liquidation
within a 12-month period, generally no gain or loss is recognized
by the selling corporation (except to the extent of recapture
and other tax benefit items). Gain or loss is recognized,
however, by the shareholders of the liquidating corporation based
upon the difference between the amount of the liquidation
proceeds received and their stock basis. If the target
corporation sells its assets for installment notes that are
distributed in liquidation, the target shareholders can report
their gain on the installment basis to the extent they receive
the notes.
2. Taxable Stock Acquisitions
In General. If a transaction is a taxable stock
acquisition, gain or loss generally will be recognized by the
selling shareholders, but may be reported on the installment
method if installment notes are received. The tax consequences
to the target corporation and the acquiring corporation depend
upon whether the acquiring corporation sakes a section 338
election.
The immediate effect of a taxable stock acquisition is that
the target corporation becomes a subsidiary of the purchasing
corporation. If no section 338 election is made for the target
corporation, no gain or loss is recognized-with respect to
target's assets and its corporate tax attributes are preserved,
subject to certain limitations discussed below. If a section 338
election is made, the taxable stock acquisition takes on most of
the characteristics of a taxable asset acquisition from a
liquidating target corporation.
Section 338 Elections. A section 338 election is available
where one corporation purchases at least 80 percent of the stock
of a target corporation over a 12-month period. In such case,
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the purchasing corporation may elect to adjust the basis of the
assets of the target corporation as though the target corporation
sold all of.its assets to a new corporation in connection with a
plan for complete liquidation within a 12-month period. The
price at which the assets are deemed sold by the target
corporation and purchased by the new corporation is generally the
purchasing corporation's basis in the target's stock at the
acquisition date..!/ A section 338 election requires that the
target corporatin generally recognize its recapture and other
tax benefit items as if it had sold its assets pursuant to a plan
of complete liquidation.
Section 338 also contains consistency rules designed to
prevent a purchasing corporation from obtaining a step-up in
basis for some of the target's assets, while preserving target's
corporate tax attributes and historic tax basis for other assets.
The typical case addressed by these rules is one where target has
one group of high value, low basis assets with respect to which
the purchaser wants to take depreciation, amortization, and
depletion deductions on a stepped-up basis, and another group of
assets which may carry either a significant recapture or other
tax liability or valuable tax attributes (such as net operating
loss or credit carryforwards). If the purchasing corporation
were to acquire all of target's assets, all assets would receive
a stepped-up basis, target (assuming target liquidated within a
12-month period) would be taxed only on the recapture and tax
benefit items on all assets, and the corporate tax attributes of
target would be extinguished. From a tax planning perspective,
the purchasing corporation would like to step-up the basis of the
first group of assets (for instance, by a direct asset purchase),
yet avoid the recapture tax and maintain a carryover of basis for
Section 338(a)(1) provides that the target corporation is
deemed to sell its assets at their fair market value on the
acquisition date. Alternatively, in the case of a bargain
stock purchase, an election may be made under section
338(h)(11) to determine the aggregate deemed sale price on
the basis of a formula that takes into account the price paid
for the target corporation's stock during the acquisition
period (grossed-up to 100 percent) plus liabilities
(including taxes on tecapture and other tax benefit items
generated in the deemed sale) and other relevant items.
Section 338(b) provides that the new corporation is deemed to
purchase the target corporation's assets at an aggregate
price equal to the grossed-up basis of recently purchased
stock plus the basis of nonrecently purchased stock (subject
to an election under section 338(b)(3) to step-up the basis
of such nonrecently purchased stock) plus liabilities
(including taxes on recapture and other tax benefit items
generated in the deemed sale) and other relevant items.
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the second group of assets and the valuable corporate tax
attributes of target (by acquiring all of the target stock and
not caking a section 338 election).
To prevent this type of tax motivated tailoring acquisitions,
the consistency rules require that the purchasing corporation
must elect either to step-up the basis of all acquired assets
(with the associated recapture and loss of corporate tax
attributes) or to carry over the basis of all acquired assets
(generally with the continuation of tax attributes). Section 338
generally provides that a step-up in basis (and attendant
recapture and other tax consequences) will be triggered
automatically if, within the period beginning one year before the
beginning of the acquisition and ending one year after control is
acquired, any member of the purchasing group acquires the stock
of any corporation affiliated with the target corporation (target
group) or an asset from any member of the target group, other
than in certain defined transactions.*/
C. Carry Over of Corporate Tax Attributes
1. In General
Under current law, a corporation that incurs a net operating
loss in one year generally is permitted to carry back the loss to
offset income earned in the three taxable years preceding the
year in which the loss is incurred and to carry forward any
excess to offset income earned in the 15 years after the loss is
incurred. A net capital loss generally may be carried back to
the three taxable years preceding the loss and then carried
forward to the five taxable years succeeding the loss. The
underlying premise of allowing a corporation to deduct a net
operating loss or a net capital loss incurred in one year against
taxable income earned in another year is to ameliorate the unduly
harsh consequences of an annual accounting system. In other
The excepted transactions included transactions in the
ordinary course of business, carryover basis transactions,
pre-effective date transactions, and other transactions to
the extent provided in regulations. In some cases, the
consistency rules can operate to require taxpayers to take a
step-up in basis and pay recapture taxes or suffer other tax
detriments where no manipulative scheme exists. As
contemplated by Congress in the Tax Reform Act of 1984,
Treasury is considering-allowing taxpayers to elect carryover
basis (or cost basis when less than carryover basis in a
particular asset) in all'assets that a corporation acquires
during the consistency period. we do not believe that the
providing of this 'carryover basis election' would create any
significant new tax incentives for corporate acquisitions
provided there are appropriate safeguards.
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words, the ability to carry losses back and forward is intended
as an averaging device. For similar reasons, corporations that
are unable to use all their credits against tax in the year in
which the credits are earned may use such excess credits to
offset tax liability in the three prior taxable years and the 15
succeeding taxable years.
The ability to carry over net operating losses, unused
credits, and other tax attributes following certain corporate
acquisitions, as described briefly above, may affect such
acquisitions in a variety of ways. The ability to carry over
corporate tax attributes, for example, may affect both the form
of acquisitive transactions and the price paid or the value of
other consideration used in such transactions. Moreover, the
ability to carry over tax attributes may in certain instances
influence whether an acquisition will be undertaken. The ability
to carry over tax attributes after a corporate acquisition,
however, is limited under current law in several respects.
As mentioned above, the tax attributes of a target
corporation generally survive a tax-free reorganization and carry
over to the acquiring corporation. In addition, if a corporation-
acquires the stock of another corporation in a taxable
transaction, the tax attributes of the target corporation also
survive the acquisition, unless a section 338 election is made
for the target corporation. Moreover, although a purchasing
corporation that does not make a section 338 election will not
succeed directly to the tax attributes of the target corporation,
it may benefit from the target corporation's net operating
losses, net capital losses, unused credits, and other tax
attributes, if the target and purchasing corporations join to
file a consolidated income tax return. Alternatively, a
purchasing corporation that does not make a section 338 election
may inherit the tax attributes of the target corporation if the
target is liquidated or merged into the purchasing corporation.
2. Limitations on the Carry Over of Tax Attributes
Under sections 382 and 383, */ the ability of an acquiring or
purchasing corporation to use or benefit from the net operating
Sections 382 and 383 were substantially amended in the Tax
Reform Act of 1976, but the effective date of those amendments
has been delayed several times. Most recently, section 61 of
the Tax Reform Act of 1984 extended the effective date of the
1976 Act amendments until December 31, 1985. The 1976 Act
rules, as well as current law, have been criticized and a number
of reform proposals have been made. Although we understand that
the Subcommittees are not examining sections 382 and 383 in
detail at this hearing, we believe that it is important that
Congress address these provisions this year and we look forward
to working with the Congress in developing reasonable rules
governing the carry over of corporate tax attributes.
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losses and other tax attributes of a target corporation following
a taxable stock acquisition or a tax-free reorganization say be
limited. Sections 382 and 383 were enacted to establish
objective tests that would curb "trafficking' in corporations
with unused net operating losses and other favorable tax
attributes. In the case of net operating loss carryovers,
Congress was particularly concerned that profitable, operating
corporations were acquiring shell corporations whose principal
assets were unused net operating losses that could be applied
against income of the acquiring corporations that was unrelated
to the business activity of the acquired corporations.
In addition to the specific objective limitations provided by
sections 382 and 383, the carry over-of net operating losses and
other favorable tax attributes may be disallowed under section
269, whenever the principal purpose of an acquisition of stock or
assets is to obtain the benefit of losses, deductions, or
credits. Thus, section 269 say be applied to deter misuse of the
general carryover limitation provisions.
rinally, the ability of an acquiring corporation to benefit
from the tax attributes of a target corporation by joining with
the target to file a consolidated income tax return is limited by
the "separate return limitation year' and 'consolidated return
change of ownership" rules provided in applicable Treasury
regulations. in addition to limiting use of net operating loss
and credit carryovers, the consolidated return regulations under
certain circumstances also limit the ability to benefit from
"built-in' losses following an acquisition.
II. Structural Aspects of the Income Tax That May Encourage
Corporate ACQUIsitions and Takeovers
While we believe economic as opposed to tax considerations
typically drive a corporation's decision to acquire another
corporation, we recognize that there are a number of structural
features of our current income tax system that may encourage
corporate acquisitions. The Committees say wish to consider
removing or modifying some of the current aw provisions that
encourage merger activity. As the discussion below will
indicate, however, some of the incentives in current law are
rooted in the basic structure of how we tax corporations and
their shareholders and could not be altered without fundamentally
changing the present income tax system.
A. Double Taxation of Corporate Earnings
Our current income tax system generally treats corporations
as taxpaying entities separate from their shareholders. A
corporation separately computes and reports its taxable income,
and in making this calculation it is not entitled to a deduction
for dividends paid to shareholders. Moreover, these dividends
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are taxed to individual shareholders as ordinary income (except
for a $100 per year exclusion). Consequently, corporate taxable
income paid as dividends to individual shareholders generally
bears two taxes, the corporate income tax and the individual
income tax.
The double taxation of corporate earnings that are
distributed as dividends to shareholders affects dividend
distribution policies in ways that may encourage merger activity.
In particular, corporations,, especially those with shareholders
in relatively high income tax brackets, are encouraged to retain
earnings in order to allow the shareholders to defer imposition
of the second tax.*/ This pressure to accumulate corporate
earnings not only Interferes with ordinary market incentives to
place funds in the hands of the most efficient users, but also
stimulates corporate acquisitions in at least two ways.
first, corporations that accumulate cash funds in excess of
their needs for working capital must reinvest those funds;
acquiring the stock or assets of other corporations is an
investment alternative that must be considered by any corporation
with excess funds to invest. Second, a corporation with large
amounts of funds invested in nonoperating assets may become an
attractive target, because the market may not immediately reflect
the value of those nonoperating assets (which may not generate
financial reported earnings commensurate with their values).
Because of this potential undervaluation of the target's
nonoperating assets, a potential acquiring corporation may view
the nonoperating assets as cheap funds available to finance the
acquisition of the underlying business operations of the target.
The mitigation or elimination of the double tax on corporate
dividends, through any form of integration of the corporate and
individual income taxes, would reduce or eliminate these effects.
In contrast to the taxation of corporate earnings distributed
as dividends, corporate income distributed to creditors as
interest is deductible by the corporation and thus taxed only
once, to the creditors. The disparate tax treatment of debt and
equity in the corporate sector distorts decisions regarding a
corporation's capitalization, 'making corporations more vulnerable
to takeover during economic downturns, and also may encourage
leveraged buyouts, because interest payments on the debt incurred
in such a transaction offset income earned by the target
corporation.
Indeed, in some cases the shareholder-level tax can be
permanently avoided if the retained earnings are distributed
in liquidation following the death of the shareholder, which
occasions a tax-free increase in the stock's basis to its
fair market value. The double taxation of dividends and the
tax-free basis step-up at death operate in tandem to place
extreme pressure on closely-held corporations to retain
rather than distribute earnings.
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Since interest payments on debt financing are deductible and
dividends paid on equity are not, corporations are encouraged by
the tax law to utilize debt rather than equity to finance their
ongoing operations. This may result in an increased debt to
equity ratio that increases the risk of bankruptcy and
vulnerability to downturns in the business cycle; and any
corporation that is temporarily crippled by an economic downturn
becomes a likely takeover candidate. The incentive for leveraged
buyouts conferred by the more favorable tax treatment of interest
payments is discussed further in part III.A.1., below.
D. Capital Gain - Ordinary Income Distinction
Currently, corporations are subject to tax on ordinary income
at a maximum rate of 46 percent and on capital gains at a maximum
rate of 28 percent. Individuals are subject to tax on ordinary
income at a maximum rate of 50 percent and on capital gains at a
maximum rate of 20 percent. While corporate taxable income
distributed to individual shareholders as dividends generally
bears two ordinary income taxes, the shareholder's receipt of
cash or property in exchange for his stock in a purchase of the
corporation results in a significant lessening of the double tax
burden when compared with the receipt of such cash or property as
dividend income. Even though corporate earnings distributed as
dividends would be taxed to the shareholders at ordinary income
tax rates, the gain attributable to retained earnings is taxed at
preferential capital gains rates if the shareholders sell their
stock. This capital gain opportunity results in an incentive for
the corporations to retain income in corporate solution and for
corporate acquisitions.
C. Underutilization of Capital Subsidies
Capital subsidies (such as certain credits and accelerated
depreciation) provided through the tax system may have an
unintended ancillary effect of encouraging mergers and
acquisitions. In some cases the amount of these tax subsidies
have outstripped the recipient corporation's ability to use them
effectively by investing in operating assets. To the extent that
a corporation cannot effectively reinvest the tax subsidies in
operating assets, such amounts are invested in nonoperating
assets, which stimulate merger activity as detailed in part
II.A., above.
In addition, whenever a company does not have enough income
and tax liability to benefit from the accelerated depreciation
and tax credit capital subsidies, an incentive for mergers is
created. As summarized earlier, there are limitations on the use
of tax attributes of an acquired corporation, but these
limitations do not apply to certain forms of mergers or
acquisitions. And even in cases in which the limitations apply,
the acquiring corporation may nevertheless benefit to some extent
from the target corporation's tax attributes.
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For example, the limitations provided in sections 382 and 383
generally would not apply if a corporation with substantial
unused net operating losses and excess credits acquired a
profitable target corporation's stock or assets in either a
tax-free or taxable acquisition. Accordingly, income and tax
liability generated by the target corporation or its assets could
be offset in future years by the acquiring corporation's unused
tax attributes. Similarly, if an acquiring corporation purchased
the stock of a target corporation in a taxable acquisition and
did not make a section 338 election, the acquiring corporation
could use the target corporation's net operating losses to offset
future income of the target corporation. If, on the other hand,
the acquiring corporation made a section 338 election, although
it would not succeed to the target corporation's tax attributes,
any income realized by the target corporation by virtue of the
section 338 election and the accompanying tax liability could be
offset by the target corporation's net operating loss and credit
carryforwards.
The ability to benefit from net operating loss and other
carryforwards following the acquisition of a corporation is not
necessarily inconsistent with sound tax policy. As discussed
earlier, a corporation is allowed to carry back and carry forward
its unused net operating losses and credits without limitation
(other than on the number of carryback and carryforward years).
These unused net operating losses and credits may result from
capital subsidies to which the corporation is entitled, but is
unable to utilize currently. The carry over of net operating
losses and other tax attributes following a corporate acquisition
may properly allow the target corporation to effectively benefit
from the capital subsidies in the same manner as if no
acquisition had occurred. Nevertheless, the tax rules governing
the carry over of tax attributes should not encourage corporate
acquisitions that would not be undertaken on purely economic
grounds. Moreover, those rules should not result in tax
attributes becoming more valuable in the hands of an acquiring
corporation than they would have been in the hands of a target
corporation.
in general, we believe that the existing limitations on the
carry over of corporate tax attributes do not work well in some
respects and improperly allow the carry over of tax attributes in
some cases. we do not believe, however, that either the ability
to carry over tax attributes in a corporate acquisition or the
imperfections in the existing statutory and regulatory
limitations on such carryovers is the fuel driving the recent
surge of corporate acquisitions. Nevertheless, we do look
forward,to working with the Congress in reforming those rules
this year.
We want to point out, however, that the existence of unused
tax attributes and the ability to benefit from such attributes by
acquiring control of a corporation would be of much less concern
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if corporate taxable income were measured correctly and, for
example, the existence of unused net operating losses meant that
a corporation had realized actual economic losses. Under current
law, however, a corporation that earns a significant profit may
nevertheless have substantial net operating losses and other
unused tax attributes. Current law does not provide for direct
reimbursement of net operating losses or refundability of credits
by the Federal government and does not permit corporations with
unused tax attributes to transfer those attributes freely to
other corporations that can benefit from them. The consequence
of such a system is the existence of an increased volume of tax
attributes that can not be used by the corporations to which they
are made available. The lack of refundability or free
transferability and the resulting increase in the volume of
unused tax attributes place significant pressure on the rules
that are designed to limit the use of net operating losses and
excess tax credits following an acquisition and provide an
incentive to acquire corporations with such unused tax
attributes.
Moreover, the aismeasurement of income for tax purposes and
the resulting increased volume of unused tax attributes may favor.
conglomeration by encouraging corporations that are engaged in
business activities that generate 'tax losses" and excess tax
credits to combine with other corporations that are engaged in
activities with fewer tax attributes. The tax laws should not
create such a bias between diversified and non-diversified
entities.
The adoption of a system that correctly measures economic
income would eliminate the possibility that profitable
corporations could have unused net operating losses or excess tax
credits and would ensure that companies with loss carryforwards
had suffered equivalent economic losses. The importance of rules
limiting the use of tax attributes following corporate
acquisition would thus be decreased. The proper measurement of
corporate income also would greatly diminish the volume of unused
favorable tax attributes, and correspondingly reduce the
importance of tax attributes in decisions regarding corporate
acquisitions and conglomeration.
D. General Utilities Doctrine
Some have argued that the section 338 rules and the
liquidation rules conflict with the general scheme for taxing a
corporation and its shareholders and may encourage corporate
acquisitions. Generally, as described above, a corporation is
subject to tax on the profits derived from its operations and its
shareholders are subject to a second level of tax on the
distributions of those profits as dividends. in a liquidating
sale of assets or sale of stock with a section 338 election,
there is a step-up in basis of assets with only a partial
corporate level tax; recapture and tax benefit items are taxed,
but other potential gains are not. This result stems from the
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rule attributed to General Utilities s Operating Co. v.
eelverin , 296 U.S.-700 (1935), that is now codified in sections
311(a), 336, and 337. Under those provisions, a corporation
recognizes no gain (other than recapture and tax benefit items)
on distributions, including liquidating distributions, made to
its shareholders. These rules say give an additional incentive
to a corporation to sell assets in some cases because it
increases the likelihood that the present value of the tax
benefits that accompany property ownership (e.g., depreciation
and depletion deductions) may exceed the seller's tax detriment
incurred on the sale. Thus, the same assets may be sore valuable
to a buyer than to the current owner.
Congress has reduced this incentive to sell corporate
properties by limiting the scope of the General Utilities rule.
For example, TEFRA made distributions of appreciated property in
a partial liquidation taxable to the distributing corporation.
In addition, the Tax Reform Act of 1984 (the '1984 Act') imposed
the same treatment on dividend distributions of appreciated
property. One major aspect of the General Utilities doctrine
remains, however. Nonrecognition of gain y t e selling
corporation continues to be the general rule in connection with a?
complete liquidation and a deemed asset sale in connection with a
section 338 election (although recapture and tax benefit items
are taxed). While repeal of this last major exception would
simplify the tax laws, we do not believe that the failure of the
corporate tax regime to impose two levels of tax on liquidation
transactions is primarily motivating corporate acquisitions.
Further, as we have indicated in prior testimony before the
Senate finance Committee, we believe that in considering the
repeal of General Utilities in liquidation transactions, relief
from double taxation of liquidation proceeds must also be
considered.
9. Inadequate Recapture Taxes
1. In General
Some have suggested that the imperfections in the current
recapture rules may be a factor encouraging corporate mergers and
acquisitions. If the General Utilities rule were fully repealed
and a corporation were required to recognize gain to the extent
the amount realized exceeds its basis in assets, the
effectiveness of the recapture rules would not be as important.
Short of a complete repeal of the General Utilities rule in a
liquidation context, it may be appropriate o q ten current
recapture rules. for example, under current law, a liquidating
corporation that used the last-in first-out ('LIFO') method of
accounting for inventories is required to recognize income
attributable to the difference between the value of inventory
determined on the LIFO basis and that determined on a first-in
first-out ('FIFO') basis (commonly called LIFO reserve). This
rule could be expanded to include all inventory profit (not just
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the difference between LIFO and FIFO) and all other ordinary
income. In addition, the recapture rules on section 1250
property (including residential real estate) could be conformed
to the section 1245 recapture rules applicable to personal
property to require the liquidating corporation to recapture
ordinary income to the extent of the full amount of prior
depreciation allowed. These changes would be premised on the
notion that the corporation claiming tax benefits should return
those benefits at the time of sale (whether by actual sale or in
liquidation) if the sale shows that the earlier granted benefits
were excessive.*/ Any strengthening of the recapture rules,
however, magnifies the potential double taxation of corporate
earnings and any change in the recapture rules should be
coordinated with proposals to relieve that double tax burden.
2. Mineral Property
Under current law, gain on the disposition of mineral
property is recaptured as ordinary income under section 1254 to
the extent of intangible drilling costs that were deducted after
December 31, 1975. There is no recapture, however, with respect
to gains from the sale of mineral property for which intangible
drilling costs were deducted prior to that date. Consequently,
on the sale or exchange of mineral properties, gain attributable
to expenses deductible against ordinary income as intangible
drilling costs prior to 1976 is taxable at capital gain rates
even though the drilling expenses were deducted against ordinary
income.
*/ It should be noted that recapture and tax benefit items
generally are not recognized upon the sale of a subsidiary.
However, such a result may be inconsistent with the basic
principles of the recapture rules where the selling
corporation and its subsidiary joined in filing a
consolidated return for all years in which the deductions (or
credits) were claimed. The consolidated return regulations
provide for an annual basis increase (or decrease) in the
parent's stock in the subsidiary based on the annual increase
(or decrease) in earnings and profits, rather than taxable
income, of the subsidiary for such year. Some have suggested
that these rules may permit the selling parent corporation to
understate its gain (as well as avoid recapture income)
because the basis of. the subsidiary's stock is
inappropriately increased whenever the earnings and profits
increase in an amount greater than taxable income. This
disparity between earnings and profits and taxable income
typically is due to certain tax subsidies, such as
accelerated depreciation. The Internal Revenue Service takes
the position that allowing this basis increase would result
in impermissible double deductions to the selling affiliated
group and is currently litigating this issue.
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Prior to 1975 integrated oil companies could deduct
percentage depletion at a rate of 22 percent with respect to
mineral property. Percentage depletion deductions are not
limited to the taxpayer's basis in the mineral property; so that,
with respect to pre-1975 properties, the adjusted depletable
basis (investment costs other than intangible drilling costs) for
most taxpayers is zero. Since 1975, however, integrated oil
companies have been required to use cost depletion. Thus, in
effect, most integrated oil companies receive no depletion
allowances if they continue to produce from pre-1975 properties.
Upon a disposition of mineral property to another who would be
allowed cost depletion for the same property, current law does
not require recapture of either cost or percentage depletion
allowances; this rule applies whether or not percentage depletion
allowances were taken in excess of the taxpayer's basis.
Some have suggested that recapture rules should be applied to
intangible drilling costs deducted in respect of mineral
properties regardless of when the deductions were taken. We
cannot support such a change. The recapture of intangible
drilling costs was considered extensively by Congress in
connection with legislation in 1976. Congress enacted a
recapture provision at that time and settled upon what it
considered to be a fair transition rule. We do not believe that
it is appropriate to change that transition rule retroactively.
Suggestions' also have been put forth to apply recapture rules
to percentage and cost depletion allowances. Normally, as in the
case of depreciable personal property, recapture of depreciation
is provided when the property is sold or exchanged; only the
excess of the selling price over original basis is eligible for
capital gains rates (and nonrecognition at the corporate level in
a liquidating sale). The lack of adequate recapture rules
creates an incentive to sell to a buyer who will obtain the
benefit of a step-up in basis (and therefore larger deductions
against ordinary income) at the cost of only a capital gains tax
to the seller. The failure to recapture cost depletion
allowances thus may provide some incentive for acquisitions of
companies with mineral properties. We do not believe the
recapture rules applicable to mineral property should differ from
the current recapture rules applicable to personal property. In
either case, full recapture is needed to minimize inefficient
churning of such property solely for tax reasons.
Although we would support full recapture of cost depletion,
we would not support the application of recapture rules to
percentage depletion. The percentage depletion allowance is, in
effect, a negative excise tax on the production of minerals which
results in a lower effective income tax rate for those eligible
for its benefits. While it may be appropriate to consider
reducing or eliminating future allowances for percentage
depletion, we do not believe the special rate of tax on mineral
properties that Congress provided by way of the percentage
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depletion allowance should be retroactively repealed by extending
the recapture rules. Congress dealt with the policy
considerations involving the availability of this special tax
incentive to integrated oil companies by limiting such taxpayers
to cost depletion for taxable years ending after December 31,
1974.
III. Recent Developments in Corporate Acquisitions that Raise
Significant Tax Policy Issues
The structural aspects of the current income tax law
discussed above may encourage merger and acquisition activity to
some degree, but as stated at the outset, we do not believe they
are the driving force behind the current flurry of activity. A
number of the publicized acquisitions that are of interest to the
Committees involve tax techniques that have only recently
evolved, and to some extent these techniques are based upon
recently enacted tax incentives. we are concerned that these tax
incentives are being employed in mergers and acquisitions in ways
that Congress did not intend. Principal among our concerns are
the use of ESOPs in leveraged buyouts and the carryover of tax
attributes in mergers and acquisitions of thrift institutions. I
would also like to comment upon the growing use of asset
reversions from overfunded defined benefit plans to finance
mergers and acquisitions.
A. Leveraged Buyouts and the, Growing Use of ESOPs
1. Leveraged Buyouts
The prototypical leveraged buyout involves the conversion of
a publicly held company into a private company pursuant to an
acquisition by a newly organized private company of all of the
target company's stock. The acquiring company usually is
organized and controlled by the senior management of the target
company. The private company's acquisition of the target stock
is largely debt financed, with the expectation that the debt will
be retired out of future earnings of the company.
As is the case with other mergers and acquisitions, we expect
that leveraged buyouts are motivated primarily by economic
factors. Nevertheless, the income tax law to some extent may
encourage leveraged buyouts of corporations by the more favorable
tax treatment of interest payments. As discussed earlier in part
II.A., the deductibility of interest payments by a corporation
compared to the nondeductibility of dividends encourages
corporations to use debt rather than equity in financing
operations or acquisitions because of the potential for double
taxation of corporate earnings distributed as dividends.
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The. deductibility of interest incurred in connection with
debt-financed acquisitions also encourages these acquisitions to
the extent that our tax system does not take account of inflation
properly. Nominal interest rates typically include an inflation
component which compensates the lender for the anticipated future
reduction in the real value of a fixed dollar amount debt
obligation and acts as an offsetting charge to the borrower for
the inflationary reduction in the value of the principal amount
of the borrowing. Where borrowed funds are invested in assets
that also increase in value by virtue of inflation, the tax law
permits a current deduction for interest expenses but no
realization of the increase in value of the asset until its sale
or disposition. In such cases the interest deduction can be used
to offset income that otherwise would be taxed currently.
The use of installment debt in acquisitions leads to
significant mismatching of the gain that is deferred by the
seller and the allowance to the purchaser of depreciation,
amortization, or depletion deductions determined by reference to
asset values that have been stepped-up to fair market value as a
result of the acquisition. This asymmetrical treatment of a
sale, under which the buyer is treated as acquiring full
ownership of the asset while the seller is treated as making only
partial sales each year over the term of the contract may create
a tax bias for installment debt-financed acquisitions. In a
taxable corporate acquisition (an asset acquisition or a stock
acquisition with a section 338 election), this mismatching is
reduced to some extent if the target corporation's assets are
subject to recapture tax since the recapture income is recognized
immediately. The asymmetrical treatment arising from installment
sales debt is a problem that should concern these Committees, but
the problem exists in every installment sale of a depreciable
asset and is by no means unique to corporate acquisitions.
The tax arbitrage from debt financing generally is available
for all debt-financed assets, not just those acquired in a
corporate merger or acquisition. The only special limitation on
the deductibility of interest on debt incurred in acquisitions is
found in section 279 which applies only under very limited
circumstances. Although it may be appropriate to give
consideration to revising the general rules regarding the
deductibility of interest we see no justification for a further
limitation on the deductibility of interest expense that is aimed
specifically at debt incurred in connection with corporate
acquisitions.
2. Leveraged Employee Stock Ownership Plans
while every leveraged buyout raises the concerns just noted,
we have particular concerns about the use of leveraged employee
stock ownership plans (ESOPs) to effectuate leveraged buyouts and
to defend against attempted takeovers. Since Congress first
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established special tax incentives for ESOPs, these plans have
been used frequently in leveraged buyouts, but the 1984 Act makes
ESOPs an even sore attractive vehicle for purchasing shares in a
leveraged buyout.
in a leveraged ESOP, the ESOP borrows to purchase stock of
the company that establishes the ESOP, and the company obligates
itself to contribute amounts to the ESOP sufficient to enable it
to service the debt. The employer may deduct these contributions
to the ESOP currently without regard to the restrictive limits on
employer contributions to other types of employee benefit plans.
Because the ESOP is a qualified plan, an employee participating
in the ESOP is not required to include these contributions in
income until he or she receives a distribution from the plan.
Under the terms of a typical leveraged ESOP, employees are
not entitled to distributions from the plan until separation from
service. when the ESOP distributes stock to a participant, the
employee is taxed on the value of the stock (determined with
reference to the price paid by the ESOP) and accumulated income
which has been allocated to the participant's account. A
participant has the right to require the employer to purchase the
stock from the participant at fair market value, unless the stock
is readily marketable and traded on an established securities
market.
An ESOP is required to give covered employees the right to
vote publicly traded shares held by the ESOP. But employees can
vote shares held by the ESOP that are not publicly traded, only
with respect to actions (such as mergers or liquidations) which
require an affirmative vote of more than a majority of the
corporation's shares.
it is possible that the nominal beneficiaries of the ESOP,
the corporation's employees, will obtain little current benefit
from the arrangement. This is true because, while the ESOP may
own a significant percentage of the outstanding employer
securities, a participant employee will not realize the value of
the securities originally purchased by the ESOP until separation
from service. Finally, because leveraged buyouts involve
privately held corporations, the employees generally are entitled
to only very limited voting rights with respect to ESOP stock.
Despite the uncertainty of the benefits that an ESOP confers
on covered employees, in the 1984 Act Congress expanded the
incentives for employee stock ownership through ESOPs in four
ways: (1) banks, insurance companies, and other commercial
lenders say exclude one-half of the interest paid or accrued on a
loan the proceeds of which are used by a leveraged ESOP to
purchase qualified stock; (2) taxpayers are permitted to defer
gain from the sale of stock to an ESOP if the proceeds are used
to purchase stock in a second corporation; (3) corporations may
deduct dividends paid to employees with respect to stock of the
employer held in an ESOP or stock bonus plan; and (4) an ESOP may
assume the estate tax liability with respect to stock of a
closely held business which is transferred to the ESOP.
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Historically, the employer's right to deduct ESOP
contributions while the employees participating in the ESOP defer
income has been a significant subsidy which has made the use of
ESOPs a favored vehicle for leveraged buyouts. The 1984 Act,
however, so enhanced the tax benefits available to leveraged
ESOPs that we believe not only will the use of ESOPs in leveraged
buyouts increase, but the total number of leveraged buyouts may
actually increase. In addition, we expect that these new
incentives will greatly increase the use of leveraged ESOPs to
defend against potential takeovers.
The most significant of the new incentives for the use of
ESOPs in leveraged buyouts is section 133 of the Code which
permits banks, insurance companies, and other commercial lenders
to exclude one-half of the interest paid or accrued on a loan the
proceeds of which are used by a leveraged ESOP to purchase
qualified stock. This permits lenders to charge a lower interest
rate and thus lower the costs of acquiring employer securities
through an ESOP. We understand that the subsidy provided under
section 133 allows qualifying lenders to provide financing to an
ESOP at approximately 80 percent of the otherwise available
interest rate. For example, if the rate available to the ESOP
would be 10 percent without regard to section 133, the ESOP could
save approximately $140,000 in interest charges on a ten-year,
level payment, $1,000,000 obligation, assuming an actual interest
rate of 8 percent. Such a significant reduction in the cash flow
required to finance an acquisition is certain to stimulate
leveraged buyouts.
The 1984 Act provisions also created an incentive for owners
of businesses to sell to their ESOPs rather than to others. New
section 1042 allows a shareholder to defer the gain on the sale
of shares in the corporation to an ESOP if certain requirements
are not. Presumably, the availability of deferral for a
shareholder selling to an ESOP will result in a lower purchase
price for the shares to the ESOP. Although our limited
experience with this provision makes it impossible to know to
what extent the special tax benefit to the selling shareholder
will be reflected in the price to the ESOP, any reduction in the
cost of acquiring a corporation through an ESOP will obviously
create a further incentive for leveraged buyouts through ESOPs.
The cumulative effect of these subsidies is to create
substantial tax incentives for leveraged buyouts through ESOPs.
These benefits inure to those in a position to establish an ESOP
and through that device to take a public company private. It
also appears that ESOPs are frequently employed as a defensive
takeover tactic. These tactics may have an unnecessary dampening
effect upon otherwise advisable mergers and acquisitions.
Although the goal of encouraging employee ownership may be
worthwhile, we believe that any examination of mergers and
acquisitions should include an examination of the effects on
mergers and acquisitions of the indirect subsidies provided
through the current tax provisions relating to ESOPs.
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C. Overfunded Defined Benefit Plans
Concern also has been expressed recently about the
involvement of overfunded qualified defined benefit plans in
corporate mergers and acquisitions. Under current law, a company
may terminate its defined benefit plan and receive any assets
that are in excess of the present value of the participants'
accrued benefits as of such termination. There are no
restrictions on the company's use of such excess assets.
Because overfunded defined benefit plans thus constitute
relatively attractive sources of cash, companies with
significantly overfunded plans are thereby made more attractive
takeover targets. There are several recent examples of acquiring
companies terminating target companies' overfunded plans to
partially fund the acquisitions. Also, it is not surprising that
other companies have terminated their own overfunded plans to
reduce the readily available pool of assets to which the
companies have access and thereby to make themselves less
attractive to other companies. These companies generally have
used the excess assets to make less liquid investments (such as
equipment purchases), to finance "going private" transactions, or
to take defensive actions (such as establishing an ESOP to hold
company stock) against potential takeover attempts. Finally,
some companies have terminated their overfunded plans to use the
assets offensively in their own takeover initiatives or to retire
debt incurred in completed takeover transactions.
in assessing the role of defined benefit plans in mergers and
acquisitions, one should understand the essential features of
such plans and why and in what sense they are overfunded. The
law grants favorable tax treatment to employer-maintained
retirement plans that satisfy various qualification requirements.
There are two types of qualified retirement plans: defined
contribution plans and defined benefit plans. Under a defined
contribution plan, a participant's accrued benefit is equal to
the value of the assets allocated to such participant's account
and all plan assets are allocated to participants' accounts.
Thus, no assets are available for employer recoupment.
Under a defined benefit plan, however, the participant's
accrued benefit is determined under a benefit formula, which
generally is based on the participant's compensation and years of
participation in the plan. The company maintaining the plan (the
sponsor) has the responsibility to make sufficient contributions
to the plan to maintain a pool of funds sufficient to provide the
participants' promised retirement benefits as they come due.
Accordingly, unlike a company maintaining a defined contribution
plan, the sponsor of a defined benefit plan bears the full risk
of investment gains and losses in the plan's assets.
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There are numerous reasons why a defined benefit plan may, at
any particular time, hold assets in excess of the present value
of participants' accrued benefits at such time. The most basic
reason is the inherent nature of the sponsor's obligation to fund
a defined benefit plan, as reflected in the minimum funding
standards of section 412 of the Code. These standards generally
require that a sponsor fund the plan on a 'going concern," rather
than a "termination," basis. This means that sponsors must
currently fund not merely accrued benefits, but also some portion
of participants' projected benefits at normal retirement age. In
projecting future benefits, future salary increases and inflation
ordinarily are considered. In addition, in order to avoid an
ever-increasing funding obligation as its workforce ages, a
sponsor may choose to fund its plan in accordance with a
level-funding actuarial funding method that tends to accelerate
contributions relative to the rate of benefit accrual. As a
consequence of the natural operation of the funding rules, a
defined benefit plan that is not fully funded on a going concern
basis may well be overfunded on a termination basis.
The actuarial methods commonly used in determining sponsors'
defined benefit funding obligations rely on long-term assumptions
regarding such items as investment returns and salary increases.
To the extent that plan investments earn more than anticipated or
salaries increase less than expected, overfunding will tend to be
greater. For example, during recent years, the rates of return
on equity investments have exceeded most actuarial assumptions,
which themselves tend to be quite conservative, and salary
increases have generally been less than expected.
Furthermore, in determining a defined benefit plan's excess
assets, it is necessary to calculate the present value of
participants' accrued benefits. The higher the interest rate
assumption used in this calculation, the fewer assets are
necessary to provide participants' accrued benefits. During
recent years, insurance companies have been pricing both
immediate and deferred annuity contracts for terminating defined
benefit plans using recent high interest rates. By reducing the
current cost of providing for participants' accrued benefits upon
plan termination, this has contributed significantly to the
excess termination-basis funding of many defined benefit plans.
Finally, within certain limits (section 404 of the Code), a
sponsor is permitted to deduct defined benefit plan contributions
in excess of the required contribution under the minimum funding
standards. This may of course encourage further employer
contributions to a plan, particularly in profitable years, and
consequently larger overfunding.
The tax law requires a defined benefit plan to be maintained
for the exclusive benefit of the participants and their
beneficiaries. In addition, it must be impossible at any time
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prior to the satisfaction of all liabilities with respect to the
sponsor's employees and their beneficiaries under the plan, for
any part of the plan's assets to be used for, or diverted to,
purposes other than the exclusive benefit of the employees and
their beneficiaries. Because it is not possible to satisfy all
plan liabilities before plan termination, a sponsor may recoup
plan assets only by terminating its plan. And, in this regard,
because a sponsor may voluntarily establish a qualified plan and
may voluntarily terminate its plan as it desires, this particular
restriction rarely poses a practical obstacle.
A significantly overfunded defined benefit plan thus may be
seen, both from the sponsor's perspective and from the
perspectives of other companies that may be interested in
attempting to take over the sponsor, as a relatively accessible
and attractive pool of liquid assets. Of course, the desire to
recoup excess plan assets is not limited to companies involved in
merger and acquisition transactions. Any business need that
requires significant financing--e.g., diversification, expansion
of capacity, modernization, advertising--may be sufficient
motivation. Nevertheless, due to the substantial cash
requirements of acquisitions and acquisition-related
transactions, it is natural that companies involved in such
transactions will look to defined benefit plans as a potential
source of ready funds.
While any assets received upon plan termination must be
included in income, the sponsor is entitled to offset this
inclusion by any available deductions and credits (including
interest deductions and loss carryovers). Thus, because the
decision to terminate is in the hands of the plan sponsor, it
frequently is possible to time the termination so that none or
only a small portion of the assets is subject to tax. To the
extent a sponsor is able to achieve this result, terminating an
overfunded defined benefit plan becomes more attractive.
One of the primary concerns expressed about the terminations
of defined benefit plans to recoup plan assets is the security of
the participants' benefits. Under current law, there is no
requirement that participants continue to accrue benefits after a
plan has terminated. It is thus inevitable that where a sponsor
terminates a defined benefit plan and does not establish any
other plan in its place, participants will not receive the
benefits at retirement that they would have received--and may
well have expected to receive-if the plan had not been
terminated. In a voluntary pension system, there is very little
that the government can do to prevent such terminations beyond
assuring that all of the participants' benefits as of the
termination are adequately provided.
Of greater recent concern, however, have been reversion
transactions under which a sponsor receives plan assets while
effectively continuing to maintain the defined benefit plan.
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These transactions generally have taken two forms: (1) the
termination of the defined, benefit plan and the establishment of
a new defined benefit plan, often identical to the terminated
plan (reestablishment transaction); and (2) the spinoff of a
defined benefit plan into two plans, one for active employees and
one for retirees, the allocation of the excess assets to the
retirees' plan, the termination of the retirees' plan, and the
continuation of the defined benefit plan for the active employees
(spinoff transaction).
In May 1983, the BRISk agencies (the Department of Treasury,
the Internal Revenue Service, the Department of Labor, and the
Pension Benefit Guaranty Corporation) issued enforcement
guidelines (the Guidelines) for purposes of processing
reestablishment and spinoff transactions. By requiring the full
vesting of all benefits and the purchase of annuity contracts
from insurance companies guaranteeing participants' accrued
benefits, the Guidelines assure that the security of
participants' benefits accrued before the transaction is not
adversely affected. In addition, the Guidelines attempt to
impose substantive parity between reestablishment transactions
and spinoff transactions by requiring the continuing plan in the
spinoff transaction to satisfy all of the substantive'
requirements of a formal termination--e.g., full vesting of
benefits, formal notice to participants, and third-party
annuitization of benefits. Moreover, the Guidelines extend
additional security to plan participants in the continuing plans
with respect to benefits accrued after the transactions by
strengthening the funding requirements under such plans.
Finally, the Guidelines prevent a sponsor from undertaking
reestablishment and spinoff transactions on a regular basis by
specifying that such transactions may not be undertaken more than
once every fifteen years.
We believe that, within the confines of existing
administrative authority, the Guidelines appropriately protect
the interests of participants in plans that are involved in
reestablishment or spinoff transactions. we recognize that some
believe that additional protections are necessary, but we are
comfortable that the Guidelines strike the proper balance between
assuring the security of participants' benefits and not
encouraging defined benefit plan sponsors to terminate their
plans without establishing a successor plan. we do not believe
that legislation with respect to these specific transactions is
necessary.
Similarly, it is our view that the recent involvement of
overfunded defined benefit plans in acquisitions and acquisition-
related transactions does not warrant specific legislation to
limit the rights of plan sponsors to terminate their defined
benefit plans as they desire. We are concerned that any such
legislative action to curb the termination of plans may
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unnecessarily discourage employers from maintaining or properly
funding defined benefit plans. We must be careful not to
undermine the voluntary nature of the pension system in an
attempt to dampen related merger and acquisition activity.
We recognize, however, that, in the context of a broader
examination of pension and tax policy, it is appropriate to
consider action to reduce the general incentive for plan sponsors
to terminate plans and extract assets for nonretirement purposes.
The impetus for any such action should not, however, be the
involvement of overfunded plans in acquisition
transactions--although this certainly would a factor to be
considered--but rather should.be based only on a full
consideration of the applicable pension and tax policies. Thus,
any proposal to reduce the incentive to terminate defined benefit
plans should apply on an across-the-board basis, without regard
to either the reason the sponsor is terminating the plan or the
intent of the sponsor to establish a successor plan. For
example, after further deliberations, it may be appropriate on
pension and tax policy grounds to apply a special excise or
minimum tax to asset reversions. This or similar action would
reduce the attractiveness of terminating overfunded defined
benefit plans in all circumstances.
D. S ecial Problems With Res ect To Carr Over of Tax
Attributes of Thrift institutions
In the Economic Recovery Tax Act of 1981 ('ERTA"), Congress
amended Section 368 of the Code to provide rules relating to
bankruptcy reorganizations of thrift institutions (i.e., savings
and loan associations and savings banks). These changes,
proposed by the Federal Some Loan Bank Board (the "Bank Board'),
were designed to resolve the issue of how the continuity of
interest requirement applies in reorganizations involving thrift
institutions.
Prior to ERTA, the Internal Revenue Service took the position
that a merger of a stock association into a mutual association
could not qualify as a tax-free reorganization. The Service
reasoned that the exchange of the shareholders' stock for
deposits in the mutual fails to satisfy the continuity of
interest requirement because the deposits are cash equivalents.
The courts generally rejected the Service's position, but without
the concurrence of the Internal Revenue Service, combinations of
stocks and mutuals could not be assured tax-free status.!/
*/ The Supreme Court recently sustained the Service's position
in Paulsen v. Commissioner, O.S. , 105 S. Ct. 627
(1985)o ruling that the merger of a s ock into a mutual
does not satisfy the continuity of interest requirement. in
this case, which arose prior to ERTA, the Court held that the
interests of the former shareholders of the stock association
in the mutual were essentially cash equivalents and, thus,
the transaction failed the continuity of interest test.
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There was also uncertainty as to the application of the
continuity of interest requirement in reoganizations involving
thrifts under section 368(a)(1)(G) ("G reorganizations"). In
many reorganizations involving thrifts, the transferor's solvency
was in question and the Internal Revenue Service took the
position that the transaction could qualify as a tax-free
acquisition only if it satisfied the G reorganization
requirements. However, it was not clear how the continuity of
interest requirement applied in a G reorganization involving
thrifts. In the case of a mutual association there are no
stockholders and the principal creditors are depositors whose
interests generally are insured and who are not likely to
exchange those claims for stock. further, stock associations
were unwilling to issue stock to those depositors. Consequently,
it appeared that the continuity of interest requirement generally
barred the reorganization of a thrift from qualifying as a
tax-free G reorganization.
To resolve these issues, Congress lifted the continuity of
interest requirement in G reorganizations involving a transferor
thrift if certain requirements are not. Generally, under these
rules, a transaction otherwise qualifying as a G reorganization,
in which the transferor is a financial institution to which
section 593 applies, will not be disqualified merely because no
stock or securities of the transferee are issued, provided: (i)
the transferee acquires substantially all of the assets of the
thrift and the thrift distributes any remaining assets pursuant
to the plan; (ii) substantially all of the liabilities of the
thrift (including deposits) become liabilities of the transferee;
and (iii) the appropriate agency certifies that, under 12 U.S.C.
51464(d)(6)(A)(i), (ii) or (iii), either that the transferee
thrift is insolvent, the assets of the thrift are substantially
dissipated, or the thrift is in an unsafe and unsound condition
to conduct business. The Bank Board, the Federal Savings and
Loan Insurance Corporation ("FSLIC') or, if neither has
supervisory authority over the thrift, the equivalent state
authority may certify that one of the grounds specified in 12
U.S.C. 51464(d)(6)(A) exists. In addition, section 382(b)(7)(B)
was added to provide that the transferee's and transferor's
depositors are taken into account in determining the level of
continuity of interest for purposes of section 381.
In these acquisitions a profitable financial institution
typically agrees to assume the transferor thrift's obligations in
consideration for payments from a regulatory body, such as the
FSLIC, and the right to succeed to the transferor's tax
attributes. The tax attributes which the acquiring corporation
seeks to preserve are the thrift's accumulated net operating
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losses and other carryyforwards and the transferor thrift's basis
in its assets (typically-residential mortgages with basis
significantly above fair market value).!/
In tax-free reorganizations the continuity of interest
requirement limits tax-free treatment to those transactions in
which the owners of the target corporation receive a meaningful
ownership interest in the acquiring corporation. The transfer of
stock in the target corporation for stock in the acquiring
corporation is tax-free because the owners of the target
corporation are deemed to have merely changed the form of their
investment. Moreover, the notion that tax attributes carry over
in a tax-free reorganization hinges on the continuity of interest
doctrine. The tax law considers it appropriate for tax
attributes to be used to offset income earned after the
acquisition whenever the historic shareholders who incurred the
unused attributes continue to hold a sufficient equity position
after the reorganization.
Under the revised rules for thrifts, neither the stockholders
nor the creditors (i.e., the depositors) of the troubled thrift
receive a continuing ownership interest in the acquiring
corporation. To permit tax attributes to carry over in these
transactions thus departs from the traditional principles
underlying the tax-free reorganization provisions, and provides a
tax subsidy for private acquisitions of thrift institutions. In
effect, this subsidy may operate to shift'some or all of the
burden of thrift losses from FSLIC, the private insurance agency
funded by the thrift industry, to the Federal government.
Congress thus should consider carefully whether subsidies for the
thrift industry are necessary, and whether they should be made
through direct appropriations or through the tax laws,
recognizing that the latter route may be less efficient and more
costly in the long run. No recognize, however, that the thrift
industry is undergoing a period of restructuring and there may be
nontax considerations for encouraging the flow of capital into
the thrift industry.
This carryover basis would leave the transferee with
substantial built-in losses which could be realized merely by
selling the loans. Alternatively, if the transferee does not
sell the loans, the carryover basis permits the transferee to
treat payments other than stated interest as repayments of
principals if the transferee took a fair market value basis
in the loans, a portion of the 'principal' repayments would
constitute market discount under section 1277 and thus be
treated as ordinary income.
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Attachment A
(Continued)
Not Reviewed by the Office of Management and Budget
Due to Time Constraints
For Release Upon Delivery
Expected at A.M., E.S.T.
April 22, 1985
STATEMENT OF
RONALD A. PEARLMAN
ASSISTANT SECRETARY (TAX POLICY)
DEPARTMENT OF THE TREASURY
BEFORE THE
SUBCOMMITTEE ON TAXATION AND DEBT MANAGEMENT
OF THE
SENATE FINANCE COMMITTEE
Mr. Chairman and Members of the Subcommittee:
I am pleased to appear before you today to present the views
of the Treasury Department on three bills (S. 476, S. 420, and
S. 632) relating to corporate acquisitions. These bills appear
to be prompted by the recent surge in merger activity generally,
but are particularly directed at hostile merger activity. The
bills would substantially penalize, if not render economically
impossible, mergers and acquisitions that are considered
"hostile."
We do not believe that Congress should enact special tax
provisions aimed only at hostile as opposed to friendly
acquisitions. Indeed, we do not believe that Congress should
amend the tax laws for the purpose of discouraging mergers and
acquisition activity generally.
We do not know all of the economic and other reasons behind
the recent flurry of activity. We doubt, however, that the tax
laws are the driving force, but rather suspect that other market
forces precipitate these transactions; forces that reallocate
resources to higher valued uses, promote economies of scale,
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increase shareholders' return on investment, replace inefficient
management, and free up capital for new investment opportunities.
Only those persons responsible for the merger activity know for
certain the forces that drive their decisions.
The bills that are the subject of today's hearing would
discourage hostile takeovers by disallowing interest deductions
with respect to certain indebtedness and mandating a section 338
election for certain stock purchases. In addition, the bills
would discourage attempted takeovers by imposing an excise tax on
certain profits realized by persons who take substantial
investment positions in companies that are the subject of an
attempted takeover. These profits have recently been referred to
as greenmail profits. The bills also would clarify that under
current law no deduction is available with respect to any
greenmail payments.
The Treasury Department opposes these bills. As a matter of
tax policy, we do not believe hostile acquisitions should be
treated differently under the tax laws than friendly
acquisitions, nor do we believe that a clear distinction can be
drawn. Thus, we believe that interest deductions and section 338
elections should be equally available for hostile and friendly
acquisitions. Further, we do not believe that certain gains from
sales or exchanges of stock, labeled greenmail profits, should be
subject to an excise tax. Finally, while greenmail payments are
not deductible under current law, we would not be opposed to a
statutory confirmation of this point.
Hostile Versus Friendly Acquisitions
All of the bills that are the subject of today's hearing
would limit interest deductions, and both S. 632 and S. 420 would
mandate section 338 elections, for all hostile acquisitions.
Hostile acquisitions are defined in two different ways, however.
S. 476 defines the term "hostile acquisition" generally as an
acquisition of corporate property or stock by persons who have
acquired a 20 percent or greater interest in the target
corporation within the preceding year, if the transaction, before
consummation, is not formally approved by a majority (consisting
of at least two members) of the independent members of the board
of directors of the target corporation. No member of the board
would be treated as independent if such member is an officer or
employee of the corporation or was nominated by the persons
making the acquisition.
Both S. 632 and S. 420, framed more broadly than S. 476,
apply to acquisitions by any persons, if the acquisition is
pursuant to a "hostile offer." The term "hostile offer" turns on
the same factor as S. 476 -- disapproval by a majority
(consisting of at least two members) of the independent members
of the board of directors of the target corporation. The
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definition of an independent director is more restrictive under
S. 632 and S. 420 than S. 476, as it not only excludes from the
definition a person that is an officer or employee of the target
corporation, but also any person that has substantial financial
or commercial ties to that corporation, except for ownership of
stock.
We do not believe the tax consequences of corporate
acquisitions should turn on whether a corporation's independent
directors approve or disapprove of the acquisition. Moreover,
the effect of these bills would be to bring new and extreme
pressure to bear on the decision making processes of independent
directors. Because of the harsh tax consequences resulting from
characterization of an acquisition as hostile, independent
directors would in effect have a veto over corporate acquisition
decisions. On the other hand, there may be substantial enough
pressures on the independent directors that would, under certain
circumstances, tend to make them vote for, rather than against, a
proposed acquisition. For only by their favorable votes could
the sanctions imposed by these bills be avoided. Such pressures
would seem to undermine the very rationale for independent
directors.
Further, many closely held corporations do not have
independent members on their boards of directors. In such cases,
the tax penalties could not come into play no matter how
vigorously a takeover is resisted. The bills do not suggest any
rationale for this arbitrary distinction. If these tax penalty
provisions were enacted, however, companies would have an
incentive not to have independent directors. We doubt that the
sponsors of the bills intend such a result.
We believe very strongly that the market place (i.e.,
shareholders rather than independent directors) should determine
whether a proposed acquisition is economically beneficial. The
tax laws should not bias this decision towards friendly or
against hostile acquisitions, as a hostile acquisition may turn
out to be an economically beneficiary acquisition. Only a free
market can make the optimal economic decision.
Disallowance of Interest Deductions on Certain Hostile
Acquisitions
All of the bills before the Subcommittee limit the
deductibility of interest incurred in connection with "hostile"
takeovers. The genesis of these bills apparently stems from the
publicity received by a number of recent acquisitions financed by
the use of so-called junk bonds (i.e., high risk, high yield
subordinated debt) and a concern that the current tax treatment
of interest may encourage mergers, especially hostile
acquisitions. The basic structure of our current income tax
system may encourage corporations to utilize debt rather than
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equity in financing operations or acquisitions because of the
more favorable tax treatment of interest compared to dividends
and the arbitrage potential from debt financing.
S. 476 would disallow a deduction for any interest paid or
accrued during the taxable year with respect to "hostile
acquisition indebtedness." Hostile acquisition indebtedness is
defined as any "junior obligation" issued after February 18,
1985, in connection with a hostile acquisition. A "junior
obligation" is any obligation evidenced by a bond, debenture,
note or certificate, or other evidence of indebtedness issued by
any person which, upon issuance, bears any one or more of the
following characteristics: (1) the indebtedness is expressly
subordinated to the payment of any substantial amount of
unsecured indebtedness of the issuer or the corporation that is
the target of the hostile acquisition, (2) the indebtedness is
issued by a person whose assets are (or following the hostile
acquisition would be) comprised predominantly of the stock of the
target corporation, cash, and cash equivalents, or (3) the
indebtedness bears a rating from any nationally recognized rating
agency which is at least two ratings inferior to the rating from
such agency in respect of any other substantial class of
indebtedness of the issuer or the target corporation. S. 476 is
effective with respect to interest paid or accrued with respect
to obligations issued after February 18, 1985.
S. 632 differs slightly from S. 476 in that it disallows a
deduction for any interest paid or accrued on indebtedness
incurred or continued to acquire (or carry) stock or assets
acquired pursuant to a "hostile offer." The definition of
"hostile offer" differs only slightly from the definition of
"hostile acquisition" in S. 476 as discussed above. S. 632 is
effective with respect to indebtedness incurred or continued to
acquire (or carry) stock acquired after March 6, 1985. For
assets acquired pursuant to a "hostile offer," S. 632 fails to
provide a specific effective date for its application to
indebtedness incurred or continued to acquire (or carry) such
assets.
S. 420 is identical to S. 632 with respect to the
disallowance of interest deductions, except that it does not
apply to indebtedness incurred or continued to acquire (or carry)
assets; it is limited to acquisitions of stock. S. 420 is
effective with respect to indebtedness incurred or continued to
acquire (or carry) stock which is acquired after February 6,
1985.
Our current income tax system generally treats corporations
as taxpaying entities separate from their shareholders. A
corporation separately computes and reports its taxable income,
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and in making this calculation it is not entitled to a deduction
for dividends paid to shareholders. Moreover, these dividends
are taxed to individual shareholders as ordinary income (except
for a $100 per year exclusion). Consequently, corporate taxable
income paid as dividends to individual shareholders generally
bears two taxes, the corporate income tax and the individual
income tax.
The double taxation of corporate earnings that are
distributed as dividends to shareholders affects dividend
distribution policies in ways that may encourage merger activity.
In particular, corporations, especially those with shareholders
in relatively high income tax brackets, are encouraged to retain
earnings in order to allow the shareholders to defer imposition
of the second tax.*/ This pressure to accumulate corporate
earnings not only interferes with ordinary market incentives to
place funds in the hands of the most efficient users, but also
stimulates corporate acquisitions in at least two ways.
First, corporations that accumulate cash funds in excess of
their needs for working capital must reinvest those funds;
acquiring the stock or assets of other corporations is an
investment alternative that must be considered by any corporation
with excess funds to invest. Second, a corporation with large
amounts of funds invested in nonoperating assets may itself
become an attractive target, because the market may not
immediately reflect the value of those nonoperating assets (which
may not generate financial reported earnings commensurate with
their values). Because of this potential undervaluation of the
target's nonoperating assets, a potential acquiring corporation
may view the nonoperating asset as cheap funds available to
finance the acquisition of the underlying business operations of
the target. The mitigation or elimination of the double tax on
corporate dividends, through any form of integration of the
corporate and individual income taxes, would reduce or eliminate
these effects.
*/ indeed, in some cases the shareholder-level tax can be
permanently avoided if the retained earnings are distributed
in liquidation following the death of the shareholder, which
occasions a tax-free increase in the stock's basis to its
fair market value. However, if the corporation is formed or
availed of for the purpose of avoiding the second
shareholder-level tax by permitting earnings and profits to
accumulate instead of being distributed, there is imposed on
the corporation a penalty accumulated earnings tax.
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In contrast to the taxation of corporate earnings distributed
as dividends, corporate income distributed to creditors as
interest is deductible by the corporation and thus taxed only
once, to the creditors. The disparate tax treatment of debt and
equity in the corporate sector distorts decisions regarding a
corporation's capitalization, making corporations more vulnerable
to takeover during economic downturns, and also may encourage
leveraged buyouts, because interest payments on the debt incurred
in such a transaction offset income earned by the target
corporation.
Since interest payments on debt financing are deductible and
dividends paid on equity are not, corporations are encouraged by
the tax law to utilize debt rather than equity to finance their
ongoing operations. This may result in an increased
debt-to-equity ratio that increases the risk of bankruptcy and
vulnerability to downturns in the business cycle; and any
corporation that is temporarily crippled by an economic downturn
becomes a likely takeover candidate.
The deductibility of interest incurred in connection with
debt-financed acquisitions also encourages acquisitions to the
extent that our tax system does not take account of inflation
properly. Nominal interest rates typically include an inflation
component which compensates the lender for the anticipated future
reduction in the real value of a fixed dollar amount debt
obligation and acts as an offsetting charge to the borrower for
the inflationary reduction in the value of the principal amount
of the borrowing. Where borrowed funds are invested in assets
that also increase in value by virtue of inflation, the tax law
permits a current deduction for interest expense but no
realization of the increase in value of the asset until its sale
or disposition. In such cases, the interest deduction can be
used to offset income that otherwise would be taxed currently.
The use of installment debt in acquisitions also leads to
significant mismatching of the gain that is deferred by the
seller and the allowance to the purchaser of depreciation,
amortization, or depletion deductions determined by reference to
asset values that have been stepped-up to fair market value as a
result of the acquisition. This asymmetrical treatment of a
sale, under which the buyer is treated as acquiring full
ownership of the asset while the seller is treated as making only
partial sales each year over the term of the contract may create
a tax bias for installment debt-financed acquisitions. In a
taxable corporate acquisition (an asset acquisition or a stock
acquisition with a section 338 election), this mismatching is
reduced to some extent if the target corporation's assets are
subject to recapture tax since the recapture income is recognized
immediately. The asymmetrical treatment arising from installment
sales debt is a problem that should concern this Subcommittee,
but the problem exists in every installment sale of a depreciable
asset and is by no means unique to corporate acquisitions.
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One of the bills, S. 476, would deny deductions for interest
paid on high yield, subordinated bonds used to finance hostile
acquisitions. The concern generating the bill may have been that
a number of these bonds, referred to as "junk bonds," have been
used in connection with recent highly leveraged acquisitions.
There is a substantial argument that some of these bonds would be
more appropriately classified as equity rather than debt.
Although there are significant differences in the tax treatment
of debt versus equity, it is extremely difficult to develop
general rules to differentiate a debt interest from an equity
interest. Section 385 lists certain factors that are to be taken
into account in distinguishing debt from equity interests.
Although section 385 was enacted in 1969, to date no satisfactory
general rules have been developed. The Internal Revenue Service
has administered this area, and will continue to differentiate
instruments including junk bonds, on a case by case basis.
S. 476 does not consider any facts and circumstances other than
those enumerated in its definition of junior obligation and,
therefore, may inappropriately characterize some junior
obligations as equity.
Two of the bills before the Subcommittee, S. 632 and S. 420,
address the disparate treatment of debt and equity and the
potential arbitrage from debt financing by limiting interest
deductions on all indebtedness incurred or continued in
connection with hostile acquisitions. The tax arbitrage from
debt financing generally is available, however, for all
debt-financed corporate assets, not just those acquired in a
corporate merger or acquisition. The only special limitation on
the deductibility of interest on debt incurred in acquisitions is
found in section 279 which applies only under very limited
circumstances. Although it may be appropriate to give
consideration to revising the general rules regarding the
deductibility of interest, we see no justification for a further
limitation on the deductibility of interest expense that is aimed
specifically at debt incurred in connection with hostile
acquisitions. Any tax advantage to utilizing debt in a corporate
acquisition is available both to hostile as well as friendly
acquisitions. we believe that any remedy to limit the advantage
to utilizing debt rather than equity to finance corporate
acquisitions should be done in a neutral manner.
Mandatory Section 338 Election in the Case of Hostile Stock
Purc ases
Two of the bills before the Subcommittee mandate that in a
hostile stock acquisition, the acquiring company is deemed to
have made a section 338 election for the target corporation, and
that certain other provisions of the tax law that generally apply
when a section 338 election is made, do not apply.
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Generally, as described above, a corporation is subject to
tax on the profits derived from its operations and its
shareholders are subject to a second level of tax on the
distributions of those profits as dividends. In a liquidating
sale of assets or sale of stock subject to a a section 338
election, the acquiring company obtains the benefits of a step-up
in basis of the acquired assets with only a partial corporate
level tax; recapture and tax benefit items are taxed, but other
potential gains are not. This result stems from the rule
attributed to General Utilities & Operating Co. v. Helverin , 296
U.S. 200 (1935), that is now codified in sections 311(a), 6 and
337. Under those provisions, a corporation does not recognize
gain (other than recapture and tax benefit items) on certain
distributions, including liquidating distributions, made to its
shareholders.
The General Utilities rule applies when a section 338
election is made. The election is available generally whenever
one corporation purchases at least 80 percent of the stock of a
target corporation over a 12-month period. If such election is
made, the basis of the assets of the target corporation is
adjusted in a manner similar to the adjustments that would occur
if the target corporation had sold all of its assets to the
acquiring corporation in connection with a plan for complete
liquidation. The target corporation does not recognize gain (or
loss) on such deemed sale (except for recapture and tax benefit
items). The price at which the assets are deemed sold by the
target corporation and purchased by the new corporation is
generally the purchasing corporation's basis in the target's
stock at the acquisition date.*/
*/ Section 338(a)(1) provides that the target corporation is
deemed to sell its assets at their fair market value on the
acquisition date. Alternatively, in the case of a bargain
stock purchase, an election may be made under section
338(h)(11) to determine the aggregate deemed sale price on
the basis of a formula that takes into account the price paid
for the target corporation's stock during the acquisition
period (grossed-up to 100 percent) plus liabilities
(including taxes on recapture and other tax benefit items
generated in the deemed sale) and other relevant items.
Section 338(b) provides that the new corporation is deemed to
purchase the target corporation's assets at an aggregate
price equal to the grossed-up basis of recently purchased
stock plus the basis of nonrecently purchased stock (subject
to an election under section 338(b)(3) to step-up the basis
of such nonrecently purchased stock) plus liabilities
(including taxes on recapture and other tax benefit items
generated in the deemed sale) and other relevant items.
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There is generally no requirement that a purchasing
corporation make a section 338 election for the target
corporation. If no section 338 election is made for the target,
no gain or loss is recognized with respect to target's assets and
its corporate tax attributes are preserved, subject to certain
limitations.
S. 632 provides that in the case of any hostile qualified
stock purchase, the purchasing corporation will be treated as
having made a section 338 election with respect to such purchase.
In addition, all gain, not just recapture and tax benefit items,
will be recognized on the deemed sale of assets. Moreover, the
basis of the target's assets deemed purchased will be reduced by
the amount of tax imposed on the target corporation as a result
of the deemed sale. S. 632 is effective for hostile qualified
stock purchases after March 6, 1985.
S. 420 is identical to S. 632, except that there is no
requirement that the basis of target's assets deemed purchased be
reduced by the amount of the tax imposed on the target
corporation on the deemed sale. S. 420 is effective for hostile
qualified stock purchases after February 6, 1985.
The availability of the section 338 election does not create
any significant tax incentives for either hostile or friendly
acquisitions. The provision was intended to facilitate mergers
and acquisitions by permitting the acquiring corporation to
replicate the tax consequences that would follow from an asset
acquisition without requiring an actual sale and transfer of
those assets. In many cases, however, the tax consequences of an
actual asset acquisition or a deemed asset acquisition under
section 338 will be adverse. Acquiring corporations have always
been able to avoid such consequences by acquiring the stock of
the target corporation and forgoing any adjustment in the basis
of the assets of the target company. There are no tax policy
considerations that suggest this latter alternative should be
foreclosed to hostile takeovers. If a mandatory section 338
election were imposed, there would be a substantial bias in the
tax law against hostile acquisitions of certain companies,
especially those with large recapture and tax benefit items. We
do not believe there is a sound tax policy reason for imposing
that bias.
Similarly, we do not believe that there is any sound basis
for imposing the additional tax penalties on hostile stock
acquisitions that are proposed by S. 420 and S. 632. Whether all
gains, not just recapture and tax benefit items, should be
recognized on an actual liquidating sale of corporate assets or a
deemed sale pursuant to a section 338 election, is not an issue
that should turn on whether the acquisition is hostile or
friendly. Finally, the reduction in basis for the tax liability
generated on the deemed sale in a mandatory section 338 election
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prescribed by S. 632 is contrary to fundamental tax concepts, and
amounts to an awkward and ill-conceived penalty on hostile
acquisitions.
Excise Tax on Greenmail Profits and Deductibility of Greenmail
Payments
Although the bills, as discussed above, generally attempt to
distinguish between hostile and friendly acquisitions, they also
deal with so-called "greenmail" paid and received in either
hostile or friendly situations. As the term is commonly used,
greenmail refers to a payment made by a corporation to a
particular shareholder, often referred to as a "raider," who has
purchased a substantial amount of the corporation's stock as part
of a plan to acquire the corporation.*/ The offer to purchase
the raider's stock is usually not made to all shareholders and is
thus known as "greenmail." In exchange for the payment, the
raider sells his stock to the target corporation and agrees to
refrain from further attempts to acquire the corporation (a
"standstill agreement"). Although the payment is made in
exchange for the stock surrendered by the raider, it also may
include reimbursement for expenses incurred by the raider in the
takeover attempt.
In an attempt to eliminate greenmail payments, S. 476 and
S. 420 impose a nondeductible 50 percent excise tax on any person
who realizes "greenmail profits." Although greenmail, as
described generally above, commonly refers to payments made by a
corporation to an unwanted shareholder, both bills would sweep
more broadly. In particular, greenmail profits are defined-under
*/ Because shares of a publicly traded target corporation are
readily available for purchase on a stock exchange and the
raider is generally not required to disclose his intentions
until he has acquired five percent of the corporation's
stock, the existence and identity of a potential raider may
not be known by the target corporation until the raider has
acquired the threshold five percent. Under the Williams Act,
owners of five percent or more of a corporation's stock are
required publicly to disclose the amount of their ownership
and their plans with respect to the corporation.
Accordingly, neither the target nor the market may be aware
of a takeover attempt until the raider has acquired a
substantial amount of stock.
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S. 420 to include any gain realized by a "4-percent
shareholder"*/ on the sale or exchange of any stock in the
corporation if (1) the shareholder held such stock for a period
of less than two years, and (2) there was a public tender offer
for stock in the corporation at any time during the two-year
period ending on the date of such sale or exchange. Under
S. 476, greenmail profits also arise from a sale or exchange if,
at any time during the two-year period, any 4-percent shareholder
submitted a written proposal to such corporation which suggests
or sets forth a plan involving a public tender offer, regardless
of whether a public tender offer is actually made.**/
The tax would not apply, however, to'a gain realized by any
person on the sale or exchange of stock in any corporation if,
throughout the 12-month period ending on the date of such sale or
exchange, such person had been an officer, director, or employee
of the corporation or a 4-percent shareholder. Under the bills,
therefore, the 50 percent excise tax would generally apply to
gains realized by relatively large, short-term shareholders.
Both bills would be effective for sales and exchanges made after
February 6, 1985, except for sales or exchanges made pursuant to
a written agreement in existence on February 5, 1985.
The 50 percent excise tax proposed by both bills is deficient
in several respects. First, the Treasury Department does not
believe that any valid tax policy is served by subjecting
greenmail profits to an additional tax. If greenmail payments
are determined to be contrary to the public interest, they should
be deterred directly, rather than through use of the tax laws.
For example, state corporate laws could be amended to prohibit
greenmail payments. Moreover, if such payments are judged by
shareholders to be generally unacceptable, direct action may be
taken. In particular, as many corporations have done, corporate
charters may be amended to proscribe such payments.
*/ Under both bills, a "4-percent shareholder" means any person
who owns stock possessing four percent or more of the total
combined voting power of all classes of stock entitled to
vote. For purposes of determining whether a person is a
4-percent shareholder, stock owned both directly and
indirectly (through the application of section 318) is
considered.
**/ The term public tender offer is defined under both bills to
mean any offer to purchase (or otherwise acquire) stock if
the offer is required to be filed or registered with any
Federal or state agency regulating securities.
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In addition to the fact that the tax law is an inappropriate
tool to deter greenmail payments, the technique adopted by the
bills seems overly harsh and imprecise. Under current law, gains
realized on a sale or exchange of stock are generally treated as
capital gains. Assuming the shareholder had no capital losses,
gains from the sale or exchange of stock held for six months or
less are taxed as ordinary income at a maximum rate of 50
percent, while gains from stock held for more than six months
receive preferential tax treatment. In particular, individuals
and other noncorporate taxpayers may exclude 60 percent of the
gain from income, and corporations are subject to a maximum rate
of 28 percent on such gain. Under the bills, therefore, an
individual shareholder who owned four percent of a corporation's
stock for six months or less at the time of the sale could be
subject to a 100 percent tax on any gain, a 50 percent ordinary
income tax and the 50 percent excise tax.*/ The Treasury
Department does not believe that such a confiscatory rate of tax
is appropriate under any circumstances.
Moreover, we believe that a 4-percent shareholder, like any
other investor, is subject to the vagaries of the market and
should be taxed as any other investor. We perceive no tax policy
rationale for taxing a larger shareholder at a higher rate than a
smaller shareholder on an identical economic gain.
In addition, although the bills are styled as imposing an
excise tax on "greenmail," their reach is much broader. in
particular, the excise tax would apply to any investor who
purchased more than four percent of a corporation's stock,
regardless of whether the shareholder purchased the stock with an
intent to acquire the entire corporation. Such large
shareholders could include a variety of institutional investors,
such as pension plans, college and museum endowment funds, and
large private investors. While such investors normally hold
stock for periods of longer than one year, and would thus be
excluded from the excise tax under both bills, situations would
arise in which such investors, who had recently purchased stock,
would want to sell. These situations would include a variety of
circumstances under which institutions may be forced to liquidate
an investment for external reasons, as well as the simple desire
*/ Even if the shareholder had held the stock at the time of the
sale for more than six months, but less than one year, the
gain could be taxed at 70 percent. Corporate shareholders,
depending on the length of their holding periods, would be
subject to maximum effective rate of either 96 percent or 78
percent.
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to take advantage of appreciation caused by an actual or
anticipated public tender offer. We do not believe that such
investors should be subject to the punitive tax proposed by the
bills.*/ While such large shareholders could avoid application
of the excise tax by holding their stock for more than one year,
such potentially noneconomic behavior should not be required by
the tax laws.**/
The final class of persons who might be subject to the
greenmail excise tax are so-called "arbitrageurs." Such
investors often take relatively large positions in a
corporation's stock in anticipation of a tender offer at a price
in excess of the prevailing market price. While such an investor
may seek to benefit directly from a raider's attempt to acquire
control of a corporation, we do not believe that any tax policy
justifies taxing such person at exorbitant rates.
In summary, the Treasury Department believes that S. 420 and
S. 476 represent an imprecise and overly harsh response to a
perceived problem that may not be a problem at all. In any
event, the solution does not reside in the tax laws.
Consequently, we oppose the excise tax provisions in both bills.
Focusing narrowly-on the tax treatment of "greenmail" by the
corporation, S. 632 provides expressly for the disallowance of a
deduction for any "greenmail payment." A greenmail payment is
defined by S. 632 as any payment made by a corporation in
redemption of its stock from a 4-percent shareholder if (1) such
shareholder held such stock for a period of less than two years,
and (2) there was a public tender offer for stock in the
corporation at any time during the two-year period ending on the
date of such sale or exchange. A greenmail payment also would
include any payment to a 4-percent shareholder or other person
for any expenses paid or incurred in connection with a redemption
or public tender offer. Like S. 476 and S. 420, the term
4-percent shareholder does not include a person who holds at
least four percent of the total voting power of the corporation's
stock throughout the one-year period preceding the redemption or
who was an officer, director, or employee of the corporation
throughout that period. There is no specific effective date for
these provisions in S. 632.
*/ Even if institutions that are exempt from the income tax also
were exempted from the excise tax, it would still fall
inappropriately on some large taxable investors.
**/ The one year exception in the bill would permit a raider to
avoid the excise tax simply by holding a four percent
interest for one year. while business and other factors
might preclude the use of such a tactic, the exception will
diminish the effectiveness of the provision.
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Under current law, the repurchase of stock by a corporation,
regardless of the amount of stock owned by the shareholder from
whom the stock is redeemed, is a capital transaction that can not
give rise to a deductible loss and payments made by a corporation
in such a transaction are not deductible.*/ Consequently, the
Treasury Department believes that the provision of S. 632 denying
a deduction for redemption payments made to a 4-percent
shareholder under certain circumstances represents a limited
restatement of current law principles.
S. 632, however, contains an exception for redemption
payments made to a shareholder who, throughout the one-year
period preceding the redemption, was an officer, director, or
employee of the corporation or a 4-percent shareholder.
Moreover, S. 632 does not apply to redemption payments made to a
shareholder who owns stock possessing less than four percent of
the voting power of all the corporation's stock. Because
redemption payments are not generally deductible under existing
law regardless of the size or identity of the redeemed
shareholder, we believe that S. 632 is defective to the extent
that it suggests that redemption payments made to such
shareholders could be deducted by a corporation.
*/ The courts have held repeatedly that an amount paid by a
corporation to redeem its stock is a nondeductible capital
transaction. See H. and G. Industries, Inc. v. Commissioner,
495 F.2d 653 (!Cir. 1974); Jim Walter Corp. v. United
States, 498 F.2d 638 (5th Cir. 1974); Richmond,
Fredericksburg and Potomac Railroad Co. v. Commissioner, 528
F.2d 917 (4th Cir. 1975); Markham & Brown, Inc. v. United
States, 648 F.2d 1043 (5th Cir. 1981); Harder Services, Inc.
v. Commissioner, 67 T.C. 584 (1976); Proskauer v.
Commissioner, 46 T.C.M. 679 (1983). In one isolated case,
Five Star Manufacturing Co. v. Commissioner, 355 F.2d 724
(5th Cir. 1966), a court held that an amount paid by a
corporation to repurchase its own stock was a deductible
business expense in light of a showing that liquidation of
the corporation was imminent in the absence of the
redemption, no value would have been realized by the
shareholders upon such a liquidation, and the redemption
represented the only chance for the corporation's survival.
Regardless of whether Five Star Manufacturing was correctly
decided, it has since been strictly limi to its unusual
facts, see, e.g., Jim Walter Corp, supra, and its continuing
vitality, even on those unusual facts, is unclear, see
Woodward v. Commissioner, 397 U.S. 572 (1970).
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Despite the clarity of existing law and repeated losses in
litigation, some corporations engaged in takeover fights have
apparently taken the position that redemption payments may be
deductible for Federal income tax purposes on the theory that
they are made to "save" the corporation. We believe that
treating redemption payments as deductible expenses under the
circumstances contemplated by S. 632 is inconsistent with
existing law. Nevertheless, we would not object to an express
statutory confirmation that existing law bars the deductibility
of redemption payments. If such an amendment were adopted,
however, it should expressly deny deductibility for all
redemption payments, regardless of the size or status of the
shareholder, and the accompanying legislative history should
state clearly that the amendment does not create any inference
that the Congress believes such payments are deductible under
existing law.
This concludes my prepared remarks. I would be happy to
respond to your questions.
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.tachment B
THE WHITE HOUSE
March 8, 1985
MEMORANDUM FOR THE PRESIDENT
FROM: THE CABINET COUNCIL ON ECONOMIC AFFAIRS
SUBJECT: Corporate Takeovers
There has recently been much attention focused on corporate
takeovers and the need for any Federal legislation restricting
such activities. A House subcommittee is currently holding
hearings on takeovers and has asked the Administration to testify
on March 12. This memorandum presents the Cabinet Council's
findings on the value of takeovers and recommendations for an
Administration position on possible Federal legislation.
Background
Mergers and acquisitions occur because of, among other
factors, the belief that the combined company can operate more
efficiently than two companies operating separately. In friendly
mergers and acquisitions, which account for the overwhelming
majority of such transactions, both parties agree on these
benefits. In hostile takeovers, managers of the target company
(the company being acquired) oppose the transaction because they:
(a) fear the loss of their jobs; and/or (b) believe their
shareholders would be better off if the company remained
independent or merged with a different company.
In a hostile takeover, a bidder typically buys a significant
percentage of the target company's stock and offers to pay other
shareholders a premium for their shares. The bidder seeks to
obtain enough shares, usually 51 percent, to gain control of the
target company. The target management seeks to prevent the
bidder from gaining control, typically through defensive tactics
such as litigating against the bidder or buying the shares
already owned by the bidder.
Last year, the Senate passed amendments to the banking bill
restricting certain takeover activity, while the House
considered, but did not pass, separate legislation. The
Securities and Exchange Commission (SEC) proposed restrictive
legislation last year, but recently indicated it will oppose such
legislation this year. While there will be pressure from some
segments of the business community for restricting bidder tactics
and from stockholder groups for restricting defensive tactics,
the likelihood in this session of Federal legislation restricting
takeovers appears to be limited.
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Principal Findings
The Cabinet Council on Economic Affairs has conducted a
detailed study which examined two central issues: (1) the
economic impact of takeovers and the extent of abuses; and (2)
the appropriate Federal role, if any, in correcting these abuses.
Based on this study, the Cabinet Council has approved
recommending to you a statement of the Administration's position
on corporate takeovers to guide Administration testimony on this
issue. A copy of the proposed statement is attached. The
principal findings of the Cabinet Council study are:
1. Corporate takeovers generally benefit the economy by
enabling companies to achieve efficiencies, shift assets to
higher valued uses, and police management conduct.
2. To the extent there are abuses in the takeover process,
it appears shareholders need protection from the management of
the target company, rather than from the bidding company.
Because managers may primarily be interested in keeping their
jobs, they may oppose a takeover bid that is in the best
interests of the shareholders of the target company.
3. There is great capacity through the market, the States,
and the courts to correct these abuses. There is no compelling
evidence that these checks are inadequate. The market can react
through changes in corporate charters. Institutional investors
are starting to oppose target managements that resist takeovers.
The States can pass laws governing abusive defensive tactics.
The courts are able to distinguish between abusive and legitimate
uses of defensive tactics by considering the unique facts of a
particular case.
4. Only if there is a serious market failure of national
dimensions should the Federal Government then consider taking
appropriate steps to curb the potential for abuse. This position
is shared by the chairman of the SEC.
The Council also considered the three major arguments made by
critics of takeovers:
o Takeovers reduce competition. By reducing the number of
competitors in an industry, takeovers increase the
likelihood of higher prices than what a more competitive
market would have produced.
However, the Department of Justice and Federal Trade Commission
actively oppose mergers and acquisitions, whether friendly or
hostile, that threaten to reduce competition.
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o Takeovers financed by borrowing divert capital from more
productive uses. When a bidder borrows bank funds for a
takeover, it ties up money the bank could have lent to
companies making "real" investments, instead of simply
pursuing "paper profits."
Takeovers result in real benefits of greater efficiency, and not
simply the pursuit of paper profits. Moreover, when a bidder
buys shares in the target company, the funds are not diverted.
The shareholders selling their shares to the bidder in turn
invest these funds in the economy.
o Hostile takeovers force managers to focus on short-term
protection against takeovers, rather than on long-term
investments.
This argument overlooks the point that the best means of avoiding
hostile takeover attempts is to maximize shareholder wealth,
which reflects the long-term competitive prospects of the
company. If the stock market does not think a company is making
good long-term investments, the price of the company's share will
fall, making it more vulnerable to takeovers.
Recommendation
The Cabinet Council on Economic Affairs unanimously recommends
that you approve the attached Administration position on
corporate takeovers.
Approv
es A. Baker III
Chairman Pro Tempore
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PROPOSED ADMINISTRATION POSITION
CORPORATE TAKEOVERS
I Corporate takeovers perform several beneficial functions
and are generally good for the economy.
II. The Williams Act represents a compromise between the
desire to afford target shareholders and managements
adequate disclosure and a reasonable period of time in
which to evaluate offers, and the needs of the competitive
markets in securities and in corporate control to operate
with a minimum of government regulatory interference. We
have not seen sufficient evidence that the existing
provisions of the Williams Act are inadequate to achieve
their purpose.
III. Various limitations on bidder activities have been
proposed, but a need for additional restrictions
on bidders has not been demonstrated.
IV. Target company shareholders need and have protection from
abuses by target managements in conjunction with contests
for corporate control.
V. State law, enforceable in the courts, governs the
permissible terms of corporate charters, management
contracts, and managers' and directors' fiduciary
obligations, each of which may serve to check management
abuses. From existing state statutes and decisions of
state and Federal courts, however, it is unclear whether
state law is adequate to portect target company share-
holders from abuses by target management. As new
defensive tactics evolve, moreover, existing protections
may prove inadequate.
VI. The balance between management's need to act expeditiously
in the interest of the corporation and the shareholder's
right to call that action into account should be resolved
at the level closest to the problem and the relevant
facts--by the corporation, its owners, and managers in
the first instance; by state law, if necessary; and, by
Federal law only as a last resort. If there is a serious
market failure of national dimensions, then the Federal
Government should consider taking appropriate steps to
curb the potential for abuse. Otherwise, the Federal
Government should take no step towards the establishment
of Federal corporation law to govern relationships between
shareholders and managers.
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VII. While matters of corporation law have traditionally
been the subject of state rather than Federal jurisdiction,
the Federal Government should play an informational role
by making public the best information about critical
issues that shareholders are likely to face in many
corporate change of control contests.
VIII. The Federal Government should also carefully consider
the unintended effects that other Federal policy
decisions may have on merger and acquisition activity.
To the extent that these Federal decisions encourage
more or less merger and acquisition activity than
otherwise would have taken place in a free market,
resources may be misallocated.
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