Tax Reform Plan May Put a Chill on Merger Fever
The business of buying and selling companies may be one of the industries most sharply affected by the new tax bill.
The proposal repeals the so-called General Utilities rule, an obscure tax provision derived from a 1935 Supreme Court ruling involving a company by that name. The rule provided a way for acquirers of companies to avoid paying capital gains tax on the assets that they purchase.
By increasing the potential tax on corporate mergers and acquisitions, some investment professionals say, the repeal may restrain the explosive activity in that field. (Sellers of companies, such as its stockholders, already pay a capital gains tax when they sell their stock for cash.) Others believe that its impact will be seen only in the long run, in relatively lower bids for companies in such industries as natural resources, broadcasting and others with similar asset structures.
“There’s no question it’s going to make transactions more difficult and cut the value of certain companies,” said Arthur Feder, a lawyer at the firm of Fried, Frank, Harris, Shriver & Jacobson. “A double tax on any transaction is not an attractive prospect.”
One other element of the tax bill that could affect the mergers-and-acquisitions game renders non-deductible a company’s expense in repurchasing its stock under certain conditions. This will discourage “greenmail,” in which a speculator accumulates threatening concentrations of a target company’s stock in order to force the company to repurchase his holdings at a premium.
Wasting an Opportunity
Although many merger professionals say repeal of the General Utilities rule is long overdue, they say Congress is wasting an opportunity to enact a long-awaited comprehensive revision of tax rules relating to takeovers. For the last year, the Senate Finance Committee has been considering such a revision in order to eliminate the inequities that make certain merger transactions taxable and others, such as stock-for-stock exchanges, tax exempt.
In the race for tax reform, the House Ways and Means Committee stole a march on the upper house by including a repeal of the General Utilities rule in its own tax proposal last November and attaching an estimate that it would raise more than $4 billion in revenue over five years. In the latest conference bill, Congress directs the Treasury Department to propose a comprehensive revision by Jan. 1, 1988.
“That’s a long time to leave the tax law relating to major corporate transactions half-baked,” Feder said.
Under the General Utilities rule, the buyer and liquidator of a company could revalue its assets to the equivalent of what he paid for them without paying the customary capital gains tax on the increase.
Consider the hypothetical acquisition for $300 million of a chain of three television stations valued on the old owner’s books at their historical value of $10 million each.
The General Utilities rule allowed the new owner to step up the value of each station to $100 million--the price he paid--without paying capital gains tax on the additional $90 million per station. The advantage of the step-up is to give the new owner the right to depreciate the higher value over a period of years, providing an annual tax deduction; if he chose to sell the stations, the next buyer would reap similar benefits from the stepped-up values.
One restraining factor in such maneuvers has been that Internal Revenue Service rules require a purchaser who steps up asset values to pay a tax on the previous depreciation of his acquisition’s capital assets. This tax is known as a “recapture,” for it represents the repayment of tax deductions from earlier years.
As a result, the General Utilities tax break has been rarely used in the purchases of capital-intensive industrial companies, for the recapture of years of deductions on heavy equipment would nearly offset any tax advantage from a step-up of other assets.
“People have been focusing on the writeoffs and not mentioning that in most cases there’s a fairly substantial recapture from the prior owner’s depreciation,” said Leonard I. Green, partner in Gibbons, Green, van Amerongen, an investment firm specializing in leveraged buyouts. Green argued that the role of tax computations in merger bids has been given greater prominence in the public mind than they warrant.
“In our business, I like to think that most professionals look at businesses at their intrinsic value,” he said. “Tax benefits should be ancillary.”
Still, the General Utilities rule has been a significant factor in takeover bidding in industries with little fixed capital investment but sharp asset appreciation. These include timber companies, which experienced a wave of takeover speculation in recent years because the inherent value of their resources had far outstripped their stock prices.
Recoup Costs
Speculators could take over the companies at their stocks’ low prices, after which the General Utilities rule allowed them to recoup part of their costs by stepping up the book value of their assets and taking the resulting depreciation deduction. Because such companies had taken meager depreciation deductions in the past, the recapture tax was not a restraining factor.
George James, then executive vice president of San Francisco-based Crown Zellerbach, appealed before a congressional committee last year for a change in the rules. At the time Crown was engaged in an ultimately unsuccessful defense against takeover-minded Sir James Goldsmith, the Anglo-French financier. “We feel that the increase in the target’s assets should give rise to a taxable gain,” James said.
Similar situations existed at the time in the oil and gas industry and the broadcasting business, where the inherent value of assets exceeded stock prices. In both industries the acquisition fever of 1985 may have broken. Broadcast companies’ stock prices have experienced rapid run-ups, and the business’ revenue forecasts have turned pessimistic; the collapse in oil prices at the beginning of this year brought asset values and stock prices closer into line.
Treatment Candidates
But some tax experts say that repealing the General Utilities rule may put a crimp in such newer trends as Coca-Cola Co.’s acquisition of its independent bottling companies, on the reasoning that the bottlers’ territorial franchises and distribution systems are assets that will become taxable to a greater extent than their bottling equipment was deductible. Furthermore, companies with large holdings of real estate, including retailers, were frequently candidates for the jeopardized General Utilities treatment.
Accountants and lawyers familiar with the merger rules say the tax changes will certainly force acquirers to develop their post-acquisition strategies well in advance, for repeal of the General Utilities rule means that buying a company to run it will have sharply different tax consequences from buying it in order to sell it off piecemeal.
“Companies will have to do a lot more hard thinking about their plans for their acquired businesses,” said Thomas Ochsenschlager, tax partner at the auditing firm of Alexander Grant & Co.
Some professionals believe that the congressional package may inspire a flood of mergers and liquidations between now and the end of this year, as the bill provides a generous grace period before killing the General Utilities rule outright. Any such transaction completed by the end of this year will close under the rule, the bill says, as will any merger closed by the end of 1987 for which a liquidation plan was prepared by Aug. 1 of this year. Those standards are more liberal than the House Ways and Means Committee’s proposal of last year.
The new bill does treat some transactions more harshly than the House proposal. These are mergers involving closely held companies--those in which a handful of investors own most of the stock. The House bill would have exempted such deals from the repeal for several years, but the latest version restricts such relief only to closely held companies valued at less than $5 million.
“That’s a most important development,” said Ira Shapiro, tax partner-in-charge in the Washington office of the accounting firm of Coopers & Lybrand. “The exception would have been significant for a lot of entrepreneurial enterprises.”
