Cox Communications spent $2.7 billion in cash in 1999 to acquire 522,000 cable subscribers from the Gannet Company - a record $5,100 per subscriber. But the acquisition also generated $350 million in tax benefits for Cox, because Cox took advantage of an Internal Revenue Tax Code (IRC) election that allows certain stock purchases of a subsidiary company to be treated as an asset acquisition.
This often-overlooked tax provision enabled Cox to step-up the tax basis of Gannet's cable television assets to the purchase price ($2.7 billion). "In the Cox-Gannett transaction, the amount of the step-up was in the neighborhood of $2 billion, which meant that extra depreciation and amortization deductions resulted in $350 million of tax savings, in present value terms, for Cox," says Merle Erickson, associate professor of accounting at the University of Chicago Graduate School of Business.
In recent research, "The Effect of Transaction Structure on Price: Evidence from Subsidiary Sales," Erickson analyzes the effects of the IRC §338(h)(10) election on the purchase price paid for 200 subsidiary stock sales from 1994 to 1998. Information on transaction tax structure was obtained from documents filed with the Securities and Exchange Commission (SEC) or from phone conversations with financial executives at acquiring firms. Information on acquisition price and form of consideration was obtained from Securities Data Company and SEC filings.
Together with co-author Shiing-wu Wang of the University of Southern California, the researchers find that purchase prices were higher in transactions where the election was made. As the Cox-Gannett acquisition shows, acquirers are willing to pay a premium acquisition price to obtain the tax benefits derived from the election.
Furthermore, when considering the acquisition of an entire freestanding corporation (e.g., Time Warner), the acquirer should consider the value of subsequent sales of target subsidiaries (e.g., Turner Broadcasting System, a subsidiary or Time Warner). Erickson's study shows that the price that a subsidiary will bring in is determined in part by whether or not the tax option will be made in the subsidiary sale.
"When acquiring an entire company, think about the value of any tax benefits associated with future sales of target subsidiaries," says Erickson. "These tax benefits could influence how much you will be willing to pay for the entire target corporation."
Reading Between the Lines
When a company buys the stock of a wholly owned subsidiary of another company, the transaction is taxed as a stock sale or an asset sale, depending on whether a §338(h)(10) election is made. And the impact of the election often can result in tax benefits of hundreds of millions of dollars for the acquirer.
All of the spoils of the election, however, do not belong solely to the buyer. The subsidiary being acquired has some leverage in the transaction. First, the only way to make a valid selection is if both parties agree. "Both Cox and Gannett must sign off," says Erickson. "So typically, Cox will pay Gannett to get them to cooperate in making the §338(h)(10) election. The amount of that payment will include a portion of the tax benefit, and it is not unusual for the premium paid for the seller's cooperation to exceed 10 percent of the deal's value."
Next, the divesting parent company may incur a tax liability. The extra premium paid by the acquiring company offsets that liability. Thus in the actual transaction, Cox paid Gannett an extra $150 million to $200 million, says Erickson, or roughly half of the $350 million tax credit.
Of course, there are cases where the election is economically detrimental to one or both parties. Such was the case in the Quaker Oats Co.'s $300 million sale of Snapple to Triarc Co. If an election had been made, Quaker Oats would have paid $35 million in taxes and received no tax refund. Both parties agreed not to make the election and Quaker Oats recognized a capital loss of $1.4 billion as a result, which it carried back to obtain a tax refund of approximately $250 million.
The key difference in how a subsidiary sale is taxed and the liability of the seller is dependent on the parent or divesting firm's stake in the stock and assets of the sold subsidiary. "The option becomes less favorable as the difference between the tax basis of the subsidiary's net assets and the subsidiary's stock increases," says Erickson.
Quaker Oats had a $1.7 billion tax basis in Snapple's stock and a $200 million tax basis in Snapple's assets. On the one hand, a transaction taxed as an asset sale would have resulted in a gain by Quaker Oats of $100 million, or the difference between the price of the acquisition ($300 million) and the parent company's stake or basis of the subsidiary's assets ($200 million).
On the other hand, a transaction taxed as a stock sale (without the tax election) resulted in a loss by Quaker Oats of $1.4 billion, or the difference between the purchase price ($300 million) and the divesting parent company's tax basis in the sold subsidiary's stock ($1.7 billion). The $1.7 billion is the amount Quaker Oats originally paid in 1994 when it purchased all of Snapple's stock.
As the Quaker Oats example illustrates, a company's stock and asset basis in a subsidiary company can differ. "Most people don't realize there are at least two different bases in a subsidiary," says Erickson. "In the Quaker Oats-Snapple example, the common assumption is that only the $1.7 billion stock basis exists."
According to Erickson, this difference originates in the way that Quaker acquired Snapple. In Quaker's acquisition of Snapple, Quaker paid $1.7 billion but did not step-up the tax basis of Snapple's assets. The reason is because Snapple was a freestanding corporation when acquired by Quaker. The tax structure used to acquire a freestanding corporation differs from the tax structure used to acquire a corporate subsidiary. That is, when acquiring a freestanding corporation, the tax basis of the target's assets is not stepped up because the tax cost of such action exceeds the tax benefits.
In Cox's acquisition of Gannet's cable television business, there was a step-up in the basis of Gannett's assets because the target corporation was a subsidiary of another corporation. U.S. tax rules are such that you almost never step-up the tax basis of the assets of a freestanding corporation in an acquisition, but often step-up the tax basis of the target's assets in the purchase of a subsidiary.
"If Cox had been acquiring a free-standing corporation, the election would not have been an option," says Erickson. "The §338(h)(10) election is not available when the target is a freestanding corporation, only when the target is a subsidiary."
Nevertheless, if a company had acquired Quaker Oats and planned to sell Snapple, then the tax structure of the subsequent Snapple sale should be considered. "An acquirer should anticipate that there would be a tax savings of $250 million associated with the sale of Snapple if the Snapple sale was structured properly," advises Erickson.
Simply stated, the tax structure of the subsidiary sale affects the purchase price. Further, in a subsidiary sale, the seller should often be able to extract a purchase price premium for the tax benefits associated with the deal and the buyer should be willing to pay such a premium.
Merle Erickson is associate professor of accounting at the University of Chicago Graduate School of Business. "The Effect of Transaction Structure on Price: Evidence from Subsidiary Sales" was published in the Journal of Accounting and Economics, Vol. 30, No. 1 (August 2000).