Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVIII. Topics in Corporate
Finance- Mergers and
Acquisitions
(^870) © The McGraw−Hill
Companies, 2002
TAXES AND ACQUISITIONS
If one firm buys another firm, the transaction may be taxable or tax-free. In a taxable ac-
quisition,the shareholders of the target firm are considered to have sold their shares, and
they will have capital gains or losses that will be taxed. In a tax-free acquisition,the ac-
quisition is considered an exchange instead of a sale, so no capital gain or loss occurs at
the time of the transaction.
Determinants of Tax Status
The general requirements for tax-free status are that the acquisition be for a business
purpose, and not to avoid taxes, and that there be a continuity of equity interest. In other
words, the stockholders in the target firm must retain an equity interest in the bidder.
The specific requirements for a tax-free acquisition depend on the legal form of the
acquisition, but, in general, if the buying firm offers the selling firm cash for its equity,
it will be a taxable acquisition. If shares of stock are offered, the transaction will gener-
ally be a tax-free acquisition.
In a tax-free acquisition, the selling shareholders are considered to have exchanged
their old shares for new ones of equal value, so that no capital gains or losses are
experienced.
Taxable versus Tax-Free Acquisitions
There are two factors to consider when comparing a tax-free acquisition and a taxable
acquisition: the capital gains effect and the write-up effect. The capital gains effect
refers to the fact that the target firm’s shareholders may have to pay capital gains taxes
in a taxable acquisition. They may demand a higher price as compensation, thereby in-
creasing the cost of the merger. This is a cost of a taxable acquisition.
The tax status of an acquisition also affects the appraised value of the assets of the sell-
ing firm. In a taxable acquisition, the assets of the selling firm are revalued or “written up”
from their historic book value to their estimated current market value. This is the write-up
effect,and it is important because it means that the depreciation expense on the acquired
firm’s assets can be increased in taxable acquisitions. Remember that an increase in de-
preciation is a noncash expense, but it has the desirable effect of reducing taxes.
The benefit from the write-up effect was sharply curtailed by the Tax Reform Act of
- The reason is that the increase in value from writing up the assets is now consid-
ered a taxable gain. Before this change, taxable mergers were much more attractive, be-
cause the write-up was not taxed.
ACCOUNTING FOR ACQUISITIONS
Prior to 2001, when one firm acquired another, the bidder had to decide whether the ac-
quisition would be treated as a purchaseor a pooling of interestsfor accounting purposes.CONCEPT QUESTIONS
25.2a What factors influence the choice between a taxable and a tax-free acquisition?
25.2bUnder current tax law, why are taxable acquisitions less attractive than they
once were?846 PART EIGHT Topics in Corporate Finance