Lower Taxes

Tax gains are a powerful incentive for some acquisitions. The possible tax gains from an acquisition include the following:

1. The use of tax losses

2. The use of unused debt capacity

3. The use of surplus funds

4. The ability to write up the value of depreciable assets

Net Operating Losses Firms that lose money on a pretax basis will not pay taxes. Such firms can end up with tax losses they cannot use. These tax losses are referred to as net operating losses (NOL).

A firm with net operating losses may be an attractive merger partner for a firm with significant tax liabilities. Absent any other effects, the combined firm will have a lower tax bill than the two firms considered separately. This is a good example of how a firm can be more valuable merged than standing alone. There are two qualifications to our NOL discussion:

1. Federal tax laws permit firms that experience periods of profit and loss to even things out through loss carry-back and carry-forward provisions. A firm that has been profitable in the past but has a loss in the current year can get refunds of income taxes paid in the past three years. After that, losses can be carried forward for up to 15 years. Thus, a merger to exploit unused tax shields must offer tax savings over and above what can be accomplished by firms via carry-overs.6

2. The IRS may disallow an acquisition if the principal purpose of the acquisition is to avoid federal tax by acquiring a deduction or credit that would not otherwise be available.

Unused Debt Capacity Some firms do not use as much debt as they are able. This makes them potential acquisition candidates. Adding debt can provide important tax savings, and many acquisitions are financed with debt. The acquiring company can deduct interest payments on the newly created debt and reduce taxes.

Surplus Funds Another quirk in the tax laws involves surplus funds. Consider a firm that has free cash flow—cash flow available after all taxes have been paid and after all positive net present value projects have been financed. In such a situation, aside from

6Under the 1986 Tax Reform Act, a corporation's ability to carry forward net operating losses (and other tax credits) is limited when more than 50 percent of the stock changes hands over a three-year period.

Ross et al.: Fundamentals VIII. Topics in Corporate 25. Mergers and of Corporate Finance, Sixth Finance Acquisitions

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purchasing fixed-income securities, the firm has several ways to spend the free cash flow, including:

1. Paying dividends

2. Buying back its own shares

3. Acquiring shares in another firm

We discussed the first two options in Chapter 18. We saw that an extra dividend will increase the income tax paid by some investors. A share repurchase will reduce the taxes paid by shareholders as compared to paying dividends, but this is not a legal option if the sole purpose is to avoid taxes that would have otherwise been paid by shareholders.

To avoid these problems, the firm can buy another firm. By doing this, the firm avoids the tax problem associated with paying a dividend. Also, the dividends received from the purchased firm are not taxed in a merger.

Asset Write-Ups We have previously observed that, in a taxable acquisition, the assets of the acquired firm can be revalued. If the value of the assets is increased, tax deductions for depreciation will be a benefit, but this benefit will usually be more than offset by taxes due on the write-up.

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