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 increasing 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 selling 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 depreciation 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 1986. The reason is that the increase in value from writing up the assets is now considered a taxable gain. Before this change, taxable mergers were much more attractive, because the write-up was not taxed.

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