Push-down accounting and alternatives: risks and opportunities in corporate consolidations.

As the pace of corporate consolidations -- mostly through mergers and acquisitions -- escalates throughout the United States and the balance of the world, numerous state and local tax concerns are be coming increasingly important. Because many of these concerns arise from issues that rarely have any federal tax effect, owing to the general use of consolidated federal returns, the issues often escape thorough examination and analysis prior to the execution of the business transactions; this can be a very costly mistake for taxpayers. The treatment of interest expense and certain balance sheet items are the most significant and accordingly are the focus of this article.

Deductibility of Interest Expense

Perhaps the most common area of controversy and a subject ripe for planning arises when one corporation ("Holding") incurs substantial debt to acquire stock of another corporation ("Target"). When Holding has substantial interest expense but little or no income and Target has substantial net operating income, taxpayers often seek to utilize the interest expense to offset Target's income.

A. Push-Down Accounting

Push-down accounting is the practice of attributing a corporate parent's item of income or expense (or asset, liability, or basis) to a subsidiary of that parent. The item is generally attributable to or related to the subsidiary, but was originally, and still might be legally, the parent's. This concept is justified under Generally Accepted Accounting Principles (GAAP).

The Securities and Exchange Commission (SEC) has issued a bulletin stating that debt should be pushed down if "(1) [Target] is to assume the debt of [Holding,] either presently or in a planned transaction in the future; (2) the proceeds of a debt or equity offering of [Target] will be used to retire all or a part of [Holding's] debt; or (3) [Target] guarantees or pledges its assets as collateral for [Holding's] debt." "Push Down" Basis of Accounting for Parent Company Debt Related to Subsidiary Acquisition, SEC Staff Accounting Bulletin No. 73 (Dec. 30, 1987). In situations where a corporation has incurred debt in connection with its acquisition of stock of another corporation and these criteria are not met or where the SEC rules are not applicable to the transaction, push down of debt, while not required, is still an acceptable accounting method.

Some corporations have, as an accounting practice, simply placed Holding's interest expense on Target's books and records. The tax agency may argue that this type of bookkeeping self-help can have no tax effect. The taxpayer, however, should demonstrate that in economic reality -- which should be controlling -- Holding's lenders' perception (which is completely accurate) was, and is, that Target's assets and operations were, and are, the only sources available for servicing the debt. Thus, accurate accounting (including tax accounting) requires the matching of expenses with income directly related to them and, here, the direct relation is obvious: Target's assets and income are really paying the interest expenses (and the principal).

The use of push-down accounting to push down the debt by changing book entries can also affect taxes based on capital stock. If the debt is placed on Target's books as an intercompany payable to Holding, the tax agency might argue that the debt is part of Target's capital base. For example, Alabama's statute provides that capital of a foreign corporation includes "[t]he amount of bonds, notes, debentures, or other evidences of indebtedness...payable at the time to...another corporation owning more than 50 percent of the outstanding capital stock of the taxpayer...unless the other corporation...is also required to pay a franchise tax to the State of Alabama." Ala. Code [sections] 40-14-41(b)(4). In interpreting the application of this provision, an Alabama Department of Revenue Administrative Law Judge determined that even though an intercompany payable "was included on the Taxpayer's financial statements as a result of `push-down' accounting...in substance, there was no underlying indebtedness owed by the Taxpayer to [Holding.]" The accounting-entry debt did not have to be included in the subsidiary's capital, since (1) the accounting entry was not evidenced by an instrument of indebtedness, (2) push-down accounting was not required by GAAP, and (3) the Department did not establish that the Target's capital would have increased, as a result of its acquisition, in the absence of push-down accounting. Speedring, Inc., Alabama Department of Revenue, Docket Nos. F. 95-237, F. 95-288, 1996 Ala. Tax LEX IS 65 (1996). See also Pechiney Corp. v. State of Alabama, Department of Revenue, Admin. L. Div., Docket No. F. 96-106 (Jan. 16, 1997) (in which an Administrative Law Judge used the same reasoning to determine that a parent corporation did not have to include in its capital base amounts that had been loaned to two subsidiaries so that they could repurchase their outstanding debt).

In a Texas Comptroller's Decision, an Administrative Law Judge determined that a taxpayer could not reduce its surplus by the amount of pushed-down debt because GAAP did not require the taxpayer's parent corporation to push down the debt and the Texas statute appears to only permit reduction of a taxpayer's surplus by debt belonging to the taxpayer in question, not by debt that belongs to the parent corporation of the taxpayer. Comptroller's Decision No. 28,919, 1995 Tex. Tax LEXIS 261 (June 13, 1995). Furthermore, in another Comptroller's Decision, it was determined that a guarantee of the parent's acquisition debt would not be sufficient to cause the pushed-down debt to reduce the taxpayer's surplus. Comptroller's Decision No. 24,931, 1992 Tex. Tax LEXIS 74 (Apr. 3, 1992).

B. Alternative Scenarios

1. Mirror Debt. One "push-down' strategy that might be helpful would be to use "mirror" debt. The use of mirror debt will create an actual liability on the part of Target rather than merely be an accounting entry. Under this strategy, if Target pays interest expenses to Holding that matches or almost matches the interest expense paid by Holding to third parties, the operating income of Target should be effectively sheltered. The debt between Target and Holding will often be pursuant to a promissory note of Target that is given to Holding either in exchange for property or cash or, more commonly, as a distribution (dividend or otherwise).

For this strategy to work, the debt must be respected for tax purposes. To defeat the tax agency's argument that the structure is merely a tax gimmick without substance and that the debt owed by Target to Holding should be disregarded, Target and Holding must be able to demonstrate that the debt had the form of a debt instrument, that the parties intended that it be a debt instrument, and that economically the instrument was a debt.

To satisfy the first requirement, the instrument should be in writing, be designated as a debt instrument, have fixed payment dates, contain a promise to pay a sum certain at a fixed date in the future, provide for adequate, noncontingent interest, and be enforceable by the creditor. Furthermore, in determining whether the parties intend that the instrument evidence a debt that has legal and economic significance, the parties' subjective intent will be ascertained from objective factors, such as whether payments due under the instrument are in fact made and the parties' treatment of the instrument for legal and financial accounting purposes.

Finally, for the debt instrument to satisfy the principles of economic reality, the debt should be of the type that a third-party investor would have made under the same or similar terms. The principles of section 482 of the Internal Revenue Code should be relevant; if a debt instrument contains arm's-length terms, it should be deemed to be a debt under principles of economic reality. In a Texas Comptroller's Decision, an Administrative Law Judge determined that the taxpayer was not allowed to exclude pushed-down debt in calculating its surplus. The parent corporation pushed down debt associated with the taxpayer, prior to spinning-off the taxpayer, in exchange for the taxpayer's note. The ALJ determined that --

[A]lthough the note submitted by [the taxpayer]

appears on its face to be certain as to the amount

and time of payment, there is no evidence that the

obligation constituted a legally enforceable obligation

of [the taxpayer] for the report periods in

issue.

More specifically, the ALJ stated that the taxpayer had not offered any evidence of why the note was pushed down after being carried on the parent's book for four years, no payment had been made and no interest had been paid or accrued on the debt through the audit period, and no evidence had been adduced demonstrating what the taxpayer had received to trigger its issuance of the note. Comptroller's Decision No. 33,517, 1995 Tex. Tax LEXIS 468 (July 10, 1995). This decision seemingly flowed from the failure to prove the validity of the note and the underlying debt, thus leaving open the possibility that a valid debt instrument might be able to reduce Target's surplus for purposes of the Texas Franchise Tax.

The relevant taxing authority might contend that the interest expense on "mirror debt" is nonbusiness expense that cannot be used to offset Target's business income. To avoid this, the taxpayer should argue that the new debt of Target to Holding is merely a recapitalization of Target. For example, if when a corporation started doing business in a state it had a debt-equity ratio of 50 percent, and had always had such a ratio, the interest paid to service that debt would surely be considered a business expense. The result should be no different if a corporation changes its debt-equity ratio, for example, from 50 percent to 60 percent.

2. Combined Reporting. In jurisdictions where combined reporting of corporations entails applying a single combined apportionment formula to a single combined income figure (sometimes called state "consolidated" returns), the use of push-down accounting might not be necessary inasmuch as the problem that push-down accounting is intended to mitigate -- me offsetting of Target's income with Holding's interest expense -- can be addressed by the filing of a combined return; a taxpayer should not encounter any problems in using the interest payments to offset Target's income in those states that permit taxpayers, in either a de jure or a de facto manner, to elect combination. See Colorado (Colo. Rev. Stat. [sections] 39-22-305(1) (1996), but see Reg. [sections] 39-22-305.3); Arizona (Ariz. Rev. Stat. [sections] 43-947 (1996)).

In those states that allow combination only for those companies involved in the conduct of a unitary business, the answer is not so clear, especially if Holding is purely a holding company because whether a pure holding company can be engaged in a unitary business (i.e., whether it conducts any business at all) is not always clear. In The First National Bank of Manhattan v. Kansas, 779 P. 2d 457 (Kan. Ct. App. 1989), the Kansas Court of Appeals determined that a holding company formed for the purpose of holding the stock of a bank, which had no employees or officers and owned virtually no property, was not involved in a unitary business with its subsidiary bank. The facts in this case are particularly relevant since the holding company's only activity was the paying off of debt that it had incurred in acquiring the stock of its subsidiary bank; the holding company received the money with which to pay off its debt from dividends distributed by the bank.

After years of uncertainty in California, the State Board of Equalization issued a determination in which it held that a passive holding company could be engaged in a unitary business with its subsidiaries. Matter of PBS Building Systems, Inc., State Board of Equalization, Nos. 89A-1014 and 89Aa-1015, 1994 Cal. Tax LEXIS 434 (Nov. 17, 1994). The Board further concluded that such a determination is to be made by use of the standard method used to determine the presence of a unitary business. The Board specified that in a holding company situation, "[c]onsiderable unity of operation may exist, for example by virtue of intercompany financing, including loans, loan guarantees, debt refinancing and debt reduction, and by virtue of large tax loss carry-forwards owned by the holding company which are utilized by the operating subsidiary." See also Gam Rad West, Inc., State Board of Equalization, 1996 Cal. Tax LEXIS 257 (Sept. 11, 1996); Legal Ruling 95-7, 1995 Cal. FTB LEXIS 30 (Nov. 29, 1995); Legal Ruling 95-8, 1995 Cal. FTB LEXIS 31 (Nov. 29, 1995).

The New York State regulations provide, as an illustration of whether corporations are conducting a unitary business, an example where two corporations -- a holding company and its wholly owned subsidiary -- are not deemed to be conducting a unitary business when the holding company's only activity is receiving dividends from the subsidiary. In contrast, in Matter of Autotote Limited, TSB-D-90(4)C, 1990 N.Y. Tax LEXIS 144 (Apr. 12, 1990), the New York State Tax Appeals Tribunal determined that a corporation was involved in a unitary business with its parent, a holding company, when the parent corporation lent money to the subsidiary, was involved in obtaining outside financing for the subsidiary's business activities, had no employees of its own, and relied completely on the subsidiary's facilities and employees.

In those states allowing combined reporting only when the transactions and relationships between and among the putative group members are non-arm's length, taxpayers can instill non-arm's-length pricing, which may require some transactions to be implemented between the corporate entities. This should apply in all states where combination is permissible when necessary "properly to reflect income."(1) (The unitary issue should also be taken into consideration.)

Taxpayers could have a problem in using a parent's debt to offset a subsidiary's income in a state that does not allow combined reporting because taxpayers have not yet been successful in establishing a constitutional right to combined reporting; some statutory predicate has been needed. For example, the Arkansas Supreme Court determined that the Arkansas statute (which corresponds to UDITPA [sections] 18) grants the Commissioner the discretionary power to permit filing on a combined basis. Leathers v. Jacuzzi, Inc., 935 S.W. 2d 252 (Ark. 1996). Thus, in these states, resort to push-down accounting principles might be necessary.

Even in those states where Holding's and Target's tax liability can be determined on a combined basis, the relevant taxing authority might try to argue that Holding's debt is allocable nonbusiness income and thus that Holding's debt should not be used to offset Target's income. Even though there is not much authority on this issue, expenses and losses should probably be allocated and/or apportioned according to the same business/nonbusiness distinctions as are items of income. For example, MTC Regulation IV.1.(d) provides:

In most cases an allowable deduction of a taxpayer

will be applicable to only the business income

arising from a particular trade or business or to a

particular item of nonbusiness income. In some

cases, an allowable deduction may be applicable

to the business incomes of more than one trade or

business and/or to several items of nonbusiness

income. In such cases, the deduction shall be prorated

among those trades or businesses and those

items of nonbusiness income in a manner which

fairly distributes the deduction among the classes

of income to which it is applicable.

Thus, a tax agency may assert that Holding's interest expense is a nonbusiness expense of Holding (or of the group) and, consequently, nondeductible against Target's business income.

It will be important to determine whether the business/nonbusiness determination should be decided by looking at the activities of Holding by itself or at the combined activities of the entire Holding group. If the corporations are engaged in a unitary business, the interest expense is arguably a business expense from the unitary business. Thus, if Holding and Target are deemed to be involved in a unitary business, they could contend that the interest expense should be a business expense when looking at the unitary business as a whole.

If the corporations are not deemed to be involved in the conduct of a unitary business, the interest expense will more likely be considered a nonbusiness expense because only Holding's business will be used to make such a determination. The tax agency's argument might be that the actual day-to-day business operations of the group did not change after Holding acquired the debt and that, therefore, it would be inappropriate to allow the interest expense deduction. In one case, the Kansas Court of Appeals determined that a bank subsidiary could not deduct interest paid by its parent on indebtedness incurred on the purchase of the bank subsidiary's stock because the parent corporation had been formed for the benefit of the family that owned all of its shares (the holding company was formed for and utilized in the family's attempt to obtain all of the bank's shares). First National Bank v. Kansas Dep't of Revenue, 779 P. 2d 457 (Kan. Ct. App. 1989).

In response, the taxpayer's argument might be that the acquisition of the debt (1) did affect operations by requiring more attention to cash flow, margins, and efficiencies (the great amount of publicity regarding corporate restructurings and resizings following LBOs is an indication of this) and (2) every business must pay its capital investors (including debt capital) to maintain its business and the amount of debt capital naturally changes over time.

Under certain circumstances, Mississippi permits affiliated corporations to file consolidated or combined returns and authorizes the Commissioner to require such returns. Miss. Code Ann. [sections] 27-7-37(2)(a) (1996). See also Miss. Reg. 807. Furthermore, Mississippi's statute specifies that "[i]f a corporation...enters into any transaction that is for the benefit of its shareholders or for the benefit of an affiliated corporation without an equal mutual business benefit of the corporation, then, the transaction will be adjusted or eliminated to arrive at taxable income to this state." Miss. Code Ann. [sections] 27-7-9(j)(6). Mississippi's regulations continue to provide that "[i]nterest expense incurred for the purchase of its own stock...or for leveraged buyouts are not for the benefit of the corporation and may not be taken as an expense of the corporation." Miss. Reg. 808.

3. Target Incurring the Debt. If at all possible, to avoid these issues, planning would dictate that the debt -- either the initial acquisition debt itself or debt procured to replace such debt -- be incurred by Target, not Holding. For example, Target could borrow the money itself prior to the acquisition or after the acquisition Target could borrow money from a third party and either lend the money to Holding or dividend the money to Holding so that Holding could satisfy any debt that it may have incurred in the acquisition.

Balance Sheet Issues Raised by Push-Down Accounting

Another issue that arises concerning push-down accounting concerns a corporation's balance sheet. Consider the example of one corporation ("Holding") that acquires the stock of another corporation ("Target") for less than (or more than) the historic cost of Target's assets. By use of push-down accounting, the basis of Target's assets will be decreased (or increased) by the amount of the difference between the historic cost of the assets and the purchase price of the assets.

A. GAAP Principles

In 1983, the SEC issued a Staff Accounting Bulletin in which it determined that the push-down method of accounting should be used to redetermine the basis of assets held by a company which is acquired, as long as the acquired company becomes substantially wholly owned by the acquiring company. Application of "Push Down" Basis of Accounting in Financial Statements of Subsidiaries Acquired by Purchase, SEC Staff Accounting Bulletin No. 54 (Nov. 3, 1983).

Furthermore, although the SEC did not insist on the use of push-down accounting to redetermine the basis of the acquired company's assets when less than substantially all of the acquired company's assets were acquired or the acquired company had publicly held debt or preferred stock at the time that it was acquired, the SEC did specifically encourage the use of push-down accounting in such situations. In addition, in transactions in which the SEC rules are not applicable, the use of push-down accounting to adjust the basis of Target's assets, while permissible, is not required.

B. Competing Objectives

In those states in which a taxpayer is taxed on the value of its capital stock, the taxing agency will want to use the amount of any increase in the basis of Target's assets in computing the basis of the tax, while Target will want to exclude any such increase. If push-down accounting results in a decrease in the capital stock tax base, the taxpayer will want to use the altered figures to decrease its tax base, while the tax agency will want to use the historic cost of the assets.

This issue has been subject to much activity in Texas concerning the computation of taxable capital. From 1988 to 1993, Texas's rules required the use of push-down accounting. Then, in 1993, a Comptroller's decision was issued which determined that the rule providing for the mandatory use of push-down accounting was invalid. Comptroller's Decision No. 27,377. After the Comptroller issued various pronouncements concerning the Texas treatment of push-down accounting, the Texas legislature added section 171.109(m) to the Texas Code, which prohibits the use of push-down accounting in computing a corporation's surplus for franchise tax reports due on or after January 1, 1994. Additionally, there have been several cases in which the taxpayers have attempted to argue, to no avail, that their use of push-down accounting for periods prior to January 1, 1994 was incorrectly disallowed.

In Pennsylvania, the issue has arisen whether the corporation's share of the excess of the amount that was incurred to purchase the taxpayer's parent corporation over the historic cost of the parent corporation's assets should be included in computing the taxpayer's capital stock tax liability.

C. Issues Concerning Depreciation

One last issue that arises concerning the situation where the stock of a corporation has been purchased for more than the historic value of its assets is whether increasing the basis of those assets will increase the value of the assets for purposes of depreciation. Although no published state authority appears to exist on this issue, the Internal Revenue Service has issued regulations providing that a corporation cannot use the push-down method to determine the basis of an asset of an acquired foreign corporation, for purposes of depreciation. Prop. Reg. [sections] 1.964-1(c)(1)(iii)(D).

(1) In New York, "no combined report covering any corporation not a taxpayer shall be required unless the commissioner deems such a report necessary, because of inter-company transactions or some agreement, understanding, arrangement or transaction...in order properly to reflect the tax liability." N.Y. Tax Law [sections] 211.4. In Connecticut, no combined return shall be required with a corporation that is not a taxpayer, unless the commissioner "deems such a return necessary, because of intercompany transactions or some agreement, understanding, arrangement or transaction...in order properly to reflect the tax liability." Ct. G.S. [sections] 12-223a.(2). In Georgia, "[w]hen any method which distorts net income among and between affiliates is used, the Commissioner will require the consolidation of income of all such affiliates and then proceed to compute the entire net income." Ga. Reg. [sections] 560-7-8.07. In North Carolina, "[i]f the Secretary of Revenue shall find as a fact that a report by such corporation does not disclose the true earnings of such corporation on its business carried on in this state, the Secretary may require that such corporation file a consolidated return with its subsidiaries." N.C. Gen. Stat. [sections] 105-130.6. In Virginia, the Department may require the filing of a consolidated return showing the combined gross and net income of corporations in those situations in which it appears to the Department that "any arrangements exist in such a manner as improperly to reflect the business done or the Virginia taxable income earned from business done" in Virginia. Va. Code Ann. [sections] 58.1-446

ARTHUR R. ROSEN is a partner with McDermott, Will & Enery in New York City. Mr. Rosen was formerly the Deputy Counsel of the New York State Department of Taxation and Finance and has held executive management positions at Xerox and AT&T. He is a past chairman of the Committee on State and Local Taxes of the American Bar Association's Tax Section, a member of the Executive Committee of the New York State Bar Association, and chairman of the National Association of State Bar Tax Sections.

ALYSSE GROSSMAN is an associate with the firm. She received her law degree from Fordham University where she was a member of the law review. She has written numerous articles on state and local tax issues and is a member of the State and Local Tax Committee of the ABA's Section of Taxation.