Taking aims at LBOs: the new tax act's corporate provisions; a tax adviser's checklist of the significant provisions of the Revenue Reconciliation Act.

TAKING AIM AT LBOs: THE NEW TAX ACT'S CORPORATE PROVISIONS

A tax adviser's checklist of the significant provisions of the Revenue Reconciliation Act.

New tax legislation has become as much of an autumn ritual as Thanksgiving. Although the Revenue Reconciliation Act of 1989 may be remembered better for what was dropped--capital gains--it nevertheless contains several significant provisions that will profoundly affect how leveraged buyouts (LBOs) are handled. That's because legislators took aim at a number of "abuses" perceived to exist in the mergers and acquisitions area. This article presents a checklist of the act's corporate provisions.

[check mark] MONETIZING NET OPERATING LOSSES 

A corporation often will attempt to extract value from a net operating loss carryforward by generating taxable income against which the NOL can be offset.

One popular technique borrowed from the savings and loan industry involved creating a special purpose subsidiary that issued preferred stock to the public. The sub would invest its funds in interest-bearing obligations (such as mortgages or mortgage-backed securities) and would enjoy a "spread" (versus its cost of funds) because

1. The preferred dividend rate was reset at 49-day intervals, thus tracking short-term money market rates.

2. The dividend rate reflected the fact that corporate investors would be entitled to a 70% dividends received deduction.

The success of this strategy depended on the sub's ability to join in its parent's consolidated return, so that the latter's NOLs could be used to offset the former's income. This goal, in turn, depended on the parent owning at least 80% of the total combined voting power of all classes of its sub's stock and 80% of the total value of that stock. Even though in most cases the preferred held by the outside investors represented more than 20% of the sub's equity value, consolidation was possible because preferred stock with attributes similar to the preferred issued by the typical NOL monetization subsidiary was excluded from the consolidation calculation.

Offset limited. After much debate, Congress interdicted this strategy via a relatively simple mechanism. For stock issued after November 17, 1989, a subsidiary member of a consolidated group won't be able to offset losses incurred by other group members against the portion of its separate taxable income used to pay dividends on stock held by nonmembers. Stock issued before November 18, 1989, is grandfathered; but this protection is lost if the sub ceases to be a member of its original group. This imposition of taxes on a sub's income diminishes the earnings spread and, effectively, renders the strategy uneconomical.

[check mark] ORIGINAL ISSUE DISCOUNT

Many LBOs feature extensive use of deferred interest securities. These instruments permit the issuer to offer a yield commensurate with its tenuous credit quality and to defer payments until the venture can generate the cash flow to service its debt. Such securities generally are issued at a discount to their redemption price at maturity. This is known as original issue discount (OID) and is "accreted" into income on a constant yield basis by the holder--with the issuer entitled to corresponding deductions. Thus, for LBOs, OID securities yielded tax deductions in advance of the cash payments to which the deductions were attributable.

A new instrument. To police this benefit, Congress curtailed OID cash flows for a new category of debt instrument--an applicable "high yield discount obligation" (HYDO). According to the act, an HYDO is a debt instrument that has

1. A term exceeding five years.

2. A yield to maturity exceeding the Treasury yield plus 500 basis points.

3. "Significant" OID--that is, more than one year's worth of interest deferral.

For HYDOs issued after July 10, 1989, the OID is divided into qualified and disqualified portions. The former is deductible only when actually paid in cash or property (other than stock or another debt instrument), and the latter is considered a non-deductible dividend. The disqualified portion of OID corresponds to the ratio of the instrument's "disqualified yield" to its total yield; the disqualified yield is the portion of total yield exceeding the relevant Treasury rate plus 600 basis points.

Observation. Interestingly, Congress eliminated the symmetry that has always existed in the OID area. Even though issuers will be subject to deduction deferral, holders will include OID on a current basis.

[check mark] NOL CARRYBACKS

Closely related to the OID provision is a rule that will restrict a highly leveraged corporation's ability to carry back NOLs--and thus obtain tax refunds--attributable to the interest expense generated by its borrowings. If a corporation experiences a "corporate equity reduction transaction" (CERT), it's prohibited for the year of the CERT and the two ensuing years (the loss-limitation years) from carrying back losses attributable to interest on debt allocable to the CERT.

A CERT is either a major stock acquisition or an excess distribution.

* A major stock acquisition involves the acquisition by one corporation, "pursuant to a plan," of a least 50% of the stock (by voting power or value) of another corporation. All acquisitions during a 24-month period are presumed "pursuant to a plan."

* An excess distribution occurs if a corporation's aggregate distributions (including stock buybacks) during a taxable year exceed the greater of 150% of the average annual distributions during the three preceding years, or 10% of the value of its stock at the beginning of the year.

In each case, the new tax law requires that distributions be reduced by the proceeds derived from stock issuances during the relevant period. And as indicated, the portion of any NOLs traceable to interest on CERT-related debt can't be carried back to offset income earned in prior years. However, this "tainted" NOL portion can't be greater than the amount by which the interest expense in a loss limitation year exceeds the entity's average interest for the three-year interval preceding the CERT.

[check mark] INSTALLMENT SALES

In 1988, a technique used by Campeau Corporation to break up Federated Department Stores gained popularity. The strategy involved selling a sub for installment notes. This form of consideration permitted deferral of the resulting gain until the note was retired or otherwise disposed of. In the interim, the seller could pledge the note as collateral for a loan and, without triggering the deferred tax liability, have the use of cash in an amount roughly equal to what it would have obtained if it sold the sub's stock for cash.

Congress quickly moved to close this loophole by imposing an interest charge for taxes deferred via an installment sale. And more important, it accelerated the recognition of deferred gains when installment paper is pledged as loan collateral.

It rapidly became clear, however, this new rule could be circumvented if the sale was structured as a section 351 incorporation. Thus, if the buyer and seller jointly created a new corporation--to which the seller would convey the sub's stock for preferred stock and debt securities, and the buyer would convey liquid assets for common stock--the debt securities (which were not installment obligations) could be pledged without triggering the gains inherent in the securities.

A variation of this technique--which basically took advantage of the narrow definition of installment obligations--involved a sale of the sub's stock preceded by a dividend from the sub in the form of a debt security. The dividend would reduce the parent's basis in the sub's stock and often create a negative basis (or excess loss account) to be triggered into income on the disposition of such stock. The consolidated return regulations permitted a seller to elect to apply the excess loss account to reduce the tax basis of any debt securities retained by the parent in the sub. Thus, the parent would hold the sub's securities at a low basis, but the gain was deferred until maturity and, because securities acquired as a result of a dividend aren't installment obligations, deferral would not be terminated if the securities were pledged as loan collateral.

Closing the Campeau loophole. These techniques were attacked in the new tax law. Section 351 was amended to provide that securities could no longer be received on a tax-free basis. This means securities obtained in an otherwise tax-free incorporation will be treated as "boot" and, hence, as installment obligations, subject to the interest charge and pledge restrictions devised to combat the original Campeau strategy. In the dividend area, Congress removed the ability to reallocate an excess loss account to reduce the basis of retained debt securities. Thus, in each case, Congress has terminated unceremoniously the tax deferral on which these techniques previously were based.

[check mark] ESOPs

Employee stock ownership plans flourished in 1989 because of their use as an antitakeover tool and their unique tax advantages. Most notably, if an ESOP borrows from a "qualified lender" to finance the purchase of sponsor stock, the lender can exclude from its income 50% of the interest earned. (A qualified lender is a bank, insurance company, mutual fund or corporation actively engaged in the business of lending money.) In addition, the sponsor can deduct the contributions it makes to the ESOP to service the debt and can deduct dividends distributed on the stock held by the ESOP to the extent they are dedicated to debt service on the ESOP loan. Finally, shareholders in privately held corporations can defer otherwise taxable gains on certain sales of stock to an ESOP, provided the sale proceeds are reinvested in qualified replacement property.

Reducing the tax benefits. The 1989 act made five major modifications to these benefits.

1. Henceforth, the interest exclusion for ESOP loans will be available only if the ESOP owns more than 50% of each class of sponsor stock or 50% of the total value of all outstanding stock immediately after the securities are acquired with the loan proceeds.

2. An eligible loan must mature within 15 years.

3. ESOP participants must have the right to direct how shares acquired with the loan and allocated to their accounts are voted.

4. If the ESOP owns convertible preferred stock, as is typical, that stock must be imbued with voting rights equivalent to those of the common stock into which it's convertible.

5. A 10% penalty is levied if the ESOP's stock is disposed of in less than three years after it's acquired.

These restrictions generally apply to loans extended after July 10, 1989. They won't apply to loans closed before November 18, 1989, with respect to ESOPs that satisfied the above requirements when substituting a 30% versus a more-than-50% ownership threshold.

The dividends paid deduction, surprisingly, survived essentially intact. A dividend used to defray an ESOP loan will be deductible to the extent the dividend is paid with respect to securities acquired with the loan proceeds. Such loan, however, need not be one that meets the new standards for an interest exclusion. Finally, for shareholders of private entities, the former more-than-one-year holding period was extended in the 1989 act to a three-year presale period of ownership.

[check mark] EARNINGS STRIPPING

One of the most controversial sections of the Revenue Reconciliation Act is the so-called earnings stripping rules. These rules are designed to ensure foreign bidders of U.S. targets aren't treated more favorably than U.S. bidders. The rules disallow a U.S. corporation's interest deductions to the extent such interest is classified as "disqualified" interest, which can't exceed the entity's "excess interest expense." Notwithstanding the presence of both disqualified and excess interest, however, tax deductions won't be denied for any year in which the corporation's debt/equity ratio is less than 1.5:1.

Disqualified interest is defined as interest paid to a related person (generally, a controlling shareholder) on which no U.S. tax is imposed. As a practical matter, a prohibited payee will be either a foreign shareholder or a shareholder, such as a pension fund, that's otherwise exempt from U.S. income tax.

The other condition for disallowance, the presence of excess interest expense, exists only if the payer's net interest expense exceeds the sum of 50% of its adjusted taxable income and its "excess limitation carryforward." Adjusted taxable income equals taxable income before deducting net interest expense, NOLs and noncash charges such as depreciation and amortization--in effect, it's akin to operating cash flow. According to the new law, a corporation has an excess limitation carryforward, which enjoys a three-year life if, for any year, 50% of its adjusted taxable income exceeds its net interest expense.

Observation. Multinational groups faced with potential interest disallowance might consider refinancing intercompany debt with third party debt that's buttressed by a parent guarantee. In cases where the guarantee is given "in the ordinary course," and the third party lender isn't relying on the guarantor's credit, this should be an effective strategy. Congress has specifically directed the Internal Revenue Service to publish regulations dealing with guarantee situations. And, these regulations may only be prospective if they adopt positions more stringent than those currently used by the IRS and the courts to recharacterize guaranteed debt as disguised equity.

The earnings stripping rule applies to interest paid or accrued in years beginning after July 10, 1989, except for interest with respect to debt with fixed terms issued before July 11, 1989.

[check mark] OTHER PROVISIONS

Franchise amortization. The tax law had been favorable to amortizing the purchase of franchises, trademarks and trade names. If such an asset was acquired in a transaction in which the seller retained a significant right or power (such as the ability to dictate quality control standards), the law permitted the buyer to

* Amortize fixed-sum payments over a period not exceeding 10 years.

* Deduct contingent payments currently.

The Revenue Reconciliation Act restricts these benefits to a significant event. For transactions in which the fixed-sum payments exceed $100,000, the 10-year amortization is eliminated. Further, contingent payments will only be deductible if they're part of a series of payments that are

* Payable at least annually throughout the term of the transfer agreement.

* Substantially equal in amount or payable according to a fixed formula.

The term of the transfer agreement is the entire period (including renewal options) over which the rights are transferred; a fixed formula is a formula based on a percentage of gross receipts that does not vary for any year in the transfer agreement. If payments that previously enjoyed favored status don't meet the new act's standards, they may be amortized over a 25-year period, commencing with the year in which the transfer takes place. Quite obviously, the after-tax cost of securing a franchise will increase dramatically as a result of the new law.

New IRS report. When at least 50% of a corporation's stock is acquired or it effects a recapitalization or other substantial change in capital structure, it must file a new report with the IRS. This report, due initially for transactions occurring after March 31, 1990, must detail the parties to the transaction and the fees and changes in capital structure.

Presumably, the report will assist the IRS in making sure expenses it regards as capital items aren't being deducted currently. Recently, the Tax Court in the National Starch & Chemical case upheld the IRS's assertion that fees (including the cost of a fairness opinion) incurred in a friendly acquisition must be capitalized. The IRS has extended this conclusion to fees associated with a hostile offer that's successfully resisted by locating a "white knight."

Built-in loss rules. If a corporation with NOLs experiences an "ownership change," the amount of income the NOLs can offset is limited annually to the loss corporation's equity value times the long-term tax-exempt bond rate. "Built-in losses" that are recognized within five years of the change date are treated as though they were NOLs and, thus, their deduction is limited.

Before the new law, however, a corporation was viewed as bereft of built-in losses if the aggregate amount of such items as of the change date did not exceed 25% of the value of the corporation's assets. The new act expands the built-in loss rules by lowering the threshold to the lesser of 15% of asset values or $10 million.

Mutual fund distributions. To avoid an excise tax, a mutual fund must distribute, by December 31 of each year, 97% of its ordinary net income earned during the prior calendar year and 98% of its net capital gains for the 12-month period ending on October 31 of that year. The Revenue Reconciliation Act increases to 98% the distribution percentage pertaining to ordinary income.

Dividend receipt. Mutual funds, like all other taxpayers, have included dividends in income on the date such dividends are received. For reasons not readily apparent, however, the new act alters this venerable rule so that, in general, mutual funds must report dividend income on the date the underlying stock becomes "ex" with respect to the dividend.

This rule will accelerate the mutual fund's income recognition; and because of the timely distribution rules, it will have a similar acceleration effect at the shareholder level.

M&A MADE TOUGHER

Although the Revenue Reconciliation Act did not change capital gain rates, selected transactions will be profoundly affected by its provisions--especially transactions in the mergers and acquisitions area. When added to the provisions of its recent predecessors, this new law dramatically alters the tax profile of an acquisition.

ROBERT WILLENS, CPA, is senior vice-president at Shearson Lehman Hutton. He is a member of the New York State Society of CPAs and the Wall Street Tax Association.