In the event of an acquisition, it is typical for acquired assets to be stepped-up to their fair market values.

The resultant increase in depreciation and amortization has the ‘potential’ to reduce taxes for the acquirer, depending on how the business combination has been structured.

Asset deal

The acquisition of individual assets and liabilities is commonly referred to as an ‘asset deal’. Under this arrangement, the purchase agreement must deal separately with each of the assets and liabilities subject to acquisition.

It is probably evident that the process of individual valuation and title transfer has the potential for being both extremely complex and expensive to execute. However, it may be necessary to structure the deal in this way where the target is a division rather than a subsidiary since in the case of a division the net assets are not held within a separate legal entity.

Of course, it is entirely possible that a division’s net assets could be allocated to a new corporate wrapper prior to the sale, thus structuring the sale as ‘stock deal’. However, this negates the major benefit of the ‘asset deal’ structure for the buyer.

Stepped up tax basis

Under an ‘asset deal’ disposal, the seller is required to transfer the title of its individual net assets at their fair market values, potentially suffering capital gains tax in the process. Consequently, the buyer accepts the assets onto its tax balance sheet also at their stepped-up values. This revised tax basis allows the buyer to benefit from enhanced tax depreciation and amortization going forward, enjoying a corresponding tax shield effect, which reduces tax payable in future periods.

Stock deal

In contrast, a ‘stock deal’ is a somewhat more comprehensive, ‘catch-all’ approach, whereby the buyer acquires the equity from the target company’s shareholders. There are some distinct advantages to this structure beyond its obvious simplicity. Notably, the transfer of long-term contracts with customers would require separate negotiation and is therefore often extremely challenging to realize within an ‘asset deal’ but is made relatively simple when embedded in a ‘stock deal’. However, buyer beware, a notable disadvantage of a stock deal is the danger of unwittingly acquiring liabilities which were not uncovered during due diligence.

Deferred tax

The principal disadvantage of a ‘stock deal’ for the acquirer is, however, the inability to revise the tax basis of the acquired net assets, instead of having to carry over the legacy tax basis from the seller. This is a consequence of the legal ownership of the acquired net assets remaining unchanged, continuing to be held within the legal wrapper of the acquired company.

Any step up failing to qualify for a revision of the tax basis will nevertheless still attract increased accounting depreciation, reducing the tax expense in the income statement. However, since this additional depreciation will be disregarded by the tax authorities the tax liability in the balance sheet will remain unchanged at a higher level.

Since this difference is temporary, the higher tax liability and subsequent cash outflow effectively operate like a prepayment, resulting in the creation of a deferred tax asset.

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