Academic journal article Journal of Accountancy

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

Academic journal article Journal of Accountancy

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

Article excerpt

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. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.