Tax Strategy for Financial Restructuring ProcessReacting to increasing competition in global markets, in the early 1980s U.S. businesses began a process of restructuring. Restructuring now is ongoing for many firms throughout the world, particularly in the European Union. The main focus of these efforts is to increase the value of the firm. This post discusses how, once the firm has committed to restructuring, proper tax management can enhance valueadding.

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Financial Restructuring

Firms develop a capital structure policy as part of their corporatelevel strategy. As with business-level strategy, a firm’s financial structure must respond to the evolving needs of the firm and to the changing environment in which it operates. This part of the post focuses on firm recapitalizations and their related tax consequences.

 

Early Retirement of Bonds

When a firm redeems its bonds, under U.S. generally accepted accounting principles (GAAP) and tax-accounting rules, it recognizes a gain or loss. The amount or gain or loss is the difference between the price paid (the call) and the bonds’ principal amount. This amount is reduced by accrued interest, which is interest expense.

Firms usually call bonds if their interest rate is much higher than the market (and the transactions costs do not exceed any interest savings). Another reason for calling bonds is that often the difference generates a financial-accounting gain, because in virtually all cases, the call price of the bond is higher than its face value.

In the United States, even though there is a book gain, the firm can make the transaction tax free if it reissues bonds to the existing bondholders. This is called a type “E” tax-free reorganization, because the details that must be attended to in order to qualify for it are found in IRC Section 368(a)(1)(E). To qualify, the principal amount of the debt surrendered cannot be less than that of the debt received.

Case Example-1:

Assume this transaction:

Financial Restructuring Graph-1
This is a common transaction, where the firm takes advantage of decreased interest rates. Note that here the transaction is tax free to both the bondholders and the firm. What if the firm offers some bondholders either cash or stock? Then the entire transaction becomes taxable.

 

Converting Bonds

If bonds are converted into common shares, there is no gain or loss to either the corporation or the shareholder if:

  • the conversion is pro rata (or if the bonds are designed to be convertible pro rata); and
  • no boot is given in addition to the shares.

 

Boot is consideration, other than shares, given by the corporation to the bondholders. An example would be cash. It is called boot because it is added “to boot” in order to balance the value of major items being exchanged in a deal. The result does not change regardless of whether the firm calls the bonds or converts the bonds. Nor does it make any difference if it is the shareholders who decide on their own to convert.

Case Example-2:

Assume this transaction:

Financial Restructuring Process-3 

This is a tax-free transaction as long as each bond is tradable for the same amount of common stock and cannot be traded for preferred stock.

 

Stock Redemptions

If common stock is convertible into another type of common stock or into bonds, in the United States the conversion is tax free to both the corporation and the stockholder as long as the convertibility feature is proportional and no boot is given.

Case Example-3:

Either of the next transactions is tax free to both shareholders and the firm, if the distributions are pro rata and do not involve preferred stock:

Business Restructuring Process 

Sometimes the firm simply buys back some outstanding shares for cash. In 2008, for example, such buybacks amounted to $250 billion, up from nearly $100 billion in 2008. As noted previously, buybacks have no tax consequence to the firm and are taxed as capital gains to shareholders.

 

Tax Strategy for Financial Restructuring

Because interest on bonds is deductible and dividend payments are not—except for employee stock ownership plans (ESOPs)—the firm’s current and anticipated tax status affects its after-tax cost of capital. Assuming that pretax dividend payments are equal to interest payment on bonds, the firm’s tax status favors capital structure as shown in below figure:

Impact of Firms Tax Status on Optimal Capital Structure

 
A strategic advantage of convertibility is that if the firm transits in or out of a taxpaying status, it can adjust its capital structure accordingly. Of course, transaction costs should not outweigh the benefits of financial restructuring. Further, the firm should attempt to anticipate its tax status if it is to optimize its tax-minimizing strategy.

 

Value-Adding

In addition to the after-tax cost of capital consideration, tax management should consider the effects on the firm’s financial statements. For example:

  • Will a change to more debt result in costly debt covenant violations?
  • Because interest expense reduces financial earnings, would such a recapitalization reduce earnings per share (EPS) and have negative effects on market value or manager’s bonuses?

 

Case Example-4:

Suppose a firm has decided it wants to replace existing common stock with 8% bonds. The motivation for the decision was twofold: undervaluation of the firm’s common stock and transition from a period of net operating loss (NOL) carryforwards into a taxable status. The transaction would be:

Tax Strategy 

In the United States, interest expense usually is tax deductible but dividends are not (with rare exceptions, like certain dividends paid by ESOPs). At a 35% tax bracket, the switch to debt would save the firm 35% × 8% × $100 million = $2,800,000 per year in taxes. Assume also the firm was paying the equivalent of an 8% dividend each year. Assume these condensed financial statements before the transaction ($ millions):

Condensed Financial Statement

 

What nontax effect will the recapitalization have? Without considering management’s bonuses, the new financial statements would be:

Financial Statements 

Two negative effects occur:

  • First, management bonuses decline by about 10%($50,000,000 – $42,000,000) = $800,000, unless the firm somehow negotiates with management.
  • Second, the firm’s debtequity ratio goes from 0% to 50%. How this is perceived (in terms of riskiness) by debt and equity markets might not be too bad, if the ratio falls within industry standards.

 

Anticipation

Firms should engineer their debt-equity mix to maximize after-tax value-added. This is most important when tax rates, or a firm’s tax status, are likely to change. One way to obtain flexibility in the event of changing tax situations is to issue debt or equity securities that are convertible at the firm’s discretion. For example, if convertible stock is issued, it can be converted into bonds if the firm’s tax rate goes up. This would allow the firm to convert payments of nondeductible dividends paid on the stock into deductible interest paid on the bonds.

 

Business Process Restructuring

Starting in the 1990s, many firms targeted changes to their business processes as part of business-level strategy. This often is referred to as core process reengineering (CPR) or total quality management (TQM). The basic idea of process restructuring is to actively identify what products or services the firm is best suited to continue (or start) and to redesign the firm’s systems to deliver products or services better, cheaper, or faster than competitors.

The U.S. tax treatment of the costs involved depends on their nature. If the costs are related to improving the actual manufacturing process, then they are eligible for the 20% incremental research and development (R&D) tax credit. Capital expenditures related to process R&D are eligible for three-year tax write-offs, unless the equipment cannot be put to an alternative use, in which case it is expensed. Other costs are almost always expensed as incurred.

Case Example-5:

Suppose a company pays a consulting firm $500,000 for advice on reengineering its manufacturing process. As a result, $300,000 is spent on process R&D, $400,000 is spent on new equipment, and new personnel are added at a cost of $600,000/year in salary. The tax treatment is:

Management consulting fee –>  Deductible
Process R&D –> Tax credit at 20%
New equipment –> Depreciate under MACRS
New salaries –> Annual deduction

 

An old but well-written commentary on how to capture these expenses in a manner most easily accepted by IRS auditors can be found at www.irs.gov/pub/irsutl/cost_capturing_approaches_2004-05-24.pdf