Copyright (c) 1993 Tax Analysts

Tax Notes

JULY 26, 1993

LENGTH: 1853 words

DEPARTMENT: Current and Quotable (CQT)

CITE: 60 Tax Notes 531

HEADLINE: 60 Tax Notes 531 - EFFECTIVE TAX RATES ON HIGH-GOODWILL TAKEOVERS UNDER HOUSE AND SENATE BILLS.

AUTHOR: Johnson, Calvin H.

SUMMARY:

The following letter was sent on July 15, 1993, by Professor Calvin Johnson of the University of Texas School of Law to Sen. Daniel Patrick Moynihan, D-N.Y., chairman of the Senate Finance

TEXT: Dear Senator Moynihan:

The Conference on the Budget Reconciliation Bill of 1993 needs to resolve the differences between the House and Senate proposals for amortization of intangibles in favor of the Senate provision. The House bill allows intangibles to be amortized over 14 years; the Senate bill allows only 75 percent of the basis of intangibles to be amortized over the same period and denies amortization of the rest.

The House bill would dramatically increase the tax incentives for corporation takeovers by allowing now nondepreciable goodwill to be written off over 14 years. For some large takeovers for which data are publicly available, the 14-year amortization would reduce the effective tax rate on the investment from the 34-percent general tax rate to a real or effective tax rate of 16 percent. Debt-financed corporate acquisitions would bear a tax of negative 18 percent, meaning that the government would refund the acquirer's unrelated taxes at the rate of 18 cents for every dollar earned on the acquisitions.

Goodwill is not a depreciable asset under current law because the acquiring corporation's investment may fluctuate in value, but it does not waste away nor dissipate. The House proposal is scored as a revenue gain of $2.09 billion because it would lengthen the tax life of some intangibles, even while it allows amortization of goodwill for the first time. The revenue-gain projections, however, assume that nondepreciable goodwill now represents a very modest percentage of the value of the target business and the low percentage is wrong, often much too low, for takeovers in the most important, dynamic segments of the economy.

High-Goodwill Takeovers

A number of the recent, multibillion dollar takeovers have reported goodwill for nontax accounting purposes that is substantially all of the acquired company. For example, 90 percent of the $13 billion Philip Morris paid for Kraft was attributable to goodwill and 80 percent of the $14 billion Warner paid for Time Inc. was attributable to goodwill. /1/ Allowing 14-year amortization to acquisitions with high fractions of goodwill drops the real or effective tax rate on takeover investments to a small fraction of the general tax rate. The going-concern and goodwill values of Kraft and Time Magazine, for instance, have not depreciated since they were acquired, although values do fluctuate. The acquirers' investments have remained intact.

Allowing 14-year amortization of investments that remain intact yields a blended tax rate for the investment that is substantially below the general 34-percent corporate tax rate. Assume, for instance, that 85 percent of an acquisition is goodwill (half way between the Kraft and the Time Inc. figures) and that the rest of the investment is properly accounted for, so it bears a 34-percent tax. The blended tax rate for the acquisition as a whole would be 16.24 percent. /2/ That 16.24-percent tax rate is generally under half of the tax rate applicable to corporate investments. The rate reduction is substantial, and will cause corporations to eschew productive but more highly taxed investments in favor of corporate takeovers.

Negative Tax From Debt Financing

After the Tax Reform Act of 1986, moreover, debt financing of corporate acquisition is more advantageous than equity financing. For the corporate acquirer, debt financing means that the interest costs of the acquisition are deductible from 34-percent corporate income, whereas the investment returns from the acquisition are taxed, for instance, at only 16.24 percent. The tax law mismatches the interest and the return that it produces, unzipping revenue and cost, with cost-saving tax at 34 percent and related return being subject to 16- percent tax. The result of the mismatch is a negative tax at a 17.75- percent rate. The negative tax is not refundable, but it does avoid the tax the acquiring corporation would otherwise pay on unrelated business income. The negative tax is a subsidy better than no tax or tax exemption for the transaction. /3/

Goodwill in a Routine Business

Nondepreciable intangibles represent a large percentage of the acquisition cost not just in publicized megadeals, but also in more routine takeovers. Almost all businesses are worth substantially more as going concerns than the assets are worth if sold separately. An ongoing business is a living organism that recruits and replaces employees, suppliers, and customers. A business is often just a gossamer net of people who show up to work on time and who know how to pull resources from suppliers, add value to the resources, and market the product to customers. The business may have no assets, except for its going concern value. As we grow into the 21st century, more businesses will look like Kraft and Time Inc., that is, having no substantial assets except for goodwill. A few declining manufacturing businesses, with valuable assets but not much goodwill, may have a percentage of goodwill consistent with the projected revenue gain, but the revenue gain has no application to the thriving business of today or tomorrow. It is those, the most important businesses, for which the tax incentive for takeovers will be most intense.

Bias in the Data

The congressional staff's estimate that goodwill is a low percentage of acquisition value also is based on taxpayer claims that are very seriously biased toward understatement. Taxpayer claims seriously understate nondepreciable goodwill. Because goodwill is nondepreciable, acquiring corporations allocate their costs of corporate acquisitions away from goodwill and to depreciable, especially short-life assets. The game is called 'pigeonhole stuffing.' Costs are allocated to short-lived assets to a point just short of fraud, and when the pigeon hole is filled, another short- life intangible asset is invented. Experts are hired to validate the short-life claims and prevent fraud penalty. All serious students of the subject know that taxpayer claims are aggressively biased toward understatement of goodwill. No serious student can use taxpayer claims as the basis of economic valuation of goodwill.

This history of real estate shelters after the 1981 tax act provides some indication of the power of the tax subsidy. In 1981 Congress provided for a 15-year tax write-off period for commercial real estate. Commercial real estate ordinarily has an expected economic life of 70 years, so that the 15-year amortization period was like granting an effective tax rate of 16.5 percent, very close to the effective tax that the House bill would give to acquisitions like the Kraft and Time Inc. takeovers. Syndicators responded to the 1981 subsidy by packaging real estate tax shelters, which were just debt-financed investments in low-tax real estate. We built lots of 'see-through' buildings in cities across America that were not productive in real terms, but were built only because of the tax subsidy. The House bill would provide for a similar subsidy for corporate takeovers, and we can similarly expect corporate investment to shift from more productive investments and into takeovers.

The Senate bill, allowing amortization of only 75 percent of the cost of goodwill, is a better bill. Using the same discount rate (5 percent after tax) and other assumptions, the Senate provision would generate a blended tax rate of 21.66 percent for the takeovers where goodwill represents 85 percent of the value of the target. The rate is lower than the generally applicable corporate 34-percent tax rate, but it is not so intense a subsidy for takeovers as the House bill would provide.

Conclusion

The House version of section 197, allowing goodwill to be amortized over 14 years, would create an intense negative tax or subsidy that would favor corporate takeovers over alternative, more productive investments. Under reasonable assumptions true of well- publicized takeovers, the House bill would create a blended effective tax rate of 16.24 percent, which means a subsidy or negative tax of 17.76 percent for debt-financed corporate takeovers. Allowing amortization of the entire amount of the goodwill over 14 years misdescribes the investment and seriously undertaxes it. Combining the low tax with debt financing means there is a negative tax or subsidy better than no tax on the acquisitions. The subsidy will induce uneconomic acquisitions that would not have been undertaken in absence of tax. The conference committee should thus adopt the Senate provisions, which allow only 75 percent of the cost of the goodwill to be amortized.

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FOOTNOTES

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/1/ Davis, 'Goodwill Accounting: Time for an Overhaul,' 713 J. of Accountancy 75, 76 (1992) (citing S&P Computsat Services Inc.).

/2/ The 16.24-percent rate is a blend of a 34-percent rate on the investment attributable to assets other than goodwill and a 13.11-percent effective tax on what is now nondepreciable goodwill. The effective tax rate of 13.11 percent on nondepreciable goodwill is computed under the following logic: Effective tax rate tells how much tax reduces the annualized pretax return rate, 'i': Effective tax rate = (id)/i, where 'd' (for discount rate) is the posttax return rate. The discount rate 'd' is now 5 percent consistent with a long- term pretax rate i of 7.58 percent reduced by a 34-percent corporate tax. The relationship beween d and i for a tax-amortized perpetuity is found by the following logic: The return (e.g., $1) from a perpetual investment of 'P' will be Pi, so that P = 1/i. A buyer would willingly pay an investment amount P if the present value of the after-tax returns and tax benefits are worth P:

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P = 1(1 - t)/d + tP/n*[1-(1 + d) - n]/d,

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where 't' is the tax rate (34 percent here) and n is the number of years for tax amortization. The first term on the right side of the equation represents the present value of a $1-per-year perpetual return reduced by tax. The second term represents the present value of the amortization deduction over period n, which offsets the tax burden. Substituting 1/i for P and simplifying,

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i = [d - t/n[1 - (1 + d) - n]]/(1 - t).

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With d = 5 percent, t = 34 percent, n = 14 years, i becomes 5.8 percent, and (id)/i becomes 13.11 percent.

The formula yielding the 16.24-percent blended rate is

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Blended rate = %GW x 13.11% + (1 - %GW)*34%,

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where %GW is the percent that goodwill represents of the whole purchase price.

/3/ Corporate debt is held in part by taxable entities so that the Treasury will collect some tax on interest on debt issued to acquire another corporation. The market for takeover debt, however, is unified with the market for any other kind of debt. That means that creditors of takeover debt cannot raise their interest rates to capture any of the negative tax subsidies that the takeover issue gets. That means in turn that the tax the creditor pays will not affect the incentive aspects a negative tax has in encouraging takeovers over other investments.

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