Buying or selling a member of a consolidated group.

• Author: Salem, Irving
• Position: Part 2

A Catalogue of the Unique Consolidated Return Rules, the Related Contractual Protections/ and a Model of the Tax Provisions for the Acquisition Agreement

Introduction

Too often the tax adviser is given an unduly limited role in the drafting of the acquisition contract. For example, the corporate lawyer will begin with his or her standard agreement and with less than 24 hours before the signing of the contract, will rhetorically ask, "You don't have any problems with the tax reps, do you? I took it from the ABC deal and prestigious firms X and Y were involved."

Exacerbating the timing problem is that many corporations are sold through an auction process, whereby the seller drafts the contract and prospective buyers are told to fill in the purchase price blank and note any changes on the contract. Shortly before the bid contract is to be returned, the corporate lawyer is likely to ask: "You don't have any significant problems with the tax provisions, do you?" He or she may also add, "You realize that the fewer the changes, the better our shot at winning the bid."

Given the complexity of the Internal Revenue Code and the Treasury Regulations dealing with consolidated returns (the customary election of the selling group), and the rapid pace at which deals are closed, it behooves the tax adviser to be ready to react on a moment's notice. A prior article published in 1989 made an attempt to do just that.(1) Since then the consolidated return regulations have undergone a major overhaul with over a dozen newly minted Treasury Decisions, the latest being the significant changes in the SRLY and section 382 rules (effective June 25, 1999) and the treatment of overall foreign losses (effective August 11, 1999). Single or dual member LLCs can be found in many consolidated groups, adding further complexity. Finally, more sophisticated tax representations and warranties have developed, in part because of prior language failures. Hence, this sequel is obligatory.

I. The Economic Significance of Representations, Covenants, and Indemnities

To place the suggested contractual provisions in perspective, keep in mind that the basic purpose of the various provisions is to identify and possibly reduce the risks in the transaction, primarily from the buyer's standpoint. Broken down, the risk identification and reduction is achieved as follows:

1. Representations have three principal purposes:

   1. Discovery: By requiring disclosure of, for example, all material tax elections or tax attributes, representations smoke out the hidden problems.

   2. Right to Walk: If the representations are not materially true as of the time made or as of the closing date, the buyer has acquired the right to walk (and consequently the right to renegotiate the purchase price).

   3. Economic Protection: If the buyer is damaged by a misrepresentation discovered after the closing, the buyer may have a cause of action against the seller. That assumes the representations survive the closing, something surprisingly easy to obtain from the seller with respect to taxes.

2. Covenants: These are promises to do something positive (e.g., terminate all existing tax-sharing agreements) or refrain from taking certain actions. Again, the buyer can walk if the seller has not complied with any pre-closing covenant.

3. Indemnity: The payment of damages for breach of representations or covenants is required in the indemnity provisions. They spell out the obligations, the conditions, and the procedures for enforcing such indemnities.

   II. Introduction To Model Agreement

   We have attached a Model Agreement to demonstrate the tax-related representations, covenants, and indemnity provisions that might appear in a negotiated acquisition agreement. The suggested Model Agreement is designed to resolve the competing interests of the Selling and Acquiring Groups in a balanced and fair manner. In close cases, we have proposed alternative solutions in the footnotes. Of course, the agreement reached in each transaction will depend on all of the facts and circumstances, including, most importantly, the relative bargaining power of the Selling and Acquiring Groups.

   III. Introduction To The Catalogue

   The following Catalogue of consolidated return rules is essentially a primer designed to get the practitioner comfortable with the special consolidated return rules he or she will encounter in connection with an acquisition. Consider it a prelude to the Model Agreement.

   The consolidated return regulations are very complex and volumes can and have been written. We have attached Exhibit A as an addendum to the Catalogue; it describes issues that do not arise very often. To avoid undue complexity, such items are not covered in the Model Agreement or the Catalogue. However, such items are worth considering--especially for the consolidated return aficionados -- during the due diligence process.

   IV. Basic Facts Assumed

   For purposes of the accompanying Catalogue and Model Agreement, the following basic set of facts is assumed:

   Target company ("Target" or "Company") is a 100-percent owned subsidiary in a selling group ("Selling Group"). Target has a wholly owned subsidiary ("Subsidiary") that is deemed to be included within the term "Target," unless otherwise specified. Target is being acquired in a taxable purchase by a purchaser (the "Purchaser"), a member of an acquiring group ("Acquiring Group") and no section 338 election is being made. Both Selling Group and Acquiring Group file consolidated returns.

   It is also assumed that (i) Selling Group and Acquiring Group enter into an agreement for the purchase and sale of Target's stock (the "Acquisition Agreement"), and (ii) the closing of such purchase and sale (the "Closing") will occur on a subsequent date (the "Closing Date"). While this base-line case is being used to simplify the analysis, note that most of the consolidated return rules would apply if Target were the common parent of Selling Group, or if the acquisition were in the form of a tax-free reorganization, although the contractual protections may be different.

   The Catalogue Summary of Consolidated Summary of Protective Return Rules That May Provisions That May Be Affect the Acquisition Included in Acquisition Agreement I. Taxable Periods and Due Dates of Related Tax Returns A. General Rule: Premature A. Obtain representation Closing of Taxable Period. that all returns for Selling The taxable year of Target Group that include Target closes at the end of the that are due on or prior to day in which it ceases to the Closing Date have been be a member of Selling timely filed and all taxes Group (Treas. Reg. due for such periods have [sections] 1.1502-76(b)(1) been paid or provided for. (ii)(A)).(2) The resulting If the taxable year of short period (assuming that Target does not close on the disposition does not the Closing Date (e.g., for occur on the natural year state tax purposes), the ends of both the Selling Acquisition Agreement should and Acquiring Groups) prescribe rules on how to counts as a taxable year allocate the taxes due for for carryover and other the pre- and post-closing purposes ([sections]-76(b) partial periods. Establish (2)(i)).If Selling Group's responsibility for filing taxable year differs from returns (and paying tax) Acquiring Group's taxable for the period including the year, then Target must Closing Date. Include adopt Acquiring Group's provision for contesting taxable year ([sections] issues arising thereunder. -76(a)(1)). Acquiring Group in particular needs contractual B. Exception: Reverse protections. See Craigie Acquisition. In the case v. Commissioner, 84 T.C. 466 of a reverse acquisition (1985) (by operation of (i.e., shareholders of [sections]-77, common Target obtain more than parent of Selling Group 50 percent of the fair controls issues arising market value of the stock in pre-closing consolidated of the common parent of return years). Important Acquiring Group), Target's contest issues include: (a) taxable year will not who controls the contest close; Acquiring Group's with the IRS, particularly taxable year, however, if its resolution would will close ([sections] have a continuing effect; -75(d)(3)(v)). (b) who bears the costs; and (c) notice requirements. C. Due Dates of Related The parties should focus on Tax Returns. [sections] whether to require a payment -76(c) sets out rules with respect to tax benefits to determine when arising from an item giving Target's short period rise to an indemnity return must be filed.(3) payment, and the extent If the Acquiring Group's such item produces consolidated return must indemnifiable tax benefits. be filed before the due Also need provisions date (determined without dealing with access to regard to the acquisition books and records. and including extensions of time) for the Target's separate return, then the Target's short period return must be filed no later than the due date (including extensions of time) of the Acquiring Group's consolidated return ([sections]-76 (c)(1)). If the Acquiring Group's consolidated return is not due (including extensions of time) until after the due date of the Target's short period return (determined without regard to the acquisition and including extensions of time), then on the due date for the Target's short period return, the Target must file a separate return for its short period, or for its entire taxable year ([sections]-76(c)(2)). Appropriate amended returns must be filed if Target files what turns out to be an inappropriate return. For example, if the Target files a separate return for its entire taxable year and the Acquiring Group subsequently files a consolidated return, the Target must file an amended return for the portion of the Target's taxable year that is not included in the consolidated return. II. Taxable Income For Last Period Target Included in Selling Group A. Allocation of Income for A. Acquisition Agreement Short Period. Unless should reflect the...