Push-down accounting and alternatives: risks and opportunities in corporate consolidations.

• Author: Rosen, Arthur R.

As the pace of corporate consolidations -- mostly through mergers and acquisitions -- escalates throughout the United States and the balance of the world, numerous state and local tax concerns are be coming increasingly important. Because many of these concerns arise from issues that rarely have any federal tax effect, owing to the general use of consolidated federal returns, the issues often escape thorough examination and analysis prior to the execution of the business transactions; this can be a very costly mistake for taxpayers. The treatment of interest expense and certain balance sheet items are the most significant and accordingly are the focus of this article.

Deductibility of Interest Expense

Perhaps the most common area of controversy and a subject ripe for planning arises when one corporation ("Holding") incurs substantial debt to acquire stock of another corporation ("Target"). When Holding has substantial interest expense but little or no income and Target has substantial net operating income, taxpayers often seek to utilize the interest expense to offset Target's income.

1. Push-Down Accounting

   Push-down accounting is the practice of attributing a corporate parent's item of income or expense (or asset, liability, or basis) to a subsidiary of that parent. The item is generally attributable to or related to the subsidiary, but was originally, and still might be legally, the parent's. This concept is justified under Generally Accepted Accounting Principles (GAAP).

   The Securities and Exchange Commission (SEC) has issued a bulletin stating that debt should be pushed down if "(1) [Target] is to assume the debt of [Holding,] either presently or in a planned transaction in the future; (2) the proceeds of a debt or equity offering of [Target] will be used to retire all or a part of [Holding's] debt; or (3) [Target] guarantees or pledges its assets as collateral for [Holding's] debt." "Push Down" Basis of Accounting for Parent Company Debt Related to Subsidiary Acquisition, SEC Staff Accounting Bulletin No. 73 (Dec. 30, 1987). In situations where a corporation has incurred debt in connection with its acquisition of stock of another corporation and these criteria are not met or where the SEC rules are not applicable to the transaction, push down of debt, while not required, is still an acceptable accounting method.

   Some corporations have, as an accounting practice, simply placed Holding's interest expense on Target's books and records. The tax agency may argue that this type of bookkeeping self-help can have no tax effect. The taxpayer, however, should demonstrate that in economic reality -- which should be controlling -- Holding's lenders' perception (which is completely accurate) was, and is, that Target's assets and operations were, and are, the only sources available for servicing the debt. Thus, accurate accounting (including tax accounting) requires the matching of expenses with income directly related to them and, here, the direct relation is obvious: Target's assets and income are really paying the interest expenses (and the principal).

   The use of push-down accounting to push down the debt by changing book entries can also affect taxes based on capital stock. If the debt is placed on Target's books as an intercompany payable to Holding, the tax agency might argue that the debt is part of Target's capital base. For example, Alabama's statute provides that capital of a foreign corporation includes "[t]he amount of bonds, notes, debentures, or other evidences of indebtedness...payable at the time to...another corporation owning more than 50 percent of the outstanding capital stock of the taxpayer...unless the other corporation...is also required to pay a franchise tax to the State of Alabama." Ala. Code [sections] 40-14-41(b)(4). In interpreting the application of this provision, an Alabama Department of Revenue Administrative Law Judge determined that even though an intercompany payable "was included on the Taxpayer's financial statements as a result of `push-down' accounting...in substance, there was no underlying indebtedness owed by the Taxpayer to [Holding.]" The accounting-entry debt did not have to be included in the subsidiary's capital, since (1) the accounting entry was not evidenced by an instrument of indebtedness, (2) push-down accounting was not required by GAAP, and (3) the Department did not establish that the Target's capital would have increased, as a result of its acquisition, in the absence of push-down accounting. Speedring, Inc., Alabama Department of Revenue, Docket Nos. F. 95-237, F. 95-288, 1996 Ala. Tax LEX IS 65 (1996). See also Pechiney Corp. v. State of Alabama, Department of Revenue, Admin. L. Div., Docket No. F. 96-106 (Jan. 16, 1997) (in which an Administrative Law Judge used the same reasoning to determine that a parent corporation did not have to include in its capital base amounts that had been loaned to two subsidiaries so that they could repurchase their outstanding debt).

   In a Texas Comptroller's Decision, an Administrative Law Judge determined that a taxpayer could not reduce its surplus by the amount of pushed-down debt because GAAP did not require the taxpayer's parent corporation to push down the debt and the Texas statute appears to only permit reduction of a taxpayer's surplus by debt belonging to the taxpayer in question, not by debt that belongs to the parent corporation of the taxpayer. Comptroller's Decision No...