What s News in Tax Analysis That Matters from Washington National Tax

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1 What s News in Tax Analysis That Matters from Washington National Tax Consider the Consideration Companies across all industries are routinely involved in business acquisitions (both taxable and tax-free) in which all or a portion of the purchase price may be contingent upon one or more future events. As this article discusses, the tax treatment of contingent consideration may yield an often-overlooked opportunity for the buyer, in the form of a deduction for unstated interest. Monday, September 9, 2013 by Carol Conjura and Kathleen Milone, Washington National Tax Carol Conjura is a partner and Kathleen Milone is a manager in WNT s Income Tax and Accounting group. In many circumstances, a portion of the amount that is nominally considered part of the purchase price in the agreement, when and if paid to the seller, is required to be recharacterized by the buyer as interest expense under the imputed interest rules of section 483. The result to the buyer is typically favorable in that the resulting unstated interest expense may be currently deducted in the year paid rather than being capitalized as part of the purchase price of the assets of the business. The deferred payment rules of section 483 provide for this treatment even though the additional consideration, because it is contingent and subject to the terms of the sales contract, is not considered to be a loan or debt instrument issued by the buyer to the seller. Section 483 can be applied if identified at the time of the transaction, or it can instead be applied later in the process via a change in accounting method. What Is Contingent Consideration? Contingent consideration may constitute all or a portion of the purchase price and may be in the form of cash, stock or securities, or assumed liabilities. In some cases, the contingent consideration may be placed in an escrow account and then is either released to the seller, if and to the extent the contingency is resolved in the seller s favor, or returned to the buyer. Common examples of contingent consideration include purchase price adjustments based on future earnings performance of the target business, resolution of contingent liabilities pending on the acquisition date. KPMG and the KPMG logo are registered trademarks of KPMG International Cooperative, a Swiss entity.

2 Consider the Consideration page 2 As ownership does not transfer until the contingency is resolved, these terms allow for the treatment of these payments as deferred payments. Section 483 affords for interest to be imputed on such deferred payments. What Are the Requirements of Section 483? Section 483 may cause interest to be imputed on certain transactions involving a sale or exchange of property accompanied by a deferred payment right in the contract. 1 The deferred payment may be fixed or contingent, and it may or may not be indebtedness. 2 Section 483 applies to payments made under the contract, which may constitute all or part of the sales price, that are due more than 6 months after the date of the sale or exchange. Further technical requirements under section 483 are as follows: The contract for the sale or exchange of property [3] provides for one or more payments due more than 1 year after the date of the sale or exchange; The contract does not provide for adequate stated interest; [4] and The sales price (determined at the time of sale) is more than $3,000. Section 483 operates to ensure that a minimum amount of the deferred payments is treated as interest for tax purposes. For example, if a contract provides for stated interest that is not adequate stated interest, section 483 will cause additional interest to be imputed. Unless otherwise indicated, references to section or sections in this article are to the Internal Revenue Code of 1986 (the Code ), as most recently amended, or to the U.S. Department of the Treasury regulations (the regulations ), as most recently adopted or amended The contract may be expressed (written or oral) or implied. In addition to deferred sales contracts that are not indebtedness for tax purposes, section 483 can apply to debt instruments for which an issue price is determined under section 1273(b)(4). In many but not all instances in which a deferred sales contract is indebtedness for tax purposes, the issue price of the debt instrument will be determined under section Section 1274 provides rules that are similar to section 483 to ensure that a debt instrument to which it applies provides for a minimum amount of interest, including imputed interest, for tax purposes. Section 1274, unlike section 483, applies only to instruments that are debt for tax purposes. Defined as any transaction treated as a sale or exchange for tax purposes. This includes both taxable transactions and tax-free transactions. See, e.g., section (b)(2), Example (2); Rev. Rul , C.B If the contract provides for a single fixed rate of interest that is paid or compounded at least annually, and that rate is equal to or greater than the test rate (as defined in section and determined by reference to the applicable federal rate), the contract provides for adequate stated interest.

3 Consider the Consideration page 3 What Is the Treatment for Escrow Accounts? In some cases, contingent consideration may be placed in an escrow account pending resolution of the contingency. When an escrow account is used, it is necessary to determine whether the consideration placed in the escrow is considered to be currently owned by the buyer or to have been immediately transferred to the seller on the date of the sale. If the latter, then there is an immediate payment in the sale, and section 483 would not apply. If the former, then the section 483 opportunity would apply. Revenue Ruling addresses the distinction made by section 483 between escrowed property owned by the buyer and escrowed property owned by the seller. Specifically, that ruling considers whether section 483 interest should be imputed on acquiring stock issued pursuant to a section 368(a)(1)(A) reorganization that was placed into a contingent escrow. The ruling takes the view that, because the shares deposited in escrow were issued in the names of the former target shareholders who also were entitled to vote and receive all dividends paid on such stock, all of the shares placed in escrow were transferred to the stockholders as of the effective date of the reorganization. Accordingly, section 483 does not apply to the shares of stock placed in escrow (and to the subsequent releases of those shares), as there was no deferred payment sales contract. Therefore, if the parties would like for section 483 imputed interest to be applicable to the transaction, the buyers retention of legal ownership and beneficial rights (voting, dividend, and liquidation rights) to the stock should be considered. How Is Unstated Interest Imputed under Section 483? The amount of interest imputed under section 483 (unstated interest) is the amount by which the total of the deferred payments that are part of the sales price (and are due more than 6 months from the date of the sale) exceeds the sum of the present value of the deferred payments plus the present value of the stated interest payments under the contract. Interest under the contract is computed and accounted for under rules similar to those that would apply as if the contract were a debt instrument subject to section (or section (c) in the case of a contract with one or more contingent payments) i.e., as if the contract were a debt

4 Consider the Consideration page 4 instrument subject to original issue discount rules for contingent payment debt issued for nonpublicly traded property. Consequently, for a contract with contingent payments to qualify for section 483 treatment: All noncontingent payments must be treated as if they were made under a separate contract; Interest accruals on this separate contract must be computed under rules similar to those contained in section (c)(3); and Each contingent payment under the overall contract must be characterized as principal and interest under similar rules contained under section (c)(4). 5 In terms of the applicable interest rate that would be used in imputing interest, section states that the rate of interest would be the same as the test rate that would apply under section if the contract were a debt instrument. section (b) then states that the applicable Federal rate for a debt instrument is based on the term of the instrument (i.e. short-term, mid-term or long-term), as defined under section 1274(d). Accordingly, the interest rate would be the applicable Federal rate stated in the IRS s monthly Internal Revenue Bulletin for the applicable month using the specific category 6 (i.e. short-term, mid-term or long-term), as defined under section 1274(d). Example 1 (Basic Case) Company A acquired all of the outstanding stock of Company B from Company B s parent, Company C, for $5 million on December 31, 2012; under the terms of this acquisition, Company A must make a down payment of $2 million and a deferred fixed payment of the remaining $3 million. The fixed payment is due on December 31, In addition, the contract provides for contingent payments (referred to under the contract 5 6 The difference between sections (c) and is that under section 483, any interest or amount treated as interest is taken into account by a taxpayer under the taxpayer's regular method of accounting (e.g., an accrual method or the cash receipts and disbursements method). This methodology is consistent with the interest rate used in Example 1 of section (b).

5 Consider the Consideration page 5 as interest) to be made on December 31 of each year, equal to 1 percent of the gross income of Company B for the respective year. Assume that on December 31, 2013, $20,000 is received from Company A, equal to 1 percent of Company B s gross income. As this portion of the purchase price was contingent consideration, the $20,000 would be treated separately from the deferred fixed payment as a payment of principal of $19,231 (the present value, as of the date of sale of the $20,000 payment, calculated using the short-term applicable federal tax rate of 2 percent for purposes of this example) and an interest payment under section 483 of $392 for the remaining portion. Accordingly, the interest is includible in Company C s gross income and is deductible by Company A, under their respective accounting methods. All further contingent payments would be accounted for similarly. The $3 million fixed payment is accounted for separately under section 483. Although fixed in amount, it is nevertheless a deferred payment under the contract that does not bear stated interest and therefore is also subject to section 483. Interest would therefore be imputed (equal to the difference between the $3 million and the present value of the payment using the mid-term applicable federal rate in effect when the sale or exchange occurred). Example 2 (Escrowed Stock) Assume the same facts as Example 1, except that instead of the $3 million fixed deferred payment, there is an escrow account held by Company A containing 30,000 shares of Company A preferred stock, which will be released when the trading price of Company A s publicly traded stock exceeds $10 per share. On December 31, 2017, the stock price exceeds $10 per share and the escrow releases the shares to Company C, at which time the fair market value of the released shares is $3 million. Under this example, there would be a deferred payment if Company A (seller) retained ownership of the escrow account (and stock held in escrow) until the date when the threshold stock price was achieved and shares were released. In that case, the release of shares would be a deferred payment subject to section 483 and would require that a portion of the shares be treated as unstated interest. Note that section 1274 does

6 Consider the Consideration page 6 not apply to the right to receive shares of stock because the right is not a debt instrument for federal income tax purposes. The amount of interest allocable to the shares is equal to the excess of $3 million (the fair market value of the shares when released) over approximately $2.7 million (the present value of $3 million, determined by discounting the payment at the applicable federal tax rate of 4 percent for purposes of this example, compounded annually from December 31, 2012, to December 31, 2017). As a result, the amount of interest allocable to the payment of the shares is approximately $300,000 ($3 million less $2.7 million). Company A takes the interest deduction in the year ending December 31, 2017, when the contingency was resolved. Because section 483 applies equally to both sides of a transaction, Company C takes the same amount into income as interest income. The amount of interest allocable to the shares is equal to the excess of $3 million (the fair market value of the shares when released) over approximately $2.7 million (the present value of $3 million, determined by discounting the payment at the applicable federal tax rate of four percent for purposes of this example, compounded annually from December 31, 2012, to December 31, 2017). As a result, the amount of interest allocable to the payment of the shares is approximately $300,000 ($3 million less $2.7 million). Company A takes the interest deduction in the year ending December 31, 2017, when the contingency was resolved. Because section 483 applies equally to both sides of a transaction, Company C takes the same amount into income as interest income. Accounting Method Change Considerations If the applicability of section 483 is identified at the time of an acquisition, generally, it can be properly applied on a taxpayer s original tax returns. However, even if it is not identified for a number of years after the year of the acquisition, a benefit from this opportunity can be obtained via a change in accounting method (and assuming the taxpayer has adopted a method of accounting for contingent consideration which does not include interest imputation). In this case, the taxpayer would be able to currently deduct, under section 481(a), the difference between the amount of contingent consideration previously capitalized and amortized or otherwise recovered and the amount of interest expense that would have been deducted in the year the contingent consideration was paid had section 483 been applied on the original tax returns.

7 Consider the Consideration page 7 To determine whether a change in accounting method is necessary, a review should be performed to determine how the taxpayer is currently treating contingent consideration items and whether a method has been considered to have been adopted. As a general rule, if the taxpayer either has not applied section 483, or has applied it incorrectly to the contingent consideration in two or more consecutive tax returns, the taxpayer will be considered to have established a method of accounting and, therefore, would need to request consent under the non-automatic accounting method change procedures of Revenue Procedure A Form 3115, Application for Change in Accounting Method, requesting consent for a non-automatic accounting method change must be filed with the IRS National Office by the end of the year for which the change is being requested (i.e., December 31 for calendar-year companies). Special rules apply to taxpayers under IRS examination. Planning Considerations As a pre-transaction planning matter, section 483 is of interest to both buyers and sellers. Its application generally is favorable to buyers as it would permit them to deduct a portion of their purchase price. On the other hand, it may be detrimental to sellers with a preference for capital gains rather than ordinary income (e.g., corporations with capital losses or individuals), as it would increase their ordinary income and reduce their capital gain. Such sellers would have an interest in causing section 483 not to apply to the transaction or in making sure that the acquisition agreement otherwise takes this tax treatment into account (e.g., in pricing the deal). However, if the seller is indifferent to ordinary income versus capital gain, there may be more tax value in the overall transaction if the buyer is able to deduct a portion of its consideration without affecting the seller s tax position. Obtaining these benefits (or causing section 483 not to apply) would require the parties to tailor the terms of the deferred payments to satisfy (or not satisfy) the requirements of section 483, with a focus on the buyer s retention of ownership of the contingent consideration, the length of time between when payment is received and contract date, and other factors (stated above). Therefore, if a merger/acquisition potentially involving contingent consideration is being contemplated for the near future, it may be helpful to discuss the potential for deducting interest under section 483 before the parties finalize the merger/acquisition

8 Consider the Consideration page 8 agreement so that such requirements can be taken into account in drafting the agreement. Other Considerations Section 483 applies to tax-free as well as taxable stock or asset acquisitions, thereby resulting in a permanent difference. The assumption of liabilities by the buyer is considered a form of transaction consideration under section (a)(1), and section 483 could apply even if the agreement itself does not explicitly refer to contingent consideration. The benefit relates mainly to the buyer, as the seller would have to recognize interest income when the contingency has been resolved for amounts that might otherwise be characterized as capital gain. Note, however, that the application of section 483 is not optional. In the case of a corporate recipient, the interest withholding rules would not apply to imputed interest under section 483. There may be deferred compensation implications, to the extent a contract calls for earn-outs tied to future service by the individual employees or prior owners, and/or to the extent employees who had options or deferred compensation (mostly Restricted Stock UNIT plans), which are rolled into the escrow account. KPMG s What's News in Tax is a publication from Washington National Tax that contains thoughtful analysis of new developments and practical, relevant discussions of existing rules and recurring tax issues. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the author or authors only, and does not necessarily represent the views or professional advice of KPMG LLP.