EFTA02676202.pdf

Understanding Tax Receivable Agreements Financial sponsors and other sellers are increasingly using tax receivable agreements to monetize tax attributes of corporations being brought to market in initial public offerings (IPOs). ndcr a tax receivable agreement (TRA), a newly the tax treatment of TRAs to the payor-corporations and the U public company pays the pre-IPO equity holders (the historic equity owners) for the value of the corporation's tax attributes as those tax attributes arc used payee-historic equity owners. TRAs AND IPO VALUATION after the IPO. This creates a market dynamic that permits In the 030 market,TRAs do not appear to impact the valuation value to be extracted from the corporation after the IPO, of a corporation in its IPO, despite shifting value from the apparently without decreasing the value of the corporation corporation to its historic equity owners.There arc several pos- in the offering. sible explanations for why the value is not adjusted downwards This article examines the structural context, principal terms by a corresponding amount (on a present value basis). a and operation of the most common types ofIRAs, as well as June 2011 I pranicallawsom 2013 Manson Acorns AA risks resenot EFTA_R1_01967198 EFTA02676202 AUTHORS Deborah L. Paul Michael Sabbah PARTNER ASSOCIATE WACHTELL, LIPTON, ROSEN & KATZ WACHTELL, LIPTON, ROSEN & KATZ Deborah is a partner in the ni'Cla Department, Michael W an associate ill the firm'. lax where she focuses on the tax aspects of domestic and Department. lie locuaw on the tax aspects cross-border osrporate transactions. including mergers ("domestic and ma-horsier mergers and and acquisitions, joint ventues, spin offs and financial acquisitions. spin. offs, leveraged buyouts, instruments. She has been the principal tax lawyer on jot ventures and financing transactions. numennis strategic acquisitions, private equity buyouts, spin-ofTs and other transactions. It has become conventional wisdom that public stockholders tend COMMON TYPES OF TRAs not to assign full value to the tax attributes of a corporation. Typically, a corporation enters into aTRA with the owners Similarly, public stockholders apparently do not discount the immediately prior to the IPO of the equity of the business value of a corporation to account fully for future payments to being sold. Investors who purchase stock in the offering do be made under a TRA. A possible explanation for this is that not enter into the TRA. the tax attributes, and especially the terms of TRAs, are not fully understood by public stockholders, even though these Under aTRA, the corporation agrees to make payments to the agreements are publicly disclosed. historic equity owners in an amount equal to a percentage of the benefit the corporation derives from certain specified tax In addition, public company valuations generally are based attributes, if, as and when realized.The specified tax attribute on EBITDA (earnings before interest, taxes, depredation is most often basis in the corporation's assets (a Basis TRA). and amortization) which disregards tax attributes because A corporation's basis in its assets generates amortization and EBITDA does not take account of taxes. Another reason may depredation deductions over time. In other deals, the specified be that tax attributes are difficult to value accurately, because tax attribute is a net operating loss (NOL) existing at the time any valuation would rely on income projections and other of the IPO (an NOL TRA). NOLs can be used over time to assumptions about the corporation's ability to use the tax reduce a corporation's taxable income. In at least one deal, attributes in the future. the specified tax attribute was a deduction arising from the InIRAs where the specified tax attribute is basis in the cor- exercise of compensatory stock options (a Stock OptionTRA). poration's assets, the payments are sometimes viewed as compensation to historic equity owners who incur an upfront BASIS TRAs tax on the sale of their equity in connection with the IPO and In a Basis TRA, the specified tax attribute results from a pre- who agree to structure the transaction so that it delivers an IPO restructuring specifically designed to deliver a fair market asset basis step-up for the corporation. Often, however, this value basis in the public company's assets.This type of IPO is tax would be incurred regardless of whether the transaction sometimes referred to as a `supercharged" IPO and generally resulted in a basis step-up to the corporation. takes one of two forms: ■ Internal Revenue Code (IRC) Section 338(h)( I 0) Therefore, it may be that TRAs relate simply to value. transaction. Through the TRA, the IPO corporation pays for a valuable tax attribute (for example, a basis step-up), just as a buyer of • Up-C structure. assets would normally pay more than a buyer of stock because In both the Section 338(h)( I 0) transaction and the Up-C of the basis step-up that a buyer obtains in an asset sale. In structure, the valuable tax attribute is an asset basis step-up a stock sale, the corporation's basis in its assets generally for the public company. The value of a basis step-up lies in the remains unchanged. resulting incremental increase in depreciation or amortization tax deductions. >> For more informal on on Ile tax treatment of Mock and asset sales. search Slock Archisil ore lax Overview and Asset Acquisitons Fax Basis attributable to goodwill and certain other intangibles is (Werner/ on our nrecarte. especially valuable, both because these assets can be amortized over 1 S years and because these assets tend to represent a 2013 Thomson Mum. .ill tighrs 'crawl Practical law 1be journal I Transactions & limoss I June 201 S 7 EFTA_R1_01967199 EFTA02676203  SPOT LIGHT ON In addition to providing a path to a step-up in asset basis, the Up-C structure also allows pre-IPO owners to preserve their retained ownership in the business through a pass-though entity for US federal income tax purposes, which generally avoids an entity level corporate tax. significant portion of the value of many businesses. In certain Economically, the operating partnership interests retained by cases, the amortization of intangibles can be subject to limita- the pre-IPO owners are recapitalized to create parity in value tions under so-called anti-churning rules in IRC Section 197, between the operating partnership interests and the public which should be carefully analyzed. Certain tangible assets company stock. Those operating partnership interests are (for example, real property (other than land, which is not also made exchangeable into the public company stock. This depreciable)) have depredation periods longer than I S years. gives the pre-IPO owners liquidity in their retained operating partnership interests. Section 338(h)( I 0) Transaction In an IRC Section 338(h)(10) transaction, the stock of the A critical element of an Up-C structure is an election by the historic operating corporation is contributed to a newly- operating partnership under IRC Section 754.This tax election formed corporation, which will serve as the public company. provides a purchaser of partnership interests with a fair market The contribution (together with the subsequent sale of stock value basis in the assets of the partnership to the extent of to public investors) intentionally fails IRC Section 351 and any the proportionate share of the purchased interest. As a result, other tax rules that would otherwise treat the contribution as when the pre-IPO owners sell operating partnership interests a tax-free transaction (often referred to as a busted Section to the public company in connection with the 11'O, or exchange 351 transaction). Instead, the contributors and the transferee operating partnership interests for public company stock in the make a joint election under Section 338(h)(10) to treat the future by exercising the exchange right, the public company (as contribution as a taxable deemed sale of assets for US federal purchaser) obtains a fair market value basis in a proportionate income tax purposes, and not as a sale of stock. share of the assets of the operating partnership. This structure results in a fair market value basis in the public The Up-C structure has been especially popular in connection company's assets.To bust the tax-free Section 351 transaction, with the ll'Os of asset management companies (for example, the historic equity owners often must sell a portion of their The Blackstone Group LP and Fortress Investment Group stock in the public company as part of the IPO. In addition, the LLC) because these types of businesses tend to be operated public company may also issue stock to the public in a primary as partnerships prior to an IPO. Other examples include the offering. An example of a BasisTRA using a Section 338(h)(10) lI'Os of Duff & Phelps Corporation and Graham Packaging transaction is the TRA entered into in connection with the IPO Company Inc. (which also entered into an NOL Tit A, as by Cooper Industries, Inc. of its subsidiary, Belden Inc. General mentioned below). Electric also used this structure in connection with the IPO of In addition to providing a path to a step-up in asset basis, the its Genworth subsidiary. Up-C structure also allows pre-IPO owners to preserve their retained ownership in the business through a pass-though entity Up-C Structure for US federal income tax purposes, which generally avoids an Recently, partnership or 'Up-C" structures have also achieved entity level corporate tax. a fair market value asset basis in connection with ll'Os of businesses historically operated as partnerships. Under this >> For more trammatmo on tne taxation of pass.ttinough entities. search structure, a newly-formed corporation is organized to serve Taxation of Pass-through Entities on our websile. as the public company.Thc public company uses cash it raises to buy interests in the partnership or limited liability company (LLC) (the operating partnership) from the pre-IPO owners NOL TRAs of the operating partnership. The pre-IPO owners generally Under an NOI.TRA, a corporation with significant NOLs retain operating partnership interests as well. agrees to make payments to the historic equity owners over 76 June 2015 I pntnicallan.com tC 2013 Thomson Mum.NI twigs tete:oat EFTA_R1_01967200 EFTA02676204  CORPORATE & SECURITIES time, generally equal to a portion of the tax benefit of NOLs as if the relevant tax benefit (amortization or depreciation as they are used by the corporation to offset taxable income. deductions in the case of a Basis TRA and NOL deductions in the case of an NOLTRA) did not exist. The excess of the While the IRC limits the use of NOLs following a "change of hypothetical tax liability over the actual tax liability for each control," including a change of control resulting from a primary tax year is the tax benefit on which the amount of the annual or secondary stock offering, a tax benefit often is still available payment is based. from NOLs following an IPO. First, the IPO might not result in a change of control that would trigger the IRC Section 382 For example, Corporation A, currently owned by Financial lass limitation rules. Second, the IRC Section 382 loss limita- Sponsor X, has 5500 of NOLs and is contemplating an IPO. tion rules impose an annual ceiling on the use of NOLs, rather In connection with the IPO, Corporation A enters into a TRA than a complete disallowance of those losses. with Financial Sponsor X relating to the 5500 of NOLs. Under IRC Section 382, Corporation A is limited to using only 550 >>Fox more infwmaton on N0Ls and M IRC Sector 382 loss limitation of NOLs each year after the IPO. In the first post-IPO tax rules, search Stock Acquisitions Tax Overnew and Tax Taps in an Acquisition eta inancay Distressed Target on our websrte year, Corporation A has 5100 of income (without regard to the NOL). Assuming a tax rate of40%, Corporation A's actual As discussed above, conventional wisdom is that the value of a tax liability is 520 (S 100 of income minus S50 of NOL deduc- corporation's NOLs is not fully reflected in the price assigned tions times a 40% tax rate). Corporation A's hypothetical tax by public investors to the corporation. As a result, entering liability without the benefit of the NOLs would he S40 (5100 into a TRA based on pre-IPO NOLs, despite being fully dis- of income times a 40% tax rate).Therefore, the tax benefit for closed in offering documents, is believed not to decrease the that year would be 520 ($40 minus 520). As further discussed valuation of the corporation in the IPO by an amount equal to below, 85% of tax benefits are typically paid under the TRA. the value of payments made under theTRA. Examples of IPOs Therefore, the payment under the TRA for that year would he that included NOL TRAs arc Spirit Airlines, Inc., Vanth, Inc., 512 (S20 times 85%). Graham Packaging Company Inc., and most recently, Berry One effect of the with and without" method is that all the Plastics Corporation. corporation's other items of deduction and credit are used first before taking into amount the specified tax attribute (which is STOCK OPTION TRAs taken into account last). For instance, in the example set forth In at least one publicly filed TRA, the specified tax attribute above, if Corporation A also had $75 of interest deductions, was a deduction arising from the exercise of compensatory its actual tax liability would be equal to 50 ($100 of income stock options. In connection with becoming a public company minus 575 of interest deductions minus $25 of NOL deduc- (achieved through a merger with a smaller, publicly traded tions times a 40% tax rate). Corporation A's hypothetical tax industry participant), Endo Pharmaceuticals I loldings Inc. liability without the benefit of the NOLs but with the interest enteredinto aTRA with an I.I.0 to which certain equity own- deduction would be equal to 510 (S 100 of income minus $75 ers contributed their shares of Endo stock. of interest deductions times a 40% tax rate).The tax benefit of Certain employee stock options were amended in connection the NOL is only 510. Therefore, the payment under the TRA with the transaction to provide that they would be exercisable for that year would be 5830 (510 times 85%). for the shares held by the I.I.0 (as distinguished from new If payments under aTRA arc treated for US federal income tax shares issued by Endo). Nonetheless, Endo would obtain a de- purposes as additional consideration for the sale of partnership duction upon the exercise of the stock options, because it was interests or assets (as may be the case in a Basis TRA), the the employer of the individuals exercising the stock options. calculation of the tax benefit can include an iterative element. The payments under the TRA were calculated by reference Because the consideration paid for the partnership interests to the deduction obtained by Endo upon the exercise of the or assets increases as a result of the TRA payment, the asset employee stock options. basis giving rise to the tax benefit increases by a corresponding amount (except with respect to any portion of the payment PRINCIPAL TERMS OF A TRA treated as imputed interest).This in turn increases the amount While TRAs may relate to different specified tax attributes, of the tax benefit and the payments under the TRA. A similar the agreements typically operate in similar vrays.The principal phenomenon occurs with respect to any imputed interest, terms arc explained below. because imputed interest gives rise to additional deductions and therefore additional TRA payments. COMPUTATION OF TAX BENEFIT TRAs typically calculate payments using a "with and without" AMOUNT OF PAYMENT approach. In other words, the actual tax liability of the cor- TRAs customarily provide for a payment of 85% of each poration is compared to a hypothetical tax liability computed year's tax benefit to the relevant historic equity owners. This 2013 Thar. Reuten..1linghrs num.!. Prankal law Tier Journal I Transainiort. & &mints, I June 2013 77 EFTA_R1_01967201 EFTA02676205  SPOTLIGHT ON percentage is itself arbitrary and certain agreements provide interest rate environment, any imputed interest payments for other percentages (for example, the Sprint Airlines TRA would generally be small. provided for 90%). Paying less than 100% of the tax benefit aligns the interests of TAX TREATMENT the payor-corporation and the payee-historic equity owners. The US federal income tax consequences of aTRA depend on Both the payer and the payees have an economic incentive to the type of TRA and the form of the transaction. maximize the value of the relevant tax attributes. For example, a corporation that is entitled to a portion of the economic TAX TREATMENT OF BASIS TRAs benefit of its NOLs is more likely to protect the availability Payments under a RasisTRA arc generally treated as additional of that NOL by monitoring any activity that could result in a consideration for: limitation on its use. ■ The sale or exchange of operating partnership interests (either at the time of the IPO or upon an exchange of TERMINATION AND CHANGE OF CONTROL operating partnership interests for public company stock) TRAs frequently accelerate payments in certain circumstances, in the case of an Up-C structure. including a mutual early termination of the agreement by the ■ The deemed sale of assets in a Section 338(h)(I 0) parties and certain material breaches of the agreement by the transaction. pavor-corporation. Some TRAs also accelerate payments upon a change of control of the payor-corporation. The recipient should he able to report the payments using the installment method of reporting (MC § 453). Because Alternatively, other TRAs provide that following a change of the amount of the payments is not determinable at the time control of the payor-corporation, payments, while not ac- of the transaction, the contingent payment installment sale celerated, are calculated by making certain assumptions (for rules apply to determine hmv much basis is allocated to each example, that the corporation will have sufficient income in payment. As discussed above, a portion of each payment would each subsequent year to fully utilize the relevant tax attribute generally be recharacterized as interest to account for the time in that year). value of money. If the payments under aTRA are accelerated, the termination If the installment method is inapplicable and the "closed" payment generally equals the present value (based on an agreed transaction method applies, the fair market value of the right discount rate) of the tax benefit payments that would otherwise to receive payments under the Basis TRA is generally treated be paid after the termination.The calculation of the tax benefit as consideration realized upfront (as of the date of the sale or payments is based on certain assumptions (for example, that exchange) and the sellers should recognize any resulting gain the corporation will have sufficient income in each year to at that time. Going forward, payments made under the TRA fully utilize the relevant tax attribute and that the applicable (other than any portion recharacterized as interest) give rise to tax rates will not change). additional income or gain at the time of receipt. to the extent those payments exceed the amount taken into income upfront. IMPUTED INTEREST Potentially, such excess payments would he characterized as Payments under a TRA that are treated for US federal income ordinary income or capital gain by reference to the sale or tax purposes as additional consideration for partnership interests exchange. I lowever, this tax treatment is uncertain because or assets may be subject to rules applicable to deferred sale or exchange treatment may be at odds with the closed payments (for example, IRC Sections 453 and 483). Whether transaction method. any resulting gain is recognized by the recipient upfront or over time as payments arc received depends on whether the install- The "open* transaction method may serve as an alternative ment method of reporting under IRC Section 453 applies (see way for a seller to report gain. The open transaction method below Tax Treatment). permits gain recognition only when payments are received or fixed (depending on the applicable method of accounting In addition, a portion of each deferred payment generally is and with basis being recovered first). I lowever, the open recharacterized as interest to account for the time value of transaction method can generally only be used in those rare and money. Any imputed interest payments would generally he extraordinary cases where the lair market value of the payment deductible to the payor-corporation and includible In income obligation cannot berea.sonabIs ascertained." to the payee-historic equity owners. Regardless of whether the installment method applies, the Basis TRAs generally provide that the deduction arising gain resulting from a Basis TRA (other than any imputed from any imputed interest is taken into account in the interest) should generally be characterized as capital gain rather calculation of the tax benefit and therefore gives rise to ad- than ordinary income (with certain exceptions, such as asset ditional payments under the agreement. In the current low TS June 201 I I pratticallaxsom C 20O Manson krauts All risks retard. EFTA_R1_01967202 EFTA02676206  CORPORATE & SECURITIES level gain relating to depreciation recapture or inventory). Another approach to distributing the NO!. TRA to historic The capital gain should qualify as long term capital gain if the equity owners may he to style the TRA as a class of stock of operating partnership interests or assets were held for more the corporation and distribute that stock to the historic equity than one year. owners. That is, the TRA would contain the same terms that it would other isv have hut it would be incorporated in the In addition, regardless of the method chosen by the seller for corporation's charter, rather than be in the form of a contract. reporting the transaction, the public company generally obtains additional basis in the underlying assets as payments under the In this case, IRC Section 305 may treat the stock distribution as Basis TRA are made. As discussed above, both the corpora- tax-free. If so, a historic equity owner's basis in its stock in the tion's incremental basis and its deduction of imputed interest corporation would be allocated between the historic stock and generally give rise to additional payments under the agreement. the new NOLTRA stock. Going forward, payments under the TRA may he viewed as distributions by the corporation to the TAX TREATMENT OF NOL TRAs historic equity owners in respect of the new NOLTRA stock, The tax treatment of an NOI. TRA is less clear. The act of which may be taxed in whole or in part as dividend income entering into the TRA may itself be viewed as a distribution (ordinary income to the recipient). from the corporation to the historic equity owners in respect of their stock. In this case, the fair market value of a historic TAX TREATMENT OF STOCK OPTION TRAs equity owner's rights under the TRA (which is based on a In the Endo TRA, the parties agreed to treat any payments discounted present value of future payments under theTRA) under the agreement as redemptions of stock under IRC would be taxed as follows: Section 302. This treatment provided the equity owners with • Dividend income up to the amount of the corporation's capital gain treatment (unless the distribution was found earnings and profits. to be essentially equivalent to a dividend). However, this tax treatment seems to be specific to the structure used in • Non-taxable recovery of basis to the extent of the historic that agreement as the shares against which the options were equity owner's basis in the stock. exercisable were those held by the payee under the TRA. • Any remaining amounts as capital gain. Going fonvard, payments made under the TRA that exceed TRAs IN PRIVATE TRANSACTIONS the amount already taken into account should apparently he Although TRAs have generally been entered into in connection treated as ordinary income, but the method for recovering with IPOs,TRAs or similar arrangements can also he used in basis in the contract right (for example, first, last or pro connection with other types of transactions, including private rata) is unclear. company sales. It is not uncommon for the seller of a business Alternatively, if the stock held by a historic equity holder is to seek an increase in purchase price in exchange for valuable recapitalized into a new class of stock to which the rights tax attributes of the sold business (for example, a basis step-up under theTRA attach, the transaction may qualify as a tax-free or NOL) or to compensate the seller for incremental tax reorganization under IRC Section 368. In this case, no gain is liability resulting from a transaction that delivers a basis step-up recognized by the equity holders at the time of the recapitaliza- in the business' assets to the buyer (for example, a stock sale tion. When payments arc made under theTRA, they should be with a Section 338(h)(10) election). treated as taxable distributions from the corporation. 11mi/ever, agreeing on the value of these tax attributes upfront To bolster this tax treatment, the TRA and the stock must gen- may be difficult because the value depends on assumptions erally be "stapled." This means that if a historic equity owner about the ability of the buyer to utilize the tax attributes in transfers the stock, the historic equity owner must also transfer the future. Instead, aTRA can provide for additional payments its rights under theTRA, and vice versa. However, upon a sale by the buyer to the seller if, as and when the relevant tax of the stock to the public, as a practical matter, the stock and 'butes yield a tax benefit for the buyer. the TRA must detach from one another. As the use of TRAs becomes more common in the II'O context, The treatment of the detachment for US federal income tax we can expect to see these arrangements used in an increasing purposes is not completely clear. One possibility is that the number of other types of transactions, as a means for sellers to historic equity owner is treated as receiving a distribution monetize the value of their business' tax attributes. in respect of its stock in the form of the right to receive the remaining payments under the TRA. Alternatively, the detachment of the stock and the TRA could he treated as a recapitalization with taxable boot to the historic equity owners consisting of theTRA. ▪ 2013 Thomson Recans.All !iglu% menvtl. Ilse If Plumed myhtun an! wind n tublea TO the roto. of Practical I aw Tlw journal I Transactions & I ju !1)1 Uw llmtp://totneciicallantron/2.383-090)and hliwy &hey amp. Ihnprarmalletcom/Z1•383•66921. EFTA_R1_01967203 EFTA02676207