CAPITAL GAINS TAX REDUCTION WOULD ENCOURAGE LBOs, CRS SAYS.

                       CRS REPORT FOR CONGRESS

The causes, consequences, and possible solutions to the increase in leveraged buy outs (LBO's) have been the subject of considerable interest in recent months. This increase in LBO's, which has occurred over the past several years, has also been accompanied by an overall increase in the ratio of debt to assets in the corporate sector, fueling concerns about increases in bankruptcy risk. Among the issues surrounding this increase in LBO's is the degree to which taxes play a role in either affecting current activity or as a vehicle for restricting them. The tax advantage of debt relative to equity has been a particularly important issue.

LBO's are part of a general merger wave which has been taking place over the past few years. This merger wave has been accompanied by an increase in debt/asset ratios. Although these ratios are relatively high, they are not outside of historical experience; nor are they high by international standards. While the causes of the step up in these transactions are not clear, in general they have not been primarily attributed to tax advantages. Indeed, it is not even clear that there is a tax benefit to LBO's under current tax law; taxes may instead impose penalties.

Arguments have been made that LBO's are merely the efficient operation of the market; others criticize these transactions for harming existing creditors and increasing the risk of bankruptcy. If there is a desire to discourage LBO's, one barrier is the full taxation of capital gains. Reducing capital gains taxes would encourage these activities. Targeted restrictions on acquisition debt are an option, but they would complicate the tax law and restrict many other activities if written broadly enough to preclude a lot of avoidance. More general approaches to discouraging debt finance are integration of the corporate income tax or a restriction on the deductibility of interest accompanied by a partial dividend deduction.

CONTENTS

THE GROWTH IN LBO'S CAUSES AND CONSEQUENCES TAX CONSEQUENCES OF LBO'S TAX POLICY OPTIONS

TAX CONSEQUENCES OF LEVERAGED BUYOUTS

The causes, consequences, and possible solutions to the increase in leveraged buy outs (LBO's) have been the subject of considerable interest in recent months. This increase in LBO's, which has occurred over the past several years, has also been accompanied by an overall increase in the ratio of debt to assets in the corporate sector, fueling concerns about increases in bankruptcy risk. Among the issues surrounding this increase in LBO's is the degree to which taxes play a role in either affecting current activity or as a vehicle for influencing these activities. The tax advantage of debt relative to equity has been a particularly important issue.

This study considers the role that the tax system might play in encouraging LBO's as well as possible tax revisions which might be addressed. The first section of the study is an overview of the growth in LBO's and the debt/asset ratio. The next section discusses some of the causes and consequences of these transactions. The following section addresses the question of the role that taxes currently play in these transactions. The final section discusses a variety of legislative options.

THE GROWTH IN LBO'S

Leveraged buyouts can either involve a firm acquiring another firm, using borrowed funds to purchase the target firm, or a firm's managers borrowing funds to purchase existing shares. This latter operation may involve a desire by the firm's managers to acquire a controlling interest in the firm in order to alter the management policies of the firm by removing the accountability to other shareholders. In general, leveraged buyouts involve a subsequent reduction of leverage when the firm's managers sell off some part of the firm to reduce the level of debt.

These LBO's are only a part of a general merger wave which has been taking place since 1981. As shown in Table 1, they initially accounted for about five percent of the value of transactions, but in recent years up to 20 percent of the value of transactions. This merger wave is generally rated as one of the four largest merger waves in the modern U.S. economy (the others occurred during the period 1898-1901, 1926-1930, and 1965-1970). Measured as a percentage of GNP, the current merger wave is about the scale of that in the late sixties, but smaller than the earlier waves; transactions average about three times those in a normal period. ¹

   TABLE 1: LEVERAGED BUYOUTS, VALUE AND AS A PERCENTAGE OF MERGERS

The increase in mergers has also occurred simultaneously with a substantial increase in the ratio of debt to assets over the past several years, and this increase has been of some concern. As Table 2 indicates, however, while current aggregate levels of debt are high, they are not outside the range of historical experience. Indeed, the economy experienced a similar level of debt for the period 1966-1974. It is primarily by comparing the debt level to only the last few years that the impression of a rapid run up in the debt level appears.

                 TABLE 2: HISTORICAL DEBT/ASSET SHARES

CAUSES AND CONSEQUENCES

There is an extensive economics literature devoted to the causes and consequences of mergers and general restructuring of firms. A full review of this literature is beyond the scope of this study. The following is a summary of views expressed in a conference held by the Federal Reserve Bank of Boston ⁴ :

(1) The current merger boom has many potential causes, but among them is the pressure of competition (both international and due to deregulation of industries), financial innovations (including more sophisticated institutional investors more willing to invest in less secure investments and more skilled at valuing firms), more liberal anti-trust enforcement, and certain macroeconomic considerations (low interest rates and high stock market values) which are associated with these activities.

(2) The current boom is different from past merger waves in that much of the activity is "bust-up", that is selling off the components of large diversified firms. It is also unusual in the large size of target firms, in the use of debt finance, in the prevalence of hostile takeovers, and in management buyouts. Some views were expressed that the splitting up of diversified companies was a consequence of over diversification in the conglomerate merger wage of the late sixties.

(3) Shareholders of target companies tend to gain, although there was disagreement about whether these gains reflect real efficiency gains or unrealistic expectations on the part of acquiring firms or the managers in the case of a management buyout. Some saw this activity as exerting an important discipline on managers to operate efficiently and forcing the test of the marketplace (i.e. if a firm is being badly managed so that its price is depressed, it will become a takeover target); others felt there is little evidence that firms perform better in the aftermath of a takeover.

In general, in the course of the discussion there was no indication that these activities were motivated by tax avoidance. One reason for this position is that firms are capable of achieving tax reductions more efficiently through other avenues, as discussed below. Taxes may have played a part, however, in the timing of transactions which were otherwise contemplated (for example, in the spurt of transactions in 1986).

TAX CONSEQUENCES OF LBO'S

Whether tax motivations play an important role in LBO's is not clear. Certainly, the current tax system is probably as discouraging of these activities as it has ever been, owing in part to the full taxation of capital gains and certain restrictions on the ability of firms to engage in tax motivated reorganizations.

The LBO triggers a number of tax consequences. As noted above, the first is the triggering of capital gains taxes. There are two basic ways that a takeover can occur. First, the acquiring firm can directly purchase stock from the firm's shareholders. Secondly, the acquiring firm can directly purchase assets of the firm and the proceeds of the sale can be used by the target firm to redeem shares of the stockholders. Both types of acquisitions trigger a capital gains tax on the part of the firm's shareholders. The latter operation will also trigger gain at the firm level (from the sale of the assets themselves) and also increase the basis for and restart depreciation. That is, this latter transaction will involve two sales; the sale of assets by the firm to the acquiring party and the sale of stock by the shareholders to the target firm. The treatment of the sale of assets as such is an election the firm can make. (There may be circumstances where the acquiring firm wishes to acquire assets so as to not be encumbered with any liabilities of the firm, such as product liability suits, etc.). In general, it is not advantageous under current law to elect asset sale for tax purposes because the capital gains tax is larger than the present value of increased depreciation deductions. If, however, the firm has a lot of expiring net operating losses which can be used to shield the capital gains tax, then an asset sale may be advantageous and actually reduce taxes.

For purposes of calculations, the assumption is made that only one level of gain is involved, the gain to the stockholders. This gain will occur whether acquisition by another firm is involved or the firms' own managers are purchasing shares, as long as the firm is actually purchased (as opposed to being merged with another firm through, for example, a stock for stock exchange). As with any sale of assets, this transaction increases revenue for the government, with the revenue being the tax rate of the stockholders times the amount of stock purchased less the basis. Of course, if these assets would have been sold at any time in the future, the gain is the value of receiving the taxes today versus receiving them in the future.

The government loses revenue from the increase in leveraging. For debt, the only tax paid is at the personal level, whereas for equity there is a corporate level tax (which is generally higher than the personal tax) and a tax on dividends and capital gains. For a permanent change in leverage, there is a continual stream of tax loss which is the difference between the corporate level tax and the individual level tax. If this stream is discounted at the interest rate, the effect in present value terms is the equivalent of the difference between the tax on equity and the tax on debt. If the debt is subsequently reduced by selling some parts of the firm, the advantage of leveraging and the revenue loss is reduced.

Thus, the total revenue gain in present value terms is:

[equation omitted]

where r is the discount rate, T is the number of years the stock would have been held in the absence of the buyout, t is the individual tax rate, V is the original value of the purchase, B is the basis of the stock which is sold, u is the corporate tax rate, v is the personal level tax rate on equity (lower than t because of the deferral of the tax on capital gains) and S is the amount of the firm which is subsequently sold to reduce debt.

The expression in equation (1) is simplified in many respects. It does not take into account that shares may be purchased (indeed are necessarily purchased) at values above their current market price. This increase in value can reflect either expectations of increased profitability from more efficient management or because there is a shift in the distribution of asset values (i.e. stockholders gain while bondholders lose). To the extent that the take over produces a more efficient firm, income and thus tax revenues will be larger. It also assumes that the interest rate and the discount rate are identical. It does not take account of possible differences in holding periods between the seller and purchaser. Finally, it does not take account of the second round of tax consequences when assets are sold off to repay debt, i.e. the capital gains taxes which occur with this second transaction. (These taxes would be likely to be relatively small if debt is repaid quickly). The purpose of this analysis is, however, not so much to produce an estimate of the revenue consequences, but rather to show how variable the consequences are.

The value of expression (1) can be either positive or negative. It depends on the holding period for capital gains involved, which affects basis relative to value, the timing value of the capital gain tax, and the effective tax rate on corporate equity at the personal level (v). It also depends on the value of S, the amount of subsequent reduction of debt. Table 2 charts the revenue gain or loss in present value terms for combinations of the holding period assumed and the ratio of S to V. Note that the likelihood of a gain has been increased substantially due to the full taxation of capital gains enacted in 1986. (This change may also explain part of the surge of transactions in 1986 as individuals moved to recognize gains under the more generous tax rules.)

      TABLE 2: PRESENT VALUE OF REVENUE GAIN OR LOSS AS FRACTION

While there are a range of numbers in Table 3, there are reasons to believe that, on average, there is relatively little net gain or loss. Bailey ⁵ sets the holding period at 40 years. It is relatively long to take account of assets which are transferred at death without payment of capital gains taxes. Jensen, Kaplan and Stiglin ⁶ indicate that the reduction in debt should be about 40 percent, based on their study of LBO's from 1979-1985. In addition, about 14 percent of the capitalization is equity. These numbers would correspond roughly to the row for 40 years and the column for 50 percent, resulting in a slight revenue gain for the government. Again, these calculations do not take into account the tax on any real economic gain which occurs as a results of the transaction.

The analysis raises an additional issue. There are actually two phenomena going on. The first is the restructuring of the firm through merger (or takeover by current management through purchase of shares in their own rights) frequently followed by the sale of parts of the company. The second is an increase in leveraging. The two do not necessarily go hand in hand. Firms always have the option of increasing their leveraging ratio by borrowing to redeem stock, which would not necessarily involve a change in control. In addition, the restructuring could occur without any increase in leveraging. These events could be seen as two independent events and they have offsetting tax consequences. (Of course, if the change in management itself leads to the increased preference for debt, then the two activities are more closely related).

The sale of the firm results in a tax penalty which would be measured as the last column of table 3. Such a penalty is the consequence of a tax system which taxes capital gains on a realization basis rather than an accrual basis. Essentially, such a tax system would always impose a penalty on sale of assets.

The leveraging itself typically involves a tax saving for the firm as measured by the first column of table 3. This effect results from a system which has a separate corporate income tax; such a system necessarily favors debt over equity finance. The U.S. tax system goes a bit farther than necessary in this regard because interest payments are not indexed for inflation.

Note that the firm would not be advised, for purposes of tax minimization, to engage in a leveraged buyout followed by a subsequent reduction in debt, since that scheme results in realizing gain on the entire sale, but ultimately benefitting only partially from leveraging. Rather, the objective of tax minimization would be served simply by redeeming shares in the amount of the long run optimal amount of increase in debt. Thus, the LBO as a strategy for tax reduction is not optimal.

This above analysis is, of course, oversimplified in many respects. In the case of leveraging alone, the stockholders who are more willing to sell may be those with shorter holding periods so that the capital gains tax penalty is likely to be smaller. But it does illustrate the range of tax consequences which are possible in these types of transactions.

TAX POLICY OPTIONS

There are essentially two opposing views of LBO's. To some, they are a natural working out of efficient markets and therefore not to be discouraged and likely to run their course. If LBO's result in more efficiently managed firms, then the economy is more productive if they are allowed to continue. Indeed, the possibility that taxes act as a barrier to these transactions suggests that there should be more such transactions. If this view is taken, there is no need to take any corrective action. The LBO transactions have, however, highlighted a fundamental problem in the current tax system -- the favorable treatment of debt as compared to equity finance and further changes in the tax system to reduce or eliminate this distortion might be considered.

An alternative view is that LBO's involve dangerous speculation and high debt equity ratios which jeopardize the viability of the firm, reduce the value of existing creditors' claims and could lead to repercussions in the banking system (since banks provide a considerable amount of debt) were these firms to become bankrupt. Under this view, some action either through tax penalties or regulation, might be taken to discourage LBO's.

First, as noted above there is already a substantial tax penalty for purchase of a firm considered apart from the leveraging issue. This penalty has been strengthened by the full taxation of capital gains. There have been some arguments that capital gains should be given preferential treatment. However, if the objective is to discourage these types of activities, one of the most important policies which can be undertaken is to maintain the full taxation of capital gains. Another policy would be to extend the carryback or carryforward periods for net operating losses, which can occasionally produce a tax advantage to a sale.

There are essentially two types of approaches to the leveraging issue. One is a targeted restriction of the deductibility of interest aimed at takeover debt. There is a provision in the tax law currently (Section 279) which limits deductions for debt obligations which are substantially subordinated, carry an equity participation, and involve a very high debt/equity ratio. This section has not been very effective in restricting leveraged buyouts, as it is relatively easy to avoid the characteristics which trigger the restriction.

A more far reaching proposal was contained in the House version of the Revenue Act of 1987, but was dropped. Some have argued that consideration of this provision contributed to the drop in the stock market in late 1987, although such effects are highly speculative. At any rate, the provision was not enacted. This provision would have denied a deduction for interest in excess of $5 million per year incurred by a corporation for debt supporting the acquisition of 50 percent or more of another corporation or the redemption by a corporation of 50 percent of more of its own stock. All acquisitions occurring over a three year period would have been aggregated for purposes of determining the 50 percent limits. The interest limitation would have applied to both interest incurred directly for making the acquisition and to interest indirectly allocable. Interest indirectly allocable would be total interest (excluding directly allocable interest expense) multiplied by the ratio of the basis of the stock acquired to the basis of the corporation's total assets, and would cover the five year period following the acquisition. The bill would also have disallowed the deduction of interest for hostile acquisitions involving purchase of twenty percent or more of the stock.

Targeted restrictions should raise tax revenues and discourage LBO's. The disadvantage of targeted restrictions is that they add complexity to the tax code. They also encourage firms to find ways to avoid them, and to prevent such avoidance must be broadly applicable to many types of transactions including those which are not the objective of the restriction.

A broader approach would be to narrow the differentials between debt and equity finance in the corporate sector. One approach would be full integration of the corporate and individual income taxes (through taxing corporate source income on a partnership basis). Practically, one could use the corporation as a withholding device and then give shareholders credits against their tax for dividends received. Such a major revision would involve both budget and practical problems. Such full integration would be quite costly. It would also eliminate much of the penalty for sale of a firm since such an approach would do away with much of the capital gains tax on corporate stock. (Under a system with partnership taxation, the basis of assets would be increased by the amount of retained earnings, so that capital gains taxes would apply to a smaller fraction of the sales price.) Thus, it is not clear that this approach would discourage LBO's in cases where debt would have been reduced relatively quickly. (If the concern about LBO's is the leveraging per se, however, such an effect may be desirable).

An alternative would be to index interest payments for inflation, that is, allow only the part of the interest that reflects real interest rates to be deducted. (A similar adjustment excluding a portion of interest payments would need to be made on the creditors' side). A revenue neutral change could be provided by using the revenues raised to allow a portion of dividends to be deducted. Indeed, such proposals were part of the original Treasury tax reform package in 1984. A change of this type should discourage LBO's since it would reduce the tax benefits of additional debt finance, without reducing the capital gains tax which acts as a hurdle to these transactions. One difficulty with this proposal, however, is that it would provide windfall benefits to firms with low leverage and high dividends, while resulting in a lump sum tax on firms with high leverage and low dividends. These effects could be mitigated by phasing in the changes; however, phase-ins tend to distort decisions during the phase in periods (e.g. encourage firms to delay dividends until the tax treatment becomes more generous).

Both of the above proposals should result in a more neutral tax system in general, however, and might be considered on their own merits, apart from the LBO issue.

² The Taxation of Income from Capital: A Comparative Study of the United States, the United Kingdom, Sweden, and West Germany. Ed. by Mervyn A. King and Don Fullerton. National Bureau of Economic Research, Chicago: University of Chicago Press, 1984.

³ Ando, Albert and Alan J. Auerbach, The Cost of Capital in the U.S. and Japan: A Comparison, National Bureau of Economic Research, Working Paper No. 2286, June 1987. Their numbers are based the ratio of financial liabilities to the sum of those liabilities plus the market value of equity. The numbers in Table 2 use the replacement cost of tangible assets plus financial assets in the denominator. Their historical patterns differ, therefore, and in particular tend to find debt falling in recent years as the stock market rises.

⁴ Lynn E. Browne and Eric S. Rosengren, The Merger Boom: An Overview, in The Merger Boom, ed. Lynn E. Browne and Eric S. Rosengren, Federal Reserve Bank of Boston, October, 1987.

⁵ Martin J. Bailey, "Capital Gains and Income Taxation," In the Taxation of Income from Capital, edited by Arnold C. Harberger and Martin J. Bailey. Washington, D.C. The Brookings Institution, 1969.

⁶ Michael C. Jensen, Steven Kaplan, and Laura Stiflin. "Effects of LBOs on Tax Revenues of the U.S. Treasury." Tax Notes. February 6, 1989.