Rationalizing the taxation of reorganizations and other corporate acquisitions.

It is difficult to argue that this provision has anything to do with sound tax policy; it was presumably enacted for the benefit of private equity firms and other such generally legislatively neglected folks. Nonetheless, its specific carrot--deferral of realized gain--is one that begs for justification, since its impact depends entirely on the existence and the magnitude of H's realized gain. If the underlying theory is neither illiquidity (H sold X for cash) nor the possible imprecision of the measurement of gain (H sold X for cash), what is it? The answer, which will make its appearance again, albeit in an arguably more principled way when I return to the corporate reorganization context, is that H should not be taxed on his gain with respect to X because such gain represents nothing more than "paper profits." That is, H may yet lose some or all of such gain if his subsequent investment performs sufficiently poorly! So phrased, this theory has no logical limit short of a conversion of the income tax into a consumption or cash-flow tax; that is, the theory applies equally well to any cash sale of any asset so long as the proceeds are reinvested in any alternative asset.

Finally, if H's asset X is indeed "qualified small business" stock, how are H's additional investment returns likely to differ as a result of selling such stock and reinvesting the proceeds in other qualified small business stock? The answer to that question lies above; the question is identical to that obtained in the like-kind exchange context. (34)

IV. A TALE OF TWO CORPORATE ACQUISITIONS (CONTINUED)

Before examining the question of whether there is anything special about corporate mergers and acquisitions that justifies treating them either more favorably or more harshly than other transactions that are (assuming the statutory prerequisites are met) granted nonrecognition treatment, it is worthwhile to examine how Acquisitions #1 and #2 compare, purely in terms of additional investment returns, with the transactions discussed immediately above.

A. Acquisition #1

I assume that but for the purchase of X stock by GE, X would have produced investment returns for H that are identical to those described for the like-named asset X in the prior part of this article. That is, H's X stock represents all of the equity of a corporation that has assets valued at $3 million and liabilities of $2 million. I assume that X's assets, over the relevant three-year time horizon, would have generated sufficient current cash flow to exactly provide both the lender and H with a 10% annual return, taking the assets' terminal cash flow into account. (35) At the end of three years, the assets would have generated a single terminal random cash flow that with equal probability would have been anywhere between $1 million and $5 million. Thus, 25% of the time, H's unrealized gain of $1 million would have evaporated (since the assets' terminal cash flow of less than or equal to $2 million would have been entirely dedicated to repaying liabilities). The remaining 75% of the time, H would have received an additional capital-gain-type return with respect to his X stock that, with equal probability, would have been anywhere between -100% and +200%. H's expected additional "capital gain" would have been +12.5%.

How shall I model the investment returns from owning GE's stock? Given both GE's size and the diversity of its businesses, it is unrealistic to even pretend that such returns will look anything like those of the asset Y in the prior part of this article. Thus, I assume that GE's $1 trillion worth of assets will produce a terminal gross return that, with equal probability, lies anywhere between $850 billion and $1.25 trillion. Thus, an initial investment of $1 million in GE stock may fall in value to $625,000, or rise in value to $1.625 million, or do anything in between. It follows that H receives an additional capital-gain-type return that, with equal probability, lies anywhere between -37.5% and +62.5%. H's expected additional "capital gain" is +12.5%.

Finally, for ease of mathematical exposition, I begin with the simplifying assumption that the terminal values of X and GE are uncorrelated. (Since X's assets are now a part of GE's overall asset base, this cannot literally be true. However, I can safely ignore the effects of X's assets on GE's returns as they will be clearly immaterial.) Under this admittedly extreme assumption, H's additional investment return after selling his X stock to GE will be within 10% of what such return would have been had he not made such sale only approximately 6% of the time.

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Of course, even though X's assets and GE's assets are very different, the returns from such assets are likely to be somewhat, albeit less than perfectly, correlated. Accordingly, and again for ease of mathematical exposition, I will make the opposite simplifying assumption, namely that the terminal values of X and GE are perfectly correlated. Under this also admittedly extreme (but polar opposite) assumption, H's additional investment return after selling his X stock to GE will be within 10% of what such return would have been had he not made such sale only approximately 6.7% of the time.

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Given a more realistic assumption of partial but not complete correlation, a result in between those presented above would be produced. Whatever such intermediate result, however, H's additional investment returns realized as a result of the sale of X to GE will differ materially from what such returns would have been had he not sold X to GE.

B. Acquisition #2

Whereas it would have been highly unrealistic to model GE's investment returns on those of asset Y in the prior part of this article, it is not at all unrealistic to model RUC's returns on the returns of such asset. After all, RUC is relatively small and highly undiversified. Thus, I assume that prior to its combination with X, RUC's assets were like asset Y. To wit, such assets had a fair value of $5 million and were acquired subject to liabilities in the amount of $4 million. Over the relevant three year time horizon, RUC's assets would have generated sufficient current cash flow to exactly provide both its lenders and its shareholders with a 10% annual return. At the end of three years, RUC's assets would have produced a single terminal random cash flow that, with equal probability, would have been anywhere between $0 and $8.33 million. Thus, 48% of the time, RUC's shareholders would have been wiped out (since the assets' terminal cash flow of less than or equal to $4 million would have been entirely dedicated to repaying RUC's lenders). The remaining 52% of the time, RUC's shareholders would have received a capital-gain-type return that, with equal probability, would have been anywhere between -100% and +333%. The expected "capital gain" would have been +12.5%.

How does X's combination with RUC affect H's investment performance? To measure the change, I must combine the gross returns from X's pre-combination assets and the gross returns from RUC's pre-combination assets. For ease of mathematical exposition, I will perform such combination under the simplifying assumption that the terminal values of X's assets and RUC's assets are uncorrelated. Under this admittedly extreme assumption, H's additional investment return after the combination of X and RUC will be within 10% of what such return would have been had the combination not been consummated only approximately 17.7% of the time (with nearly 80% of such overlap arising in situations where both X and RUC are worthless, since their liabilities exceed the fair value of their assets).

Of course, the returns from X's and RUC's assets are actually likely to be rather well correlated, given that the assets are of a very similar type. Accordingly, and again for ease of mathematical exposition, I now make the opposite simplifying assumption, namely that the terminal values of X's and RUC's assets are perfectly correlated. Under this also admittedly extreme (but polar opposite) assumption, H's additional investment return after the combination of X and RUC will be within 10% of what such return would have been had the combination not been consummated approximately 36.8% of the time (with nearly 75% of such overlap arising in situations where both X and RUC are worthless, since their liabilities exceed the fair value of their assets).

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Given a more realistic assumption of partial but not complete correlation, a result in between those presented above would be produced. Whatever such intermediate result, however, H's additional investment returns realized as a result of the combination of X and RUC will differ materially from what such returns would have been but for the combination.

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C. Summary

As can be seen from Table 3 below, Acquisitions #1 and #2 are not, in terms of their economic characteristics, beyond the pale of exchanges that routinely garner nonrecognition treatment. Indeed, under this criterion, Acquisition #1 is marginally more deserving of nonrecognition treatment than is an installment sale of the very same asset, and Acquisition #2 is marginally more deserving of nonrecognition treatment than would be a like-kind exchange or a qualified stock rollover of the very same asset (were such a transaction possible).