05 August 2011

The Tax Code's Merger Ratchet Drives Harmful Economic Decisions

Corporate tax law students, but very few other people, spend vast amounts of their time learning how to understand the Internal Revenue Code's corporate reorganization provisions. Being tax law, this task leaves you knee deep in detail and you can lose the forest for the trees. But, in the big picture, the corporate reorganization provisions of the tax code may do more to encourage our economy's tendency to create systemically risky too big to fail businesses that interfere with consumer friendly competition than our antitrust laws do to discourage them.

Simply put, there are lots of relatively easy, safe harbor ways under the tax code to merge a business with predictable, favorable tax consequences. There are "A" reorganizations (statutory mergers), there are "B" reorganizations (stock for stock purchases of companies), there are triangular "B" reorganizations (stock for stock acquisitions by a parent company that merge the acquired company directly into one of its subsidiaries), there are "C" reorganizations (stock for asset purchases of companies), there are triangular "C" reorganizations (stock for asset acquisitions by a parent company that merge the acquired company directly into one of its subsidiaries), and there are acquisitive "D" reorganizations (another flavor of stock for asset purchases of companies). (Reorganizations are usually classified by the lettered subsection of Internal Revenue Code Section 368 that authorize them). There are also some lesser known back door ways to merge companies, such as via a contribution to capital of a sister corporation by its shareholders.

In contrast, obtaining the same kind of favorable tax treatment for divisive reorganizations (also called "D" reorganizations), which can be structured as spin-offs, split-offs, or split-ups, are fraught with tax risk and uncertainty. The IRS and tax lawyers have to pay close attention to regulations that have detailed facts and circumstances driven analysis, and a great deal of audit and pre-approval efforts to making sure that tax code requirements regarding which assets can go in which surviving corporation are met.

In a divisive tax free reorganization, like a tax free merger, nobody leaves either kind of transaction with untaxed cash at closing (although for publicly held companies the difference between stock and cash may not be all that material since anyone who wants to can readily sell their stock for full fair market value at a moment's notice and tax free, hard money margin loans are widely available if the stock is not sold), in an effort to prevent potential leaks in the regime of double taxation of corporate profits that is criticized by big business executives and liberal academics alike under our tax code.

But, our tax code discourages publicly held companies from splitting by with the frequently deal busting risk of unexpected premature taxation of all of a successor company's assets. Divisive reorganizations will often prove unworkable from a tax perspective unless the groundwork for the move is laid years in advance and even then, the freedom of businesses to split themselves up into units that make the most economic sense can be materially limited by the need of lawyers and accountants involved in the deal to control tax risk.

As a result, mergers of publicly held corporations are relatively common place, while divisive reorganizations, like the one announced by Kraft today that breaks its business into an internationally oriented snack food business and a domestically oriented grocery store product business, or the recently announced deal to unwind the merger of Wendy's and Arbys restaurants, are the much more rare and notable exceptions.

This little known bias in the tax code, at the macroeconomic level, gives us too many conglomerates, in which it is hard for stock market price discipline to hold management accountable and which create systemic risk in our economy that flows from too big to fail entities (like AIG), while discouraging the financial markets from crafting firms in a way that disaggregates separate businesses from each other to the full extent that their underlying lack of economic interdependence permits.

The merger bias in the tax code also harms the economy by reducing transparency in financial disclosures. The SEC has exacting rules on financial reporting for publicly held companies, but one of the big shortcomings of those rules, that prevents the financial markets from efficiently allocating capital to profitable businesses, while denying further resources to businesses with poor profits, is that the financial accounting rules do little to require the divisional and line of business breakdowns of corporate profits, losses, assets and liabilities necessary to do the managerial accounting analysis necessary to determine if corporate restructurings make sense.

Instead, the combination of weak subunit reporting requirements from the SEC, corporate reorganization taxation biases against divisive reorganizations, and a double taxation of corporate profits regime that encourage businesses to retain earnings from equity to reinvest in their own company even when the average stock market investor would agree that the funds would be more profitably reinvested in some other segment of the economy, all conspire to increase systemic risk in our economy, reduce transparency in our financial markets, and inefficiently allocate financially investments to business divisions that are suboptimal uses of available capital.

Indeed, the bias towards reinvestment of corporate earnings, coupled with the bias against divisive reorganizations, creates an incentive that is strongest for the least well managed businesses to acquire better run businesses that throw off cash for the primary purpose of obscuring their weak performance and diverting the cash from the successful businesses towards reinvestment in poorly run businesses.

Our economy relies on the threat of hostile takeovers by businesses who can profit by identifying mismanaged companies, buying them, jettisoning the bad management or reversing bad decisions, and improving the bottom line as a result to hold corporate executives accountable and to give them an incentive to manage their companies effectively. But, conglomerates with many units purchases to provide internal access to retained earnings that lack meaningful public disclosure of unit performance that would be available if the divisions were separate publicly held firms, discourage this kind of market discipline, as do management friendly rulings of the Delaware courts that allow publicly held corporations to discourage market efforts to hold them accountable with golden parachutes that international financial experts have widely condemned as encouraging systemic risk by rewarding senior executive mismanagement, and other poison pills to discourage shareholder and financial market identification of and intervention to end mismanagement of big businesses.

In theory, antitrust laws should prevent anticompetitive mergers that harm the public interest, but in practice, they are a toothless tiger than looks impressive but has little practical impact. Most of the harm from a bias towards mergers and against holding separate functional business units accountable flows from the collective effect of little incremental decisions whose public impacts are not obvious. By the time that antitrust regulators can truly prove that the merger of the last few oligarchic firms in an industry will harm competition, the damage has already been done, and nothing gives antitrust authorities the power to limit the formation of conglomerates that don't have monopoly power in any one industry, despite the fact that this was one of the concerns that led to the passage of these laws in the first place.

Collectively, these incentives and corporate and antitrust law flaws have not only negative economic efficiency consequences, but negative consequences for the appropriate distribution of wealth and income in society and the allocation of political power. While economically unreasonably large firms may not necessarily have unreasonable market monopolies in given industries, their sheer size does unreasonably concentrate wealth in a self-dealing economic elite of senior managers and the top professional advisers in investment banks, law firms and accounting firms (for example), and similarly, unreasonably concentrates political power in these unaccountable elites, while providing a means by which businesses have an incentive to fight for the interests of this economic elite as a social class, rather than being disaggregated into the conflicting factions of smaller firms with more particular political interests that the founders envisioned in the Federalist papers that are more easily subjected to the diffuse interests of the majority. In a nutshell, conglomerates encourage logrolling and mutual backscratching not just by politicians themselves but by the monied interests that are developing political coalitions that work to the detriment of the public interest.

Is this a lot to lay at the foot of Internal Revenue Code 368, corporate double taxation, and regulations promulgated by the IRS and SEC? Surely it is. But, the obscure pieces of our regulatory framework conspire to drive the unreasonable concentration of economic power, wealth and income, while simultaneously making our economy less competitive. They may not be flashy, but their day after day, broad systemic impact on the way that decisions are made in the dominant sector of our economy have a cumulative impact that is easily underestimated.

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