Neptune, Inc., is interested in acquiring the Blackfin, Inc., subsidiary of Bertram, Inc. Here are the facts related to this pending transaction:
• Bertram has a tax basis in the stock and assets of Blackfin of $10 million.
• The fair market value of Blackfin is $500 million.
• Bertram’s tax rate is 35%.
• Neptune’s tax rate is 35%.
• The after-tax rate of return is 6.5% and any step-up in the basis of Blackfin’s assets will be amortized straight line over 15 years.
• Neptune is offering to acquire Blackfin from Bertram in a Section 351 transaction in which Bertram will receive $500 million of voting preferred stock of NEWCO (formed by Neptune). The NEWCO preferred stock pays dividends at 10%.
• Further, Neptune has arranged for an investment bank to provide a $500 million loan, secured by the NEWCO preferred stock, to Bertram. The loan has an interest rate of 10%.
• The investment bank will charge a fee of $2.5 million per year on the loan.
• Bertram will hold the NEWCO preferred stock for 20 years, when it will be sold to pay off the loan.
• Ignore the tax effects of interest deductions and preferred stock dividends in your computations.
a. What is the present value of deferring the capital gains tax on the subsidiary sale using Section 351 relative to a taxable stock sale at a price of $500 million? That is, how much tax savings will Bertram realize from deferring the capital gain that would be triggered in a taxable sale?
b. What is the present value after-tax cost of the loan fee to Bertram (n = 20, r = 6.5%, tc = 35%)?
c. What is the maximum price that Neptune would pay in a taxable stock sale with a Section 338(h)(10) election, assuming it is willing to pay $500 million in a transaction (taxable or tax-free) that does not step-up the tax basis of Blackfin’s assets?
d. At the maximum price that Neptune will pay computed in part (c), how much is the incremental after-tax increase in Bertram’s wealth resulting from the Section 338(h)(10) election, relative to a taxable transaction with no election?
e. The amount computed in part a can be considered, for purposes of this problem only, as the gross tax savings from this tax strategy. The sum of the amounts computed in parts (b) and (d) can be considered the costs of the strategy. Given your computations, what is the net tax saving (cost) of this strategy?