The impact of taxes on the choice of divestiture method

Journal of Accounting and Economics 28 (1999) 117}150

The impact of taxes on the choice of divestiture methodq Edward L. Maydew!, Katherine Schipper", Linda Vincent#,* !Kenan-Flagler Business School, University of North Carolina, Chapel Hill, NC 27599, USA "Fuqua School of Business, Duke University, Durham, NC 27706, USA #Kellogg Graduate School of Management, Northwestern University, Evanston, IL 60201, USA Received 29 January 1997; accepted 30 October 1999

Abstract This paper estimates the magnitude of tax costs and their impact on the decision to divest assets via a taxable sale rather than a tax-free spin-o!. We "nd that the tax costs are substantial, averaging 8% of market value of the divested assets, and that crosssectional variation in tax costs has a large impact on managers' choice of divestiture method. Our results are consistent with two explanations. First, managers are willing to incur avoidable tax costs to gain earnings and cash #ow bene"ts. Second, managers choose taxable sales because the acquisition premia on the sales exceed the avoidable tax costs. ( 1999 Elsevier Science B.V. All rights reserved. JEL classixcation: G34; H25; M41 Keywords: Divestitures; Taxes; Income smoothing; Spin-o!s

q We thank Robert Chirinko, Julie Collins, Merle Erickson, Jennifer Francis, David Guenther, Deen Kemsley, Richard Leftwich, Lillian Mills, Richard Sansing, Doug Shackelford, Abbie Smith, Robert Trezevant, Ross Watts (the editor), Ed Outslay (the referee), as well as an anonymous referee, and workshop participants at the University of Chicago and Michigan State University for helpful comments. Marcus Butler, Massimo Capretta, Je! Maydew, Britt Trukenbrod, and Ira Weiss provided excellent research assistance. We appreciate the willingness of Steve Cohen of Ernst & Young, and Albert Remeikis and Mark Boyer of PricewaterhouseCoopers (Washington National Tax Service) to discuss divestiture-related issues at length. Finally, we are grateful to the Graduate School of Business of the University of Chicago, to KPMG LLP, to the William S. Fishman Faculty Research Fund, and to the Ernst & Young Foundation for "nancial support. * Corresponding author. Tel.: #1-847-491-2659; fax: #1-847-467-1202. E-mail address: [email protected] (L. Vincent)

0165-4101/00/$ - see front matter ( 1999 Elsevier Science B.V. All rights reserved. PII: S 0 1 6 5 - 4 1 0 1 ( 9 9 ) 0 0 0 2 2 - 1

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1. Introduction This paper investigates the extent to which taxes in#uence the choice of divestiture method for divestitures that could have been either tax-free spin-o!s or taxable sales. We assume that managers maximize shareholder wealth in their divestiture decisions, incurring avoidable taxes or foregoing tax bene"ts only if doing so achieves o!setting nontax bene"ts (e.g., "rms choosing taxable sales may o!set the bene"ts of enhanced cash #ow against the taxes paid). This assumption is consistent with discussions with investment bankers, consultants and accountants, who indicate that such decisions generally involve analysis of the tax and nontax e!ects of both sales and spin-o!s. The foundation of our analysis is the estimation of the magnitude of tax costs and bene"ts. We use these estimates to quantify the magnitude of the various nontax costs and bene"ts of sales versus spin-o!s. Our tax cost and bene"t estimates are based on a multilateral tax perspective (Scholes and Wolfson, 1992), incorporating both the seller's tax costs and the buyer's tax bene"ts from the step-up in tax basis of the acquired assets. The estimates also take into account di!erences between the book value and tax basis of assets when estimating the seller tax costs and buyer tax bene"ts.1 The sample consists of 218 taxable sales transactions and 52 nontaxable spin-o! transactions. Because our sample spin-o!s are all nontaxable, the estimated tax bene"t of a spin-o! (applicable when the divested unit has an unrealized taxable gain) is equal to the tax the divesting "rm avoided by choosing a spin-o! instead of an asset sale; the estimated tax cost of a spin-o! (applicable when the divested unit has an unrealized tax deductible loss) is equal to the estimated tax deduction the divesting "rm would have obtained had the unit been sold for a deductible loss. Because our sample sales are all taxable, the tax cost of a sale is equal to the estimated taxes paid (for tax gain transactions) and the tax bene"t is equal to the estimated tax deduction (for tax loss transactions). We estimate the tax and cash #ow implications for the taxable sales transactions as if they had been accomplished as nontaxable spin-o!s; we likewise estimate the tax and cash #ow implications for the nontaxable spin-o!s as if they had been accomplished as taxable sales. In order to accomplish these calculations we necessarily make important assumptions about the hypothetical price paid (as if it had been a sale) for each spin-o! transaction and about the hypothetical trading value of the sales transaction had it been a spin-o!. We use 1 We believe we are the "rst to use direct measures (instead of proxies) to compare the tax costs of taxable sales with the tax bene"ts of nontaxable spin-o!s. The idea is to use direct estimates to calibrate the tax costs "rms are willing to bear to achieve nontax bene"ts. Direct estimates of tax costs and bene"ts have also been used in studies of accounting method choice (e.g., Dopuch and Pincus, 1988), pension reversion decisions (e.g., Clinch and Shibano, 1996) and mergers (e.g., Erickson, 1998).

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the term &acquisition premium' to refer to the di!erence between the sales price a buyer would pay for a subsidiary and the market value the subsidiary would have if it were instead spun-o!. We de"ne tax disadvantaged sales as those which triggered a tax payment that could have been avoided by choosing a nontaxable spin-o!, and tax advantaged spin-o!s as those in which the divesting "rm avoided a tax obligation that would have been triggered by a taxable sale.2 The nature and implications of these assumptions are discussed in detail in Section 4. Brie#y, because we are unable to observe "rm-speci"c acquisition premia that would have been paid for spun-o! assets had they be sold, or that would have been forfeited for sales had they been spun-o!, our classi"cations of transactions as tax advantaged or tax disadvantaged are subject to error. The number of transactions we classify as tax disadvantaged varies across the range of assumptions we make about the unobserved acquisition premia. However, our estimates of the trade-o!s that "rms make between tax and nontax costs are robust across the range of assumed acquisition premia. Because we cannot observe the actual acquisition premia our results must be interpreted in the light of possible correlations between our proxies for nontax factors and measurement error in our acquisition premia estimates. We consider several explanations for tax disadvantaged sales. First, the tax costs may be negligible. Using an assumed 30% acquisition premium (the median acquisition premium in acquisitions of stand-alone "rms from 1987 to 1996) our tax cost estimates contradict this explanation. The mean tax cost for the sales is $165 million, or $37 million (8% of the mean market value of equity of the divested unit) when netted against the assumed 30% acquisition premium. The spin-o!s generate a mean $118 million in tax savings, or 9% of the mean market value of equity of the divested unit when netted against an assumed 30% acquisition premium. The second explanation is that there is in general no true choice between divestiture methods because stringent tax rules restrict the availability of nontaxable spin-o!s to a small subset of divestitures. While this explanation is undoubtedly valid for some transactions, we rule it out for our sample by including only divestitures that could have been accomplished as either a nontaxable spin-o! or a taxable sale; that is, all our sample divestitures meet the criteria for a tax-free spin-o!, so they could, in principle, have been e!ectuated using either method.3

2 A tax disadvantaged spin-o! foregoes a tax deductible loss that would have been triggered by selling the unit and a tax advantaged sale utilizes such a loss. 3 We use the terms &nontaxable' and &tax-free' interchangeably. As discussed in Section 2, quali"ed spin-o!s under IRC A355 are tax-free to the parent corporation but tax-deferred to the parent's shareholders.

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A third possible explanation is that proceeds in asset sales exceed the values that could have been obtained in spin-o!s by more than the tax costs. This explanation, which is consistent with the theory that assets devolve to their highest and best use, implies that selling the subsidiary generates more value for shareholders (in the form of an acquisition premium) than would be generated by the projected market valuation accorded a spin-o!. The notion that divestitures assist in asset devolution to higher valued uses might also imply that sales are chosen (instead of spin-o!s) for certain poorly performing units that require major operating and/or organizational changes that are more e$ciently made by a single buyer (as in a sale) rather than a di!use set of owners (as in a spin-o!). For the subsample of subsidiaries for which we have data to calculate pro"tability measures, our results con"rm that relatively less pro"table subsidiaries tend to be sold. The fourth explanation is that some "rms incur tax costs to obtain "nancial reporting bene"ts; that is, they use tax dollars to buy accounting earnings. Sales transactions trigger "nancial reporting gains and losses whereas spin-o!s do not, leading us to predict that "rms with low or decreasing earnings, or "rms with one-time earnings reductions in the divestiture year, are more likely to choose asset sales that create taxable gains. Finally, it is possible that for some "rms cash from taxable asset sales may be the least expensive source of outside capital. Because sales transactions provide cash or monetary assets, cash constrained "rms lacking access to capital from other sources may be willing to incur tax costs to improve their liquidity. Results of multivariate analysis indicate that "rms trade o! tax costs against both "nancial reporting considerations and cash needs in divestiture decisions. We compare taxable sales transactions and tax-free spin-o!s, taking the decision to divest as given. In particular, we do not focus on why "rms divest, as do, for example, Lang et al. (1995), Comment and Jarrell (1995), and John and Ofek (1995). Rather, we investigate why so many divesting "rms incur apparently avoidable tax costs, and what is gained from structuring a divestiture as a taxable sale as opposed to a tax-free spin-o!. In related work, Alford and Berger (1998) analyze the reasons for the choice of a spin-o! or a sale and "nd that their proxies for tax costs are statistically associated with the choice of divestiture method. The paper proceeds as follows. The next section describes the tax aspects of sales and spin-o!s. Section 3 describes the sample of divestitures and Section 4 reports our estimates of the tax costs and bene"ts for the sample transactions. Section 5 then discusses possible explanations for the tax disadvantaged sales. Section 6 discusses the results of the logit model used to analyze the relative importance of the various decision criteria in choosing a divestiture method. Finally, Section 7 concludes.

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2. Tax aspects of sales and spin-o4s This section discusses selected tax aspects of taxable sales and nontaxable spin-o!s. Table 1 summarizes the tax and "nancial reporting implications of each type of transaction. In a sale, the parent's shares of subsidiary stock or the subsidiary's underlying assets are sold; the consideration is usually cash, thereby causing the sale to be taxable. If the subsidiary's assets are sold, the subsidiary, and thus the parent, recognizes taxable gain or loss equal to the di!erence between the proceeds and the tax basis of the assets sold. The acquiring "rm takes a basis in the assets acquired equal to the amount paid (i.e., the assets are stepped up to fair market value). In a taxable sale of subsidiary stock, the parent recognizes capital gain to the extent the proceeds exceed its basis in the subsidiary stock. The tax code restricts the recognition of capital losses on such sales. Regardless, the acquirer's basis in the newly acquired subsidiary stock is equal to the amount paid. The bases of the subsidiary's underlying assets, however, are unchanged by the sale. That is, they are not stepped-up (or down) to fair market value, resulting in a di!erence between the inside (or subsidiary) and outside (or parent) bases. Because stock cannot be depreciated for tax purposes, whereas tangible assets generally can, buyers usually prefer that any basis step-up apply to the underlying assets of the acquired subsidiary, rather than to the subsidiary stock. To achieve this in a taxable sale of subsidiary stock, the buyer and seller can make a joint A338(h)(10) election to treat the sale as if it were actually a sale of the Table 1 Summary of "nancial accounting and tax e!ects of sales and spin-o!s Sale

Spin-o!

Financial accounting

f Parent recognizes gain or loss equal to di!erence between proceeds and book value. f Shareholders recognize no gain or loss.

f Generally no gain or loss to parent, subsidiary, or shareholders. f Parent treats like a stock dividend. f Subsidiary keeps book value that was reported on consolidated "nancial statements.

Tax

f Parent recognizes gain or loss equal to di!erence between proceeds and tax basis. f Buyer takes basis in assets acquired equal to amount paid.! f Shareholders recognize no gain or loss unless proceeds distributed as a dividend.

f Generally no gain or loss to parent or shareholders. f Subsidiary keeps basis in underlying assets it had when owned by parent. f Shareholders allocate basis in prespin-o! parent stock between subsidiary and post-spin-o! parent based on relative fair market values.

!Assuming that the sale involved either the subsidiary's assets or its stock, accompanied by an IRC Section 338(h)(10) election. See Section 2 of the text for details.

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subsidiary's underlying assets, followed by a tax-free liquidation of the subsidiary (at that point a shell with cash) into the parent.4 (Alternatively, the buyer could purchase the assets directly from the subsidiary.) This election causes the acquisition of subsidiary stock to be treated for tax purposes as if the buyer directly acquired the subsidiary's assets without costing the seller any additional taxes. In a spin-o!, a parent corporation distributes stock in a controlled subsidiary to parent company shareholders pro rata, as a dividend. Section 355 of the Internal Revenue Code speci"es the requirements for such a transaction to qualify as a nontaxable spin-o!. First, the parent must own at least 80% of the outstanding shares of the subsidiary, and the subsidiary must not have been acquired in a taxable transaction during the preceding "ve years.5 The parent must distribute at least 80% (and possibly more) of its stock in the subsidiary. In addition, the transaction must also have a valid corporate business purpose; it cannot be principally a tax-avoidance device for the distribution of earnings and pro"ts; no pre-arranged plan may exist for shareholders to sell the subsidiary stock subsequent to the distribution; and after the transaction, both the distributing and controlled corporations must actively conduct the businesses previously owned and operated (directly or indirectly) by the distributing corporation for at least "ve years.6 In a nontaxable spin-o!, the parent's shareholders allocate their bases in the pre-spin-o! parent stock between the subsidiary stock and the post-spin-o! parent stock based on the relative fair market values of the parent and subsidiary stock at the spin-o! date. Shareholders can thus defer gain (or loss) recognition until the stock is sold. The spin-o! is nontaxable in the sense that the parent's unrealized gain or loss in the subsidiary stock is never taxed. The subsidiary's tax basis in its assets is not a!ected by the spin-o!.

3. Sample We gathered a sample of 218 sales transactions from the Mergerstat Review $100 Million Club for the years 1987}1995. Because the 1986 Tax Reform Act

4 Although it is impossible to determine for most sales, based on public information, whether a joint A338(h)(10) election was made by the parties, conversations with M & A consultants indicate that such elections are common. 5 We refer to the divested unit in both a spin-o! and a sale as a subsidiary, recognizing that the unit might be a division (i.e., not a separate legal entity from the parent) of the parent "rm when sold. This distinction is of minor importance for our paper since parents can generally convert a division into a subsidiary without incurring any tax liability. 6 Reg. A1.355-3. Failure to satisfy these conditions makes the spin-o! a taxable distribution in which the parent generally recognizes gain but not loss on the distribution, and the parent shareholders recognize dividend income.

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(TRA '86), particularly the repeal of the General Utilities doctrine, signi"cantly altered the tax rules for divestitures, we examine only divestitures that took place after the e!ective date of TRA '86 (July 1, 1987).7 We also consider only taxable sales and nontaxable spin-o!s to keep the choice of divestiture method and the tax implications unambiguous.8 Table 2, Panel A, summarizes the sample by year and by divestiture type. To ensure that the sample includes only divestitures that could have been either sales or spin-o!s, we subject each sale to selection criteria re#ecting the requirements of the tax code for a nontaxable spin-o!. That is, the parent must own at least 80% of the outstanding shares of the subsidiary; the parent must sell all of its interests in the subsidiary; and the subsidiary must not have been acquired in a taxable transaction during the preceding "ve years. The tax code's other requirements for a nontaxable spin-o! are more di$cult to assess and are assumed met when the above conditions are met. We also limit the sellers to U.S. public companies. Table 2, Panel B summarizes the reasons for excluding sellers from the sample. The sample contains 52 nontaxable spin-o!s during the years 1987 (post TRA '86)}1995 identi"ed from several sources, including Securities Data Corporation, a keyword search of the PRNEWSWIRE data base, articles from the "nancial press, and distributions coded as spin-o!s on CRSP. The tax status is from the CCH Capital Changes Reporter. We gathered "nancial information from the parent's annual report and/or Form 10-K, and for some transactions, from the Form 10.9 Only transactions in which both the parent and subsidiary 7 Although the majority of divisive restructurings are sales, there was a noticeable increase in the number of tax-free spin-o!s in the late 1980s and early 1990s, perhaps because TRA '86 made spin-o!s the primary means for public companies to achieve a nontaxable (to the parent and tax deferred to the shareholders) divestiture. According to a study by J. P. Morgan (Lipin and Smith, 1995), spin-o!s increased from 10% to 26% of all divestitures between 1988 and 1994, and the value of spin-o!s in 1995 was more than double that of 1994. Securities Data Corporation reports the following: Year Value ($Millions) of spin-o!s No. of transactions 1992 1993 1994 1995

$ 5,714 $ 14,233 $ 22,865 $ 45,808

23 33 28 31

8 Alternatively, we could have included nontaxable sales, taxable spin-o!s and equity carve-outs. However, nontaxable sales of subsidiaries are rare (in contrast to nontaxable sales of entire companies) and taxable spin-o!s occur much less frequently than nontaxable spin-o!s in our potential sample of large divestitures. An equity carve-out, or partial public o!ering, is often a preliminary step to either a complete sale or a spin-o!, so both the divestiture method and the tax implications can be ambiguous at the time of the carve-out. We do not examine split-o!s and split-ups because they are generally used by smaller, privately held "rms. 9 The SEC requires that a Form 10 (similar to an o!ering prospectus) be "led and distributed to all shareholders in a spin-o! transaction. Because no shareholder vote is required, Form 10 is referred to as an information statement.

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Table 2 Selection of nontaxable spin-o!s and taxable sales of subsidiaries Subsidiaries must be valued at $100 million and have been divested during 1987}1995. Taxable sales must meet the criteria to be eligible to have been nontaxable spin-o!s Year!

Sales"

Spin-o!s#

Total

Panel A: Distribution of sample divestitures by year 1987 (7/1}12/31) 11 1988 27 1989 26 1990 20 1991 20 1992 12 1993 29 1994 33 1995 40

0 5 7 6 3 9 11 7 4

11 32 33 26 23 21 40 40 44

Total

52

270

218

Panel B: Reasons for exclusion of xrms from the sample SALES No. of unit sales by U.S. public companies in 1987}1995 in excess of $100 million$ 468 No. of sales e!ective before TRA &86 (29) No. of units not owned by parent for at least "ve years (39) No. of sellers for which there is insu$cient data available% (156) No. of sales which were nontaxable (incl. Morris Trust) (13) No. of sales in which the seller held less than 80% of the unit sold (6) No. of sales in which the seller was in Chapter 11 (7) ** Sample 218 SPIN-OFFS No. of spin-o!s investigated No. smaller than $100 million No. for which there is insu$cient data available% No. associated with merger& No. which were taxable No. that were "nancial institutions Sample

255 (71) (104) (12) (5) (11) ** 52

!Based on the e!ective date of the transaction. "The sample of sales transactions was gathered from the Mergerstat Review $100 Million Club and consists of taxable sales of units by publicly traded U.S. "rms. #The sample of spin-o!s consists of nontaxable spin-o! transactions in excess of $100 million in market value of equity by U.S. "rms. $The Mergerstat Review $100 Million Club for the years 1987}1995 is the source for this "gure. %Insu$cient data includes lack of CRSP or COMPUSTAT; no Annual Report or 10K; and inadequate footnote disclosure in the annual report/10K. &These transactions were part of a two part Morris Trust transaction; a stock for stock nontaxable merger was preceded by a nontaxable spin-o! by one of the parties. Because these transactions are similar to nontaxable sales, we have eliminated them from the sample.

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are U.S., public companies with data on COMPUSTAT and CRSP are included. To be consistent with the selection criteria for the sales transactions, we require that the subsidiary's market value of equity on the e!ective date be at least $100 million. Table 2, Panel B summarizes the reasons for exclusion of spin-o! "rms from the sample.

4. Estimates of tax costs and bene5ts 4.1. Method used to estimate tax costs and benexts The foundation of our analysis of tax costs and nontax bene"ts (NTB) is measurement of the tax e!ects of sales transactions. We calculate tax e!ects directly for our sample sales transactions; for the spin-o! transactions, the tax e!ects of a sale are avoided, hence not observed, so we must develop proxies for these e!ects. Our approach to estimating tax costs and bene"ts assumes that a shareholder value-maximizing manager chooses a taxable sale if SA![(SA!BASIS)q]#N¹B'SO,

(1)

where SA is the proceeds if the subsidiary is sold, BASIS is the tax basis of the subsidiary, s is the applicable corporate tax rate, NTB is the net nontax bene"ts of a sale, and SO is the market value of the subsidiary if it is spun-o!.10 For sales transactions, we directly observe SA and for spin-o!s we directly observe SO. For both types of transactions, we estimate BASIS and the marginal tax rate using the procedures described in the appendix.11 Thus, we can calculate the direct tax cost of a sample sales transaction. If we could observe SA for spin-o! transactions, we would be able to calculate directly the tax advantage (or tax cost) of choosing a spin-o! instead of a sale. Because SA for spin-o! transactions is not observable, our estimates of tax costs and bene"ts require estimates of the proceeds that would have been obtained had the spun-o! subsidiaries been sold. In estimating SA for spin-o! transactions, we take account of two sources of di!erences between the observed SO and the proceeds that would have been obtainable from a sale: tax bene"ts and possible synergistic bene"ts. The tax bene"ts arise because a taxable sale (but not a nontaxable spin-o!) typically results in a step-up in the tax basis of the subsidiary's assets, thereby providing additional depreciation deductions and lower tax costs for the buyer over the

10 We thank an anonymous referee for suggesting this notation. 11 Alternatives to direct estimation of BASIS include assuming that tax accounting and "nancial reporting are identical or that book-tax di!erences are constant over time (Maydew, 1997).

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remaining life of the purchased assets.12 Therefore, we estimate SA for spin-o! transactions (i.e., the proceeds &as if' the spin-o! had been a sale) as the market value of equity of the spun-o! "rm plus the present value of the tax savings that would have been realized by a buyer in a taxable purchase due to the step-up in basis.13 We refer to the discounted tax savings as the buyer tax bene"t or BTB. Our "rst estimate of SA (equal to SO#BTB) assumes that a buyer can use all the incremental deductions at the statutory rate and that the seller is able to extract the entire tax bene"t in the form of a higher sales price. Failing to include these buyer tax bene"ts overstates both the seller's net tax cost in a taxable sale and the parent's net tax savings in a spin-o!; both biases would make taxable sales transactions look more tax disadvantaged relative to spin-o!s. The second potential source of di!erence between the observed SO for a spin-o! transaction and the proceeds that would have been obtainable from a sale is the buyer's willingness to pay a premium for control or for projected operating or "nancial synergies. We do not attempt to estimate this premium directly, or independently of other factors (such as the BTB) that might in#uence the price a buyer would pay for the subsidiary. Instead, our proxy for the overall premium } from all sources } in a sale of the subsidiary is the premium for acquisitions of independent corporate entities during 1987}1996. Mergerstat Review indicates that this premium was approximately 40% (mean) or 30% (median) of the target's prebid market value of equity. We de"ne 30% of the purchase price in each sales transaction as the acquisition premium, and we add a 30% acquisition premium to the market value of the spin-o!s to obtain our second &as if sold' measure (SA"1.3SO) for these transactions. We perform analogous calculations to estimate the unobservable SO for sales transactions. That is, we compute SO in two ways. First, we compute the &as if spun-o!' value SO"SA!BTB, utilizing the "rm speci"c BTB; and second, we compute the &as if spun-o!' value SO"(SA/1.3), utilizing the median acquisition premium. From expression (1) the direct tax cost for the sales transactions and the &as if sold' tax cost for the spin-o!s is (SA!BASIS)q. (For spin-o! transactions, we use two estimates of SA while for sales transactions SA is disclosed.) For spin-o!

12 Discussions with M & A advisors indicate that such bene"ts are calculated by the seller as part of the determination of the sales price for the divested unit and are outlined in the sales materials provided to potential purchasers. 13 The step-up equals the di!erence between the amount paid and the seller's tax basis in the assets. We assume this basis is written o! ratably over n years (that is, we assume none of the basis step-up is allocated to land or nondeductible goodwill). We estimate n as the subsidiary's book value of property, plant and equipment divided by the subsidiary's depreciation expense. The additional write-o! is multiplied by the statutory tax rate, resulting in the nominal tax savings per year. The present value of these tax savings is calculated using a 10% discount rate to give the buyer tax bene"ts. The appendix contains details of the calculations.

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transactions, the higher the BTB, or the higher the assumed acquisition premium, the more likely it is that (estimated) SA exceeds the direct tax cost. We categorize transactions as tax advantaged or disadvantaged based on the sign of the net tax cost, de"ned as M[(SA!BASIS)q]!BTBN, or M[(SA!BASIS)q]-acquisition premiumN. Our measure of net tax cost thus incorporates both direct tax costs or bene"ts and the adjustment due to the BTB or the acquisition premium. A tax disadvantaged sale results in tax payments even after subtracting the increase in sales price enjoyed by the seller due to the BTB or acquisition premium. Likewise, a tax advantaged spin-o! avoids the payment of net taxes, even after adding the BTB or acquisition premium to the spin-o! market value. Conversely, a tax advantaged sale generates a net tax loss (to be applied against other taxable income) and a tax disadvantaged spin-o! foregoes net tax bene"ts that would have been available to shelter other income had a taxable sale been undertaken with tax deductible losses. As discussed further in Section 4.3, our classi"cations of transactions as tax advantaged and tax disadvantaged could just as readily be evidence of variation in (unobservable) acquisition premiums as evidence of tax disadvantaged restructurings. 4.2. Results of tax cost and benext estimation Table 3 shows the numbers of tax disadvantaged sales and tax advantaged spin-o!s under a range of assumptions about buyer tax bene"ts and acquisition premiums. Assuming zero BTB and zero acquisition premium, 195 of the 218 sales transactions are tax disadvantaged and 45 of the 52 spin-o! transactions

Table 3 Number of tax disadvantaged transactions under various assumptions

No buyer tax bene"t or acquisition premium Buyer tax bene"t" only Acquisition premium of 10% 20% 30% 40% 50%

No. of tax disadvantaged! sales (total sales"218)

No. of tax advantaged spin-o!s (total spin-o!s"52)

195

45

186

45

152 110 66 30 12

44 41 35 24 6

!A tax disadvantaged transaction is one for which avoidable taxes are paid or available tax savings are foregone, net of bene"ts due to buyer tax bene"ts or acquisition premiums. "The buyer tax bene"t is the present value of the tax savings that would have been realized by a buyer in a taxable purchase due to the step up in basis.

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are tax advantaged. Adding the BTB decreases the number of tax disadvantaged sales to 186 and does not change the number of tax advantaged spin-o!s. In contrast, adding a 30% acquisition premium yields 66 tax disadvantaged sales and 35 tax advantaged spin-o!s. Assuming the net tax cost is determined by the greater of the BTB and the (30%) acquisition premium does not a!ect the numbers of tax advantaged and disadvantaged transactions. Classi"cations based on acquisition premia ranging from 10% to 50% use no "rm-speci"c information other than "rms' market values, so we have undoubtedly misclassi"ed some transactions relative to the classi"cations that would result from using "rm-speci"c measures of acquisition premia. Table 4 compares selected tax measures for the tax disadvantaged sales and the tax advantaged spin-o!s, assuming an acquisition premium of 30% for the spino!s &as if sales.' The tax basis in the subsidiary as a percentage of the subsidiary's market value is not statistically di!erent for the sales and spin-o!s as indicated in Panel A. Panel B presents scaled (by market value of parent equity) estimated taxable gains and losses, de"ned as the di!erence between the market value of the subsidiary and its tax basis. For sales transactions this value is observed (i.e., SA!BASIS); for spin-o!s it is the gain or loss that would have been realized had the transaction been a taxable sale (i.e., (1.30SO)!BASIS). The spun-o! units have statistically signi"cant (at the (0.01 level) larger mean and median scaled taxable gains estimates than the sold units. Panel C of Table 4 presents the estimated dollar amount of the direct tax cost for the sales and spin-o!s &as if sales.' These numbers re#ect the actual tax cost for the sales (i.e., (SA!BASIS)q) and the tax cost estimated for the spin-o!s as though they had been sold, including the 30% acquisition premium (i.e, [(1.3SO)!BASIS]q). The mean (median) tax cost for sales is $165 million ($110 million) compared to the mean (median) tax bene"t for spin-o!s of $498 million ($301 million). All di!erences are statistically signi"cant at the 0.01 level. Panel D summarizes the 30% (assumed) acquisition premium. In the case of a spin-o! this premium is 30% of the subsidiary's initial market value; for sales it is 23% (0.3/1.3) of the actual sales price. Panel E provides the net tax cost, which nets the direct tax costs (panel C) against the cash bene"ts of the assumed acquisition premium (panel D). The net tax cost is also signi"cantly (at the 0.04 level or better) greater for the spin-o!s than for the sales. Panels F and G provide the net tax cost scaled by the market value of equity of the parent and the subsidiary. We conclude from Table 4 that, assuming a 30% acquisition premium, the magnitude of the net taxes avoided by a nontaxable spin-o! signi"cantly exceeds the net tax costs from a taxable sale. Despite the frequency of taxable sales transactions, which are presumably driven by some combination of acquisition premia and nontax bene"ts associated with sales, the choice between spin-o! and asset sale appears in#uenced by tax considerations since the largest tax costs are avoided.

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Table 4 Tax costs and bene"ts } sales versus spin-o!s (with 30% acquisition premium)) Tax disadvantaged sales (N"66)

Tax advantaged spin-o!s (N"35)

Test of di!erence! (p-value)

Panel A: Tax basis in subsidiary"/market value of subsidiary at the time of divestiture# Mean 0.081 0.064 0.20 (0.84) Median 0.188 0.157 0.42 (0.67) Panel B: Taxable gain on divestiture$/market value of parent at the end of the year preceding divestiture Mean 0.223 0.577 !4.43 (0.00) Median 0.129 0.464 !4.62 (0.00) Panel C: Tax cost in $ millions% Mean 165.42 Median 110.46

498.28 300.61

!2.79 (0.01) !2.50 (0.01)

Panel D: 30% Acquisition Premium in $ millions& Mean 128.07 Median 84.35

380.56 181.80

!2.61 (0.01) !2.59 (0.01)

Panel E: Net tax cost in $ millions' Mean 37.35 Median 22.68

117.72 31.29

!2.77 (0.01) !2.08 (0.04)

Panel F: Net tax cost/market value of equity of parent at the end of the year preceding the divestiture Mean 0.017 0.044 !3.83 (0.00) Median 0.006 0.032 !4.02 (0.00) Panel G: Net tax cost/market value of equity of subsidiary as of the date of the divestiture Mean 0.077 0.092 !0.57 (0.59) Median 0.051 0.061 !0.45 (0.65) !t-Statistic (Z-statistic) for the di!erence (sales}spin-o!s) in means (medians). "Tax basis in subsidiary""nancial accounting book value less book/tax di!erences (see the appendix). #Market value of subsidiary at the time of the divestiture"sales price for sales transactions and market value of spin-o! plus acquisition premium for spin-o! "rms. $Taxable gain on divestiture"sales proceeds less tax basis for sales transactions and 1.30 times market value of subsidiary less tax basis for spin-o!s. %Tax cost in $ millions"taxable gain on divestiture]marginal tax rate. &Acquisition premium in $ millions"30% of the sales price or the spin-o! market value. 'Net tax cost in $ millions"tax cost less acquisition premium. )Spin-o!s are treated &as if ' they were sales in the following calculations.

Because we assume that managers seek to maximize shareholder wealth, the $37 million mean net tax cost (Table 4, panel E) associated with a tax disadvantaged sales transaction, assuming a 30% acquisition premium, can be interpreted as an estimate of the nontax bene"ts that must arise on average from

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structuring the transaction as a taxable sale rather than a nontaxable spin-o!. That is, liquidity bene"ts, "nancial reporting bene"ts, or other net bene"ts must collectively add at least $37 million of value to the average sale, relative to a spin-o!, to o!set the incremental taxes paid. Likewise, for the 17 spin-o! "rms that have forgone tax benexts from not structuring the divestiture as a taxable sale, there must be some unidenti"ed o!setting bene"ts from a spin-o! to justify the spin-o! decision. 4.3. Limitations of our estimation approach for net tax costs14 As discussed above, shareholder wealth-maximizing managers choose sales when SA ![(SA !BASIS )]q #N¹B ![SA /(1#p )]'0, (1a) j j j j j j j where for transaction j, SA is the sales price, BASIS is the tax basis, q is the tax j j j rate, N¹B is the net nontax bene"ts of a sale relative to a spin-o! with j N¹B 50, and p is the pre-tax premium from selling the asset rather than j j spinning it o!. Conversely, such shareholder wealth-maximizing managers choose spin-o!s when [SO (1#p )]!M[SO (1#p )!BASIS ]q N#N¹B !SO (0, (2) j j j j j j j j where SO represents the market value of the nontaxable spin-o!, such that j SA "SO (1#p ). (3) j j j Because N¹B is assumed to be nonnegative, conditions (1a) and (2) together j imply that a taxable sale will always be chosen when MSA ![(SA !BASIS )]q N![SA /(1#p )]'0. (4) j j j j j j That is, the after-tax proceeds of the sale exceed the estimated value that would have been obtained from a spin-o!. However, if (4) is not satis"ed, a taxable sale will still be chosen if [SA /(1#p )]!MSA ![(SA !BASIS )]q N(N¹B . (5) j j j j j j j That is, the nontax bene"ts (N¹B ) exceed the value that would have been j obtained from a spin-o! less the after-tax proceeds of the sale. So a sale is chosen when the nontax bene"ts of a sale exceed the net tax costs. Conversely, a spin-o! will be selected when (5) does not hold. Ideally, we would observe both the sale and spin-o! value for each of our divestitures. Because this is not possible we estimate an &as if' SA for spin-o! j transactions and an &as if' SO for sales transactions. We do this by observing j 14

We thank an anonymous referee for suggesting this analysis.

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either the SA or SO that actually occurred and applying an estimate of p in (3) j j j to obtain the unobserved &as if' price. We estimate p in two ways; one assuming j a "rm-speci"c buyer tax bene"t (B¹B ) and the other assuming an acquisition j premium that is a constant percentage of the spin-o! value. Both our "rm-speci"c and constant percentage estimates of p are susceptible j to measurement error. The "rm-speci"c estimates of p (which take account of j buyer tax bene"ts (B¹B )) will underestimate the actual p if the buyer perceives, j j and is willing to pay for, synergistic (nontax-related) gains as well as tax bene"ts. We address this possibility by assuming instead that p equals the median j acquisition premium observed in acquisitions of free-standing companies from 1987 to 1996 (i.e., for all j), which is generally larger than the p 's obtained from j our BTB analysis. Unfortunately, assuming a constant p across all divestitures introduces measurement error to the extent that "rm-speci"c acquisition premiums di!er from the median premium that we apply.15 We investigated ways to mitigate the measurement error by estimating "rm-speci"c synergistic premia for our sample of divestitures. We reviewed variables reported in the takeover literature as explaining cross-sectional variation in acquisition premia but we were unable to arrive at a useful estimation approach. Most of the variables identi"ed } such as cash versus stock consideration and hostile versus negotiated bids } are not applicable in our setting (all our sales are for cash and all are negotiated). In order to calibrate the sensitivity of the results to the potential measurement errors, we repeat the analysis, varying the assumed p from 0% to 50%, as reported in Table 3, and recognizing that the results in Table 3 could just as readily be evidence of variation in premiums as evidence of tax disadvantaged restructurings. While the sample sizes of tax disadvantaged sales and tax advantaged spin-o!s are obviously a!ected by varying p, we "nd that the tax and nontax trade-o!s that we document (Table 7) are qualitatively unchanged by varying p across these levels. However, as we can never directly observe p , we j cannot unambiguously rule out problems associated with measurement error in our &as if' prices caused by imperfect p 's. For example, our estimates of the tax j and nontax trade-o!s that "rms make in their divestiture decisions could be biased if measurement error in our estimate of p is correlated with N¹B . j j The potential measurement error in the estimates that assume a constant p across divestitures has three implications for our analysis. First, in the empirical analysis, it is not possible to separate the e!ects of p and N¹B . Thus, j j it is possible that what our analysis attributes to cross-sectional variation in N¹B is really measurement error in our p estimates. j j 15 While our results (reported in Table 4, panel A) indicate no statistically reliable di!erences between BASIS/SA for sales transactions and spin-o! transactions, this does not rule out di!erences in speci"c cases. In addition, we "nd evidence of di!erences in both size and performance between subsidiaries that are sold and those that are spun-o! (see Table 5).

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Second, a direct implication of the unobservability of both p and N¹B is our j j inability to distinguish between a manager who trades o! taxes for nontax bene"ts and N¹B "0. If N¹B "0, then taxable sales will only be chosen j j when [SA /(1#p )]![SA !(SA !BASIS )q ](0, j j j j j j

(6)

However, sales transactions are classi"ed as tax disadvantaged only when the following is true: [SA /(1#p6 )]![SA !(SA !BASIS )q ]'0, j j j j j

(7)

where p6 is the estimated premium (e.g., p6 "0.3). Thus, if the true nontax bene"ts were zero (N¹B "0) then p 'p6 and our estimated nontax bene"ts will be j j correlated with (p !p6 ). Cross-sectional variation in (p !p6 ) driven by "rmj j speci"c tax and nontax factors a!ects our categorization of transactions as tax disadvantaged or tax advantaged. That is, if we systematically understate p6 for sales transactions, we categorize too many sales as tax disadvantaged and overstate the amount of net tax cost. Likewise, if we systematically understate p6 for spin-o! transactions, we categorize too many spin-o! transactions as tax advantaged, overstating the amount of net tax savings. The third implication of the unobservability of both p and N¹B is that the j j sample may be biased toward including sales with large NTBs and spin-o!s with low NTBs. The original sample consists of 218 sales and 52 spin-o!s. Assuming p6 "30%, the sample is reduced to 66 tax disadvantaged sales and 35 tax advantaged spin-o!s. Consider a sale transaction k that, at p6 "30%, is categorized as a tax advantaged sale. For this transaction we know that SA SA !(SA !BASIS )q ! k '0. k k k k 1.3

(8)

Eq. (8) satis"es the condition for a tax advantaged sale even if NTB is zero. Therefore, if NTB is independent of p, the tax disadvantaged sales are likely to be those with large NTBs. Conversely, consider the 35 spin-o!s that are categorized as tax advantaged spin-o!s at p6 "30%. For these tax disadvantaged spin-o!s: SO (1.3)![SO (1.3)!BASIS ]q !SO (0. j j j j j

(9)

For management to have chosen to spin-o! these subsidiaries rather than sell them, either the real premia or the associated NTBs were too small to justify paying the tax on a sale. Thus, the sample of tax advantaged spin-o!s may be biased towards including those transactions with small NTBs. While we cannot completely resolve issues about the possible e!ects of measurement error, we rerun our analyses with various values of p6 . Results of

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tests presented later in the paper (Table 7) indicate that the qualitative conclusions regarding trade-o!s of tax and nontax costs are robust to varying these assumptions. However, none of these sensitivity tests includes a "rm-speci"c measure of the acquisition premium, p.

5. Explanations for taxable sales In this section, we compare the characteristics of "rms choosing a taxable sale to those of "rms choosing a tax-free spin-o!, and we explore "nancial and "nancial reporting explanations for the choice of divestiture method. Table 5 reports univariate comparisons.16 The results in panel A indicate that the sales "rms have larger market values, sales and book values than the spin-o! parent "rms although both sets of "rms are large with median market values, sales and assets all greater than $2 billion. While our sample selection procedure ensures that all divested units have market values of at least $100 million, results in panel B of Table 5 indicate that both the mean and median market values of equity of the spun-o! units, measured at the spin-o! date, are signi"cantly larger (at the 0.01 level) than the market values of the sold units measured as the sum of the cash and stock paid for the unit by the buyer.17 (These measures do not include an assumed acquisition premium.) In addition, the spun-o! units are a larger proportion (measured by market values) of the parent. We expect that spun-o! units may be larger than sold units because the spun-o! entity must be viable as a stand-alone public entity, because a large subsidiary may be harder to sell (the universe of potential buyers is smaller) and because smaller subsidiaries, particularly those small relative to the parent, may be sold for expediency. Although the book values of the subsidiaries are not statistically di!erent (panel B), the subsidiaries' book-to-market ratios are signi"cantly greater (at the 0.0001 level) for sales than for spin-o!s.18 This di!erence is expected because the

16 In these analyses, we report both means and medians but focus primarily on the latter to avoid the in#uence of a few unusual observations. 17 We considered including spin-o!s of less than $100 million but did not do so for two reasons. First, we believe that the $100 million cuto! is important for comparability between the sales and spin-o!s. Secondly, many of the spin-o!s excluded due to size were much smaller and lacked su$cient data to include them in the analysis. 18 Book value of sold units is computed by subtracting the pretax gain or loss in the notes to the parent's "nancial statements from the amount received for the unit sold. The amount received is usually obtained from notes to the parent's "nancial statements or, when not available, from the buyer's "nancial statements or press releases. The book value of the spun-o! units is obtained from the parent's statement of changes in shareholder's equity. Because spin-o!s are treated as a dividend for "nancial statement purposes, the parent "rm debits equity (usually retained earnings) for an amount equal to the net book value of the subsidiary.

Tax advantaged spin-o!s (N"35)

t-statisticH (p-value)

366 186 0.514 0.124

0.473 !0.083 0.056 0.018 0.057 0.012 0.144 0.069

Panel C: Valuation and proxtability of the parent in the year preceding the divestiture BVE/MVE 0.447 0.517 !0.82 (0.42) B/M } ind. adj. !0.111 !0.024 !1.01 (0.31) Earnings/Price 0.042 0.035 0.42 (0.68) E/P } ind. adj. !0.062 0.018 !1.17 (0.24) Return on assets 0.049 0.051 !0.07 (0.94) ROA } ind. adj. 0.003 0.008 !0.26 (0.80) Return on equity 0.126 0.110 0.31 (0.76) ROE } ind. adj. 0.037 0.033 0.08 (0.93)

!2.61 !1.44 3.37 !3.36

3256 3845 5141 1382

Tax disadvantaged sales (N"66)

Median

(0.01) (0.16) (0.00) (0.00)

Panel B: Size of subsidiary as of the date of the divestiture in $ millions Market value 555 1649 Book value 255 423 BV/MV 0.545 0.244 [Unit MV]/ 0.253 0.514 [Parent MV]

Panel A: Size of parent as of the end of the xscal year preceding the divestiture in $ millions MVE 6485 3391 2.18 (0.03) Sales 6419 3911 1.83 (0.07) Total assets 7805 7678 0.05 (0.96) BVE 2519 1411 2.11 (0.04)

Tax disadvantaged sales (N"66)

Mean

Table 5 Characteristics of tax disadvantaged sales and tax advantaged spin-o! "rms

0.512 !0.073 0.039 0.021 0.053 0.005 0.116 0.039

788 153 0.218 0.411

2092 2637 3834 753

Tax advantaged spin-o!s (N"35)

!0.33 0.41 1.98 0.18 1.00 0.59 1.42 0.93

!2.59 !0.09 4.27 !3.77

2.20 2.31 1.58 2.71

(0.74) (0.68) (0.05) (0.86) (0.32) (0.55) (0.16) (0.35)

(0.01) (0.93) (0.00) (0.00)

(0.03) (0.02) (0.11) (0.01)

Z-statisticH (p-value)

134 E.L. Maydew et al. / Journal of Accounting and Economics 28 (1999) 117}150

0.494 !0.018 0.306

!4.76 (0.00) 0.89 (0.42) !1.93 (0.06)

0.042 !0.021 0.008

0.448 !0.013 0.273

!5.47 (0.00) !0.55 (0.58) !5.13 (0.00)

Ht-statistic (Z-statistic) for the di!erence (sales}spin-o!s) in means (medians). MVE " common shares outstanding as of FYE preceding divestiture]closing price per share at FYE ($ millions) Sales " total annual sales in $ millions for year preceding divestiture Assets " total assets in $ millions for the FYE prior to the divestiture BVE " common shareholders' equity in $ millions for the FYE prior to the divestiture Market value " for a sale, the proceeds (cash and stock) from sale of unit ($ millions); for a spin-o!, the number of shares spun-o!]closing price on e!ective date of spin-o! ($ millions) Book value " for a sale, the proceeds less gain/plus loss ($ millions); for a spin-o!, the debit to retained earnings of parent for the spin-o! ($ millions) BV/MV " ratio of book value to market value Ind. adj. " industry-adjusted ratio. The median ratio of all "rms with the same two-digit SIC code as the "rm is subtracted from the "rm's ratio to form the industry-adjusted ratio [Unit MV/Parent MV ] " ratio of the market value of the divested unit (as of the divestiture date) to the market value of the parent as of the preceding FYE BVE/MVE " ratio of book value of equity to market value of equity Earnings/Price " ratio of net income per share to price per share as of the FYE prior to the divestiture Return on assets " net income plus after tax interest expense/average total assets Return on equity " net income available to common/average common shareholders' equity Pretax gain/MVE " "nancial reporting pretax gain for sales transactions and pretax &as if ' gain for spin-o! transactions/parent's market value of equity at the end of the year preceding the divestiture * Earnings w/o gain/MVE " earnings without gain on sale less last year's earnings/parent's market value of equity at the end of the year preceding the divestiture * Earnings with gain/MVE " earnings with gain for sales and &as if ' gain for spin-o!s less last year's earnings/parent's market value of equity at the end of the year preceding the divestiture

Panel D: Financial reporting gains and losses Pretax gain/MVE 0.133 * Earnings w/o gain/MVE 0.044 * Earnings with gain/MVE 0.128

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di!erence between book and market values is a coarse proxy for the taxable gain on the sale. These results also indicate that, on average, sales transactions are not accorded higher premia relative to book values than are spin-o!s (spin-o!s are shown at their reported spin-o! market value, without imputing a BTB or acquisition premium). These results are not sensitive to assumptions about an acquisition premium because adding such a premium to the market value of spun-o! subsidiaries decreases the book-to-market ratio further. Of course, the relevant acquisition premium is not the di!erence between market value and book value but rather between SA and SO , the j j unobservable di!erence between the sales price and the spin-o! value for the same subsidiary. We also test for a di!erence between industry-adjusted book-to-market ratios of the divested units (results not reported in tables). After subtracting the median two-digit industry book-to-market ratio for the year prior to the divestiture from each divested unit's book-to-market ratio, the sold units had statistically signi"cantly greater mean and median industry-adjusted ratios than the spuno! units (p(0.0001). 5.1. Financial reporting considerations As indicated in Table 1, sales generally trigger both accounting and tax gain/loss recognition. The parent recognizes accounting gain or loss equal to the di!erence between the sales proceeds and the book value of the subsidiary's net assets. When material, both the sales proceeds and the gain or loss are disclosed in the parent's "nancial statements. A spin-o! generates no accounting gain or loss because it is treated as a dividend. This section assesses whether "rms are willing to incur tax costs in order to achieve a "nancial reporting gain. The accounting literature documents earnings management activities associated with contracting considerations and with management's perception that reported earnings matter to investors, as witnessed by the alleged importance of P/E ratios, avoidance of EPS dilution, and concern over stable growth in earnings. Panel C of Table 5 contains descriptive statistics on several accounting variables of interest to management and investors: book value to market value of equity (BVE/MVE), earnings to price (E/P), return on assets (ROA), and return on equity (ROE). One possible explanation for taxable sales, even when tax disadvantaged, is that unpro"table or marginally pro"table parents prefer the "nancial accounting gains that accompany sales. The results in panel C of Table 5, however, do not indicate that parent "rm pro"tability measures (whether industry-adjusted or not) di!er between tax disadvantaged sales and tax advantaged spin-o!s. In fact, the only signi"cant di!erence between the tax disadvantaged sales parents and the tax advantaged spin-o! parents is the former have a higher median E/P ratio.

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The "nancial accounting incentives for a spin-o! may stem from a wish to free the P/E of either parent or subsidiary to attain its &pure play' level. For the sample of spin-o! "rms, we compare the book-to-market ratios and the earnings-to-price ratios of the parent and the subsidiary on both a raw and an industry-adjusted basis; results (not reported) indicate no statistically signi"cant di!erences in either ratio for the parent and the subsidiary in either the year before or the year of the spin-o!. Panel D of Table 5 presents the accounting pretax gain from the divestiture. Pretax gains on sales are gathered from the notes to the parent's "nancial statements. For spun-o! units, the gains are &as if sold' gains, estimated by subtracting the book value of the subsidiary from its market value adjusted for the assumed 30% acquisition premium. The mean (median) pretax "nancial reporting gain for the taxable sales, scaled by the market value of equity of the divesting "rms, is 0.13 (0.04) compared to 0.49 (0.45) for the spin-o!s, consistent with the larger relative size of the spun-o! units and the lower book-to-market ratios (signi"cant at the (0.01 level). These results are not consistent with "rms maximizing reported net income regardless of the tax cost. In Panel D, we also report earnings changes with and without the accounting gain, to assess whether sales "rms' pre-transaction earnings are relatively lower than spin-o! "rms'. This comparison indicates that the median changes in earnings from the year before the divestiture to the year of the divestiture, excluding the income e!ect of the divestiture, are negative for both tax disadvantaged sales "rms and tax advantaged spin-o! "rms. However, while the income e!ect of the divestiture (the &as if sale' e!ect for spin-o!s) is positive for both sets of "rms, the median e!ect for spin-o! "rms is greater (at the 0.0001 level) than the e!ect for sales "rms. This di!erence is consistent with the view that spin-o! "rms sacri"ce accounting earnings gains to save taxes. Analyses of the tax characteristics of the parents (results not reported) indicate no statistically signi"cant di!erence in either the marginal tax rate or in the net operating loss carry-forwards at the end of the year preceding the divestiture for sales and spin-o!s. 5.2. Financing constraints Another plausible explanation for the taxable sales is that "nancing needs of the divesting "rm dominate the net tax costs. Given "nancing needs, a spin-o! may be disfavored because it generates no direct cash in#ow.19 Two main explanations are given for asset sales. First, assets move to their highest valued use, so managers sell when appropriate regardless of the "rm's "nancial position

19 Although there may be transfers between parent and subsidiary of cash and/or debt in a spin-o!, there is no net in#ow or out#ow of cash from third parties, as there is in a sale.

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(e.g., Hite et al., 1987). Second, management maximizes its own utility, which is a function of "rm size, and thus does not sell assets, regardless of e$ciency considerations, unless such sales represent the least expensive or perhaps the only source of needed capital (e.g., Lang et al., 1995). Funds provided by asset sales may also be attractive due to fewer restrictions than other external funds. Pressing capital needs might preclude a spin-o! unless there were no perceived viable alternatives and the divested subsidiary was a cash drain. Although there is no consensus in the "nance or economics literature on an operational de"nition or measurement of "nancial constraints, the existence of such constraints is generally accepted to produce a wedge between the internal and external cost of funds. The disagreement encompasses both theoretical (e.g., Chirinko, 1996) and empirical (e.g., Kaplan and Zingales, 1997) speci"cations of "nancial constraints. Most studies of "nancial constraints include measures of liquidity, leverage, and pro"tability. We incorporate these three types of measures in our univariate analyses in Table 6. Table 6 provides mixed evidence of deterioration in the "nancial health of sales "rms relative to spin-o! "rms in the two years prior to the divestiture. Speci"cally, for our samples, the leverage ratio increases, and the debt rating decreases, for sales "rms over the two years preceding the divestiture; there is no analogous change for spin-o!s. However, there is no systematic evidence of relative deterioration in the other measures. Overall, the results are only weakly consistent with "nancial constraints in#uencing the form of divestiture (i.e., parents of sold units demonstrate somewhat less "nancial #exibility than the parents of spun-o! units). Because the variables we use to measure liquidity, leverage and pro"tability are signi"cantly positively correlated, on average, we include one of the most widely used measures of "nancial constraints, the debt-to-assets ratio, in our analysis of the divestiture method choice in Section 6.20 5.3. Other considerations If we relax the assumption that managers maximize shareholder wealth, managers' preference for "rm size may lead them to favor asset sales over spin-o!s. The fact that spin-o!s occur means that this e!ect cannot dominate all transactions. Alternatively, if managers believe that the divested unit cannot be sold for its full value because of asymmetric information, they will choose a spin-o! in order to provide existing shareholders the opportunity to bene"t from the predicted increase in the value of the divested unit. This e!ect could be

20 Lang et al. (1995) report that during 1984}1989 the typical asset sale "rm performs poorly and has high leverage before the sale.

1.21 0.29 0.69 0.03 0.18 9.93 1.48 0.06 !0.00 9.30 !0.44

1.50 0.25 0.71 !0.03 0.13 4.03 0.22 0.05 !0.01 10.00 0.05 !1.72 1.23 !0.53 2.82 1.72 1.36 0.75 0.88 0.64 !1.07 !2.81

(0.09) (0.22) (0.60) (0.01) (0.09) (0.18) (0.45) (0.38) (0.52) (0.29) (0.01)

1.01 0.29 0.68 0.00 0.16 4.10 !0.05 0.05 0.00 9 0

1.23 0.25 0.70 !0.01 0.11 2.76 !0.25 0.05 0.00 10 0

Tax advantaged spin-o!s (N"35)

!1.47 0.92 !0.83 2.90 2.18 1.58 0.04 0.54 !0.33 !0.95 !1.93

(0.14) (0.36) (0.41) (0.00) (0.03) (0.11) (0.96) (0.59) (0.74) (0.34) (0.05)

Z-statistic* (p-value)

*t-Statistic (Z-statistic) for the di!erence (sales}spin-o!s) in means (medians). Current ratio " current assets/current liabilities LTD/total assets " long term debt/total assets Liab./total assets " total liabilities/total assets * Liab./tot. assets " change in liabilities/total assets ratio from the previous year CF Oper./liab. " cash from operations/total liabilities Interest coverage " (net income#interest expense # tax expense)/interest expense * Interest coverage " change in interest coverage ratio from the previous year Free CF/TA " ratio of free cash #ows of the unlevered "rm to total assets with free cash #ows calculated as cash #ow from operations less after tax interest expense less capital expenditures * Free CF/TA " change in the ratio of free cash #ows to total assets from the previous year Debt rating " S & P debt rating from COMPUSTAT where: 8"A; 9"A!; 10"BBB# * Debt rating " change in S & P debt rating from the previous year

Current ratio LTD/total assets Liab./total assets * Liab./tot. assets CF Oper./liab. Interest coverage * Interest coverage Free CF/TA * Free CF/TA Debt rating * Debt rating

Tax disadvantaged sales (N"66)

t-statistic* (p-value)

Tax disadvantaged sales (N"66)

Tax advantaged spin-o!s (N"35)

Median

Mean

Table 6 Measures of parent "rm liquidity and solvency in the year preceding the divestiture E.L. Maydew et al. / Journal of Accounting and Economics 28 (1999) 117}150 139

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observed if spin-o! values increase beyond reasonable benchmarks or expectations. Cusatis et al. (1993, 1994) report post-spin-o! stock price gains and signi"cant operating improvements by spun-o! "rms (as well as their parents). However, their stock price results are driven by takeovers within three years of the spin-o!. Because the post-transaction abnormal returns are highly correlated with measures of operating performance, it is di$cult to conclude whether the spun-o! "rms were undervalued at the spin-o! and subsequently acquired by perceptive bidders or whether their performance signi"cantly improved after the spin-o!, making them attractive takeover targets. Because the same e!ect was observed for both the parent and the subsidiary, strong inferences are elusive. Managers may also wish to divest &bad' acquisitions inconspicuously, and spin-o!s, unlike sales, avoid establishing an obvious market price (and "nancial reporting loss). However, this explanation implies smaller premiums over book value for spin-o!s than for sales, and we "nd the opposite. In addition, for large companies such as our sample "rms, the divestitures are generally well analyzed, hence not inconspicuous. Finally, di!ering (nontax) transactions costs for sales and spin-o!s may a!ect the choice of divestiture method. Our preliminary investigations (results not reported) indicate that the transactions costs are unlikely to di!er signi"cantly between the two methods.

6. Multivariate analysis of divestiture choice 6.1. Logit model of divestiture choice Building on the univariate comparisons reported in Section 5, we use a logit model to examine how tax, cash #ow and "nancial reporting considerations, taken together, in#uence the probability of choosing a taxable sale rather than a tax-free spin-o!. Our goal is to identify the key factors in the decision and to quantify the dollar magnitudes of the tradeo!s between the tax and nontax factors. Our inferences should be interpreted in the light of possible correlations between our proxies for nontax bene"ts and measurement error in our estimates of acquisition premia. While the sample sizes of tax disadvantaged sales and tax advantaged spin-o!s are obviously a!ected by varying p, we "nd that the tax and nontax trade-o!s that we document (Table 7) are qualitatively unchanged by varying p across these levels. However, as we can never directly observe p , we j cannot rule out problems associated with measurement error in our &as if' prices caused by imperfect p 's. For example, our estimates of the tax and nontax j trade-o!s associated with divestiture decisions could be biased if measurement error in our estimate of p is correlated with N¹B . j j

12.430 ((0.01)

8.579 ((0.01)

3. Including 30% acquisition premium

4. Including buyer tax bene"t (BTB) !39.761 (0.10)

!18.688 (0.10)

!14.165 (0.01)

5.270 (0.07)

!3.048 (0.85)

3.824 (0.01)

4.993 ((0.01)

(#)

CASH FLOW

3.378 (0.11)

6.110 (0.01)

2.167 (0.06)

3.968 (0.01)

(#)

CASH FLOW ]¸E<

!12.226 (0.01)

!9.508 (0.03)

!7.519 ((0.01)

!8.265 (0.01)

(!)

INCOME SMOOTH

!1.096 ((0.01)

!1.523 ((0.01)

! 0.740 ((0.01)

!0.612 ((0.01)

(!)

SUB. SIZE

!3.338 (0.01)

(!)

SUB. ROE

!0.030 (1.00)

(!)

PARENT E/P

50.9%

49.6%

19.1%

32.4%

105

91

234

217

Pseudo R2 N

NET TAX COST CASH FLOW LEV INCOME SMOOTHING

" Tax cost of sale less buyer tax bene"t or acquisition premium (if applicable) " Cash provided by sale. Equal to market value of subsidiary less tax cost of sale " Indicator variable re#ecting high leverage. 1 if ratio of long-term debt to total assets exceeds 0.24, 0 otherwise " Re#ects the distance from target earnings if the divestiture was a sale compared to the distance from target earnings if the divestiture was a spin-o!. Distance from target earnings if sale " absolute value of di!erence between net income including gain (loss) on sale and last year's net income. Distance from target earnings if spin-o! " absolute di!erence between net income excluding gain (loss) on sale and last year's net income SUSIDIARY SIZE " Natural log of the market value of the subsidiary on the date of the divestiture SUBSIDIARY ROE " Subsidiary net income divided by book value of subsidiary shareholder's equity the last "scal year-end before the divestiture less the median ROE of "rms in the same two-digit SIC code PARENT E/P " Parent net income divided by parent market value of equity the last "scal year-end before the divestiture less the median E/P of "rms in the same two-digit SIC code NET TAX COST, CASH FLOW, and INCOME SMOOTHING are all scaled by the market value of the parent's equity at the last "scal year-end before the divestiture

6.611 ((0.01)

2. As reported

(!)

(?) !44.860 ((0.01)

Intercept

7.851 ((0.01)

NET TAX COST

1. Including buyer tax bene"t (BTB)

Computation of net tax cost variable

Independent variables

Logit regressions of divestiture choice (1"tax disadvantaged sale, 0"tax advantaged spin-o!) on proxies for tax costs, cash #ow e!ects, "nancial reporting e!ects, size, and pro"tability. P-values in parentheses below the coe$cient estimates

Table 7 Logit analysis of factors a!ecting the choice of divestiture method E.L. Maydew et al. / Journal of Accounting and Economics 28 (1999) 117}150 141

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Table 7 presents the results of the following logistic regression ("rm and time subscripts omitted for simplicity): SA¸E"b #b NE¹ ¹AX COS¹#b CASH F¸O= 0 1 2 #b CASH F¸O=]¸E<#b INCOME SMOO¹HING 3 4 #b S;BSIDIAR> SIZE#b S;BSIDIAR> ROE 5 6 #b PAREN¹ E/P#e. (10) 7 SALE, the choice of divestiture method, takes on a value of one for a taxable sale and zero for a tax-free spin-o!. The seven explanatory variables include a measure of tax cost, two measures of cash #ow and leverage, a measure of the "nancial reporting e!ect, measures of the size and return on equity of the unit divested, and the parent's earnings-to-price ratio. Each explanatory variable, except SUBSIDIARY SIZE, SUBSIDIARY ROE, and PARENT E/P, is scaled by the parent's beginning of period market value of equity. We measure NET TAX COST, the incremental net tax costs of choosing a sale instead of a spin-o!, in three ways. In the "rst speci"cation, NET TAX COST is computed with the buyer tax bene"t, as described in Section 4 and in the appendix. The second speci"cation eliminates the buyer tax bene"t, so that in the case of sales, NET TAX COST re#ects only the seller's direct tax cost, while in the case of spin-o!s, NET TAX COST is the seller's tax cost on the &as if sale' price. In the third speci"cation, and consistent with the assumptions used in the univariate analyses reported in Section 5, we estimate the &as if sales' prices of spun-o! units as 130% of their spin-o! market values. We do not adjust the sales prices of units sold, since these already incorporate the acquisition premium. We expect the probability of a sale to be decreasing in NET TAX COST. As shown in Table 7, the results are consistent with this expectation. The coe$cient on NET TAX COST is negative in all four speci"cations, with signi"cance levels ranging from 0.01 ("rst two speci"cations) to 0.10 (third and fourth speci"cations). This decrease in signi"cance is not surprising, given the greatly reduced sample sizes for those speci"cations (and increased standard errors).21 CASH FLOW and CASH FLOW]LEV re#ect the incremental cash #ow e!ects of a sale compared to a spin-o!. Speci"cally, CASH FLOW is the after-tax sales proceeds and LEV is a dummy variable that captures cross-sectional variation in 21 The sample size is reduced in the third speci"cation because assuming a 30% acquisition premium reduces the number of sales classi"ed as tax disadvantaged (see Table 3). The sample is reduced in the fourth speci"cation because the data necessary to calculate subsidiary ROE are often not disclosed. The fourth speci"cation uses the NET TAX COST computed with the BTB rather than the 30% acquisition premium because of the substantial reduction in sample size caused by a combination of ROE and 30% acquisition premium.

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the extent to which parents are likely to value cash #ow, consistent with the "nancial constraints literature discussed above. LEV is one if the parent's ratio of long-term debt to total assets is greater than 0.24 (the median leverage of the sample "rms), and zero otherwise. Both long-term debt and total assets are measured at the end of the year preceding the divestiture. A positive sign on CASH FLOW is consistent with greater cash #ow from a sale increasing the probability of a sale. A positive sign on CASH FLOW]LEV is consistent with relatively highly levered "rms attaching greater importance to divestitures generating cash #ows. The coe$cient on CASH FLOW is positive and signi"cant at the 0.01 level in the "rst and second speci"cations, insigni"cant at conventional levels in the third speci"cation, and positive and signi"cant at the 0.07 level in the fourth speci"cation. The coe$cients on CASH FLOW]LEV are positive in all speci"cations, with signi"cance levels ranging from 0.01 to 0.11. INCOME SMOOTHING is designed to re#ect the parent's proximity to its &target' earnings (de"ned as last year's earnings) if it chooses a sale rather than a spin-o!. In other words, this variable assesses the propensity of a parent to match last year's earnings, preferring to incur neither unusual gains nor avoidable losses.22 We de"ne INCOME SMOOTHING as the absolute value of the distance from target earnings if the divestiture were to be a sale, less the absolute value of the distance from target earnings if the divestiture were to be a spin-o!. When INCOME SMOOTHING is negative (positive) a sale (spin-o!) minimizes the deviation from target earnings, so we expect the probability of choosing a tax disadvantaged sale to be decreasing in INCOME SMOOTHING. Consistent with this prediction, the coe$cient on INCOME SMOOTHING is negative and signi"cant at the 0.03 level or better in each of the four speci"cations. SUBSIDIARY SIZE is the log of the market value of the divested unit at the divestiture date. We expect that larger subsidiaries are more likely to be viable as stand-alone public entities and thus are more likely to be spun-o!. In addition, there may be fewer potential buyers for the larger units. As predicted, the coe$cient on SUBSIDIARY SIZE is negative and signi"cant at the 0.01 level or better in each of the four speci"cations. SUBSIDIARY ROE is de"ned as the subsidiary's net income divided by its book value of equity as of the last "scal year-end prior to the divestiture, less the median return on equity of "rms in the same two-digit industry. This variable is designed to test the prediction that under-performing subsidiaries tend to be sold. Alternatively, parent shareholders may want the option of continuing to participate in the growth of well-performing units; a spin-o! allows shareholders

22 An alternative earnings management hypothesis based on managers' wish to take large special charges (sometimes called a &big bath') does not apply to our sample since we include only parents with gains in the divested units.

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to choose whether to hold or to sell the shares of the spun-o! subsidiary. Both conjectures imply a negative coe$cient on SUBSIDIARY ROE, which is re#ected in the results. Including this variable reduces the sample size by over one-half because many sales transactions did not disclose the divested unit's income. We de"ne PARENT E/P as the parent's net income divided by the parent's market value of equity, both measured at the last "scal year-end prior to the divestiture, less the median E/P of "rms in the same two-digit industry. A negative coe$cient on this variable implies that parents with high future earnings prospects, as re#ected by a low E/P ratio, wish to report gains, so they choose to divest by a sale. As indicated in Table 7, the estimated coe$cient on this variable is insigni"cant. Our inferences about tradeo!s between tax and nontax factors should be interpreted in the light of the possibility of correlations between our proxies for nontax bene"ts and measurement error in our estimate of the "rm-speci"c acquisition premium. Although varying p6 alters the numbers of sales and spin-o!s classi"ed as tax disadvantaged and tax advantaged, respectively, our inferences are robust across various levels of p6 . However, as we can never directly observe p , we cannot unambiguously rule out problems associated with j measurement error in our &as if' prices caused by imperfect p 's. For example, the j estimates of the tax and nontax trade-o!s based on the results in Table 7 could be biased if measurement error in our estimate of p is correlated with N¹B . j j 6.2. Economic signixcance of tax and nontax determinants of divestiture choice Because NET TAX COST, CASH FLOW, and INCOME SMOOTHING are all scaled by the parent's market value, they are comparable in dollar terms and we can use the results reported in Table 7 to analyze the economic tradeo!s involved in choosing a divestiture method. This analysis would not be possible if we had used proxies (instead of direct dollar measures) for net tax cost. Thus, one bene"t of the direct measurement approach is that we can assess the economic signi"cance of our estimation results.23 Our analysis of economic tradeo!s uses a one standard deviation increase in NET TAX COST as the benchmark change in the probability of choosing a taxable sale. We then estimate the amount of change required in CASH FLOW and INCOME SMOOTHING necessary to produce an equivalent change in probability. To keep the analysis from becoming too cumbersome we focus on the "rst speci"cation in Table 7.

23 It should also be noted, of course, that our direct measures rest on several assumptions, such as the magnitudes of acquisition premiums. As discussed earlier, our results } even the numbers of transactions categorized as tax disadvantaged or tax advantaged } are sensitive to changes in these assumptions.

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With the explanatory variables at their mean values, highly levered "rms (i.e., LEV"1) have a 97% probability of choosing a taxable sale. For below-median leverage (LEV"0) and the other variables at their mean values, the probability decreases to 90%. The remainder of the analysis assumes LEV"1.24 A one standard deviation increase in NET TAX COST (an increase from the mean of 3.3% to 9.8% of parent market value of equity), with all other explanatory variables held constant at their mean values, decreases the probability of choosing a sale by 32% (from 97% to 65%). Holding all other variables constant at their means, we "nd that reducing the cash #ow provided by a sale from 33.1% of the parent's market value of equity (its mean value) to 0.6% of the parent's market value of equity produces a 32% decline in the probability of choosing a sale. In other words, an equivalent decline in the probability of a sale can result from either an increase in net tax cost of 6.5% of the parent's market value or from a decrease of 32.5% in the cash #ow provided by a sale. Translated to dollars, a $0.20 increase in net tax costs produces the same change in probability as a $1 decrease in cash #ow. Similarly, reported earnings must deviate from target earnings by 35.1% of the parent's market value (an increase from the mean of 5.7% to 40.8%) to produce a 32% decline in the probability of choosing a sale. Thus, an increase in the net tax cost of $0.19 produces the same change in probability of a sale as a $1 increase in the deviation from target earnings.

7. Summary and conclusions Using a sample of 218 taxable sales transactions and 52 nontaxable spin-o! transactions, we investigate how shareholder-value maximizing managers trade-o! tax and nontax costs and bene"ts in choosing a divestiture method. We estimate the magnitude of the tax costs, rather than using proxies, in order to gauge the economic signi"cance of taxes in divestitures and to calibrate nontax e!ects. Because our sales transactions could have been spin-o!s, we hypothesize that managers who choose taxable sales incur tax costs in pursuit of acquisition premia and nontax bene"ts. Our results are consistent with two explanations: managers are willing to incur avoidable tax costs to gain earnings and cash #ow bene"ts, and managers choose taxable sales rather than nontaxable spin-o!s because the acquisition premia on the sales exceed the avoidable tax costs. In our main results, the tax cost estimates are the net of the direct tax cost of the divestiture and the greater of the future tax bene"ts generated by the step-up in tax basis in a sale and the

24 See Caudill and Jackson (1989) for a discussion of measuring marginal e!ects in logit models that include indicator variables, either independent or as part of an interaction term.

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assumed acquisition premium received by selling the subsidiary rather than spinning it o!. The true acquisition premium is unobservable, however, and our results must be interpreted in the light of the unavoidable measurement error in the estimates of the acquisition premium, especially if the measurement error is correlated with any of the proxies for the nontax bene"ts. We investigate two likely forms of nontax bene"ts: "nancial reporting gains and cash in#ows. Our multivariate analyses provide evidence that "nancially constrained "rms will incur tax costs for the bene"ts of either or both capital in#ows and "nancial reporting bene"ts. Because we develop dollar measures of tax costs, we are able to quantify the tradeo! between tax costs and nontax bene"ts. Speci"cally, we estimate that cash-constrained "rms are willing to incur $0.20 of extra tax cost for $1 of additional cash #ow provided by a sale, and are willing to incur $0.19 of extra tax cost to bring reported earnings $1 closer to the earnings target. These results are robust across di!erent estimates of the acquisition premia.

Appendix A. Estimated net tax cost of taxable sales and nontaxable spin-o4s A.1. Background and discussion A.1.1. Net tax cost measurement for nontaxable spin-ows We use &net tax cost' to describe the di!erence in tax obligation induced by divesting via a taxable sale rather than a nontaxable spin-o!. We adopt a multilateral perspective (in the sense of Scholes and Wolfson, 1992) by taking into account tax e!ects related to both the buyer and the seller. For nontaxable spin-o!s, we estimate the &direct tax cost' as the taxes the divesting parent would have paid had it sold the subsidiary instead of spinning it o!. We net this direct tax cost against the tax bene"ts the buyer receives from stepping up the tax basis of the subsidiary's assets and thereby generating additional future depreciation deductions. The &buyer tax bene"t' (BTB) is the present value of these future deductions. Taking a multilateral perspective, we subtract the buyer tax bene"t from the direct tax cost to the seller to obtain the net tax cost. The net tax cost is determined by the taxable gain to the seller and a tax bene"t which derives from the step up in basis. Even if the subsidiary is not expected to perform better as part of the buyer than it would have as a spun-o!, stand-alone "rm, the value of the subsidiary to the buyer will still exceed the spin-o! market value, because the sale generates tax bene"ts from increased depreciation deductions, while a spin-o! does not. In some calculations we assume that the seller can extract this entire bene"t from the buyer in the form of a higher sales price; that is, we add the BTB to the spin-o! market value (SO) to obtain an &as if sold' price (SA). The net tax cost to the seller, therefore, is the di!erence between the seller's incremental tax payment (the direct tax cost) and

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147

the portion of the BTB it can extract from the buyer in the form of a higher sales price. Clearly, this second element of the net tax cost depends on the relative bargaining power of the two parties. Our tests are conservative in that they minimize the net tax cost by assuming that the seller receives the entire BTB. In sensitivity tests, we assume that the seller extracts none of the BTB, making the net tax cost much larger. In other tests, we replace the BTB with a 30% acquisition premium (presumably re#ecting the buyer's willingness to pay for synergistic gains). A.1.2. Net tax cost measurement for taxable sales For taxable sales transactions, we compute the direct tax cost using the observed sales price of the subsidiary (SA), its tax basis (BASIS), and the parent's marginal tax rate (s). As before, we estimate the buyer tax bene"t (BTB) as the present value of the additional depreciation deductions from the step-up in asset basis. This analysis assumes that the seller is able to extract the BTB in the form of an increased sales price; for sales transactions we observe the sales price (so no adjustment is needed). A.2. Calculations of net tax costs The formulas we used to calculate the net tax cost of spin-o!s and sales are detailed below. Net tax cost to recasting a spin-ow as a sale: Net tax cost " Direct tax cost!buyer tax bene"t Direct tax cost " Taxable gain]marginal tax rate25 Buyer tax bene"t " Rn [(Taxable gain/n) (q) (1#0.10)~i] i/1 Taxable gain26 " &As if sale' proceeds (SA)!tax basis (BASIS) &As if sale' proceeds (SA) " Market value equity at date of spin-o! plus buyer tax bene"t Tax basis (BASIS) " Financial accounting book value!book/tax di!erences Financial accounting " Book value of equity at date of spin-o! book value 25 We calculate the marginal tax rate according to Manzon (1994): The marginal tax rate is the statutory rate for "rms without NOLCFs and, for "rms with NOLCFs, it is the present value of the statutory rate expected in the period of the expiration or projected depletion of the NOLCFs. The projected depletion date is estimated by dividing the NOLCF by the expected future taxable income, which in turn is estimated as the market value of the "rm multiplied by the rate of return. Empirically, however, the marginal tax rate thus calculated does not, on average in our sample, di!er signi"cantly from the statutory rate as most of our sample "rms are pro"table. 26 Note that the taxable gain depends on the sales price, which depends on the buyer tax bene"t, which in turn depends on the taxable gain. This relation is solvable, however, by some tedious algebra that produces the following relation: &As if ' taxable gain " M[Market value equity!tax basis]/[1!Rn (1/10)(q)(1#0.10)~i]N where we assume a discount rate of 10%. i/1

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Adjusted pretax "nancial " Pretax "nancial accounting gain!previous accounting gain write-o!s Book/tax di!erences27 " [Deferred tax liability (asset) ](1!q)]/q Deferred tax liability (asset) q n

" Deferred tax liability (asset) of subsidiary " Statutory corporate tax rate " Years of depreciable life, estimated as the subsidiary's property, plant, and equipment/depreciation expense

Net tax cost of a sale, as reported: Net tax cost " Direct tax cost!buyer tax bene"t Direct tax cost " Taxable gain]marginal tax rate Buyer tax bene"t " Rn [(Taxable gain/n) (q) (1#0.10)~i] i/1 Taxable gain " Actual sales proceeds (SA)!tax basis (BASIS) Tax basis (BASIS) " Financial accounting book value!book/tax di!erences Financial accounting " Sales proceeds (SA)!adjusted pretax "nancial book value accounting gain Adjusted pretax "nancial " Pretax "nancial accounting gain!previous accounting gain write-o!s Book/tax di!erences " [Deferred tax liability (asset)](1!q)]/q Deferred tax liability " Deferred tax liability (asset) of parent as of FYE (asset) preceding sale](book value of subsidiary/book value of parent) q " Statutory corporate tax rate n " Years of depreciable life, estimated as the subsidiary's property, plant, and equipment/depreciation expense. A.3. Adjusting for book}tax diwerences We use deferred tax liabilities and deferred tax assets to estimate the di!erences between book values and tax bases of the subsidiary's assets and liabilities,28 so that we can compute a taxable gain or loss as distinct from the 27 See the following section on book}tax di!erences for a derivation of this expression. 28 This estimation cannot incorporate the e!ects of permanent di!erences. However, permanent di!erences are typically quite small compared to temporary or timing di!erences. The basis adjustment assumes that "rms use the balance sheet method of accounting for deferred taxes (SFAS 109 or SFAS 96). Use of the income statement approach to compute deferred taxes (APB 11) would result in a similar adjustment, except that the deferred tax liability would be divided by the average tax rate in e!ect when the timing di!erences originated rather than the tax rate in e!ect in the year of the divestiture. Given the stability of the corporate tax rate during the period of our study, such a di!erence is not likely to be signi"cant.

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"nancial reporting gain or loss. In general, book value exceeds tax basis because of the speci"cs of timing di!erences between tax and "nancial reporting rules (e.g., accelerated depreciation for tax, straight-line for "nancial reporting). Intuitively, the adjustment for book}tax di!erences is related to the net deferred tax liability (asset) and the corporate tax rate. For our sample "rms, we adjust the "nancial accounting book value for book}tax di!erences that give rise to deferred taxes. This basis adjustment, which is subtracted from the "nancial reporting book value, is equal to DefTax (1!q)/q, where DefTax is the net deferred tax liability (asset) attributable to the divested unit and q is the corporate statutory tax rate. To illustrate this adjustment, let BV be the "nancial reporting book value, let TB be the tax basis, and let Temp be the net di!erences between the book values and tax bases of assets and liabilities. Because deferred taxes are neither an asset nor a liability for tax purposes, they must be added back to book value to obtain the timing di!erences: ¹emp"B<#Def¹ax!¹B. Since Def¹ax"¹emp q, we can solve for the tax basis of the subsidiary, TB, as follows: ¹B"B<#Def¹ax!(Def¹ax/q)"B
(A.1)

We use a numerical example to illustrate the application of expression (A.1) to estimate the tax basis (TB) of the net assets of the divested subsidiary: Assets } Liabilities (other than deferred tax assets and liabilities) Net deferred tax liability (asset) Shareholder's equity

Book $100 $20 $80

Tax $TB * *

If q"0.35, ($100!TB) 0.35"$20 and TB"$42.86. Equivalently, TB" $80!$20 (1!0.35)/0.35"$42.86. For spin-o! transactions, deferred taxes are obtained from the "rst annual report of the subsidiary following the spin-o!. Deferred taxes are not available for the sales, because the unit sold does not release separate "nancial statements. To estimate the deferred taxes attributable to the unit sold, we prorate the parent's deferred taxes at the "scal year end prior to the sale between the assets sold and the assets retained, with deferred taxes of sold unit"deferred taxes of parent](book value of unit sold/book value of parent).

References Alford, A., Berger, P., 1998. The role of taxes, "nancial reporting, and other market imperfections in structuring divisive reorganizations. Unpublished Working Paper, University of Pennsylvania. Caudill, S., Jackson, J., 1989. Measuring marginal e!ects in limited dependent variable models. The Statistician 38, 203}206.

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