Taxation and the Dynamics of Corporate Control: The Uncertain Case for Tax Motivated Acquisitions

We develop an analytic framework to examine the familiar claim that the tax system favors corporate acquisitions. The framework is then applied to the three most commonly identified sources of tax gains from acquisitions: the change in asset basis available through taxable acquisitions; the faster use of net operating losses available through nontaxable acquisitions; and the tax deduction available for interest paid on funds borrowed to finance acquisitions. To isolate the role of tax rules, consideration of each of the three sources of tax gains begins with examination of acquisitions and the related alternatives in a perfect market. In such a setting, the alternatives are found to weakly dominate acquisitions as a means of achieving tax gains. We then take one step closer to the real world, relaxing the perfect market assumption to introduce transaction and other information costs. These costs sometimes reinforce and sometimes weaken the perfect market results. The analysis also suggests that, at least with respect to change in basis from acquisitions, the availability of a tax gain may do more than create an incentive to engage in socially wasteful transactions that achieve only tax gains but consume real resources. It appears that in a setting of imperfect information, the provision of a tax gain from asset transfers may operate as a subsidy to mitigate the problem of underinvestment in search for enhanced operating efficiencies. After consideration of the net gains to acquisitions, examination of whether these gains explain the size of acquisition premiums leads to a negative conclusion, in large part because tax gains are anticipated.