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Eight Surprising M&A Candidates

NEW YORK ( TheStreet) -- What if many of the worst performing companies from the 2008 crisis, most of which are either still losing money or struggling to make a profit, started buying up healthy, profitable companies?

Such a scenario is entirely plausible, according to Robert Willens, a corporate tax expert and head of Robert Willens LLC.

The purpose of such an odd-seeming transaction is straightforward enough: Tax avoidance. The losers lost so much money in recent years, they won't have to pay taxes for a very long time. The problem is that they don't make much money either, so they can't make full use of the losses.

If, however, they buy one or more profitable companies, their problem is solved. Why would a profitable company want to be acquired by a giant money loser? Why, to pay no taxes, of course!

Sound absurd? It may, but it is legal, and it was done recently by a little-known company called Clarus Corp. (BDE - Get Report), a former financial software developer that acquired two makers of outdoor sporting equipment. Since the deal was announced on May 10, Clarus's stock has soared, even while the broader market has struggled.

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If this is such a great opportunity, why aren't companies talking about it?

One reason may be that talking about the opportunity is a good way to wreck it. To take advantage of the tax loophole, companies must argue, if challenged by the Internal Revenue Service, that tax avoidance is not the primary purpose of the deal.

"It's always good to sort of play down the tax opportunities," Willens says.

Other companies may not be aware of the opportunity to make use of the losses, Willens says.

That may be because people are used to thinking about struggling companies as potential takeover targets, not acquirers. But while buying a struggling company in order to make use of its losses is virtually impossible, "the tax law is much more liberal when it comes to an acquiring company using its losses against the profits of an acquired company," Willens says.

Other companies may be aware of the opportunity, but they may be cautious because doing an acquisition for tax-related reasons, while pretending to do it for a different reason, might result in bad publicity. John Delaney, Chairman of CapitalSource (CSE) argues his company won't need an acquisition to generate profits in short order in an interview with TheStreet.

Still, many companies have quietly taken steps to preserve the tax losses, which could be wiped out in the event of an ownership change, defined as a 5% shareholder increasing his stake by 50% or more. If an owner of 5% of one of these companies tries to up his stake by 50%, these "poison pill" provisions would trigger heavy dilution. Interestingly, though, companies that go through bankruptcy do not necessarily trigger the ownership change rule that would wipe out the tax credits.

Before I get to the list of companies who could make use of this strategy, a note on tax jargon: A net deferred tax asset counts as an asset on a company's balance sheet, while a valuation allowance is a liability. Both reflect a company's past losses. The difference is that a company's accountants force it to take a valuation allowance if they believe the company in question has a less than 50% chance of realizing enough earnings to make use of the loss.

Put differently, if a company has a valuation allowance, the acquisition of a profitable company can be especially beneficial because it can effectively turn a liability into an asset, leading to a rise in book value.

In an attempt to simplify this presentation, I included a catch-all category called "tax asset." Companies have different ways of describing the assets that can be used to offset taxes, and to avoid inaccuracies, I have tried as much as possible to replicate the language they use in their regulatory filings. Even though technically a valuation allowance is not an asset, it can become one via an acquisition, as Clarus has shown. To come up with the number for the category "tax-free earnings potential," I used the standard corporate tax rate of 35%.

Here, then, are eight companies with very large tax losses, and some thoughts about how likely they are to make use of them through acquisitions.
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