Tax Efficient Structures for Middle Market Transactions
When conducting a middle market merger or acquisition, tax due diligence can often be the key to realising the full financial benefits and adding value to the company. Tax planning enables acquirers and sellers to optimally structure their transaction and post-transaction strategy by taking into account whatever tax implications apply. Understanding the various factors, options and consequences when making a deal can help sellers maximise their after-tax profits and buyers minimise their net costs and drive the transaction to success.
The importance of early planning
Overlooking tax issues can lead to a dismal outcome. In some cases, it can reduce the net value-add of a deal by half. According to a 2007 review of 180 studies on M&A activity over the last 20 years, conducted by Dr Robert F. Bruner at the University of Virginia, about two-thirds of deals failed to achieve the targeted results. Of these, one-third actually destroyed value for the buyer. In some cases, inadequate tax planning was at the source of lost opportunities.
The most crucial tax issues are those that can be dealbreakers, says Anthony DiGiacinto, a Senior Tax Consultant at EisnerAmper, Politziner & Mattia, LLP. “The economic feasibility of the deal may depend upon special tax incentives offered to the industry, for instance. Meeting the qualification to recognise the benefits of these tax incentives should be of the greatest importance. Other common crucial areas are transfer pricing, state and local taxation, and obviously cross-border issues.”
It is necessary to identify the crucial areas, especially if they may lead to regulatory disputes. For instance, disagreements with tax authorities can surface over stamp duty or the amount of tax deductions available for interest on intra group debt. Tax planning is also a way for the acquirer to avoid surprises, such as unpaid tax liabilities or golden parachute packages for executives.
Appropriate contractual warranty and indemnity protection should always be sought, according to Robert Gaut, a partner at Fried, Frank, Harris, Shriver & Jacobson (London) LLP. “If historic tax attributes of the target company are important – net operating losses, tax depreciation and capital losses – appropriate warranties should be sought and price adjustments made if appropriate. Advisers should be alert to any signs that a target has a high tax-risk profile, such as a high level of connected party debt.”
Unfortunately, some buyers fail to address tax issues until late in the due diligence process, as tax benefits are seldom the primary reason for conducting a merger or acquisition. But to be of the greatest value, and to avoid unfavourable tax structures, early planning is vital. The risks of considering tax implications too late in the deal can cost both parties time and in some cases millions in lost benefits or tax liabilities. For example, in the UK, if debt is sourced after an acquisition has closed, tax authorities may question the purpose of the leverage. If the buyer does not have a, adequate response, the debt may be deemed to fall under the UK’s ‘unallowable purpose’ rule in Schedule 9, paragraph 13 of the 1996 Finance Act.
Tax optimisation principles
Different strategies and tax efficient options are available to middle-market companies. One of the most important is the decision to purchase either the stock (shares) or assets of the target company. In some cases, the final decision depends on the tax attributes of each alternative, for both the purchaser and the seller, and on where the deal is conducted. In other cases, the buyer may have no choice, as Mr DiGiacinto points out. “Particular regulations may dictate that the stock of the company must be purchased to obtain licences or contractual rights,” he says. “In these situations an election under Section 338 of the US Internal revenue Code may provide relief. This election allows a stock purchase to be taxed as an asset purchase, thereby allowing the purchaser to obtain a step-up in the assets. The tax attributes of the seller will impact the value of the election and in certain situations is a win-win proposition.”
In the UK, a domestic acquirer planning to buy another domestic company and continue its operations, also has an important decision to make on whether to structure a stock purchase or asset purchase. In general, the acquisition of the business’ assets is the preferred option, according to Mr Gaut. “Tax depreciation will normally be available on capital assets used for the purpose of a trade, as well as on acquired goodwill and intangible assets. Stamp taxes are generally not payable on asset purchase, save in the case of real estate where rates of up to 4 percent apply,” he explains. But some tense negotiations may follow, as a seller in the UK will normally prefer to sell shares, from a tax perspective, due to certain tax exemptions on share sales.
Some general principles apply when maximising favourable tax structures in a midmarket M&A deal. The timing and the character of tax benefits are overriding concerns. “Generally, the faster a company can recoup its investment in tax deductions, the greater the benefit will be,” says Mr DiGiacinto. “The character of the tax benefit is also very important. Tax credits that are a direct offset to tax liability are the most valuable. Deductions that reduce income in low tax jurisdictions are less valuable,” he adds.
Other key principles have to be carefully examined in tax due diligence to achieve the projected financial benefits. For example, maximising tax depreciation on tangible and intangible assets or optimising the recovery of indirect taxes, are among the crucial areas that should not be overlooked. Buyers should also seek to avoid or reduce common tax traps such as withholding taxes on payments of interest, royalties or dividends or unclaimed tax reliefs.
Another common pitfall relates to the tax deductions potentially available on the exercise of employee share options on a takeover, as Mr Gaut notes. “With careful management, the deduction may be made available to the acquiring group, which can increase its commercial value. Sellers should not overlook this issue when negotiating price. The whole area of employee interests in securities needs particularly careful review at the due diligence stage,” he says.
There are other tax related issues that both parties to the deal need to address. In the US, for example, each state imposes a range of income, sales, transfer pricing and property taxes that vary considerably from one location to another. Many states also offer attractive tax incentives. If one or both parties have branches or subsidiaries in different states, getting professional tax advice and negotiating with the state itself is important at the outset of a proposed acquisition process. This principle also applies in cross-border M&A deals, which offer various challenges for tax efficient structures.
Cross-border M&A deals
A number of important issues matter in international M&A deals to ensure that tax liabilities will be minimised for the acquiring company. Achieving favourable tax structures in cross-border transactions requires understanding jurisdictional laws and treaties, and the interaction between them. These jurisdictional differences can have tax implications on the parent firm depending on who acquirers the target company. For instance, a buyer will have to consider whether the parent company or one of its subsidiaries or a foreign subsidiary should conduct the acquisition. The use of the parent company, branches or subsidiaries also applies when losses are made, as there is a possibility of relieving losses depending on the laws of the different jurisdictions involved.
Other specific tax considerations have to be taken into account to avoid disappointing deal results. Transfer pricing between group members is one of the key issue as the penalties for non-compliance can be onerous in some countries. Withholding taxes and possible foreign tax credits against home state taxation must also be carefully considered. Another general variable to look at in an M&A deal, especially in a cross-border transaction, is whether the deal is structured to incur accelerated tax payments or whether tax obligations can be deferred. A parent company may have to pay current taxation on dividends, for example, if one of its branches is based in the US. In such cases, some companies resort to a blocker entity to control the timing of the tax liability. Concerning the purchase financing, acquirers should pay close attention to whether debt is used to facilitate the transaction, how earnings will be repatriated from the target’s country to the parent’s country and where tax relief can provide the most financial benefits to be buyer.
A successful M&A transaction relies on various factors, one of them being tax planning. Spending time on the various tax options and principles involved in deals as early as possible in the due diligence process is often the key to developing the most advantageous tax structure, and adding value to the deal. Thinking ahead about tax implications also puts the acquirer in a stronger position to negotiate.
Richard Sackin, Director of the Tax Department at EisnerAmper
Richard Sackin has over 30 years of experience in the fi elds of accounting and taxation. He is the Partner-in-Charge of EisnerAmper’s International Services Group. Rich has many years of experience in handling international tax matters, both with U.S. corporations regarding controlled foreign subsidiaries and foreign corporations regarding in-bound transactions, as well as transfer pricing for re-organizations and expatriate tax issues. Prior to joining EisnerAmper, Rich was a partner and director of the tax department of the New Jersey offi ce of Ernst & Young. He holds a Bachelor of Arts Degree in Accounting from Upsala College and has completed the Columbia University Executive Management Program.
Anthony DiGiacinto, Senior Tax Manager at EisnerAmper
Anthony's expertise centers on corporate and individual tax planning, FAS 109, FIN 48, consolidated returns, as well as mergers and acquisitions. He services clients in a variety of industries including pharmaceutical research, renewable energy, and real estate. Prior to joining EisnerAmper, Anthony was a tax controller for a large, international energy-fromwaste corporation where he handled the FAS 109 provision process, fi nancial reporting of income taxes and various federal and state tax planning projects. His rich background also includes serving as a senior tax manager with KPMG. Anthony received his Bachelor of Science Degree in Accounting from Rutgers University and his Masters of Science Degree in Taxation from Fairleigh Dickinson University. He is a member of the American Institute of Certifi ed Public Accountants and the New Jersey Society of Certifi ed Public Accountants. He has served as President of Verona Unico, the largest Italian- American service organization in the United States. In addition, he has served as an adjunct professor of taxation at William Paterson University.