Global: Using tax to enhance exit value on divestments
From the perspective of a divesting group, tax is all too often just viewed as a cost and potential barrier to a successful exit. This is understandable given the often narrow focus on the impact of tax in a divestment but by broadening this perspective there is significant incremental commercial value that can be realised. Richard Clarke and Todd Miller of EY discuss.
The tax cost of a divestment is important to understand from the perspective of the seller but this is only one side of the story. The key to accessing the implicit, sometimes hidden, tax value within a business is to put ourselves in the position of the purchaser and to look at the business through their eyes.
This approach takes strategic thinking and an understanding of the potential buyer community but can dramatically drive value. It also requires a group's tax function to be closely connected into the broader strategy around the proposed deal. Identifying the potential value is the first hurdle. Realising that value is the second and this is where many divestments fail to deliver. Understanding the pricing and completion mechanics of a process is fundamental to a seller being able to use the right tactics to ensure that tax value is priced into the deal by the buyer.
This article outlines some of the leading practices for maximising value on divestments.
Early engagement pays dividends
There is a direct correlation between early strategic planning of a divestment and the returns achieved. This is a clear conclusion in EY's 2014 Global Corporate Divestment Study and the conclusion applies equally to tax within a divestment.
As part of any strategic planning, the early consideration of the impact of tax on a divestment can move tax from being a cost to one of the drivers of commercial value – in terms of maximising both the price achieved for the divestment and the valuation of the remaining group.
This article focuses on maximising the price for the divestment. However, the impact on the valuation of the remaining group is something that is not often considered.
As part of any group's divestment strategy, the decision as to whether to divest or not considers numerous factors from the return on capital from a particular business to the impact on overall earnings of the group. Upfront tax costs are typically factored into this decision process but the impact on the future tax profile of the group is not always considered properly. For example, if the business operates in a high tax country or there is significant withholding tax leakage in the business being divested, the divestment would have a positive impact on the overall effective tax rate of the group. Whilst the overall divestment will reduce the group's earnings per share (EPS), the above tax impact would cushion the initial EPS effect and also improve the tax profile of the group going forwards.
This impact is not considered as often as it should be in the decision making process.
Know your buyer community: How do they see your business?
In the same way that a financial buyer will look at a business differently to a trade buyer from a commercial perspective, the same is true from a tax perspective. The tax characteristics that are important will differ between buyers, with certain buyer groups able to realise benefits that other buyers cannot. Similarly some buyers will identify and price in tax value, others may not.
Time is well spent looking at a business through the eyes of a buyer and through the eyes of specific buyer groups to first identify what would be of value to them and then to present that value in the right way, with sufficient certainty to ensure that it is priced into the deal.
For example, financial buyers are likely to be focussed on the ability to leverage a business to the extent commercially appropriate. For a buyer, ascertaining the debt capacity in various countries from the outside is difficult. But if the seller presents workings and forecasts to illustrate the potential it makes the task of pricing the benefit far more straight-forward.
Where the commercial fact pattern supports it, this early engagement can lead to tax having a transformational impact on deal value. There has been a recent trend in US trade buyers "inverting" out of the US as part of M&A, in that, within the transaction they change the parent company of the group from a US company to a company outside the US. This is a complex area and so is not discussed in more detail here but the tax synergies from this type of transaction can be significant for a buyer.
Understanding whether the business to be divested and the buyer profile give the right fact pattern to allow this type of transaction creates the opportunity to engage in discussions and work with a buyer to validate their thinking. Early engagement is the key to unlocking this type of value, often working with the investment banks in their pre-deal marketing phase.
Typical areas where value can be unlocked
Questions that should be asked as part of any pre-divestment planning, to identify areas where value can be unlocked, include the following:
Can the divestment be structured in a way that is preferable to a buyer?
The comparison of the tax impact of a disposal of assets versus shares is a common analysis undertaken, with the tax cost to the seller on an asset deal often out-weighing the benefit to the purchaser. As a result, consideration of the form of the divestment is often discounted early in a process.
It is, however, worth spending a little more time considering this question.
The tax rate in the country of the buyer may be such that the value to them of an asset deal is greater than expected such that it is worth keeping the structure of the sale open. For example, if a business holds its IP in Switzerland, a disposal may trigger tax at around 12% whilst a buyer could have a business reason to acquire the IP into a country, for example Belgium, with a higher tax rate of 33% and a favourable IP regime that allows for additional tax relief.
There are local domestic regimes introduced by governments that could facilitate the buyer achieving a similar result to an asset purchase. For example in the UK, recently introduced rules designed to make it possible within a commercial transaction to transfer a business to a subsidiary and sell the subsidiary without incurring UK corporation tax on the sale, whilst achieving a step-up to market value in the tax basis of capital and intangible assets. Similarly, in the US, there are specific statutory rules that can treat certain dispositions of shares as asset sales for tax purposes (for example, via Section 338 election or sale of disregarded entity). These structures allow a buyer to achieve a tax basis step-up to market value in the business purchased.
There also still remains the most simplistic solution of offsetting any gains on an asset sale against commercially realised losses in the group. To the extent that losses have limited value, or a buyer is willing to pay for the use of the losses, this continues to be something worth considering.
In multinational divestments, a sometimes overlooked consideration is the allocation of purchase price between entities and/or assets disposed. Commercial teams negotiating the deal assess value of the overall business, whilst for tax purposes the allocation of the value by jurisdiction is important. Knowing the impact of proposed allocations of purchase price between jurisdictions or between assets and shares is important in understanding the cash taxes to be incurred on the divestment and the tax treatment in the hands of a buyer.
Can tax assets be monetised?
Many buyers start with the view that they will not pay for deferred tax assets. Deferred tax is simply an accounting concept and as such there is sympathy with this view. However, to the extent that there is ascertainable value that relates to a particular loss or expense, and the way to access that value has been validated, it is often difficult for a buyer to ignore it for fear of losing competitive advantage.
For example, in the more typical scenario of losses being carried forward, giving sufficient detail to assess the impact of change of ownership provisions and using forecast projections to show when value can be obtained for the losses can maximise the ability to seek payment for the losses.
Perhaps an easier way to identify the specific benefit of tax assets arises when there are payments to be made by the divested business as part of the completion mechanics. For example, where there are bonuses to be paid or options to be exercised with an associated tax deduction, to the extent that it can be shown that the deduction can be offset against current year taxes or carried back against tax paid in previous years, this benefit should be reflected in the price obtained for the divestment.
What is the transfer tax cost of different commercial divestment structures?
Transfer taxes are typically the liability of the buyer and so to the extent that transfer taxes are less with any particular structure there is a direct benefit to the buyer.
There are often several ways to execute a divestment and the overall cost to the buyer should be considered in choosing one particular route. For example, in the UK, stamp duty is typically payable at 0.5% of the consideration paid for the transfer of shares but if a non-UK parent company of a UK group is sold no UK stamp duty should be chargeable.
Similarly where intra-group debt balances with the vendor group are left in place and it is procured that the debt is repaid as part of the completion mechanics, the consideration paid for the shares and potentially any associated transfer taxes is less.
The hardest question of all: How do you make sure that the tax value is priced into the deal?
All the involvement of tax at the strategic planning stage and the identification of tax value within the divestment will add little to enhancing sales prices unless a buyer prices in that value. It is common that a buyer will simply state that any tax value is already implicitly included in their bid. The way to maximise value is to get the buyer to explicitly state the amount of value attributed to future tax attributes, ideally as a positive adjustment to enterprise value. A locked-box completion mechanic is probably the most helpful in this regard (given the line by line inclusion of adjustments to enterprise value (EV) for net debt and debt like items) but the same logic can be applied through any completion mechanic.
Sellers need to act tactically. Some examples of this are discussed below:
Present a separate report of expected tax adjustments to EV to buyers
Rather than wait for buyers to identify tax value for themselves, the best way to highlight and engage in discussions on them is to prepare a separate report that outlines the expected tax adjustments to EV. This should be separate to any vendor due diligence or tax fact book reports prepared.
This approach allows a seller to make sure that all areas of tax value are highlighted. It also gives the opportunity to validate any assumptions and technical basis behind the value items so that buyers can quickly get comfortable that the value is accessible.
This can include all the elements discussed above: the utilisation of losses; the offset of completion payments against historical tax liabilities; and also the value of future tax deductible amortisation with respect to asset deals.
Presenting these items as adjustments to EV also supports the expectation that these items should be valued separately on top of the valuation of the underlying business.
Tactically this allows sellers to request that bids are made excluding any attribution of value to tax assets/benefits as these will be covered by a report to be released later in the process. On the release of the report, revisions to bids can be requested. The timing of the release of this report is therefore key.
Retain flexibility in deal structure
It is often preferable to present a more straight-forward deal structure – typically the sale of particular companies – but always try to retain flexibility in terms of accommodating specific commercial requests from buyers and also in presenting options to them.
Tactically, alternative structures could be presented to buyers with a request for buyers to state how much more they would be willing to increase the purchase price if the seller agreed to structure the transaction differently.
As a simplistic example, if the headline transaction was a sale of shares the alternative presented could be an asset sale with commercially generated losses elsewhere in the group available to offset any gains for the seller.
To the extent that an initial EV has been offered by the buyer for the business, the tax benefit of the asset purchase for a buyer would reflect additional value. The additional sales price to be offered by the buyer would naturally need to be compared to the perceived value of the losses to be utilised, however, it will often be the case that the final sales price offered would be greater than if the business was initially offered for sale as an asset deal.
Said another way, where a buyer does not fully recognise the tax value of an asset sale, appropriate value may not be obtained for the losses utilised by the seller. On a deal initially structured as an asset sale it is often difficult to understand what value is being given for the losses but under the above approach this assessment is clear and the seller is in a position to determine if the value is appropriate.
Tax does not have to be a blocker
It is clear that time and again tax value is not fully reflected in deal pricing where tax is not considered early, at the point when divestments decisions are being made.
Crucially, the focus needs to be shifted away from tax being a one-off cost and blocker to a divestment. Tax can and should be reflected in deal value on divestments.
Standing in the shoes of a buyer and looking at your business through their eyes is the key to accessing this often implicit value.
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Richard is a partner in our transaction tax team in London.
Richard is the transaction tax leader for EY's divestiture advisory services team, advising on all forms of disposal processes from a tax perspective.
He has been providing tax advice exclusively in relation to transactions for more than 10 years – advising on all aspects of a deal from initial due diligence and structuring, tax modeling and SPA implications, through to post-deal integration.
He is responsible for leading a large number of significant cross-border tax due diligence and structuring projects for multinational corporations, private equity and infrastructure clients.
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Todd is a partner in Ernst & Young's transaction advisory services practice and is the America's transaction tax Carve-out leader and the national leader of the Center of Excellence (Section 382, E&P and Basis Studies).
He has 22 years of experience serving a wide variety of corporate clients. Todd has significant experience coordinating and performing tax due diligence investigations for strategic acquisitions and working closely with the acquiring company, post-acquisition, to integrate the operations of the target company with the acquiring company in a tax-efficient manner. Todd also has substantial experience working with companies on both taxable and tax-deferred dispositions of subsidiaries and divisions.