Transatlantic M&A after US tax reform
Transatlantic deals between the US and Europe have fallen since the end of 2017, although activity levels in the US domestic market have increased. Can this be attributed to US tax reform? And what has US tax reform meant for transatlantic M&A more generally? EY’s James Hume and Joe Toce consider these questions and the broader impact on due diligence, financing and post-acquisition integration.
The tax challenges associated with transatlantic mergers and acquisitions (M&A) have changed. However, this is not simply due to US tax reform. While US tax reform may have introduced a new set of sticks and carrots relevant to deal making, its impact on the approach to tax in M&A must be seen in the context of a wider evolution.
Post-reform transatlantic M&A activity
The available data show that deal volume in 2018 between North American and Western European companies was down 12% on 2017 (and 8% on the five-year average).
The fall was particularly pronounced in the case of deal flow from Western Europe into the US, with volume down 22%. The fall in deal flow from the US into Western Europe, on the other hand, was down only 4%.
The outlier in all of this was the volume of deals from the US into the UK, which was up 17% on 2017 (and 11% on the five-year average).
These trends continued into early 2019, with the US M&A market enjoying its strongest opening quarter since 2000, but M&A activity in Europe has been depressed.
One must be cautious in attributing these developments to US tax reform.
Some might say that European M&A activity has for a long time been propped-up by US-headed groups seeking to deploy cash that US tax rules encouraged leaving offshore. They might then also say that the decline in European M&A activity can be explained by the removal of the relevant tax obstacles to repatriation.
However, it must be recognised that there have been plenty of other significant factors (including geopolitical uncertainty) which have affected cross-border M&A activity since the end of 2017. It is also worth noting that even in situations where cash is being repatriated to the US, it is not clear that it is necessarily funding capital expenditure.
Furthermore, while reform has certainly helped create a favourable backdrop to domestic M&A (lower tax rates have helped to increase earnings), people are still adjusting to the new regime. Many details continue to develop and uncertainty around the US tax system persists, particularly regarding the long-term future of (among other things) the 21% corporate tax rate.
Types of deal making
Looking beyond activity levels and considering the types of deals taking place, one of the more interesting market developments we are seeing in global M&A activity is an increased focus on portfolio structures and an appetite to divest non-core businesses.
The vast majority (84%) of the companies interviewed as part of EY's 2019 Global Corporate Divestment Study reported that they are looking to make divestments within the next two years.
There are many factors encouraging this, including sector convergence, shareholder activism, and perceived weaknesses around the conglomerate model. Nevertheless, for US-headed groups, tax reform has offered an incentive for divestment.
The market is still exhibiting an interest in tax-free spin transactions (including reverse Morris Trust structures) in commercially viable situations. Nevertheless, the 21% US tax rate has taken a lot of the sting out of deals that would have previously been taxed at 35%.
In addition, immediate expensing provisions that apply to acquisitions of certain depreciable property have provided incentive for incremental and creative deal structuring by providing enhanced tax benefits to the parties.
On the buy side, while cost synergies continue to be prominent in how deals are justified in an environment of increasingly high valuation multiples, we also see a broader trend towards M&A activity that focuses on enhancing capability (often digital) and opening up new markets to deal with disruption and achieve growth.
Tax challenges in contemporary transatlantic deal making
Taking a step back from these market trends and looking more specifically at the role tax now plays in transatlantic M&A, two themes stand out.
First, deal-related tax thinking needs to be more long-term, commercial and strategic. Secondly, structuring deals tax efficiently is more difficult and complex, and relies increasingly on balancing a complex range of international factors. We see these themes throughout the transaction lifecycle, from due diligence and valuation, through to acquisition and finance structuring and post-acquisition integration.
Developments in due diligence
US tax reform has not motivated all targets to unwind structures that present significant tax risks in a post-BEPS world, and when it comes to due diligence, it is not uncommon to find that US-headed multinational groups have supply chain (and internal financing) structures that, from a tax perspective, are no longer fit for purpose.
For example, prior to BEPS, the tax incentives for keeping intellectual property (IP) offshore were often greater than they are now where structures like CV/BV (where IP is held by a Netherlands Antilles CV and licenced to a Dutch incorporated BV acting as a European hub) were very popular.
Looking at things from a purely US perspective (and not seeing an effective 10.5% charge on global intangible low-taxed income, or GILTI, as unduly onerous), some of the groups that implemented these structures have not hurried to either collapse or adapt them following US tax reform.
As a result, due diligence exercises continue to identify supply chain structures with insufficient substance in key jurisdictions, and thus with post-BEPS vulnerabilities when it comes to withholding taxes (WHT), controlled foreign corporation/company (CFC) charges and transfer pricing (TP), not to mention the UK's diverted profits tax. State aid risk resulting from old local tax rulings is another symptom.
From the perspective of a buyer, these vulnerabilities and risks represent potential future costs.
In a private deal, it may be possible to address potential pre-acquisition liabilities contractually, but that will not alleviate the need to collapse or adapt the structure in order to reduce potential exposure in the post-acquisition period.
Furthermore, that remedial exercise will not necessarily be straightforward. Sophisticated buyers are increasingly conscious of the need to have substantive activity in jurisdictions to support IP ownership and corresponding profit allocations. It is fundamental to have a modern operational supply chain model that aligns IP to global business objectives.
Achieving that requires an understanding of not only the group's international footprint, but also its strategy and vision for the future, which necessitates close collaboration between the group's business and its tax function. Although worthwhile overall, the task is not to be under-estimated, and buyers need to be conscious of this going into the deal.
The need to scrutinise targets from a BEPS perspective applies whether the buyer is US or European-headed, and whether the target is US or European. Nonetheless, we have often found US purchasers are more interested in the target's US-relevant tax profile (in particular, the likely Subpart F and GILTI implications) and exposure to political change.
With regard to the latter point, it is not uncommon to find prospective US purchasers of UK-headed or otherwise UK-heavy groups concerned more about future-proofing for tax changes which might be brought in by a potential Labour government than they are about Brexit.
One of the ways in which the world of transatlantic M&A has changed the most is in relation to financing. The days of funding the acquisition of European targets by leveraging the US and passing the funding down in a way that generates more than one net deduction overall are more or less over.
The US's restriction of interest deductibility to 30% of earnings before interest, tax, depreciation and amortisation (EBITDA, and in the longer term EBIT), taken together with anti-hybrid rules in the US and elsewhere, mean that most leveraged US buyers are happy with a single net deduction.
The key challenge for a US buyer once it has worked out the maximum amount for which it can expect to obtain tax relief for financing expenses at home is to find one or more jurisdictions where the rest of the debt can be used more effectively, and where tax relief for the financing expenses can be obtained.
This again requires an international, forward-looking perspective, and an understanding of the target business. One must typically not just look at the extent to which the target group has substance in different locations, but also give careful consideration to where the target business is likely to be most profitable, most quickly. It also involves being open to possible alternatives to debt – not least where notional interest deductions against equity may be available.
Life for European buyers of US assets has changed too. The norm would once have been to on-lend into the US and take deductions there against the 35% tax rate. However, buyers wishing to take deductions in the US (even against considerably lower rates) now encounter the problem of the base erosion and anti-tax abuse tax (BEAT). Although there is still scope for pushing debt down into the US, we have therefore seen increased interest in practice in having external debt taken on at the US level (again, to the extent that the US interest restriction rules permit deductibility).
Prior to US tax reform, the default strategy following any European acquisition of a US-headed group was to implement a partial or full 'out-from-under' reorganisation of the US target's non-US subsidiaries, for example through a de-controlling share issuance to a related non-CFC. This would remove those non-US subsidiaries from the US CFC regime and reduce or eliminate US taxation on future profits.
Notwithstanding the introduction of a limited dividend exemption for certain distributions from CFCs, the GILTI inclusion and other changes to the CFC regime, have sustained this appetite for 'out-from-under' reorganisations. However, these new provisions make it considerably harder to execute such transaction tax efficiently. Opportunities remain, but the challenges associated with them are not to be underestimated.
Of greater, and increasing, prevalence is a focus on supply chains, inter-company flows, and the type of income generated by foreign subsidiaries of US targets, with a view to managing foreign tax credit limitations and CFC/GILTI inclusions.
To that end, European buyers of US assets and US buyers of European assets recognise that depending on the particular circumstances, it may be preferable for US group members to have 'foreign branch' or Subpart F income rather than GILTI inclusions.
Despite favourable proposed regulations regarding interest expense allocations for the purposes of foreign tax credits (FTCs) against GILTI, the general allocation of expenses to the new GILTI basket may lead to residual US tax by reducing foreign tax credit capacity limitations, even where the foreign income is subject to a tax rate of 13.125%. Also, excess GILTI credits cannot be carried forward or back.
Part of the post-acquisition integration exercise following US tax reform therefore involves optimising the overall structure to maximise the benefits associated with the 10.5% US tax rate differential between GILTI and other income streams, while minimising FTC limitations by driving the non-US effective tax rate on GILTI earnings to as low as possible. Converting high-tax, non-US earnings into Subpart F income or placing them into a US branch structure may help to further mitigate FTC leakage.
In practice, much of this must be considered ahead of the acquisition as part of the due diligence and valuation exercise.
Of course, it has always been necessary to consider the target's tax profile for both the past and the future, while taking into account acquisition related impacts and appropriate post-closing planning. However, US tax reform has added a new degree of complexity, requiring a different approach to information gathering and modelling.
The interaction of different parts of the new code (e.g. immediate expensing provisions, the interest deductibility limitation, the BEAT, foreign derived intangible income (FDII), GILTI, etc.) is far from straightforward, and is to a large extent dependent on the facts, meaning that an understanding of the target business and of commercial projections associated with it is now more important than ever.
Future transatlantic M&A trends
Another difficulty associated with building an effective post-acquisition strategy following US tax reform is the impossibility of knowing how long the benefits it has introduced (in particular, the 21% corporate tax rate) will last.
This uncertainty has been a feature of all parts of the tax work undertaken in transatlantic deals since December 2017, and has rightly checked some of the excitement that the reform initially triggered.
Whatever the future holds, it seems clear that in the context of cross-border M&A, US tax regime will continue to form just one part of a complex, international landscape. Navigating that landscape effectively will require a global view, and a long-term, strategic approach rooted in a deep commercial understanding of the businesses involved.
*The views expressed in this article are those of the authors and do not necessarily reflect the views of Ernst & Young or any other member firm of the global Ernst & Young organisation.
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James Hume is a tax partner in EY's London office. Prior to joining EY in 2018, James spent 12 years practicing as a tax lawyer with one of the UK's leading corporate law firms.
James advises on the tax-related aspects of private and public mergers, acquisitions, disposals and joint ventures. He has extensive experience in assisting clients with each stage of a transaction, ranging from structuring and due diligence to negotiation, execution, post-transaction integration and tax authority engagement.
Much of James' work is cross-border and multi-disciplinary and sees him working closely with other tax, legal and financial advisers around the world.
James' clients include large multinationals, sovereign wealth funds and private equity houses. In addition to assisting them with M&A, James advises them with the UK and international tax aspects of business and transaction structuring more generally.
Principal, international tax services
Tel: +44 20 7951 0253
Joe Toce is a member of EY's US tax desk in London and leads the desk's US transaction tax group. Previously, Joe spent nine years as part of EY's transaction tax practice in New York City.
Joe advises corporate and private equity clients on the US domestic and international tax aspects of mergers, acquisitions, divestitures, restructurings, and joint ventures. He has worked on a wide range of transactions, providing innovative solutions to complex tax structuring issues involving taxable acquisitions, tax-free reorganisations, cross-border restructurings, and consolidated returns. Joe has significant experience with the development of tax efficient structuring alternatives for post-acquisition integration, divestitures and pre-sale planning, and cash repatriation planning.
Joe received his AB in economics and english from Georgetown University, and his juris doctor from the Georgetown University Law Center. He is admitted to the Bar in Connecticut and New York State.