Involvement of the corporate tax function
M&A transactions receive a lot of emphasis on strategy, markets, synergies, growth and overall business development. Tax and legal issues are rather seen as risk mitigating execution actions, but the tax impact goes far beyond that. It influences the purchase price, can be a deal breaker, will impact the deal negotiations and significantly impacts the return of the transaction and thereafter.
Consequently, the corporate tax function should be involved in all phases of the deal: Starting with adequate legal structure of the group for tax purpose, early planning about the tax-optimised deal structure; preparation and execution of tax due diligence; translation of the findings into the purchase agreement (PA) and negotiations, to ensure a proper handling of tax risks, enabling the timely and compliant closing of a transaction; followed by post deal integration into the operative and legal structure; and until years later defending, during tax audits, what was done.
From a regulatory perspective, there is limited consistent guidance on an international level. This means it is difficult to make sound decisions that would otherwise prevent long discussions with the counter party or even with tax authorities in several jurisdictions. Companies are well advised to involve their tax function as early as possible.
Finally, post-deal restructurings will also have a strong tax impact, for example centralisation of intellectual property (IP), alignment of licenses for use of technical IP and trademarks, downgrading or upgrading functions and risks of acquired companies, intercompany mergers, intercompany financing of the acquired businesses and realignment of value chains, just to mention a few.
In the following article, special focus is given to selected topics that appear to be recurring in complex international transactions.
The tax burden of any M&A transaction heavily depends on the legal structure of the target.
- Asset deals are subject to ordinary taxation in most jurisdictions, in that they lead to a high cash tax burden for the seller, unless tax-loss carry-forwards are available. Furthermore, they are subject to various indirect taxes and stamp duties and are complex from an operative perspective. The purchaser typically appreciates an asset deal as it allows a step-up in tax basis with tax efficient amortisation and the amount of tax risks taken over is limited to usually only a secondary liability.
- Share deals are typically subject to reduced tax rates or they benefit from participation exemption, in that they lead to a low cash tax burden for the seller. The purchaser is less enthusiastic because he is assuming full legal liability for the target entities, not always fully disclosed in the due diligence process, and is not able to amortise the purchase price for tax purposes. From an operative perspective share deals allow fast execution of a transaction.
Given the above material differences of share and asset deals, the parties should plan as early as possible which deal structure they target.
Therefore, practically any legal restructuring of the target group, which takes place in connection to an intended M&A transaction, will trigger tax costs and incur the risk of sunk costs if the deal does not take place for whatever reason. Therefore, tax efficient deal structuring starts with any new investment and the potential M&A view should be part of the legal structure at any time.
A fully integrated legal structure with one legal entity per country appears to be efficient for current taxation or ordinary business as it allows offsetting of profits and losses of different operative activities and immediate utilisation of start-up losses from new investments. But the divestment part of such legal entity will basically only work via asset deal or split-off. In contrast, a legal structure with multiple legal entities per country, one for each business line, is very flexible towards any M&A deal and allows high portfolio flexibility, but each legal entity is a separate taxpayer, in that the tax burden is higher, unless group taxation is available, such as "Organschaft" (tax consolidation) in Germany or "Consolidated Federal Tax group" in the US, but inexistent in key emerging markets such as Brazil, China and India. The top management of each group needs to make a distinct decision whether current taxes or capital gain taxes are in the focus.
Purchase price distribution
In international deals the parties usually agree upon one total purchase price to be paid for a global business, legally speaking for a number of shares in legal entities and/or of assets, which are located to targets in different jurisdictions. Often shares and assets in a target business are not owned by one central seller but several sub-sellers within the group, depending on the legal structure of the seller group.
Given such complex structures, the allocation of the total purchase price to the usually different sub-sellers within the seller's group has a big impact on the tax burden, because of the differing tax rates and tax treatment in the relevant countries. The cash tax burden can be, for example, below 1% for a share deal from a Swiss sub-seller and up to almost 50% for an asset deal from an Indian sub-seller (including dividend distribution tax for repatriation of the funds). Therefore, tax authorities of all relevant countries will scrutinise whether everybody got his "fair share of the cake".
The only guidance, put forward by internationally accepted rules (OECD transfer pricing guidelines), says that the transaction must be at arm's-length terms. The strongest argument should be if the seller and the purchaser jointly agree on the allocation of the global purchase price to the different target businesses in the global purchase agreement. They have naturally diverging interests and the outcome of negotiations between third parties should per definition be "at arm's-length". But, on the other hand, tax authorities will argue that a group of sub-sellers shares the total purchase price, which tastes like an intercompany transaction. Therefore, taxpayers should be prepared to explain which methodology was applied and why it was chosen as the best method. Such method needs to be consistent and cannot afford to address too many local special wishes and specialties. Given the tax information exchange agreements (TIEA) which are in place and the OECD-BEPS initiatives to increase transparency, taxpayers have to assume full transparency anyway.
There are two different and basic ways to allocate a global price: bottom-up or top-down.
Bottom-up price allocation
Tax authorities often argue with a stand-alone view on the target business in their jurisdiction, which would end-up with certain (isolated) values based on multiple bottom-up calculations. Such a method is, basically, inadequate because it ignores that global purchase prices are not calculated just as a sum of the parts but also takes into account a package premium, which is paid for synergies or strategic purposes but sometimes also with discounts if the overall business is low performing. As a matter of fact, in free market transactions, at the end of the negotiations the purchaser pays what he has to pay if he wants the deal, beyond pure financial models, and accepts the risks which he can afford; and respectively the seller may take what he can get to rid himself of a non-strategic business which is heavily eating into management resources and is sometimes loss making. Such premium or discount needs to be shared appropriately between the sub-sellers, in that a pure bottom-up approach is, in most cases, neither feasible nor fair. The "cake" may not have enough pieces to all sub-sellers on a stand-alone, bottom-up price allocation.
Top-down price allocation
In light of the above weaknesses of the bottom-up calculation a (modified) top-down price allocation is usually more feasible.
The parties may agree to specific values for certain assets and shares as being appropriate to dealing at arm's length, if sufficient market data is available to justify this specific value, for example real estate values and values of certain IP assets, which could easily be sold individually. Such assets would then be excluded from any premium or discount and could mean an exception to the package rule.
In a stable business situation it doesn't really matter whether past or future numbers are applied to those allocation keys. But if the past numbers are influenced by extraordinary events then it is appropriate to normalise the numbers and to assume that the relevant income of the target routine entities should not be lower than the typical EBIT, which should be applicable based on the functions and risk analysis as per the transfer pricing documentation reports of the target entities, for example, using the first quartile of the relevant arm's-length benchmarks for equivalent independent entities. It depends on the specific case what is most appropriate, based on specific economic analysis.
Such top-down allocation may end up with unreasonable results where certain businesses may have an allocated value that is below their net assets. Therefore, the parties should agree on the principle that the value allocation for any business should not be lower than the net asset value (NAV) as per uniform definition like IFRS. Such NAV may have to be increased for operating assets which still have a stand-alone value attached for a relevant number of potential third party acquirers operating not only in the same industry because there is a transparent or clear reference market as a value indicator for such assets. In this case, a third party facing a similar negotiation process could still have a stronger willingness to include a minimum amount for the value considered for such asset in the overall computation. Such assets typically are tangible things like real estate properties (such as land and buildings).
Any adjustments to the purchase price, for instance for cash or debt or for working capital targets, have to be allocated to the specific target business, as these are economically attributable to the individual shares and business.
BEPS and M&A
The action plan on base erosion and profit shifting (BEPS), released July 19 2013 by the OECD, focuses strongly on filling gaps in the international standardisation of rules and shall increase transparency. It would be smart if it would also fill the gap of missing international guidance on the M&A transactions.
When talking about avoidance of double non-taxation, tax authorities claim that they want to have a "fair share of the cake", but inconsistent domestic rules do not respect that there is just one cake to be shared. There is limited guidance on the allocation of global purchase prices although many things have to be considered in such complex cross-border transactions. The development of allocation criteria aligned among the countries could bring an enormous help for corporations to enhance certainty by applying common guidelines, which, as per today, are only generic and create potential future friction (costs and inefficiencies) if jurisdictions have different views on the interpretation of the arm's-length principle for M&A transactions. The BEPS Action Plan expressly admits that "domestic policies cannot be designed in isolation", which is a step to the right direction, but currently M&A reality is far away from that.