During the 1990s concurrent business trends, including globalization and rapid technological advances, fueled a worldwide acquisition spree. The new millennium has brought different challenges to businesses: an economic downturn and global instability.
The aftermath of the acquisition frenzy of the last decade has companies taking a critical look at the post-transaction structure of these acquisitions, as well as looking for ways to maximize deductions. As companies' losses mount, effective loss planning from a tax perspective can have significant balance-sheet implications. Selective planned dispositions of nonessential target companies and divisions are increasingly common. In addition, changes to each country's tax laws can have a profound effect on the structure of those transactions. This article focuses on the tax trends emerging in the current economic environment and tax law changes that affect merger and acquisition (M&A) transactions.
MANAGING LOSSES THROUGH GROUPS
Many of the technology companies most sought-after in the 1990s were throwing off significant losses in hope of creating exponentially larger profits in the coming years. However, for many of those companies, the losses mounted and offsetting income has not been attained. In this situation companies may benefit from tax provisions available in some jurisdictions that allow a group of companies with common ownership to use each company's tax attributes, including losses.
For example, to increase tax efficiencies after an acquisition, Dutch target companies will, in most cases, be included in a fiscal unity with the Dutch purchaser as soon as possible. Fiscal unity allows the companies to offset results of the respective companies in the fiscal unity, including absorbing interest expenses on acquisition debt. However, non-Dutch targets cannot be included in a fiscal unity.
The concept of fiscal unity is in principle similar to that of a consolidated group in other jurisdictions. For example, United States (US) tax laws allow affiliated companies to file consolidated federal income tax returns for consolidated groups and offset the profits of one corporation against the current losses of another. A taxpayer may elect to file consolidated returns when 80% of the vote and value of the outstanding shares of the US corporation are owned by another US corporation that is a member of a group that has a common US parent corporation. Conceptually, the subsidiaries of the consolidated group are treated as direct divisions of the US common parent. However, the use of losses that a company incurred prior to its acquisition may be limited. In certain instances, losses arising from the sale of shares of a subsidiary may be disallowed, as discussed below.
In Mexico, tax consolidation is available but only 60% of the profits and losses generated or incurred by the companies constituting a consolidating group are included in calculating consolidated income. All holding companies must incorporate their tax results in the consolidation, as well as those of its subsidiaries on a 60% basis, while the remaining 40% is filed and the related tax paid individually to the tax authorities.
In Germany, group taxation rules have changed significantly. Previously, German tax law required not only financial integration but also economic and organizational integration of a subsidiary into the parent company. Now the requirements have been reduced to financial integration only. Taxpayers, of course, have welcomed the change in this provision.
However, on the other side-and different from the situation in the past-inclusion of a profit and loss pooling agreement is now required for German trade tax purposes. This means that by contract the parent company is liable for all the losses of the subsidiary. Therefore, the integration of subsidiaries having economic difficulties places additional legal obstacles before the group.
The extensive grouping provisions in the United Kingdom (UK) can lead to greater flexibility in structuring transactions to suit commercial as well as other needs of the group. From a tax perspective, there is now generally no need to hold all UK entities under a single UK holding company in order to benefit from relief for losses and other advantages. Losses can generally be transferred between UK group companies. Interestingly, no requirement exists for the UK companies to have a common UK parent benefit from this loss relief. Rather, a 75% relationship via a non-UK parent is sufficient. In addition, UK branches can receive or surrender losses to and from UK group companies.
MAXIMIZING DEDUCTIONS
The economic downturn has put increasing pressure on profitable companies to effectively use available tax deductions to lower their tax burdens as much as possible. Deductions relating to acquisition costs are frequently overlooked in many jurisdictions. Companies often assume that all costs related to an acquisition in either the target's or acquiring company's jurisdiction (or both) are capital expenses and cannot be deducted. However, a number of jurisdictions provide opportunities for companies to deduct either all or a portion of the costs incurred in relation to an acquisition. While it is generally more efficient to determine the deductibility of such costs at the time of the acquisition, a tax benefit may be obtained for acquisition costs incurred in prior open tax years.
For example, in a number of countries, including Germany, Japan, the UK, and the US, the determination of which acquisition costs are currently deductible in the year in which they are incurred will depend to a significant extent on when the costs were incurred. Costs that are incurred prior to a making a final decision to acquire a target company are generally deductible, provided the costs are deductible in nature. An expense of the same nature that is incurred after that point in time will generally be capitalized and added to the cost basis of the acquired assets or stock. However, unsurprisingly, it appears that in each jurisdiction where it is important to establish a specific point in time that a final decision took place, differences in approach and results exist between the tax authorities and the taxpayers making this determination.
In France, depending on the type of acquisition cost involved, a company may either deduct the cost in the year incurred, or the cost must be spread over a maximum period of five years. Acquisition costs that are eligible to be deducted over a five-year period are costs incurred in setting up a company. The most common costs in this category are registration duties, intermediary's fees (notaries, lawyers, etc.) and legal formality costs (public notice costs). Spreading the deduction over a number of years may be helpful for companies that are not generating enough current income to take advantage of the deductions.
In addition to acquisition costs, companies may be entitled under local laws to take advantage of amortizing intangibles, such as goodwill, over a number of years. In the US, goodwill may be amortized ratably over a 15-year period, while, in contrast, France has no provision for the amortization of goodwill.
The amortization of intangibles, including goodwill, is possible in Germany as well. The recognition of such amortization, however, requires acquisition of the intangible by the company. This result can be achieved by an internal sale of the intangible or an internal asset-deal of business assets, both of which generally are taxable events. Existing loss carryforwards may offset the resulting income taxes. Such a strategy can be used to transfer the tax benefit of loss carryforwards to another company in the form of depreciation or amortization without triggering the change-of-control rule that would limit the use of net-operating losses (NOLs) in certain circumstances.
The 2002 UK budget introduced a new tax regime for amortizing intangible property that applies to most intangible property-patents, trademarks, and other intellectual property. Most significant, however, is that for the first time amortizable intangible property includes goodwill. A budgetary provision included in the finance bill at the time of writing also provides that no stamp duty will be charged on goodwill purchased on or after April 23 2002.
In the Netherlands, any goodwill included in the acquisition price of shares cannot be amortized for Dutch tax purposes. Therefore, with regard to acquisitions of shares in foreign companies, acquisition structures are being used-where possible-to amortize goodwill locally. With regard to Dutch targets, goodwill can become tax-deductible only if the acquisition takes place as an asset-deal. Goodwill included in an asset-deal can generally be amortized in five years. However, Dutch taxing authorities are currently considering whether to extend this five-year term.
Deductions with respect to fixed assets, as opposed to intangibles, may provide tax opportunities as well. As of January 2002, Mexico's income tax law reinstated an immediate deduction procedure applicable to new fixed assets. The deduction may be claimed in the fiscal year following the year in which the use of the related asset starts. Accordingly, although this tax incentive is available as of 2002, the resulting tax benefit will not be realized until fiscal year 2003.
The deduction generally is restricted to new fixed assets used outside the metropolitan areas of Mexico City, Guadalajara, and Monterrey. Companies operating in these metropolitan areas are eligible for this tax benefit only if they have a significant labour force, use clean technologies with respect to the emission of pollutants, and do not require a significant use of water in their production processes.
MANAGING OPERATING LOSS CARRYOVERS
Effectively managing NOLs may also provide opportunities to optimize the use of such tax attributes before the expiration of these losses. In Germany, corporate income tax losses generally may be carried back one year up to an amount of EUR 511,500 ($484,930) and carried forward indefinitely. Trade tax losses can be carried forward indefinitely as well. However, German tax law restricts the use of NOLs in the event of a change of control of the corporation that has accumulated tax losses if, in a period of five years after the change of control, the corporation also receives more new business assets than it had at the time of the change of control.
As a consequence of this rule, the use of any losses accumulated at the time both requirements are fulfilled cannot be offset against future taxable income. In an economic downturn, this rule needs to be observed in M&A transactions. A general strategy to get around this problem is a straightforward asset-deal to convert the tax benefit of the NOLs to future amortization or depreciation.
The US saw significant changes last year in the rules governing the use of subsidiary losses for subsidiaries that are members of a consolidated group. An appellant court invalidated a rule that the Internal Revenue Service (IRS) had been using for more than 10 years to determine the basis adjustments and losses for subsidiary corporations leaving a consolidated group. The IRS has now issued temporary and proposed rules governing sales of stock of members of a consolidated group at a loss. The new rules allow taxpayers to chose from several different methods to calculate a subsidiary's losses and stock basis on a disposition of subsidiary stock, including application of the new rules to past transactions in open tax years.
Under the new rules, a loss on the disposition of the stock of a subsidiary is disallowed to the extent the loss is attributable to recognition of built-in gain on the subsidiary's disposition of an asset, without regard to the duplicated loss factor. The new rules also apply to reduce the basis in the stock of a subsidiary for recognized built-in gains immediately before the subsidiary ceases to be a member of any consolidated group. An asset's built-in gain generally is the amount by which the value of the asset exceeds its basis at the time the subsidiary owning the asset became a member of the consolidated group.
Although taxpayers can choose to apply either the new rules or the old rules to a subsidiary disposition, it may be difficult to establish built-in gain amounts required by the new rules for a subsidiary's assets if the subsidiary was acquired some time ago. In addition, for dispositions occurring prior to March 7 2002, a consolidated group may recalculate the amount of disallowed loss from a prior disposition of the stock of a subsidiary. Accordingly, companies that have US consolidated groups will need to carefully consider not only what the tax advantage (or disadvantage) may be applying to the new rules but also whether the requisite asset basis information is available to make such a calculation.
In the Netherlands, new provisions for loss utilization have been introduced effective January 1 2001. Upon change of control over a company, the right to carry back or carry forward tax losses could be partly or completely lost, in which case specific rules regarding the allowed volume of activities of the company before and after the change of control apply.
Since 1997 it has been possible to write down (temporarily) the cost price of Dutch participations for tax purposes. A minimum shareholding interest of 25% is required for the provision to apply. This amortization is, however, temporary in the sense that it is only possible to write down during the first five years after the acquisition. The write-down then must be recaptured within six to 10 years after acquisition. A permanent deduction generally is possible only after liquidation of the participation.
MAKING THE BEST OF A BAD SITUATION: WORTHLESS SECURITIES
While no one wants to hold worthless securities, taxpayers finding themselves in such a position should, at a minimum, seek a deduction for worthless securities. A deduction is permitted under US tax law for certain securities, which may be stock, stock rights, or debt instruments, in the year in which the security becomes worthless. However, the amount of the deductible loss is limited to the taxpayer's basis in the security.
French tax rules also allow companies to take a write down, commonly referred to as a provision, for losses on stock. However, the taxpayer must establish that the loss is probable, and not merely contingent, and that it resulted from a factual event that occurred at the time the provision was recorded. A loss on worthless stock is characterized as a long-term capital loss, which can only be used to offset long-term capital gains, rather than against ordinary trading losses.
While in the past German tax laws permitted a deduction for worthless stocks, beginning in 2002 write-offs on shares, losses resulting from share transfers, decreases in capital, and liquidations are no longer tax deductible where the parent of the worthless company is a corporation. Accordingly, companies are taking advantage of the prior law to the extent possible, or implementing alternative planning structures. For example, an alternative planning consideration may focus on debt rather than equity financing, which may allow a subsidiary to write off its loan when it becomes worthless. The German tax administration has however published a preliminary position in a draft ruling, concluding that a write-off of a loan that replaces equity is not deductible.
In Canada, a taxpayer can elect to have a 'deemed disposition at nil' for a debt that has become a bad debt in the year, for shares of a corporation that has become bankrupt, or for worthless shares of a corporation that meets certain criteria of insolvency.
PLANNED DISPOSITIONS: EXIT STRATEGIES
The bull markets of the 1990s, led by the technology sector, lured many traditional brick-and-mortar companies to expand their businesses through acquisitions of high technology companies. However, the crash of the technology market has pushed companies to return to their historical core businesses, shedding the previously acquired noncore businesses. Generally, the most tax-efficient dispositions will be those that were planned during the acquisition phase, but either way, once companies decide to divest shares or assets of a subsidiary, a tax-efficient divestiture will be key to maximizing the financial benefit of the transaction.
Taxpayers may choose to divest either assets or shares, which may be structured as either a taxable or tax-free transaction. In the US, a third alternative exists in which the taxpayer may make an election to treat the stock purchase as an asset purchase. The effect of the election, commonly referred to as a section 338 election, is a basis step-up in the target's assets that reflects the purchase price of the shares. The election is available when an unrelated company purchases at least 80% of the target company shares in a taxable transaction.
Purchasing assets generally provides a basis step-up in the assets. The higher basis creates higher depreciation deductions. Moreover, the seller generally will not inherit potential liabilities associated with the target company. A taxable purchase of assets generally is most desirable for the seller when the target corporation has losses that may be used to shelter the gain triggered on the transaction.
Sellers may prefer a stock transaction because complete businesses will often have an intrinsic value-in the goodwill or name recognition that a company has built-for which the seller will receive payment. Also, advantages in a stock sale may exist for the buyer. For example, a company purchasing the stock of another company may be able to take advantage of beneficial contracts that are in place in the target company, or target losses that may carry over to the acquiring group. However, the use of losses may be limited once an ownership change occurs.
A stock transaction may be tax free under either a participation exemption regime or reorganization provisions. Certain jurisdictions provide for participation exemptions, which may exempt share transfers as well as dividends paid on shares from capital gain. For example, in the Netherlands, the main instrument in exit strategies is the Dutch participation exemption. When the activities to be sold are part of another entity, techniques exist to carve out these activities without taxation on hidden reserves and goodwill. However, there could be a three- to six-year wait before shares in the company with carved-out activities can be sold without adverse tax consequences, such as retrospective taxation on capital gains.
Since 1998 tax-free demergers are also possible in the Netherlands prior to the sale of certain activities. Sale of the entity with the demerged activities within three years after the demerger could lead to the retroactive taxation of the hidden reserves or goodwill included in the demerged activities. Similarly, US tax law provides for tax-free spin-offs that require the demerged company stock to be held for two years prior to and following the spin-off.
LEGISLATIVE CHANGES
The 2002 UK budget introduced an exemption for capital gains on the disposal of certain shareholdings that occur on and after April 1 2002. To qualify, a shareholding of 10% or more in the ordinary shares of the company disposed of must have been held for a period of 12 months in the previous two years.
As may be imagined, this provision is likely to have a significant impact on corporate transactions in the UK purchasers are likely to have an increased preference for purchasing assets, whereas sellers are more likely to want to sell shares if the exemption is available. The exemption system will facilitate corporate restructurings.
Similarly, Germany saw substantial changes to its restructuring provisions in 2002. Germany now has a new capital gains tax exemption that applies to the disposition of the shares of a subsidiary. This substantial change in the law created the expectation that German corporate groups will increasingly restructure or dispose of subsidiaries in order to generate synergies or business and tax efficiencies and therefore create shareholder value. However, this exemption is at risk as various political parties have announced that they will withdraw the provision after September's election if they should come into power.
As companies seek to increase efficiencies in this tight economy, tax considerations can have a significant impact. Managing the use of losses as well as deductions can help improve a company's standing. Moreover, taking advantage of tax incentives that are continually arising throughout the world will help companies navigate through these troubled economic times.
The authors would like to thank the following contributors from KPMG member firms that provided input on their respective country's tax provisions and legislative changes: Acro Verhulst, Netherlands; Jose Carlos Silva, Mexico; Marc Ton-That, Canada; George Rosenbach and Heidi Groeger, Germany; Olivier Ferrari, France; and Richard Hayes, United Kingdom.
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