Part of the job description in M&A involves an ongoing high stakes chess match against the Internal Revenue Service. The downturn, however, has altered the game.
Throughout 2006 and 2007, the tax-free deal was the end goal. Today, that’s no longer always the case. According to Douglas Schaaf, chairman of Paul Hastings’ global tax advisory practice, acquirers and buyers that could easily find solutions for a tax free transaction are now looking for deals that allow the shareholders to recognize losses in an effort to offset other gains. JPMorgan’s acquisition of Bear Stearns remains the most notable example of this trend, but deal pros cite that the pattern is being duplicated throughout the M&A market.
In the current environment, taxable transactions have become an increasingly common phenomenon, despite the point that buyers who use too much cash in making an acquisition are excluded from tax-free structure. Typically, the threshold is 60 percent, though few bidders are on the verge of crossing the number.
Cynthia Mann, a tax partner at Arnold & Porter, said deals are often structured with a built-in losses, effectively giving the bidder a higher tax basis immediately upon completion of the sale. “There’s always a tension between the buyer’s and the seller’s tax goals,” she commented. While sellers are inclined to consider structuring a taxable transaction, the transaction type is harmful to the buyer, prompting a buyer to take a step down in the basis. These conflicting interests have often led to a dynamic wherein the buyer is unwilling to add in the additional cost of the detrimental tax treatment to the purchase price, and as a result, many transactions have been structured as tax free deals.
Mark W. Boyer, a tax integration partner at PricewaterhouseCoopers LLP, said, “If you have a highly motivated seller or buyer, they will accommodate the other party’s tax structure.” Meanwhile, a rising tide of distressed sellers are increasingly motivated to unload their assets. The trends throws yet another wrinkle into the complicated dynamics of who decided the deal structure.
With all of the debate over the past year surrounding mark to market reporting, pros will recall that one of the benefits of a mark to market regime is that the requirement of regular reporting to a mark-to-market regime turns the potential hurdle of a tax-free or taxable transaction into a moot issue, since there is effectively no taxable gain or loss.
As buyers look to fund acquisitions with limited access to debt, Boyer said many strategic buyers are looking to take advantage of offshore earnings to fund acquisitions of US targets.
Another unique issue related to how transactions are being structured is purchase price allocation. Scott Eisenberg, managing director of Amherst Partners, IMAP’s Detroit office, worked on a transaction recently that involved a bidder who plans to buy the assets of a particular company at below book value. As the business increases in value, he will have a significant taxable event when the buyer ultimately sells the company. “We’ll probably have to write down the inventory,” Eisenberg said.
As dealmakers look ahead at the long-term tax position of their investments, pros are more willing to recognize their capital gains now, because they expect the political environment will lead to an increase in income and capital gains tax rates. Steven M. Dresner, president of Dresner Partners, noted that the 15 percent capital gains tax is relatively low, compared to historical rates. When the current rate expires in 2011, the rate will increase to 20 percent. Dresner said, “They could legislate it to be much higher than that, and many people expect that it will.”
More locally, state tax issues are also becoming a far greater concern to deal pros, particularly as state fall victim to budget shortfalls. Paul Beecy, a tax partner at Grant Thornton LLP, said he has noticed increased scrutiny of estate tax authority issues, making it difficult to use post transaction tax attributes. As many states try to compensate for spending deficits, Beecy warned, “They change the rules quickly, and you can’t overlook the changes. The complexities just make it more difficult to make transaction planning.”
Distressed investing, meanwhile, is on the rise, though pros are warned to structure these deals carefully, considering the complicated array of tax issues that accompany distressed investments. Firstly, if a company has forgiveness of debt, it can be considered as taxable income, and should be structured with this awareness. Several different structures are available to pros looking at the distressed space. Howard Steinberg, a tax restructuring and corporate recovery partner at KPMG, said he has seen an increase in bankruptcy 363 transactions, a structure wherein a portion of a bankrupt company is sold to a bidder. He observed, “The tax implications of this are current and deferred.”
Tax structures that deal pros use are in the middle a undergoing several changes. Whether these are lasting or cyclical is likely a combination of the two. But the safest approach for dealmakers to take in learning new structures is best summed up by Scott Eisenberg’s words of wisdom. “Talk to really good tax guys,” he said. “M&A guys only know enough to be dangerous.”
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