Sell-Side Tax Considerations - Three Best Practices to Maximize Deal Value
Sell-Side Tax Considerations - Three Best Practices to Maximize Deal Value
2018 proved to be a strong year for the domestic M&A market, and the outlook for domestic M&A activity in 2019 remains positive despite investor concerns regarding U.S. trade policy and economic uncertainty. Abundant cash, unprecedented equity valuations, and low interest rates are expected to continue to fuel a robust deal market for both corporate buyers and private equity groups. These market indicators appear to signal that 2019 may remain an optimal time to sell.
M&A has not only been fueled by an abundance of capital but has been driven in large part by the disruption created from technology and innovation. This disruption has created a sense of urgency to streamline corporate structures, reduce complexity, and focus on core activities. As a result of this rapid transformation among industries, geographies, and organizations, many businesses are considering divesting of non-core activities in an effort to focus resources exclusively on core operations. Dispositions of non-core business lines has also been fueled by U.S. tax reform, as a lower U.S. corporate income tax rate has reduced the tax leakage resulting from divestitures.
These changes in the economic landscape and market conditions will result in many businesses and investors selling during 2019. As sellers prepare for a transaction, a thorough understanding of the tax aspects of the disposition is critical in order to maximize after-tax proceeds and ensure a timely and efficient deal process.
No one understands how a business operates quite like the seller; it is a deep understanding coupled with an ability to anticipate how a buyer may react to a transaction that provides the seller with an “upper-hand” when selling their business. These same principals are true from a tax perspective—sellers with a thorough understanding of their tax profile and who anticipate a buyer’s view on taxes are better positioned to have a leg-up on a buyer. Now more than ever, sellers and their advisors are beginning to appreciate the value of having a thorough understanding of a company’s tax profile, areas of potential tax risk, tax attributes, and desired structure of a transaction before undertaking a deal process. Amid these changes in the dynamics of how sellers approach taxes in sale transactions, employing best practices can have a dramatic impact on outcomes. The three best practices that follow are some of the most critical for sellers to consider in order to maximize deal value and ensure a smooth process when disposing of a business or business line.
Best Practice #1 – Performing Sell-Side Tax Due Diligence Before Conducting a Sale Process
It’s all too often that a material tax issue is identified during the course of a buyer’s tax due diligence which delays the deal process, results in a change to the terms of the transaction to the seller’s detriment, or causes a buyer to walk away from a deal. With taxes having a major impact on post-transaction cash flow as well as being one of the most significant items of potential exposure on many deals, not having a thorough understanding of a company’s tax position and potential areas of tax risk or benefits before conducting a sale process often puts sellers at a disadvantage during the deal negotiation process. Tax exposures identified by a buyer during tax due diligence provides a buyer with negotiating items to use during the ’horse-trading’ that typically occurs as the parties move toward closing. To avoid surprises and to streamline the buy-side tax due diligence process, sellers more frequently choose to perform sell-side tax due diligence.
So, what is sell-side tax due diligence? Although an appropriate work plan is one that has been well-tailored to the specific situation, sell-side tax due diligence is typically a process whereby a seller engages an independent third-party service provider to undertake a tax due diligence analysis with respect to its business with a buyer’s perspective in mind. The goal is primarily to gain a sophisticated understanding of the tax profile of the business in the context of an M&A transaction, identify potential areas of tax risk or liabilities that could be inherited by a buyer in a transaction, and to gain an understanding of the value of any tax attributes that could provide a future benefit to a buyer (e.g., net operating loss carryforwards, tax credit carryforwards, tax basis in assets, etc.). Sell-side tax due diligence is typically documented in a report that summarizes the company’s tax profile, potential areas of tax risk, and tax attributes of the business which can be shared with prospective buyers. There are several key benefits for a seller in undertaking sell-side tax due diligence before commencing a sale process.
Opportunity to Remediate Exposures Before Being Identified by a Prospective Buyer
To the extent a material tax issue is identified during the sell-side tax due diligence process, sellers have the opportunity to take steps to remediate the exposure before launching a formal sale process. Sellers can pursue voluntary disclosure agreements with the taxing authorities that typically provide for a limited lookback period in exchange for voluntary payment of a reduced tax liability. They can also cure past tax missteps, such as filing additional elections, amending previously filed tax returns, and/or seeking relief from the taxing authorities through a formal ruling process. By proactively identifying potential areas of tax risk and taking steps to reduce or eliminate this risk, sellers put themselves in a position to unilaterally choose how best to deal with identified issues (as opposed to buyer exerting influence or control). Sellers can be forthcoming with prospective buyers on the tax issues which exist within the business, thereby, reducing a buyer’s ability to seek price discounts during the sale negotiation process and reducing the risk of a ’dead’ deal.
Expedite the Deal Process
The time and resources incurred by prospective buyers and their advisors are often minimized to the extent a seller has engaged a third-party advisor to perform sell-side tax due diligence. A sell-side tax due diligence report allows buyers to quickly gain an understanding of a company’s tax profile and potential risk areas, thereby permitting buyers to focus their buy-side tax due diligence on certain key areas. While buyers will want to conduct an independent review of a target company’s historic tax positions, the buy-side tax due diligence process becomes confirmatory in nature rather than having to start the process from scratch. Having just undertaken this process on the sell-side, management is often better prepared to address buyer inquiries with respect to taxes and the information is readily available to respond to buyer information requests. As a result, the buy-side tax due diligence process is expedited, thereby reducing the strain on the organization and ensuring that tax does not hold up the deal.
Identification of Tax Attributes
Not only will buyers inherit historic tax risks of the business in a transaction, but they may also inherit tax attributes of the business that could provide a buyer with a future tax benefit. Through a sell-side tax due diligence process, sellers can identify and value tax attributes within the business (or be created by the transaction itself) and market those tax attributes to prospective buyers during the sale process. Sellers, therefore, may be able to negotiate a higher sales price for the potential value that such attributes may provide to a buyer post-transaction. At a minimum, identification of valuable tax attributes will increase the certainty of close.
Best Practice #2 – Evaluation of Tax Structuring Alternatives Available and the Resulting Implications to the Parties
Ensuring that a transaction is structured in a tax-efficient manner is critical in maximizing a seller’s after-tax proceeds. Evaluating the various structuring alternatives that are available before undertaking a formal sale process allows a seller to identify a preferred structure and set expectations with prospective buyers regarding deal structure at the onset of the sale process. By identifying a preferred structure at the onset of the process, sellers can proactively undertake pre-sale restructuring transactions that may be required to facilitate a tax-efficient disposition. Not only is it important for a seller to understand the implications of transaction alternatives from their own perspective but understanding the implications to a buyer allows a seller to anticipate how a buyer may react to a proposed transaction structure and assess whether a seller may be in a position to negotiate for additional purchase price if conceding to a structure which is more favorable to a buyer.
Stock vs. Asset Sale
One of the most basic structuring decisions that must be made for many disposition transactions is whether the disposition should be structured as a sale of a company’s stock or assets. In general, a buyer typically prefers to structure a transaction as an acquisition of assets to minimize the historic liabilities that could carry over to the buyer in the transaction and to provide the buyer with a tax basis step-up in the assets acquired in the transaction, commonly including goodwill and other intangibles. However, sellers often prefer to sell stock for various reasons such as possessing higher tax basis in the stock of the entity in relation to its assets, qualifying for long-term capital gain tax rates, and/or avoiding double taxation, among other reasons. As such, it is important for sellers to understand not only their own tax implications of a transaction, but also the tax implications to the buyer. Understanding both perspectives allows sellers to anticipate buyer pushback on its preferred transaction structure and arms a seller with the relevant data points to negotiate a higher sales price when agreeing to an alternative structure proposed by a buyer.
There are various strategies and nuances that exist when effectuating a carve-out of an existing business line or group of assets in a tax efficient manner. The manner in which a seller carves-out unwanted entities or assets from its current structure and sells such assets to a buyer may significantly impact its after-tax proceeds. For example, in the context of a corporate seller, it may be advantageous from a tax perspective to distribute the retained business or businesses to the corporations’ shareholders before selling the stock of the company which exclusively holds the unwanted business or assets, rather than causing the company to simply dispose of the unwanted assets or entities directly to a third-party. Thus, it is important for sellers to explore all structuring options available before effectuating a carve-out transaction.
Before undertaking a carve-out transaction, it is important to identify any unintended tax consequences that could result from the separation and disposal of the unwanted business. For instance, when disposing of a member of a U.S. consolidated tax filing group, sellers could be required to recognize gain that was previously deferred, may realize a loss that is disallowed for tax purposes, and/or could be required to reduce the tax attributes of the member disposed, among various other considerations. It may be necessary to settle any intercompany obligations that exist between the unwanted business and the retained business. This presents traps for the unwary—while it may be possible to extinguish these intercompany obligations in a tax-free manner, certain extinguishment transactions could give rise to cancellation of indebtedness income and a resulting U.S. federal or state income tax liability. Understanding the tax implications associated with the various alternatives available to structure a carve-out transaction can prevent a seller from triggering unexpected tax liabilities.
Best Practice #3 – Effectively Negotiating the Tax Aspects of the Purchase Agreement
A purchase agreement not only sets forth the terms and structure of the transaction, but also establishes who benefits from valuable tax deductions that may be created in connection with the transaction. It defines the parties’ role in post-closing tax matters, including hyper critical issues like tax purchase price allocations. It also establishes the methodologies for determining what constitutes pre vs. post-closing taxes and sets forth a buyer’s right to indemnification with respect to tax liabilities of the acquired business, among other things. Hence, it is of critical importance that sellers have a thorough understanding of the various tax sections of a purchase agreement and take a proactive approach to achieving the desired outcomes. In general, tax-related provisions in a purchase agreement that are favorable to a buyer are often detrimental to the seller. There is a lot at stake if a seller does not have a clear understanding of the key tax negotiating points that are addressed in the purchase agreement. Below are a few items for sellers to be mindful of when drafting and/or negotiating the purchase agreement.
Control Over Tax Matters Post-Closing
The purchase agreement sets forth the roles and responsibilities for the tax function post-closing, including with respect to pre-closing tax matters. The role that sellers are afforded in preparing pre-closing tax returns and management of tax audits related to pre-closing tax periods may ultimately impact their after-tax return on their investment. Sellers who retain the right to prepare pre-closing tax returns may have greater flexibility in taking more favorable tax positions. If a seller does not retain the right to prepare pre-closing tax returns, sellers may still maintain control over filings through a right to review and provide comments on such returns. To the extent a seller has control over a tax audit, a seller may put forth a greater effort to dispute any assessments issued by the taxing authorities than would a buyer who may be indifferent towards the outcome of the audit due to their protection under the indemnification sections of the purchase agreement. As such, it is important that sellers consider how their role in ongoing tax matters may impact their return on investment.
Purchase Price Allocation
Depending on the structure of the transaction, the parties may be required to allocate purchase price to certain assets and/or entities. While allocating additional purchase price to certain assets or entities may provide a buyer with a greater tax benefit, this benefit is often to the seller’s detriment. In an acquisition of assets, a buyer may desire to allocate as much purchase price as possible to shorter-lived assets, which will provide a buyer with a quicker recovery period, such as equipment that qualifies for immediate expensing as a result of certain changes enacted as part of tax reform. However, a seller may be required to recognize ordinary income upon the sale of such equipment (under the depreciation recapture rules), thereby potentially subjecting the seller to higher ordinary income tax rates. So, it is important that sellers consider how the allocation of purchase price will impact their tax liability for the transaction.
The indemnification section of a purchase agreement will stipulate a seller’s obligations to indemnify a buyer for tax liabilities post-closing. When a seller’s attorney drafts the tax indemnification provisions, the attorney may be able to exclude certain tax liabilities from the seller’s responsibility, limit the period in which a buyer may seek indemnification, and/or incorporate certain “baskets” or “caps” that may ultimately limit the amount of a seller’s future indemnification obligations. As buyers are typically indemnified for breaches of the tax representations and warranties set forth in the purchase agreement, having a clear understanding of the company’s tax profile and areas of tax risk is critical in being able to assess the appropriateness of the representations and warranties included in the purchase agreement. Sellers are better positioned to identify inaccurate representations and warranties and/or craft seller-favorable representations and warranties having undertaken sell-side tax due diligence.
Impact of Tax Reform on Purchase Agreement Negotiations
A number of changes were instituted as part of U.S. tax reform that impact purchase agreement negotiations. For instance, as part of tax reform, a one-time transition tax was imposed on untaxed foreign earnings of certain foreign subsidiaries of U.S. shareholders, with certain taxpayers being eligible to elect to defer the recognition of transition tax over an eight-year period. For target entities that have elected to defer the recognition of transaction tax, a question of whether buyer or seller will bear this obligation post-closing arises. Given that the obligation relates to pre-closing tax periods, but will be incurred after the closing date, many buyers will request an adjustment to the purchase price to cover the future tax obligation. It is important that sellers consider how these items are addressed in the purchase agreement.
Monetization of Tax Attributes
A seller’s understanding of the tax attributes that a buyer will inherit and/or create in the transaction (e.g., tax basis “step-up” in the assets of the business) is critical in being able to negotiate to be compensated for all or a portion of this benefit. The terms of the purchase agreement typically stipulate each party’s right to the tax benefit received from the tax attributes of the business (including any transaction related deductions that could give rise to a loss in the pre-closing tax period). It is important that sellers have a clear understanding of these provisions in the purchase agreement and ensure that such provisions are in line with their expectations toward their rights to the benefit that such attributes will provide to a buyer. It is also important to be mindful of any restrictions that can apply to limit a buyer’s ability to use its tax attributes, as such restrictions may reduce the likelihood that a buyer will be willing to compensate a seller for these tax attributes.
In summary, sellers are seeing a dramatic impact on deal outcomes when they employ best practices that give them a clear understanding of their company’s tax profile. By being proactive, sellers can maximize their after-tax return on divestiture and increase the likelihood of an on-time close. With the buyer’s perspective in mind, performing sell-side tax due diligence will allow sellers to identify and assess historic tax risks where they are given an opportunity to remediate exposure, expedite the deal process, and quantify and market existing tax attributes. By assessing various alternative structures of a transaction before launching a formal sale process, and by focusing on the tax aspects of a purchase agreement, the seller can ultimately negotiate a higher sales price.