BDO’s Private Capital Pulse Survey – Spring 2021 

BDO’s Private Capital Pulse Survey – Spring 2021, surveyed 200 PE and VC fund managers on a number of topics from M&A, ESG, and Tax to name a few.  No longer in triage mode and with a better understanding of which sectors are thriving or struggling, private equity is gearing up for a highly competitive year of M&A.
 

 Tax Takeaways for Private Equity

• Asked what tax changes funds are planning for or most concerned about in the next year, the increased taxation of digital products and services was the biggest concern (58.5%), beating out concerns for a potential capital gains tax increase by 8 points.
• Taxation of digital products and services carries broader implications and uncertainties than some other tax concerns, as there are both domestic (state income tax) considerations as well as global implications for sales into foreign jurisdictions that funds may need to navigate.
• Impacts of the interest expense deduction calculation being based on EBIT instead of EBITDA took third place for biggest tax‑related concerns (50%). Changes to the ability to deduct business interest expense may result in the need to put more capital into portfolio companies, thus constraining, to a degree, firms’ ability to be acquisitive.

Book and Tax Implications of Earnouts 

One of the many challenges in any deal negotiation is for the buyer and seller to reach an agreement on the purchase price. This is especially true during times of economic turbulence, like the COVID-19 pandemic, when current business results may not reflect the past or future earnings of the target. To reach an appropriate purchase price that takes this uncertainty into account, the parties may choose to include an “earnout” in the acquisition agreement. 

 Tax Takeaways for Private Equity

• An “earnout” or “contingent consideration” is something to take into account while negotiating a deal to buy or sell a PortCo as it may allow for a better risk-sharing arrangement between the buyer and seller
• Earnouts included in the purchase price of an acquisition may create a tax benefit to the seller as they might be able to defer some or all of the gain recognition upon sale if certain criteria are met.
• Earnouts can also be tied to performance of the company post-acquisition, where the Seller is to remain employed and the amount of consideration paid is contingent on the earnings of the company into the future.
  • This can have both favorable and unfavorable tax consequences
    • The Buyer is entitled to take a tax deduction for the earnout paid as compensation
    • The Seller who stays on as an employee is taxed at ordinary income rates up to 37% rather than at the 20% capital gains rate if the earnout were tied to the purchase price
• When considering an earnout as part of deal negotiations there are many tax and non-tax advantages and disadvantages to consider and many require a deep analysis of the facts and due diligence is encouraged on both the Buy and Sell side of the deal.

Private Equity Funds Maximize ROI with Employee Retention Credit 

Private equity (PE) funds looking to maximize their return on investment (ROI) may generate cash by claiming the recently enhanced employee retention credit (ERC) for their eligible portfolio companies.

Tax Takeaways for Private Equity

• Portfolio companies that have a significant decline in gross receipts or had operations fully or partially suspended due to a COVID government order are eligible to claim the employee retention credit in 2020 and 2021  
• Eligible portfolio companies can claim a credit up to $33,000 per employee for qualified wages paid in 2020 and 2021
• Individual portfolio companies can be eligible depending on the facts and circumstances and should be evaluated to determine if aggregation with other portfolio companies is necessary

Global Taxation of Digital Transactions Considerations for Private Equity 

Private equity firms contemplating investing in or divesting themselves of digital businesses should be considering the potential impact of a global digital tax.

Tax Takeaways for Private Equity

• NEXUS AND THRESHOLDS - Private equity firms should factor into their investment strategies and decisions not only the administrative and compliance issues that may result from having to file in multiple new jurisdictions, but the additional tax costs and advisor fees that would necessarily attend additional filings.
• ASCERTAINING IMPACT ON EBITDA, INCOME TAX – A gross receipts tax, which characterizes most digital taxes, is above the line and would impact on EBITDA.
• HOW TO NAVIGATE COMPLEXITY AND MAXIMIZE RETURNS – Scenario planning to determining how OECD digital tax proposals, if enacted, would affect global investment strategies and targets' tax positions for impact on EBITDA and potential liabilities.

Qualified Small Business Stock Can Provide a Strategic Advantage to Private Equity Groups and Venture Capitalists 

With the 100% exclusion now permanent, Section 1202 can present a valuable tax savings opportunity for PE funds and their investors upon their exit from investment in a qualified small business.

Tax Takeaways for Private Equity

• Private Equity funds may be eligible to exclude up to 100% of the gain upon exit from an investment in a qualifying small business as the sale or exchange of Qualified Small Business Stock (“QSBS”) held for more than five years, is eligible for exclusion under IRC Section 1202 (subject to limitations), providing tremendous tax savings for PE Funds and their sponsors.
• Section 1202 gain exclusion can apply to many of the typical exit strategies utilized by PE firms such as:
  • Sale of Stock as part of an IPO
  • Exchange of QSBS for publicly traded stock
  • Sale of a company for cash, or cash, stock, and debt instruments
  • Sale of a PE firm’s securities back to the company in a redemption transaction
• The eligibility criteria is complex and should be carefully considered when structuring a new target acquisition, especially as it relates to private equity funds, as the hold period of investments are generally five years or less, and the corporations chosen generally exceed the $50 million aggregate gross assets threshold, thus not qualifying as QSBS.