Avoiding Tax Inefficiencies in M&A Integration
—By Elan Keller
All legal documents are signed, covenants and conditions precedent are met, and a delicious dinner is had by all. Another merger and acquisition transaction has closed and all of the lawyers involved are feeling pretty good about themselves. But should they? Not so fast. The hard work is just about to begin.
While the lawyers wake up the next day ready to draft their next sales and purchase agreement or merger agreement, the acquirer and target are left to integrate the endless myriad of logistical and operational items that will surely make or break the economics of the deal. Sure, all the fancy spreadsheets and analytics prepared by the investment bankers set forth a very attractive internal rate of return, but how do companies achieve it? Correct assumptions always help, but that is just the start. The answer begins (and sometimes ends) with integration.
If newlyweds sleep in different beds, the marriage is destined to fail. Well, integration is the business equivalent of spooning. If you are connected, the chances of success increase dramatically! In this article, the focus is on tax issues that arise during integration, as a result of either pre-acquisition or post-closing issues.
The ability to successfully navigate through the maze of so-called “tax integration” issues will create significant value in the form of increased tax benefits, while avoiding some of the tax inefficiencies that can impair the value of the transaction. The following is a brief summary and introduction of the critical tax issues that arise during the integration process, including post-acquisition tax structuring, tax compliance and post-acquisition tax audits, and executive compensation and benefits.
Post-Acquisition Tax Structuring
When the target company has multiple domestic and international subsidiaries (or when the target company was not a U.S. taxpayer prior to being acquired), it is rare that the initial post-acquisition structure is entirely tax-efficient. When the dust settles, the post-acquisition legal entity structure may involve U.S. companies directly owning foreign companies, which may, in turn, directly own U.S. companies (the so-called CFC sandwich structure). In M&A transactions that involve inversions, the newly formed foreign parent may directly own U.S. companies that, in turn, directly own foreign companies.
In either of these post-acquisition structures, the attractive IRR of the combined entities can be significantly diluted as a result of the tax inefficiency that rears its ugly head in the form of double taxation in a cross-border context. All of this translates into a higher post-acquisition effective tax rate, which works directly against the IRR models that may have underestimated (or ignored!) the impact of such tax-inefficient post-acquisition structures.
Sophisticated U.S. tax counsel can work with the businesses to provide creative post-acquisition internal restructuring options to mitigate and eliminate such tax inefficiencies.
As icing on the cake, tax counsel may even propose a combined post-acquisition structure that creates tax benefits that were not initially contemplated in modeling the IRR. Examples of the types of tax benefits that may be created as a result of post-acquisition restructuring include reduction of subpart F income (i.e., phantom income that is taxed to the U.S. shareholders of controlled foreign corporations); tax-efficient transfer pricing (i.e., the economic allocation of income and expenses in tax jurisdictions that are more favorable to managing a company’s overall effective tax rate as supported by legal and accounting positions); and consolidation of U.S. subsidiaries into one tax group that allows for taxable losses of one subsidiary to offset taxable income of another subsidiary, while allowing all members of the tax group to share certain tax attributes.
Post-acquisition tax structuring may also create an efficient tax treaty network that allows withholding tax on payments from domestic or foreign companies to their foreign or domestic parents or affiliates to be reduced or entirely eliminated under the terms of a tax treaty between the jurisdictions in which the two affiliated companies are domiciled. Creating an efficient structure that allows for favorable usage of a tax treaty network can effectively mitigate double taxation, reduce cash tax outlays, and protect affiliated companies from unwittingly establishing tax nexus in foreign jurisdictions. A beneficial tax treaty network also allows U.S. companies to make tax-efficient interest payments to foreign affiliates, which reduces a U.S. company’s U.S. tax liability.
Finally, when combining tax-efficient cross-border tax restructuring with aligning affiliates in an efficient tax treaty network, foreign subsidiaries can dividend income up to a U.S. parent in a tax-efficient manner. This allows the U.S. parent to repatriate profits with reduced tax burdens.
Most likely, the tax benefits created are secondary to the business purposes that are served by creating the new and improved (and tax-efficient) structure. Compelling business reasons that necessitate an internal restructuring of the merged or acquired entities include creating efficient operational and business platforms that are separated by geographical location, region or business divisions; creating internal or external funding efficiencies or opportunities to leverage funding relationships; regulatory considerations, such as separation of banking assets from nonbank assets; risk management considerations, such as accountability amongst different regions, countries or business divisions; and ameliorating client or counterparty concerns that arise when structures are inefficient from a client or counterparty perspective.
Post-acquisition tax-inefficient structures do not just impact international cross-border M&A. Even if an acquisition is wholly domestic, if the newly formed businesses are operating in multiple states, similar “cross-border” issues exist in the context of state tax inefficiencies. While many business folks view state and local taxation with disdain, state and local tax inefficiencies can cause the new post-acquisition structure’s effective tax rate to increase by as much as 10 percent! Engaging with state and local tax counsel from the outset will most likely yield an excellent return on investment by enabling management of the company’s overall effective tax rate.
Tax Compliance and Post-Acquisition Tax Audits
At the time of the drafting of the definitive acquisition agreement, both parties are typically careful to negotiate post-closing tax indemnities in connection with preclosing tax issues to take into account the concerns of both the buyer and seller. Once again, however, the devil is truly in the details, and the technical provisions of the acquisition agreement turn into harsh reality when the IRS knocks (or rams down) the doors of a combined taxpayer a couple of years after the M&A transaction closed. The seller is now nowhere to be found, or the IRS combines preclosing audit issues with post-closing issues, which makes the lines of indemnification substantially blurry.
To further exacerbate matters, there are a number of tax reporting and IRS audit issues that need to be addressed during the early stages of the integration process. Moreover, the target’s internal tax and finance function may be small and relatively unsophisticated, or the target may have lost key personnel as a result of the acquisition. The operational ability of the newly combined tax group to navigate the perils of an IRS audit or even the preparation of the tax return becomes a risk management challenge that may compromise the integrity of the financial statements (in that the tax accounting may no longer be reliable) and/or lead to poor results when defending an IRS audit (which, once again, increases the effective tax rate).
The new combined tax department may have to defend itself against external accounting firm auditors who question the reliability of the tax reporting, or IRS auditors who immediately think the worst and become suspicious when they are not able to get clear, concise and organized answers to their audit queries. The tax department may encounter problems developing a coherent response due to the loss of knowledgeable target tax or finance personnel post-acquisition or lack of adequate documentation addressing the issues being raised due to resource constraints at the target prior to the acquisition. The problems that can develop with IRS audits and the tax reporting and financial statement reporting functions can, however, be largely avoided with some thoughtful planning during the beginning stages of the integration phase.
Working out a strategy as to how a tax and finance department are going to handle and defend an audit long before the IRS shows up at the door allows the tax and finance departments to collaboratively identify areas of tax risk in both substantive positions taken on the tax returns and in the tax return and financial statement preparation process. Explaining tax return positions by obtaining a thorough and sophisticated legal analysis that accentuates the strengths of such positions, as well as backing up data with properly prepared working papers that reference the numbers shown in the tax returns, allows for a strategy to defend IRS audits. This strategy is based less on desperation, which tends to be the case when a strategy is formed during the beginning stages of the tax audit, and more on the strengths of the tax return positions taken.
A preemptive discussion of the tax issues identified during due diligence, plus a healthy dose of risk management controls are two additional tools in the arsenal of proactively managing a new combined tax function. When considered early in the integration phase, this proactive planning will mitigate both inaccurate tax reporting on the financial statements and poor IRS audit results created simply by IRS suspicion, due to lack of a thorough analysis of legal positions or incomplete or inaccurate responses. All of these proactive and preemptive strategies will likely decrease a company’s tax expense and thus improve its effective tax rate.
The benefits of early communication among the relevant stakeholders, as well as the implementation of tax risk management controls, tax reporting, and tax compliance procedures and processes, can also help to address post-acquisition organizational issues and opportunities. Informational and data bridges and processes between the finance and tax departments of the target and acquiring entities can be streamlined and improved when the tax and accounting managers collaborate closely during the early stages of integration. In addition, proper staff reporting lines and leverage of in-house tax expertise can be accomplished such that the tax function becomes stable and a department that delivers value-added results.
Executive Compensation and Benefits
Deferred equity payouts to senior executives or target equity holders continue to remain a useful approach to keeping key target employees’ skin in the game. Sometimes the underlying equity component of the payout is based on the value of the entity, division or business unit that was acquired, as opposed to the overall equity value of the acquiring company. In essence, the underlying equity component is akin to a type of tracking stock that must be valued at various triggering points during the life of the payout (and such payments are generally made at the same time equity payouts are made to other equity holders).
These types of deferred equity payouts are fraught with IRC Section 409A income recognition issues (sometimes creating the unintended consequence of phantom income and excise taxes to the key employee) that need to be addressed in general terms during the pre-acquisition stage. However, the devil is always in the details, and just as importantly, the post- acquisition integration issues that arise with these types of deferred payouts need to be addressed immediately after closing.
IRC Section 409A compliance is a critical element to ensuring tax-deferred treatment of the deferred equity payouts to the key employees. Needless to say, if the 409A compliance is not correctly implemented during the integration phase, key employees become distracted and discouraged by the thought of a looming large tax liability (and no cash to pay it).
Correct implementation frequently requires the engagement of compensation and benefits counsel immediately after closing, so that traps for the unwary are not triggered. Continuing counsel and guidance from compensation and benefits counsel is necessary during the early stages of integration and through the first vesting period in order to ensure that the details of the deferred equity payout qualify for tax deferral as intended.
Additionally, a source of contention (or at least tension) frequently arises during the early part of the integration phase when the acquirer and key target employees discuss the proper valuation methodology in connection with the above-noted notional equity tracking mechanism. In cases when there is not total agreement on valuation methodology during the early part of the integration phase, key employees once again become easily distracted, discouraged and even disgruntled. This can be avoided by placing firm parameters around valuation into the acquisition agreement, securing the use of an independent valuation expert to determine the valuation, and engaging with such expert immediately after closing. With a clearer mind as to how they are going to get paid, key employees can focus on the running of the business in a fashion that will support the initial IRR projections put forth by the bankers.
While not likely to be considered deal-breaking integration issues, Section 401(k) compliance, as well as compliance with the new and onerous Affordable Care Act regulations, have a meaningful impact on the smooth operations of both the tax and human resources functions. The consequences of merging at least two 401(k) plans may have been overlooked until a plan administrator or auditor picks up on a potential compliance breach that could cause one or more plans to no longer qualify for 401(k) treatment.
While it is advisable to engage compensation and benefits counsel prior to closing so that the acquirer and target can take preemptive measures to avoid compliance breaches (such as terminating the target’s plan immediately before closing), it is not always commercially viable to terminate, or make structural changes to, plans or to deal with other HR matters prior to closing. These breaches may be remedied before catastrophe hits, but not without great time, expense and pain. Thus, at a minimum, engagement of counsel early on in the integration process allows for a smoother and more effective navigation of both the Section 401(k) and Affordable Care Act rules. In addition, making the business folks sensitive to these issues early on in the process allows the tax and HR functions to enjoy greater support in securing the necessary budget for such structural improvements.
The engagement of M&A tax counsel who is sensitive to the tax and cross-functional issues that arise during the early stages of the integration process will significantly deliver added value in the form of more cash savings, reduced tax expense, and a lower effective tax rate (all of which will drive up the IRR, making those investment bankers look really smart!). In addition, tax counsel who are certified public accountants or have prior in-house tax experience can often spot issues and opportunities, or propose solutions that may not be apparent to typical outside tax counsel. Will steering the business, tax and finance leadership toward sensitivity to these operational tax issues in the earlier stages of diligence, negotiation and integration process create a marriage made in heaven? Maybe, or maybe not, but it will definitely lead to some good spooning, which is a start in the right direction!