Sell-Side Tax Considerations for Mergers and Acquisitions – Best Practice #2: Evaluating Tax-Structuring Alternatives
REDW | May 28, 2019
This article is the second in a series that focuses on helping sellers to prepare for a merger or acquisition. Click here to read Part 1: “Performing Sell-Side Tax Due Diligence.”
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.
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.
Best Practice #2 – Evaluating Tax-Structuring Alternatives 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 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 it also 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 way 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 that 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.
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.
This article originally appeared in BDO USA, LLP’s “Insights” newsletter (March 2019). Copyright © 2019 BDO USA, LLP. All rights reserved. Content by Alexander Mayberry and B. Nathaniel Collins.