This article is the third in a series that focuses on best practices that can help sellers to prepare for a merger or acquisition. Click here to read Part 1: “Performing Sell-Side Tax Due Diligence,†and Part 2, “Evaluating Tax Structuring Alternatives.â€
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’ roles 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.
Best Practice #3 – Effectively Negotiating the Tax Aspects of the Purchase Agreement
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.
Tax Indemnification
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, 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.
Please contact Christina Roderick, (602) 730-3607, or Brian Foltyn, (602) 730-3672, to discuss the tax aspects of a merger or acquisition.
This article originally appeared in BDO USA, LLP’s “Insights†newsletter (March 2019). Copyright © 2019 BDO USA, LLP. All rights reserved.
