by Vikas Sekhri
RSM US LLP is an IMA Member
In today’s frenzied M&A environment, it can be difficult for dealmakers to take a step back from deal making to review various tax law changes. However, it is important that dealmakers stay up-to-date on tax law changes that could influence investments decisions and could impact the industry. The Tax Cuts and Jobs Act (TJCA) has brought some sweeping changes to the Internal Revenue Code that should not be overlooked. Some of the important changes in the tax code include significant reduction in corporate tax rates, 20 percent deduction on pass through income, changes in the way U.S. taxes income of multinational businesses, new rules for business interest deductions and deductibility of capital expenditures. Many of these changes directly or indirectly affect the tax consequences of M&A transactions making it important that dealmakers consider them while structuring and executing deals. Here are some of the important changes affecting domestic M&A transactions.
Tax incentives related to capital expenditures and tax shield created in business acquisitions
Prior to Tax reform, bonus depreciation of 50 percent could be claimed on certain tangible assets, which generally allowed businesses to expense 50 percent of the cost of those tangible assets in the year of purchase. However, such bonus depreciation was only available on “original use” assets and not if the taxpayer was acquiring “used” assets. As such, the bonus depreciation was not available if a taxpayer was acquiring assets in an M&A transaction.
Tax reform not only increased the bonus depreciation to 100 percent, but also allowed bonus depreciation on assets acquired through acquisition of a trade or business, thereby providing additional incentive to structure M&A transactions as “asset deals”. This change generally allows the buyers to immediately expense the purchase price allocated to qualified tangible assets in the year of acquisition, which reduces your taxable income. That is a big advantage for capital investments and is a major benefit for dealmakers.
While this is certainly a welcome change, it is important to keep in mind certain things while analyzing the benefits of this new 100% bonus depreciation in M&A transactions:
- The structure of the transaction can affect the eligibility for bonus deduction. As such, consideration should be given to structuring the transaction appropriately, to maximize the tax benefits.
- Bonus depreciation is only available on qualifying tangible assets and not to intangible assets, like goodwill. As such, parties should pay attention to how much of the purchase price is allocated toward qualifying tangible assets. While a higher value allocated to qualifying tangible assets may mean higher first year depreciation for buyers, for the sellers it may create additional ordinary income that may be taxed at a higher rate. This adds more importance to purchase price allocation agreements.
- It is also important to note, that 100 percent bonus depreciation is available through 2022 and then phased out through 2026.
New limitations on interest deductions
Tax reform introduced new limitations on net business interest deduction, which will likely have negative cash flow impact on leveraged transactions. The new rule limits the net interest expense deduction to 30 percent of adjusted taxable income (ATI). For tax years beginning after December 31, 2017, ATI is calculated using earnings before interest, federal income taxes, depreciation and amortization (EBITDA). For tax years beginning on or after January 1, 2022, ATI is calculated using earnings before interest and federal income taxes (EBIT). In other words, depreciation and amortization will not be added back for 2022 onwards resulting in lower limitation compared to previous periods.
This will have a particularly negative impact on private equity transactions. The majority of private equity deals involve debt financing and resulting interest payments. Under these new provisions, the deduction for interest could be significantly limited.
Some important items to note:
- Both EBITDA and EBIT will be calculated using taxable income and expenses and therefore will likely differ from book numbers.
- Any disallowed interest may generally be carried forward indefinitely – similar to net operating losses (NOLs) – but will be subject to same section 382 limitations as net operating losses, in addition to ATI limitation. For flow through businesses, a partner or S corporation shareholder’s share of disallowed interest will be carried forward at partner or shareholder level.
- The rules provide for a small business exception for business entities with $25 million or less in gross receipts.
The bottom line here is in leveraged transactions, it is important to consider the impact of interest limitations while modeling the cash flows related to a transaction.
Net operating loss deductions
Prior to Tax reform, corporate taxpayers were permitted to carryback an NOL two years and carry forward an NOL 20 years to offset taxable income. TCJA repeals the carryback of any NOLs generated in a tax years ending after 2017 and instead permits all such NOLs to be carried forward indefinitely. Additionally, under TCJA, for losses arising after 2017, the NOL deduction is limited to 80 percent of taxable income.
NOLs arising before 2018 retain their 20-year carry forward and remain eligible for a 100 percent income offset. All NOLs would remain subject to the rules of section 382 which may limit the utilization of NOLs after an ownership change.
From an M&A perspective, the elimination of the carryback of NOLs may pose challenges for sellers of portfolio companies seeking to capture the benefit of M&A transaction deductions. Previously where those costs generated an NOL in the pre-acquisition year, the NOL could be carried back with tax refunds paid to the seller.
Since carryback is not available anymore, sellers are asking buyers to pay for the tax benefit of NOLs incurred because the new buyer will be able to carry them forward while the seller will not be able to benefit from the carryback of an NOL.
With no carryback potential, an 80 percent income limitation and a lower corporate income tax rate the value of NOLs delivered in an M&A transaction have decreased after enactment of TCJA.
Choice of entity
With a significant reduction in corporate tax rates, there is a renewed interest in choice of entity analysis. Private equity firms are trying to determine whether corporate versus flow through partnership structures make sense when structuring portfolio company acquisitions.
When private equity firms invest in businesses, they hold these businesses either in a corporate structure or in a pass through partnership structure. Historically, many private equity firms stayed away from corporate structures because of high corporate tax rates. Now that the corporate tax rate has gone down, private equity firms are now starting to rethink their structure choices.
Some of the significant drivers in this decision include:
- the make-up of the fund’s investor base
- the location of operations (e.g., domestic versus foreign),
- the type of operations (e.g., services versus manufacturing) and
- Exit strategy (e.g., potential holding period and how much value you think a future buyer would ascribe to tax shield in a transaction).
A choice of entity for a portfolio company should be based on facts and circumstances and the decision to have portfolio companies in corporate versus partnership form may change from fund to fund and even from one investment to another.
TJCA brings many new tax dimensions that should be considered in valuing, analyzing and structuring M&A transactions. Moreover, the need for reputable, trustworthy advisors is more important than ever.
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