How tax reform is expected to alter the mergers and acquisitions landscape
May, 02nd 2018
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Buyers and sellers are sharpening their pencils and thinking strategically about how the new rules under the Tax Cuts and Jobs Act will impact 1) acquisition structures, 2) company operations and 3) plans for an eventual exit.
“Overall, structuring considerations after tax reform are complex and the rules have changed for everyone. We’re sitting down to help clients develop deal models,” says Dave Godenswager, senior manager of Transaction Advisory Services at BDO USA, LLP. “Some conventional wisdom needs to be re-evaluated, so everyone is going back to the basics. Buyers are definitely doing it and sellers would be well advised to follow suit.”
Smart Business spoke with Godenswager about tax reform and its impact on merger and acquisition deal structures.
What do you think will be the biggest changes to M&A deals?
Ultimately, the economics of the business impact the deal the most. You don’t want the tax tail to wag the dog, but you do need a view of the possible tax implications and a forecast of the potential outcomes. Many rules are still being developed, but at a 30,000-foot level, five areas of tax reform will likely impact M&A deals:
Reduced tax rates — both the corporate tax rate going from 35 percent to 21 percent, as well as a special provision for pass-through entities.
In addition, the carried interest rules’ holding period was moved to three years, but it isn’t likely to significantly impact many private equity buyers.
Details matter and are specific to each transaction, but there seems to be a growing appetite for asset sales or deemed asset sales because of the lower corporate tax rates and full expensing of certain qualified properties. Limitations on interest deductibility may change debt financing and may require more equity in deals. Buyers will need to consider how much leverage they can introduce and if they’ll hit limits on interest deductibility. Lenders will be interested in the type of entity, projected after-tax cash flow and how that debt is to be serviced. To make things more complex, in the international arena, debt placement is critical. You have interest limitations in the U.S., but you might not have those limitations in a foreign structure. You really have to run the numbers.
How else will international deals change?
There are sweeping changes in the international context. Historically, U.S. companies were thought to be at a disadvantage over foreign companies in global deals. An overall goal of tax reform was to level the playing field, but that resulted in some complex rules. The changes include a one-time transition tax on historically accumulated earnings, enactment of the partial participation exemption system for post-2017 earnings, a new global minimum tax on foreign earnings, a base erosion anti-abuse tax and more. It’s complicated and confusing, but, in general, the advantages a foreign buyer may have over a U.S. buyer have narrowed. If you’re looking at a foreign target, it is critical for buyers to do their diligence, such as what exactly will be owed if there’s a transition tax, and how will that be paid and addressed in the deal documents?
Is there anything business owners or investors should be doing now as a result?
Typically, in the deal world, it pays to act quickly. To keep pace with that — and gain a competitive advantage over someone not doing their homework — firms should invest time now to factor the changes into their deal models and acquisition strategy. BDO has developed tools to help model out the effects of tax reform, both from an operational standpoint, such as the choice of entity (S corporation, C corporation or partnership), as well as deal structure, like an asset sale versus a stock sale.
Many areas are still unknown, uncertain and to be determined, including how states will react. You and your advisers can identify the assumptions you’re making, and if those assumptions change, what the after-tax result might be. You’ll want to stay tuned as items get sorted out. For a business owner who is contemplating an exit, though, it especially makes sense to line up a team of advisers now to help you think through the options.