Tax and the Mergers & Acquisitions Deal

Although tax is commonly perceived as simply a barrier to completing a merger and acquisition deal, the effective identification and management of tax risks and opportunities can represent a significant competitive advantage.

Purpose of a Tax Due Diligence

The primary purpose of a tax due diligence process is to identify areas where there is potential exposure to a historic tax liability which a buyer will assume as part of an acquisition of a company's shares. The findings of the tax due diligence process can facilitate identifying the most appropriate approach to mitigate any issues which have been identified, through commercial negotiations and/or legal mechanisms which allocate any tax risk between the two parties to the transaction.

However, a tax due diligence is not solely a review of the tax history of a company or group; it can also be a useful tool in assessing the current tax profile of a target by understanding its tax attributes (e.g. capital allowances, losses etc) and asset profile. It is then possible to correctly value any existing tax asset or liability through tax modelling and determine the potential effective tax rate of the target’s business. Once these points have been confirmed, this additional information can be fed into the commercial valuation of the target which results in any tax risks or attributes, associated with the target, being incorporated into a more detailed valuation of the target. This more meaningful valuation of a target can present a commercial advantage to a buyer who has completed this work.

The tax due diligence process can also facilitate the development of an appropriate tax strategy or the integration of the target with the buyer’s existing tax strategy. The findings of the due diligence can also provide an insight into the target’s current tax structuring such that the buyer can identify any post deal restructuring that may be required in order to build a tax efficient group structure which incorporates the newly acquired target.

From a commercial perspective, it is important that the information which is obtained during the due diligence stage is correctly interpreted and included in the overall decision making process. This is particularly relevant in the case of a share sale as the buyer ‘steps into the shoes’ of the seller from a tax perspective. Therefore, the buyer will inherit the tax bases of assets and tax history of the target.

A number of Irish companies making acquisitions in emerging markets have discovered that historic tax liabilities can attach to the assets themselves. In such instances, any historic tax exposure will fall on the buyer post deal and where this risk is not correctly managed via pre-sale negotiations or drafting of the legal documentation, this cost can have a significant impact on the success of an acquisition.

Interpreting Due Diligence Information/Significance of Tax Risks

In conducting a tax due diligence, the types of issues considered may be general, specific or prospective. General issues would include tax exposures which are applicable to all taxpayers in the industry/sector. Issues specific to the target include its tax compliance record, existing group structure and any historical transactions/reorganisations. Prospective issues are matters which would need to be considered by the buyer, following completion of the deal, such as availability of tax attributes (losses, tax depreciation, tax holidays) or the potential low tax base of the underlying assets.

The materiality and probability of the potential tax exposure for the buyer will directly impact the significance of tax in the context of the final outcome of the deal. As the materiality of the historic tax risks or other adverse tax aspects to the transaction increase, there will be an increased emphasis on managing the risk and ensuring that steps are taken to protect the buyer from any exposure. In certain instances, the tax risk may be a ‘deal breaker’, not solely as a result of the tax liability identified, but the potential reputational risk or damage to relations with tax authorities will also play a part.

Managing Tax Risk

There are a number of different ways in which tax risk can be managed as part of the commercial deal negotiations:

• Where a potential tax liability can be accurately quantified and the basis of assessment of the tax liability is agreed between both parties, a price adjustment may be formally sought by the buyer. Where a purchaser is asked to submit a bid the potential cost of the tax issue could be simply factored into the maximum bid price which the buyer is willing to pay.
• Other mechanisms could include retention of a portion of the purchase price (escrow provision) which would be released only on the issue in question being resolved in a satisfactory way (e.g. the Revenue Commissioners confirming their view on the point). Alternatively, the cost of the tax issue could be netted against any deferred consideration payable by the buyer at a later date.
• It has become more common for potential tax liabilities to be agreed by the buyer and seller with some form of adjustment to the purchaser consideration. This approach is useful where the seller cannot offer warranties or indemnities, for example, where the seller is a private equity investor or a receiver/liquidator.
• Where the quantum of the liability cannot be reliably estimated or the basis of assessment is technically uncertain, then the buyer may seek to rely on legal mechanisms such as tax warranties or indemnities which seek to re-allocate the risk back to the seller.

Tax Review of Legal Documentation

The tax aspects of the share and asset purchase documentation mainly relate to the legal mechanisms which reallocate tax risk and the potential transfer taxes which may arise on the completion of the transaction.

• Share purchase documentation will commonly include tax warranties. These are statements of fact which a Seller provides to a Buyer. This gives the buyer an opportunity to seek formal confirmation of information which was provided as a part of the due diligence process or which may not have been available at that time. As these statements are provided under a formal legal process the Buyer can place a far higher level of reliance as there is the potential for the buyer to sue the seller for any losses which it suffers as a result of relying on any of the statements of fact.
• A tax indemnity which is provided by the seller is a formal promise that they will effectively restore the buyer to the position they would have been in if they had not been disadvantaged by certain defined issues which relate to the pre-completion period.
• The drafting of the legal documentation can also have a significant impact on the transfer taxes (e.g. stamp duty) which might arise on a transfer or VAT in the context of an asset transaction.

The input from tax specialists in reviewing the legal documentation can provide assurance to the buyer in relation to any tax risks identified. By combining the information obtained from the tax due diligence process with relevant experience of the management of tax risks, it is possible to confirm what level of legal assurance is required to address each tax issue and mitigate any tax risk. A review of the legal documentation can also provide certainty over the level of transfer taxes or other tax liabilities which may arise on completion.

Tax Structuring and Maximising Return on an M&A Deal

When determining the structure of an acquisition a buyer will have to consider such diverse requirements as the best commercial location for employees and assets, the requirements of those providing finance, any possible foreign exchange risks and regulatory/legal requirements. Since the beginning of the financial crisis in the EU, banks have enforced far stricter criteria in considering the legal structure, financial position and tax status of their borrowers. As a result, tax is likely to be only one of a number of competing demands which are placed on those determining the best structure from an overall commercial perspective.

The tax requirements of an acquisition structure are also likely to have a number of specific individual requirements including the deductibility of financing and transaction costs, minimising the effective tax rate of the group as a whole, the repatriation of profits from the locations where trading profits are earned and the potential disposal of parts of the group or particular assets. The creation of a longer term tax efficient remuneration structure for managers has also become a priority. Due to the diverse nature of these requirements, it is essential to understand the commercial priorities of the buyer in order that the correct tax aspects of the structure are prioritised and that the structure does not conflict with the efficient integration and operation of the acquisition from a commercial perspective.

Conclusion

The significance of the part tax will play in a mergers and acquisition deal is not limited to the quantum of the historic tax liabilities at the point the deal is undertaken or any tax liabilities which arise when the deal is completed. The tax attributes of the target and the effective tax rate which applies to its profits will have an impact on the overall valuation placed on the target. By engaging with tax advisors at an early stage in the process, incorporating tax into the due diligence program from the start and broadening the scope of the tax due diligence beyond merely the identification of historic tax liabilities the true impact of tax on the success of the project can be better understood. This approach can also prevent missed opportunities due to decisions being made without due consideration of the tax implications.

Gareth McNaboe is a M&A Tax Director with PwC

Telephone: 01 792 6650

Email: gareth.mcnaboe@iw.pwc.com

Rebecca Greene is a M&A Tax Manager with PwC

Telephone: 01 792 5059

Email: rebecca.greene@ie.pwc.com

Website: www.pwc.com/ie