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Top Tax Issues for Buyers and Sellers in Today’s M&A Market

by Matt Fricke
July 13, 2020

Updated February 2, 2022

The COVID-19 pandemic has helped fuel a record surge in M&A activity. In this competitive environment, buyers and sellers need to pay close attention to areas of taxation that can significantly impact a transaction’s value

Market Disparities Are Driving Deals

We have seen challenging economic times before, but the current market seems different in some ways because of the striking valuation disparities. While many companies have been struggling to survive the pandemic, others are at all-time highs.

Because of this disparity among industries, especially technology, we’ve seen significant movement in the M&A world in the past year. While public-to-public deals are happening, there has been more movement in overall deal strategies — a shift in targeted acquisitions. With many public companies cash-rich and enjoying strong stock valuations, capital investments in the so-called “Fourth Industrial Revolution” technology companies are taking place.

What does this mean for purchase price, claw-backs, escrow provisions and overall value in upcoming deals of this nature? More mature companies looking for a breakthrough in new technology or products are now targeting newer companies with something unique and different to offer the market. But, with young companies come fewer controls, smaller finance teams, and perhaps little to no tax resources. This mixture is certain to produce unrecorded liabilities, which will most likely reduce the purchase price (decrease or escrow).

Other developing factors also need to be considered. Will we see a slowdown based on our current market conditions? With inflation, the answer is definitely “maybe.” Inflation and interest rates, along with fiscal policies, all correlate and could alter the M&A market. For example, as debt becomes more expensive, companies often turn to alternative vehicles, VCs or exchange listing and postpone or eliminate dividends.

In either consolidation or expansion, protecting the cash runway is key. One often overlooked area that should be given proper time and consideration is direct/indirect taxation.

When it comes to taxes, what do buyers and sellers need to consider? In general, buyers will be looking for information from the seller to clarify the following areas:

  • Understanding the target company’s existing tax structure
  • Understanding the expected structure of the transaction
  • Reviewing the target company’s historical tax compliance
  • Identifying any existing tax exposures
  • Identifying current and projected tax liabilities of the target company and considering how they will be reflected in the deal, including federal income tax, state and local income tax, payroll tax and sales and use tax liabilities

If your profile is more seller than buyer, here are a few specific key areas of taxation that often impact the value of a transaction and should be properly addressed prior to due diligence.

International Tax and Transfer Pricing

M&A requires not only business synergies but also a thoughtful cross-collaboration of various internal and external advisors from different realms, including legal, tax, accounting and finance. During the due diligence and negotiation phase of the deal, it is very important to have a detailed review of various tax aspects of a target company’s global operations, tax attributes, jurisdiction-by-jurisdiction tax filing positions, etc.

Any significant risks identified during due diligence provide an opportunity to negotiate and structure a robust indemnification clause for any subsequent liability arising from identified risk areas. If you are a seller, the indemnification clause is a reduction in price that could be resolved in pre-deal talks. Addressing this before due diligence, as noted above, preserves your company value.

Once a deal moves forward from the due diligence stage to the planning stage, devising a tax-efficient deal structure (asset acquisition, stock acquisition, etc.) that aligns with the combined company’s operations and supply chains is critical for all parties involved (i.e., target shareholders, purchasing company and target company).

Foreign tax consequences resulting from the planned tax structure (direct tax, indirect tax, stamp duties, etc.) should be properly considered before the implementation phase. Intellectual property consolidation, legal entity integrations and employees/asset transfer should be planned in such a way that the ending structure aligns with overall business synergies, a common goal driving business combinations.

Transfer pricing — the pricing of goods, services and intangibles between related parties — is one of the most contentious areas of taxation between buyers and sellers and between taxpayers and governments. A company’s transfer pricing policy will determine how income/expenses are allocated among related entities located across the globe and the parent company. This has multiple areas of exposure: foreign taxes and book and taxable income, leading to cash tax expense and foreign tax credits, or even net operating losses.

It is important to have the correct economic analysis behind these related party transactions. Full and contemporaneous reports under IRC 6662 would also be a helpful document for anyone contemplating an acquisition, along with foreign transfer pricing reports.

Lastly, both sides need to pay close attention to legal and regulatory changes. For example, how does the Altera court decision impact share-based compensation for cost-sharing arrangements and intercompany services?

Quality of NOLs and R&D tax credits

As a company grows and expands, they often experience business losses, or net operating losses (NOLs). NOLs can be carried forward to future years, and with recent tax law changes, carried forward indefinitely, with many states having similar concepts. These NOLs are recorded as deferred tax assets because they can be used to offset future tax liabilities, and they can be enticing to the buyer, increasing the purchase price significantly.

Unfortunately, the tax code limits how useful these NOLs will be post-acquisition. When an ownership change occurs (greater than 50% change), Section 382 may restrict the use of the NOLs. By having a Section 382 analysis conducted, the seller can help the purchaser validate the quality of the target entity’s NOLs so they can assign appropriate value.

Also consider that because of COVID-19, certain valuations are low, interest rates (how the initial limitation is determined) are near zero, and proposed changes to certain provisions, if finalized, will remove beneficial adjustments to the limitation. Performing this analysis will also be helpful in validating any corporate tax credits (such as R&D tax credits), as these are also subject to the Section 382 limitations.

State Taxes

Buyers and sellers need to understand the unique taxes in each state where a business is active, including those on income, property, sales and use, gross receipts, inheritance and payroll. Buyers will look at the following issues before entering a transaction:

  • Nexus: Nexus, or the minimum connection a business must have before it is required to file taxes in a particular jurisdiction, is not the same in every state. And in the wake of South Dakota v. Wayfair, economic nexus provisions are applicable with regards to income taxes, gross receipts taxes and sales/use tax. Thus, these rules are especially applicable to out-of-state sellers that exceed a certain monetary threshold or number of transactions in various states, regardless of whether they have payroll and/or property in that state. One misunderstood law could mean thousands of dollars in penalties and interest.
  • Apportionment: Allocating an entity’s sales among its active jurisdictions can be trickier than it sounds. One state may source sales using a market-based approach, and another may source based on where the work is performed. Mistakes in apportionment can generate penalties and interest, and they can have a ripple effect into other states, as well.
  • State-specific adjustments: Not all states mimic the federal government’s choices, so state-specific tax return adjustments are required. Since the Tax Cuts and Jobs Act (TCJA) was passed at the end of 2017, there are even more federal tax deductions that states may choose to disallow on their own returns.

Buyers may have a different risk tolerance than their targets, so sellers should prepare to be questioned about their state tax practices and positions.

Stock vs. Asset Sales

Sellers tend to prefer stock sales for tax purposes. Stock sales are generally treated as long-term capital gains (assuming the seller has held their interest in the company for more than one year). As such, they are taxed at a top tax rate of 20%, plus a potential additional 3.8% net investment income tax. Asset sales can generate a combination of ordinary income (currently taxed at a top rate of 37%) and capital gains.

R&D Tax Credits

The research credit remains one of the most valuable tax incentives for taxpayers investing in research and development (R&D). Changes made to the tax code under the TCJA indirectly increased the availability and value of the research credits for taxpayers to reduce income tax or payroll tax liabilities.

Acquisitions and dispositions of trades or businesses will require adjustments to the credit year and base year computations. Research credits are valuable tax assets with a federal carryover life of 20 years. The buyer will need to evaluate whether the target’s research credits are sufficiently documented both in terms of detailed computations of qualified research expenses and documentation of qualified research activities. Without such documentation, the research credits are at high risk for disallowance by the IRS and state taxing authorities.

A target’s unused payroll credits (as a result of being a qualified small business) can be acquired and used by the buyer to offset its own payroll taxes (employer portion of FICA) for quarters after the transaction date. These R&D credits elected to be used as payroll tax credits are not subject to Section 383 limitation. This can lead to a significant cash windfall for the buyer.

Beyond Direct Taxes

If a stock acquisition takes place, you are inquiring into the life-to-date operations of a company. Direct taxes are not the only things to look at before the sale of a business. In brief, sellers should also address the following items before due diligence starts:

  • Sales tax: economic nexus post-Wayfair Wayfair (as discussed above) and collection of reseller certificates, as well as border adjustment tax (BAT) and property tax
  • Payroll tax exposure: stock compensation required withholdings and ISO/NQSO classification
  • Golden parachute under Section 280G: it’s better to plan and understand than to discover during diligence
  • Section 162(m) compliance: recently modified expanding qualified employees
  • Other matters around compensation and benefits, post-closing purchase price allocation, transaction costs, FACTA/FIRPTA, asset step-up election under 338(g), Section 1202 and more.

Sellers should also evaluate their financial reporting team, consider an audit, address contract noncompliance, and perhaps most importantly, consider whether the timing of the transaction is optimal.

Where to Start

While not an exhaustive list, these are some key tax areas that need to be addressed prior to M&A. If you are considering an exit or an acquisition, discuss the above with your tax advisor.

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Author
Matt Fricke - Tax| Armanino
Partner
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