Increased complexities in structuring mergers and acquisitions stemming from the coronavirus pandemic and distressed market conditions can lead to inadvertent tax consequences without proactive planning and due diligence.
The uncertainty in the economic environment and ever-changing tax legislation make it increasingly important for companies to identify and evaluate their strategic alternatives when considering M&A transactions, Lindsay Wietfeld of Deloitte Tax LLP said July 28 during a webcast sponsored by her firm.
That means modeling and assessing the “tax implications of all the different nuances that go on in an M&A transaction . . . as early in the transaction as possible to drive value,” Wietfeld said.
The government shutdowns in response to the COVID-19 pandemic and resulting global economic contraction led to a sharp decline in M&A activity at the end of the first quarter and into the second quarter, with some deals terminating and others put on hold. Advisers have started to see the downward spiral reverse as deal activity has picked up, albeit at times with a twist.
Wietfeld said that despite the pause in activity this year, M&A transactions have remained a “significant part of the overall strategy of our clients.”
Over the next year, activity will likely be fueled by companies resuming those suspended deals, along with those embarking on defensive M&A transactions to sell their businesses — perhaps to salvage value or maintain competitive parity — and others with offensive strategies to transform their business models, Wietfeld said.
The distressed market has necessitated more creative planning to bridge the valuation gap between what bargain buyers seek and what sellers expect from the deals, according to Wietfeld. That has included nuanced financing structures, longer and different terms for earn-out payments, and transactions involving multiple steps, she said, adding that those complications have buy-side and sell-side tax implications.
Earn-Outs Ease Tensions
Earn-outs right now help ease valuation tension and get deals done, but the detriments aren’t insignificant, Kenneth Heitner of Deloitte Tax LLP said.
Heitner pointed out that “sellers are not unreasonably claiming that the last three to six months’ results of operations are not indicative of the historic business, [while] buyers are concerned that maybe this is now the new normal and it won’t be back to business as usual, or at least not in the short term.”
Benjamin Marks of BMO Capital Markets said during a July 20 webinar hosted by CliftonLarsonAllen LLP that with the unknowns concerning performance in the second half of 2020, his firm has seen “short-term earn-outs and deferred payments tied to performance in 2020 and 2021 . . . begin to creep into deals.”
Sharon Van Zeeland of Rockwell Automation Inc. discussed the strategic deals that her M&A team has closed amid the pandemic. Speaking during a July 22 webcast hosted by EY, Van Zeeland said Rockwell understood the short-term downward pressures on the valuations, but because the upside from the long-term value proposition hadn’t waned from what the company had anticipated, deal values didn’t change significantly.
Van Zeeland said discussions with the target entity in one transaction about its aggressive growth strategies across various industries led to a jointly agreed-upon forecast, but also a restructuring of the deal — pulling out a portion of the purchase price as an earn-out and providing retention agreements so the talent would stay and help develop the business.
That was a significant shift for Rockwell because the company doesn’t typically use either mechanism in its acquisitions, Van Zeeland added.
Chris Rose of Procter & Gamble Co., who joined Van Zeeland during the EY webcast, said his company has closed about 25 transactions thus far during the pandemic, including a brand divestiture, a small acquisition, and refinancings on smaller investments.
Rose agreed that the increased uncertainty puts downward pressure on valuations, but said a strategic interest in the business provides incentive to find creative ways to structure the deal “if the other side truly believes that the ultimate value” will be achieved.
Upside and Downside
Heitner pointed out that earn-outs provide buyers with benefits beyond facilitating closing the deal, such as reducing the risk of overpaying for the target and having the ability “to finance the acquisition out of future revenue or profits” if specified conditions are met.
An earn-out is like “a mini joint venture for a discrete period of time because the seller and the buyer have [aligned] interests . . . in the success of the business,” Heitner said, adding that “often it provides the motivation for the seller’s historic management to continue, at least during the earn-out period, to manage the business on behalf of the buyer.”
The future payments also provide buyers with a pool of funds against which indemnification claims can be made, which means “the buyer doesn’t have to chase the seller” for breaches of representations and warranties or covenants, but rather can offset the effects of those against any future contingent payments, Heitner said.
Buyers, however, often must contractually keep the target business separate and ring-fenced, at least though the earn-out period, which restricts them from operating the business and may impede integrating it into their ongoing historic business, Heitner said.
Sellers benefit from being able to participate in the post-closing upside while they continue managing the business, Heitner said. The flip side is that the sellers haven’t effectively sold the business and are “still hoping for additional purchase price [payments] based on future performance,” he noted.
A mutual detriment for buyers and sellers is that earn-outs are “a lawyer’s delight” in that the provisions are complicated, prone to drafting pitfalls, “and often, [but] not always, result in disputes, and occasionally litigation,” although that hasn’t affected their use, Heitner said.
Earn-outs will likely continue to be discussed in deal negotiations during the second half of 2020 and into 2021, according to Marks.
For acquisitions of private companies, earn-outs are “typically structured as a contractual commitment in the purchase agreement,” requiring buyers, along with their payment of a specified amount at closing, to make subsequent payments over time if specified conditions are met, Heitner said.
For tax purposes, the contingent payments are treated as additions to purchase price, with the seller’s income being “either capital or ordinary depending on the nature of the asset being sold,” Heitner said, noting that the buyer’s tax basis in the assets or stock acquired increases as the payments are made.
Heitner warned that because earn-outs rarely have a stated interest component and are treated as deferred payment obligations under tax law, the interest is imputed at a statutory rate, and so a “portion of each contingent payment will be treated as interest to the seller and as tax-deductible interest to the buyer.”
For public companies, the tax treatment for earn-outs differs because the future payments are typically contingent value rights (CVRs), which are separately publicly traded, Heitner said.
“While earn-outs in the private company context are eligible for installment [sale] treatment under the tax code,” which allows for deferral of some of the seller’s gain, those rules don’t apply to the sale of publicly traded assets, Heitner said. Thus, the publicly traded price of the stock must be determined in order to value the CVR, which “has to be taken into account by the seller upfront as part of its amount realized,” he said.
Heitner warned that no published authority exists for the tax treatment of CVRs — that is, on how to recover tax basis when the payments are made and “whether the income on the payment on the CVR is ordinary or capital.” He said disclosures often explain how the transactions will be reported but include a statement that “there is no clear authority, so there’s uncertainty.”
Eye on PIPEs
Private investments in public equity (PIPEs) provide another option for investments when it’s difficult to get a foothold on companies’ shifting valuations during market downturns, according to James Watson of Deloitte Tax.
From a tax perspective, however, PIPEs — often structured as preferred investments — can create traps for the unwary, Watson said, suggesting that taxpayers be cautious of potential phantom income and deemed distributions.
It’s “always good to have a tax eye on the terms of those investments as they are being structured,” Watson advised.
Dealmakers should be wary of stumbling into the section 382 rules that limit annual losses following a change in control of a loss corporation, Watson said.
Because PIPEs represent an equity investment of less than 50 percent, there may be a tendency to think the transactions avoid those rules, Watson said. However, he warned that although a particular PIPE might not trigger the ownership change threshold, it could be the change that trips up the company, making it subject to the loss limitation rules based on cumulative ownership changes.
Section 382 restricts the use of net operating losses following an ownership change if the ownership of the acquired entity’s 5 percent shareholders has increased by more than 50 percentage points over a three-year period.
Triggering a change in control could be detrimental to a company “especially in times like these, where perhaps companies, because of uneven earnings . . . might be in a net operating loss position,” Watson said.
More NOL Tripwires
A declining share price and market volatility could also trigger an unexpected ownership change among 5 percent shareholders, resulting in NOL limitations, Watson said.
Planned equity infusions such as preferred stock or common shares may give rise to “sudden potential shifts from an ownership perspective that have an impact when you look over a three-year period at potential NOL limitations and the use of those NOLs,” Watson said.
Companies should monitor how equity market activity, the churn in ownership, and companies’ valuations, working in concert, could affect NOL limitations, particularly in today's environment, Watson said.
Carveouts Demand Diligence
Corporate divestitures and carveouts are expected to pick up as companies seek to divest unwanted assets that don’t fit into their overall portfolio and potentially use the liquidity to take advantage of opportunistic M&A deals while values are down, Wietfeld said, adding that’s not unlike what occurred after the Great Recession.
Marks similarly said M&A activity following the slowdown will likely be spurred in part by corporate carveout activities. “Many of our corporate clients, both public and closely held, are undergoing strategic portfolio reviews and best-owner analysis that will likely result in the sale of non-core businesses,” Marks said.
Sellers that “haven’t done active tax planning will come to the [negotiations] not being prepared and will leave value on the table,” Wietfeld said, emphasizing the increased importance of sale-side tax due diligence.
Tax structuring, for example, is an important element when considering selling a business, but it has become more complex following tax law changes and the economic crisis, according to Wietfeld. She said the objective is to find “a way to deliver value to buyers from tax attributes or efficiencies that allow sellers to capture [that] value through deal economics.”
Sellers’ due diligence can provide, among other things, “the tax pulse of the company,” Wietfeld said. That involves identifying potential exposures that need to be cleaned up before entering into an M&A transaction, which gives sellers the “opportunity to potentially mitigate issues in advance of a transaction, or at least control the messaging around those issues,” she added.
Sellers should also focus on tax early in transaction documents, such as in the letter of intent, Wietfeld said. If the seller is expected to be paid for a basis step-up in the sale of assets but hasn’t considered taxes before executing a letter of intent, that could be problematic later if that document is vague about the transaction structure, she said.
Sale-side tax due diligence can also be beneficial in streamlining the deal process, Wietfeld said. “Before the pandemic, we were seeing an uptick in a lot of bids, [which means many] . . . different buyers look at the same business,” Wietfeld said. That can be time-consuming amid resource constraints, which heightens the importance of being organized, understanding what information is available, and ensuring that all parties have access to the same information, she said.
Some particular risks that sellers should be mindful of in performing due diligence include cancellation of debt income and the “potential incremental limitations on tax attributes that could drive value down in delivering a buyer those tax attributes,” Wietfeld advised.
Modeling projected income can shed light on historical exposures and opportunities and transform what might otherwise be a risk into an opportunity in an M&A deal, Wietfeld said.