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BEAT Versus Regular Tax: What Rate to Use in M&A

Posted on Aug. 5, 2019
[Editor's Note:

This article originally appeared in the August 5, 2019, issue of Tax Notes Federal.

]
Ted R. Stotzer
Ted R. Stotzer

Ted R. Stotzer is tax counsel with Unilever. He thanks Greg Postian, Michael Schler, and Libin Zhang for their helpful comments.

In this article, Stotzer examines how the base erosion and antiabuse tax regime and section 163(j) affect tax rates in the mergers and acquisitions context, and he offers approaches to support the economics of deals.

I. Introduction

Mergers and acquisitions tax issues have always been fraught with potential pitfalls for the unwary. Now there is one more pitfall to add to the list: “What tax rate do I use?” Many readers, whether in-house or in private practice, have likely had this question posed to them by an M&A director, or perhaps the CFO, when a deal kicks off. If the deal model relies on a discounted cash flow (DCF) analysis to determine the synergized value of a company, using the correct cash tax rate to convert earnings before interest and tax (EBIT)1 to after-tax cash flow2 is essential to prevent overpaying for a company, especially outside the competitive auction process. Before the Tax Cuts and Jobs Act, the answer to the tax rate question was simple for most large companies: 35 percent.3

Today, with the advent of an alternative base erosion minimum tax (the base erosion and antiabuse tax) tested annually,4 the answer is not so simple. Moreover, the appropriate cash tax rate may vary depending on the circumstances — tax counsel might be prudent to advise an acquiring taxpayer (Buyer) currently subject to the BEAT (but planning to exit)5 to use the 21 percent regular tax rate6 in an attempt to avoid overvaluing the future after-tax cash flows of a company.7

However, if Buyer may be in and out of BEAT: (1) when there is an overall net profit (after taking account of tax assets; for example, amortization), using a 21 percent tax rate for both EBIT and amortization may undervalue the company; and (2) when there is an overall net loss (again, after accounting for amortization), using a 21 percent rate for EBIT and amortization may overvalue the company. Whether Buyer is subject to the BEAT or regular tax will also affect the weighted average cost of capital (WACC)8 used in the deal model, which is partially a function of the after-tax cost of debt.9 As discussed in Section II, a buyer subject to the BEAT would pay a 10 percent cash tax rate on incremental taxable income (TI) from a target, increasing after-tax cash flow. However, as discussed in Section IV, the BEAT also limits the tax-effected benefit of a Buyer’s third-party (acquisition financing) interest expense deduction to 10 percent, increasing the cost of debt and in turn increasing the WACC (discount rate) applied to the future after-tax cash flows being net present valued (NPV).

Therefore, in M&A, buyers subject to the BEAT and buyers subject to regular tax will have juxtaposing competitive advantages and disadvantages. Buyers subject to the BEAT will be disadvantaged insofar as a higher discount rate (reflecting a higher cost of debt) will generally apply to reduce the NPV of a target (and vice versa for buyers subject to regular tax); conversely, buyers subject to regular tax will be disadvantaged because after-tax cash flows from the target will be reduced using a 21 percent tax rate, reducing the target’s NPV (and vice versa for buyers subject to the 10 percent BEAT, up to a buyer’s BEAT “headroom”).10 Post-tax reform, factors including: (1) a buyer’s BEAT headroom; (2) the quantum of after-tax cash flow generated by the target; and (3) deductions generated by an acquisition (for example, interest expense, amortization, and net operating losses) will interact to affect the cost of debt and ultimately the value of a target in ways not seen under prior law.11

II. Cash Tax

A. Acquisitions

From a cash tax perspective, if a buyer is deeply in BEAT, it would pay a 10 percent cash tax rate on incremental operating TI. If the target generates sufficient TI so that regular tax applies rather than the BEAT, the buyer would pay a 21 percent cash tax rate on the portion of incremental income that pushes the buyer out of BEAT while the amount up to the BEAT headroom is taxed at 10 percent.12 Therefore, from a cash tax perspective, there is a marginal benefit to having any incremental income from an acquisition taxed at the lower 10 percent BEAT rate. This cash tax rate further decreases to approximately 7 percent to the extent the buyer has been previously limited under section 163(j) and has carryforward disallowed interest expense that is usable because of incremental income and not disallowed as base erosion payments. Table 1 demonstrates this incremental benefit.

Table 1. Incremental Income BEAT Cash Tax Impact

Regular Tax

 

BEAT

 

Gross income

$300

Gross income

$300

Deductible payments to foreign-related parties

-$200

Deductible payments to foreign-related parties

$0

Regular taxable income

$100

Modified taxable income

$300

Regular tax (A)

$21

BEAT (A)

$30

Incremental taxable income from acquisition

$50

Incremental taxable income from acquisition

$50

Total regular taxable income

$150

Total modified taxable income

$350

 

Total regular tax (B)

$32

Total BEAT (B)

$35

Incremental regular tax: (B) - (A)

$11

Incremental BEAT: (B) - (A)

$5

Rate on incremental taxable income

21%

Rate on incremental taxable income

10%

In this example, Buyer has $50 of additional annual TI through an acquisition. This income would not be sufficiently large so that Buyer pays only its regular tax liability (that is, there is still $3 of BEAT in excess of regular tax liability).13 Therefore, the $5 of incremental tax (associated with the $50 of additional income) reflects a 10 percent cash tax rate on that additional income. As noted, to the extent previously disallowed section 163(j) carryforward interest expense is also freed up by the additional income, the rate would be reduced to about 7 percent.

B. Dispositions

From a cash tax perspective, a seller deeply in BEAT would pay a 10 percent tax on incremental disposal gains. If a disposition generates sufficient TI so that regular tax applies rather than the BEAT, Seller would pay a 21 percent cash tax rate on the portion of incremental income that pushes Seller out of BEAT, while the amount up to the BEAT headroom is taxed at 10 percent. Therefore, from a cash tax perspective there is a marginal benefit to the extent any incremental income from a disposition is taxed at the lower 10 percent BEAT rate. This rate further decreases to about 7 percent to the extent Seller has been previously limited under section 163(j) and has carryforward disallowed interest expense that is usable because of incremental income.

If sale proceeds are large enough, there may be a cash tax benefit to spreading out the gain over several years through an installment sale contract to maintain the Seller’s BEAT position and the resulting 10 percent marginal tax rate. For example, assume Seller has $100 of annual gross income, excluding any one-off disposal gains. Also assume that Seller has $20 of deductible payments made to third parties, as well as $60 of deductible payments made to related non-U.S. affiliates treated as base erosion payments. In a given year, Seller would be subject to the BEAT as a minimum tax (the $8 of tax paid under the BEAT would be greater than the $4.20 owed as a regular tax liability). Now, assume that Seller disposes of a division in exchange for sales proceeds of $100. Assume for simplicity that Seller’s annual gross income (excluding the sales proceeds) otherwise does not change. If Seller recognized all $100 of gain in the current year, the regular tax liability ($25.20) would be greater than its BEAT liability ($18) and therefore Seller would pay the higher regular tax liability.

The impact is that the portion of the $100 of gain that pushes Seller out of BEAT is taxed at 21 percent while the amount up to the BEAT headroom is taxed at 10 percent; in this example the blended tax rate is 17.2 percent (that is, the difference between the tax paid with the disposition ($25.20) and without the disposition ($8) divided by the $100 of gain). Now, assume that Seller structured the disposition as an installment sale, spreading out the gain over four years. In this case Seller’s regular tax liability ($9.45) would not be greater than its BEAT liability ($10.50) and therefore the sales proceeds would be taxed at 10 percent annually, for a total of $10 of tax (the difference between the $8 of tax paid under the BEAT before disposition and the $10.50 of tax paid under the BEAT, including the disposal gains, spread out over four years, multiplied by four).

Seller’s ultimate tax liability under the installment sale scenario over a four-year period would be $42 ($10.50 of annual BEAT liability multiplied by four); Seller’s ultimate tax liability without an installment sale would be $49.20 ($25.20 of BEAT liability in the year of the sale, plus $8 of annual BEAT liability for the next three years). Therefore, in this example there’s a $7.20 gross savings (and a $4.30 net savings after reducing by the interest charge on the deferred tax liability) to electing installment sale treatment. Table 2 demonstrates this calculation.

Note that if the deferred consideration is large enough (greater than $5 million)14 then an interest charge (at the underpayment rate) will be due on the deferred tax liability15 under section 453A(a).16 However, with the underpayment rate currently at 6 percent,17 the cash tax benefit of spreading out the gains over several years would almost always outweigh the (potentially) deductible interest cost. This is especially true if spreading out income provides an incremental benefit under section 163(j),18 assuming that: (1) Seller is in a go-forward limitation position; and (2) Seller does not have historical disallowed carryforward interest expenses that may be used by recognizing a large gain in the current year.

In addition to a potential interest charge, other detriments to electing the installment sale treatment include: (1) an opportunity cost to Seller for the deferred receipt of cash consideration;19 and (2) potential risk associated with Buyer’s nonpayment of deferred consideration under the installment contract. Note that this last detriment may be mitigated through the use of an escrow or similar arrangement if the escrow arrangement imposes a “substantial restriction” within the meaning of Rev. Rul. 77-294, 1977-2 C.B. 173 and relevant case law.20 There are also limitations on the ability to elect the installment method for some assets — for example, inventory21 and some intangibles subject to the anti-churning rules.22

Table 2. Installment Sale

Annual Tax Liability (base case)

Regular Tax

BEAT

Gross income

$100

$100

Deductions

-$20

-$20

Deductible payments to foreign-related parties

-$60

$0

Taxable income (TI)

$20

$80

Cash tax (21 percent or 10 percent)

$4

$8

Full Proceeds Recognized in Y1

Regular Tax

BEAT

Additional income

$100

$100

Total TI (TI + additional income)

$120

$180

Cash tax (21 percent or 10 percent)

$25

$18

Installment Sale (4 years)

Regular Tax

BEAT

Y1 taxable income (TI + additional income/4)

$45

$105

Y2 taxable income (TI + additional income/4)

$45

$105

Y3 taxable income (TI + additional income/4)

$45

$105

Y4 taxable income (TI + additional income/4)

$45

$105

Cash tax (21 percent or 10 percent)

$38

$42

Total tax — no installment salea

$49.2

 

Total tax — installment saleb

$42

 

Gross savings

$7.2

 

Section 453A interest chargec

-$2.9

 

Net savings

$4.3

 

aIf no installment sale is elected, total tax would be regular tax of $25 in year 1 plus $8 BEAT per year (for three years) for $49 of total tax.

bIf installment sale is elected, the total tax would be annual BEAT of $10.50 (for four years) for $42 of total tax.

cUses the current federal underpayment rate of 6 percent.

III. Financial Reporting (Effective Tax Rate)

A. Acquisitions

From an effective tax rate (ETR)23 perspective, if incremental base erosion payments subject a buyer that was previously paying regular tax to BEAT, a previously 21 percent ETR will increase. See Table 3. However, for Buyer subject to BEAT before an acquisition, incremental income will have the effect of reducing ETR, until a 21 percent ETR is achieved. See Table 4.

Assume pre-acquisition that Buyer has $1,000 of gross income and $500 of deductions ($400 of which are base erosion payments). Under regular tax, Buyer would have $500 of regular TI multiplied by 21 percent resulting in $105 of regular tax liability. Under the BEAT, Buyer would have $900 of modified TI, multiplied by 10 percent, resulting in a minimum tax of $90. Therefore, the Buyer would pay only regular tax because the BEAT does not exceed the $105 of regular tax payable. Now assume that Buyer acquires Target, which has $400 of gross income and $300 of deductions, all of which are base erosion payments. Post-acquisition, under regular tax, Buyer would have $600 of regular TI multiplied by 21 percent resulting in $126 of regular tax liability. Under the BEAT, Buyer would have $1,300 of modified TI multiplied by 10 percent resulting in a minimum tax of $130.

Post-acquisition, the BEAT is greater than the regular tax liability, so Buyer would pay the minimum tax amount of $130. Pre-acquisition, Buyer’s ETR was, as would be expected, 21 percent (that is, $105/$500). Post-acquisition, because Buyer is subject to the BEAT as a minimum tax, Buyer’s ETR has diverged from the 21 percent marginal rate and has increased to 21.7 percent (that is, $130/$600). ETR on incremental income from Target is 25 percent (that is, the difference between the total BEAT of $130 and the regular tax of $105 divided by the incremental regular TI of $100) because of the $300 of associated incremental base erosion payments. See Table 3 demonstrating this incremental increase in ETR below.

Table 3. Acquisition Increases Buyer’s ETR

Regular Tax

 

BEAT

 

Gross income

$1,000

Gross income

$1,000

Deductible payments to foreign-related parties

-$400

Deductible payments to foreign-related parties

$0

Other deductible payments

-$100

Other deductible payments

-$100

Regular taxable income

$500

Modified taxable income

$900

Regular tax

$105

BEAT

$90

Incremental income from acquisition

$400

Incremental income from acquisition

$400

Incremental deductible payments to foreign-related parties

-$300

Incremental deductible payments to foreign-related parties

$0

Incremental other deductible payments

$0

Incremental other deductible payments

$0

Total regular taxable income

$600

Total modified taxable income

$1,300

Total regular tax

$126

Total BEAT

$130

Pre-acquisition ETR (regular tax/regular taxable income)

21%

ETR on income increase is $25/$100

25%

Post-acquisition ETR (BEAT/total regular taxable income)

21.7%

 

 

Now assume that Buyer was subject to the BEAT pre-acquisition. Buyer has $1,000 of gross income and $900 of deductions ($800 of which are base erosion payments). Under regular tax, Buyer would have $100 of regular TI multiplied by 21 percent, resulting in $21 of regular tax liability. Under the BEAT, Buyer would have $900 of modified TI multiplied by 10 percent resulting in a minimum tax of $90. Therefore, because the $90 BEAT exceeds the regular tax liability of $21, Buyer would pay the minimum tax amount of $90.

Now assume that Buyer acquires Target, which has $100 of TI (no base erosion payments). Post-acquisition, under regular tax, Buyer would have $200 of regular TI multiplied by 21 percent resulting in $42 of regular tax liability. Under the BEAT, the Buyer would have $1,000 of modified TI multiplied by 10 percent resulting in a minimum tax of $100. Post-acquisition, the BEAT continues to be greater than the regular tax liability of $42, so Buyer would pay the minimum tax amount of $100. Pre-acquisition, Buyer’s ETR was 90 percent (that is, $90/$100). Post-acquisition, Buyer’s ETR decreases to 50 percent (that is, $100/$200). Note that with additional income (under these simplified facts, $528), ETR would continue to decline until it reaches the marginal rate of 21 percent (break-even ETR).24

Table 4. Acquisition Decreases Buyer’s ETR

Regular Tax

 

BEAT

 

Gross income

$1,000

Gross income

$1,000

Deductible payments to foreign-related parties

-$800

Deductible payments to foreign-related parties

$0

Other deductible payments

-$100

Other deductible payments

-$100

Regular taxable income

$100

Modified taxable income

$900

Regular tax

$21

BEAT

$90

Incremental income from acquisition

$100

Incremental income from acquisition

$100

Total regular taxable income

$200

Total modified taxable income

$1,000

Total regular tax

$42

Total BEAT

$100

Pre-acquisition ETR (BEAT/regular taxable income)

90%

Break even ETR (break even regular tax/break even regular taxable income

21%

Post-acquisition ETR (BEAT/total regular taxable income)

50%

 

 

B. Dispositions

Similar to the acquisition context, a disposition of shares or assets to a non-U.S. affiliate generating a section 165 loss may generate incremental base erosion payments (that is, to the extent the disposition generates a current-year loss deduction in the United States).25 Whether a current-year loss deduction is allowed depends on: (1) the related-party transaction rules (for example, section 267); (2) the character of the property sold; (3) if the property sold is a capital asset and generates a capital loss, whether there are offsetting capital gains against which a capital loss deduction can be claimed; and (4) whether the loss exceeds income (generating an NOL).26 If the loss is large enough to generate an NOL, the base erosion percentage of the carryforward NOL used in future years will be considered a base erosion payment.27

Therefore, similar to the acquisition context, a disposal may have the effect of subjecting Seller to the BEAT, increasing the ETR above 21 percent. However, for Seller subject to the BEAT before a disposition, incremental income will have the effect of reducing ETR, until a 21 percent ETR is achieved.

IV. M&A Valuation

A. Acquisitions

In deriving an after-tax cash flow forecast to determine the enterprise value of Target using a DCF analysis, the actual cash tax projected to be paid should be used. The rate used to calculate the cash tax to be paid may vary, consistent with the year-by-year determination of whether Buyer will have a BEAT liability exceeding regular tax liability. Therefore, it’s helpful to make a tripartite distinction among buyers to generalize which cash tax rate should be used when a static forecast at the time of valuation is required.

1. Taxpayers exempt from BEAT.

Corporate buyers with a wholly domestic intercompany footprint28 or annual gross receipts of less than $500 million should generally use a 21 percent cash tax rate to determine after-tax cash flow and to tax effect tax assets (assuming Buyer separately values tax assets).29 High-tax-bracket individual investors in noncorporate entities (partnerships, S corporations, regulated investment companies, and real estate investment trusts) should use a 30 percent to 41 percent30 cash tax rate to determine after-tax cash flow and to tax effect tax assets (again, assuming Buyer separately values tax assets). Those buyers are exempt from the BEAT under section 59A(e)(1)(A) because they are not “applicable taxpayers.” It’s worth noting that while noncorporate entities (and any individual investors) are not applicable taxpayers subject to the BEAT,31 a corporate investor in such an entity may be subject to the BEAT on its share of flow-through income and therefore would need to be categorized according to the three-part framework.

2. Taxpayers potentially moving in and out of BEAT.

Whether Buyer is subject to the BEAT heavily depends on TI and profit margins;32 therefore, if Buyer is considered an applicable taxpayer (especially with thin margins) and in the year of a proposed acquisition has a base erosion percentage of 3 percent or greater, and therefore may be subject in the current year to the 10 percent BEAT tax rate, it may be more prudent to use an equally weighted, blended 15.5 percent33 cash tax rate in the DCF analysis to determine after-tax cash flow34 and to tax effect tax assets (assuming Buyer separately values tax assets). The appropriate tax rate to use will largely depend on the quantum of tax assets acquired as well as Buyer’s risk preferences.

Using a 15.5 percent blended cash tax rate to reflect the fact that Buyer may be subject to the BEAT in some years and the regular tax in others should also minimize the amount that Buyer may overpay for an amortizable tax asset in the year of an acquisition when tax amortization is separately valued as an acquisition synergy and is large relative to after-tax cash flow. If Buyer is likely to be subject to the BEAT in one or more later years, there’s a risk of Buyer paying a premium in the year of acquisition for tax amortization by tax effecting it at 21 percent while the cash tax value of that amortization in later years would be 10 percent if Buyer is subject to the BEAT.

By using a 15.5 percent cash tax rate in a DCF analysis, the amount of potential overpayment would be halved. There is a potential opportunity cost if the bid is lost based on an undervaluing of the tax assets; however, in most deals (assuming they aren’t tax-driven) the value of acquired tax assets won’t be material relative to the overall net book investment value.35 Also, the tax rate impact on after-tax cash flows used to value a target will normally have a greater effect on a target’s valuation than the tax rate impact on tax attributes.

3. Buyers structurally in BEAT.

If Buyer is structurally in BEAT (that is, with thin profit margins and large annual base erosion payments relative to TI), it should generally use a 10 percent cash tax rate to determine after-tax cash flow and to tax effect amortizable tax assets. The tax rate used is especially important when significant amortizable tax assets are acquired (for example, goodwill). When Buyer is subject to the BEAT, the value of deducting a $100 non-base erosion payment is $10 on a tax-effected basis. While the section 59A proposed regulations don’t provide for a recomputation approach,36 the result would be that if the $100 deduction was eliminated, Buyer’s ultimate tax liability would increase by $10.

For example, assume Buyer has $1,000 of gross income, $800 of base erosion payments, and $100 of non-base erosion as well as otherwise deductible amortization (related to an asset acquisition). If the $100 of amortization were eliminated, regular tax would increase from $21 to $42, and BEAT would increase from $90 to $100. While the BEAT liability is the excess of modified TI multiplied by 10 percent less regular tax liability with adjustments under section 59A(b), the BEAT ultimately operates as a floor.37 Therefore, this example demonstrates that when Buyer is structurally (that is, perpetually) subject to the BEAT and separately values acquired tax assets, those assets should be tax-effected at 10 percent to derive their value.

The effect of the BEAT and section 163(j) to the WACC (specifically the cost of debt) of buyers structurally subject to these provisions is less straightforward. However, for buyers structurally subject to section 163(j) and assuming a 3 percent interest rate,38 one potential bright-line metric would provide that if a target is acquired for a premium (that is, greater than 10x earnings before interest, taxes, and amortization),39 interest expense related to acquisition debt used to fund the premium that exceeds the 10x EBITDA multiple will be nondeductible, increasing the WACC.

Under this metric and its relevant assumptions, mathematically the maximum EBITDA multiple that could be paid for a fully financed acquisition (while still receiving a full deduction for acquisition debt) would be 10x.40 If Target is acquired for $100 (assume fully financed through acquisition debt), Target’s $10 of EBITDA multiplied by the 30 percent EBITDA limitation under section 163(j) would yield a $3 section 163(j) limitation, allowing for full tax deductibility of the $3 of interest expense. However, if a $100 premium is paid and Target is acquired for $200 (again, assume fully financed through acquisition debt) or 20x EBITDA multiple, only $3 of the $6 of interest expense would be deductible under section 163(j), with interest expense related to the 10x EBITDA premium paid disallowed and deferred (indefinitely, beginning 2022 for most taxpayers). Applying this metric to the cost of debt:

  • No section 163(j) limitation:

    • Pretax cost of debt = $6/$200 = 3 percent.

    • After-tax cost of debt = 3 percent * (100 percent - 21 percent) = 2.37 percent.

  • Section 163(j) limitation (50 percent of interest expense nondeductible):

    • Pretax cost of debt = $6/$200 = 3 percent.

    • After-tax cost of debt = 3 percent * (100 percent - (21 percent * 50 percent)) = 2.69 percent.

A similar result would follow for buyers structurally subject to the BEAT, as demonstrated in Table 5. Buyers structurally subject to section 163(j) or the BEAT will have disallowed or diminished tax deductions, causing the ETR and the cash tax rate to diverge. Because the after-tax cost of debt is intended to reflect the tax benefits of deductible interest expense, to the extent acquisition financing interest expense is nondeductible or tax effected at a lower rate, this decreased tax benefit should increase the cost of debt.

Thus, ETR should in fact be higher than 21 percent for buyers structurally subject to section 163(j) or the BEAT, which would indicate a lower cost of debt. However, this higher ETR is not a reliable proxy for the tax benefit of the deduction; for example, a buyer structurally subject to the BEAT would have an ETR greater than 21 percent, while the cash tax benefit of a third-party interest expense deduction would be 10 percent. Therefore, in determining the after-tax cost of debt, buyers structurally subject to section 163(j) or the BEAT should use the lower cash tax rate rather than the ETR to avoid artificially decreasing the WACC.

B. Dispositions

Unlike in the acquisition context, when the actual cash tax rate to which Buyer is subject should be used, Seller should use a 21 percent tax rate to derive a cash flow forecast to determine the enterprise value to a third party of a business to be disposed of (assuming a DCF analysis). The 21 percent tax rate is what a hypothetical buyer would be subject to. Using that rate would reduce the after-tax cash flows of the business to be disposed of (reducing Seller’s benchmark valuation); however, using that rate would also increase the valuation of any tax assets acquired by Buyer (for example, amortizable tax intangibles, NOLs) assuming that a hypothetical buyer would separately value such assets. Buyer and Seller will then need to negotiate to align Seller’s benchmark valuation and Buyer’s consideration value depending on the actual cash tax rate that Buyer will be subject to.

Table 5. Impact of Section 163(j) and/or the BEAT on the Cost of Debt

 

Prior Law

Current Law (section 163(j))

Current Law (BEAT)

Gross income

$100

$100

$100

Third-party interest

-$30

-$30

-$15

Section 163(j) disallowancea

$0

$15

$0

Payments to foreign-related parties

-$15

-$15

-$50

Add-back (BEAT)

$0

$0

$50

Tax at 35 percent, 21 percent, and 10 percent

$19

$15

$9

Cash tax rate

35%

21%

10%

ETR

35%

27%

24%

After-tax Cd (ETR)

1.95%

2.2%

2.27%

After-tax Cd (cash tax)b, c, d

1.95%

2.69%

2.7%

aPrior section 163(j) applied only to related-party interest and used a 50 percent rather than 30 percent of EBITDA test.

bIn the context of the section 163(j) example, only 50 percent of the third-party interest expense is tax deductible. Therefore, assuming structural disallowance under section 163(j), the 21 percent rate should be multiplied by 50 percent to reflect this decrease in the tax benefit.

cIn the context of the BEAT example, all the third-party interest expense is deductible. Therefore, assuming Buyer is structurally in BEAT, the 10 percent rate should be used to reflect this decrease in the tax benefit.

dAssumes a 3 percent pretax Cd (interest rate).

V. Conclusion

The appropriate tax rate to use varies depending on the context. In determining the cash tax impact on a group for incremental operating income or dispositional gains, there’s a benefit to using any BEAT headroom because that income is taxed at a lower rate. Also, it may be tax-efficient to structure a sale as an installment sale to use this headroom over several years.

In determining the impact of additional operating income, dispositional gains, or base erosion payments to a group’s ETR, incremental income or deductions will affect a taxpayer’s ETR differently depending on whether the BEAT liability or regular tax liability is greater — to the extent the BEAT liability is higher, the incremental income will reduce ETR; to the extent regular tax liability is greater the incremental income will not affect ETR. Incremental base erosion payments will increase ETR to the extent a taxpayer’s BEAT liability is greater than regular tax liability; to the extent regular tax liability is greater, the incremental base erosion payments will not affect ETR.

Finally, in determining the impact on a group’s M&A valuation, a distinction should be made among three categories of taxpayers: (1) those not subject to the BEAT; (2) those potentially subject to the BEAT; and (3) those structurally (perpetually) subject to the BEAT. In determining discounted after-tax cash flow used to value Target and the tax rate at which to effect Target’s tax attributes (assuming Buyer separately values tax assets), a 21 percent (corporate) tax rate or a 30 percent to 41 percent (individual) tax rate should be used for the first category of taxpayers; a 15.5 percent or 21 percent tax rate for the second category (depending on the quantum of Target’s tax assets); and a 10 percent tax rate for the third category. Taxpayers in the third category should also consider how the cost of debt is computed to avoid overstating the tax benefit of interest expense deductions.

FOOTNOTES

1 Also referred to as operating profit.

2 Also referred to as free cash flow.

3 For simplicity, this article does not consider the state tax effects on a BEAT-versus-regular tax rate analysis.

5 Using techniques discussed in myriad articles, including the modified services cost method exception, and capitalizing under section 263A otherwise base erosion payments to the cost of goods sold.

7 The concern here is the use of after-tax cash flows to value a target for an acquisition business case; that is, the higher the tax rate, the lower the after-tax cash flow, and thus the lower the resulting target valuation (and vice versa regarding the use of a lower tax rate).

8 Formula: WACC = Ce * E + Cd * D, when: (1) Ce is the cost of equity; (2) E is the taxpayer’s market cap as a percentage of total capital; (3) Cd is the after-tax cost of debt; and (4) D is the taxpayer’s debt as a percentage of total capital.

9 Formula: After-tax cost of debt (Cd) = Pre-tax cost of debt * (100 percent - ETR). As a general matter, the pre-tax cost of debt is the interest expense paid to service the debt. To determine the after-tax cost of debt, the gross (or pre-tax) cost of debt is adjusted for tax benefits (i.e., tax deductions for interest expense will decrease the pre-tax cost of debt). When interest expense is deductible, the effective tax rate is reduced. However, when the tax deduction for interest expense is actually or effectively permanently disallowed (for buyers structurally in BEAT or section 163(j)), this expense will not reduce the effective tax rate and therefore the cost of debt will necessarily increase as the tax benefit of the interest expense correspondingly decreases.

10 That is, BEAT headroom is the extent to which the BEAT liability is higher than the regular tax liability and as a result incremental income is subject to a 10 percent (versus 21 percent) marginal tax rate. In fact, because taxable profit is taxed at 10 percent, the BEAT taxpayer generally should have an overall advantage. See infra Section II.A. To put it another way, the interest expense (or other tax asset, e.g., amortization) that provides a 10 percent (or 21 percent) tax benefit offsets income of the target that is also taxed at 10 percent (or 21 percent), and the net remaining income of the target is taxed at 10 percent for the BEAT taxpayer and 21 percent for the regular taxpayer. Conversely, if there is a net loss after taking the target income and deductions into account, the regular taxpayer values the loss at 21 percent as opposed to 10 percent for the BEAT taxpayer, and therefore has an advantage.

11 In limited circumstances, an equity raise may be preferred depending on the dividends per share relative to the share price. For example, if a buyer structurally subject to section 163(j) or the BEAT may raise acquisition capital by either issuing additional shares at $100/share paying a 2 percent annual dividend versus borrowing from a third party at 3 percent interest, a buyer may choose an equity raise in lieu of debt financing (assuming other efficient capital structure considerations are met).

12 See infra Table 2 and corresponding text for a numerical application of this concept.

13 Section 59A(b). While this is technically how the BEAT is computed under section 59A (BEAT is imposed in addition to regular tax), it’s mathematically equivalent to shorthand that a taxpayer will pay the greater of either BEAT or regular tax liability (reduced by specific tax credits).

15 Section 453A(c)(3)(B). Note that this section refers to “the maximum rate of tax in effect under section . . . 11.” Therefore, a 21 percent rate will apply in computing the deferred tax liability (on which the section 453A(c)(2) interest charge is levied) even for a taxpayer subject to the 10 percent BEAT.

16 If section 453A(a)(1) applies, interest on deferred tax liability is calculated by multiplying the applicable percentage of the deferred tax liability under the installment note by the underpayment rate under section 6621(a)(2) (3 percent plus the applicable federal rate).

17 See Rev. Rul. 2019-5, 2019-11 IRB 766 (federal underpayment rate set quarterly and rounded).

18 That is, excess TI generated by a disposition that provides no additional section 163(j) benefit in the year of sale and is not carried forward.

19 For example, the deferred consideration could otherwise be deployed to earn a market return or pay down third-party debt.

20 Providing that if an escrow agreement incident to a deferred payment sales transaction imposes a substantial restriction, in addition to the payment schedule, upon the seller’s right to receipt of the sales proceeds, the IRS will allow the seller to use the installment method of reporting income from the sale, assuming the sales transaction otherwise qualifies under that provision. See also Murray v. Commissioner, 28 B.T.A. 624 (1933) (for an escrow arrangement to impose a substantial restriction, it must serve a bona fide purpose of the purchaser; that is, a real and definite restriction placed on the seller or a specific economic benefit conferred on the purchaser. In Murray, for example, receipt of payments from the escrow account was contingent on the sellers refraining from entering a competing business for five years.).

23 Formula: ETR = Total tax/Earnings before taxes. Earnings (or profits) will generally not take into account some tax adjustments (or addbacks) to convert profit before tax to TI, e.g., base erosion payments or disallowed interest expense under section 163(j).

24 That is, adding $528 of TI to the regular TI base would increase total regular TI to $728 (break-even regular taxable income), which multiplied by 21 percent would yield regular tax of $152.88 (break-even regular tax). Comparatively, this additional TI would increase total modified TI to $1,528, which multiplied by 10 percent would yield BEAT of $152.80. Break-even regular tax of $152.88 divided by break-even regular taxable income of $728 yields a break-even ETR of 21 percent.

25 REG-104259-18 at 22 (“because section 59A(d)(1) defines the first category of base erosion payment as ‘any amount paid or accrued by the taxpayer to a foreign person which is a related party of the taxpayer and with respect to which a deduction is allowable under this chapter,’ a base erosion payment also includes a payment to a foreign related party resulting in a recognized loss; for example, a loss recognized on the transfer of property to a foreign related party”).

26 See sections 165(f) and 1211(a) (losses from sales or exchanges of capital assets shall be allowed only to the extent of gains from those sales or exchanges).

28 And therefore, a base erosion percentage of less than 3 percent (2 percent for banks or dealers).

29 An M&A team may separately value tax synergies for at least two reasons: (1) to easily identify the contribution of tax synergies to the total synergized value, as tax synergies are not attributable to the operational performance of the business; and (2) to decouple tax synergy value from the actual business value drivers (that is, the business team working on an acquisition business case should assess the synergized value of a business clean of tax synergies because tax shouldn’t drive a business case, and separately valuing tax synergies will give a better underlying view of the more fundamental operational synergies; e.g., cost or revenue synergies related to supply chain optimization and headcount reduction).

30 Tax rates are inclusive of the (1) 20 percent section 199A passthrough business income deduction (assuming no phaseout under section 199A(b)(3), Target is a qualified trade or business within the meaning of section 199A(d), and no other restrictions apply); and (2) 3.8 percent net investment income tax under section 1411. This does not consider state taxes. See supra note 3.

31 Noncorporate entities would likely ignore all taxes, either regular tax or BEAT, because those flow-through entities are generally not subject to an entity-level tax.

32 To illustrate the concept that thin-margin taxpayers are more likely to be subject to the BEAT, consider a taxpayer in year 1 with $100 of gross income and $85 of deductions ($10 of which are base erosion payments). In year 1, the taxpayer would pay regular tax of $3.20 (the BEAT minimum tax acting as a floor is $2.50). Assume gross income fluctuates by up to 10 percent annually and therefore drops to $90 in year 2; the deductions stay the same. In year 2, the taxpayer would now be subject to the BEAT minimum tax because the regular tax liability of $1.05 is less than the BEAT floor of $1.50. If this same taxpayer had even thinner profit margins (assume deductible third-party advertising expenses increase by $10 in year 1), it would be subject to the BEAT minimum tax in year 1 because the regular tax liability of $1.05 would be less than the BEAT floor of $1.50.

33 That is, 10 + 21/2 = 15.5. Note that while the BEAT rate increases to 12.5 percent in 2026, because of political uncertainties and other factors, this increase may be too speculative to include in a current-year valuation.

34 Note that when tax assets are valued separately, after-tax cash flow is calculated before taking tax amortization or other tax deductions from Target into account to prevent double counting.

35 Compare this with the impact of the tax rate used in the WACC. If the after-tax cash flow being discounted is large enough, a 0.5 percent reduction in WACC may be sufficient to lead to a material undervaluation of a target, creating an opportunity cost if a bid is lost.

36 REG-104259-18 at 46. Compare the alternative minimum tax under section 55.

37 See supra note 18.

38 Aaa corporate bond yields are currently approximately 3.3 percent. SeeMoody’s Seasoned Aaa Corporate Bond Yield,” YCHARTS (June 24, 2019).

39 SeeEnterprise Value Multiples by Sector (US),” New York University (Jan. 2019).

40 Note that this multiple will change depending the interest rate, e.g., if interest rates decrease to 2 percent then the multiple would increase to 15x; conversely, if interest rates increase to 4 percent then the multiple would decrease to 7.5x.

END FOOTNOTES

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