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Rate Uncertainties Could Fuel Wave of Tax Receivable Agreements

Posted on Nov. 16, 2020

Heightened uncertainties plaguing mergers and acquisitions may trigger greater interest in tax receivable agreements to compensate a selling corporation for benefits the buyer derives from the target’s preexisting net operating losses. 

The structuring of transactions — already fraught with uncertainties stemming from the effects of the COVID-19 pandemic that have complicated the valuations of target companies — just got more complex with the unknown fate of tax policies under a new administration. 

The challenges are valuing a business “when you’re in a time of just incredible uncertainty” and assessing “the different levers that can be maneuvered to provide price protection for a buyer . . . and incentives for the seller,” David Strong of Wilson Sonsini Goodrich & Rosati said November 12 during a webinar hosted by Strafford

That focus on a risk-shifting proposition is something generally considered in an M&A deal, but it’s become more relevant in today's environment, in which several industries have suffered significantly because of the pandemic, Strong said. 

Whenever there is severe economic distress in the market environment, sellers look for ways to extract more value, which could be via tax benefits, Strong said. Practitioners should keep an eye out for “situations that could give rise to a potential benefit that can be traded in a transaction” to bridge the perceived value gap, he advised. 

One mechanism to compensate historic business owners for the value of any tax benefits that the new equity owners realize from the entity’s tax attributes — typically a stepped-up tax basis — is a tax receivable agreement, often used with initial public offerings.

While those agreements have generally been executed with IPOs, Strong emphasized that they can apply in other contexts, such as in transactions involving target corporations with NOLs. 

Gordon Warnke of KPMG LLP said it will be interesting to see if tax receivable agreements “become a wave of the future” with the uncertainty surrounding tax rates. For example, if the seller thinks tax rates will increase and that would make its NOLs more valuable, will those agreements provide flexibility to bridge the gap? Warnke noted that there are pros and cons to that approach. 

Tax Policy Lever

Dealmakers have been considering President-elect Joe Biden’s proposals to roll back features of the Tax Cuts and Jobs Act, including an increase in the corporate tax rate and upending the global intangible low-taxed income regime. 

To address uncertainties fueled by the possibility of substantial changes in tax policy, buyers and sellers are using mechanisms that have become more prominent in the pandemic-stricken world, such as earn-outs and equity rollovers, according to M&A practitioners. 

Strong said potential tax law changes could be among the levers in structuring acquisitions, but noted that there’s still much uncertainty because even under the assumption that the election has been decided, “we still have kind of a jump ball” in the Senate, pending Georgia’s runoff elections in January. 

It’s difficult to plan in a world with a 21 percent corporate tax rate and a 10.5 percent rate on GILTI that could increase to 28 percent and 21 percent, respectively, Warnke said. 

Warnke also pointed out that even if a transaction closes in 2021 before a legislative change later in the year, section 15 requires taxpayers to apply a blended tax rate for the year. 

So if a business plans to dispose of an asset, there could be “significant tax swings” depending on when the transaction closes and what happens with tax legislation next year, Warnke said, adding that the uncertainty “continues to hound” much of the work he has been doing. 

The effects of the pandemic, combined with uncertainties regarding future tax rates and some TCJA rules, exacerbate challenges dealing with market volatility and valuing a company, he added. 

Retroactivity Woes

The TCJA amended section 172 to, in most circumstances, eliminate NOL carrybacks, limit NOLs to 80 percent of taxable income, and allow carryforwards indefinitely. Pre-TCJA, most taxpayers could generally carry back losses for two years and forward for only 20 years. 

The Coronavirus Aid, Relief, and Economic Security Act (P.L. 116-136) modified section 172 to address liquidity issues arising from the pandemic by temporarily repealing the 80 percent NOL limitation and allowing deductions for loss carryovers and carrybacks to fully offset taxable income for tax years beginning before January 1, 2021.

The law also allows companies to carry back losses arising in tax years beginning in 2018 through 2020 for up to five years before the year of the loss. 

Warnke said another issue that “creates uncertainty if you’re trying to do a deal and price in . . . the value of [the] net operating losses” is that the law could be changed and made retroactive to the enactment of the CARES Act. 

Warnke pointed to the Health and Economic Recovery Omnibus Emergency Solutions (HEROES) Act (H.R. 925), not to suggest that it could still pass, but to say that it’s something practitioners should keep in mind. 

The updated version of the HEROES Act passed by the House October 1 contains the controversial provision limiting the ability to carry back NOLs. Taxpayers generally would be able to carry back NOLs incurred in 2019 and 2020 to tax years beginning in 2018, which would eliminate the tax rate arbitrage inherent in the CARES Act, which occurs when losses incurred in tax years with a 21 percent tax rate can be carried back to pre-TCJA years when the corporate tax rate was 35 percent. 

The HEROES Act would also prohibit companies with excessive executive compensation, golden parachute payments, or excessive dividend payments and stock buybacks from carrying back losses. 

Strong emphasized that state laws regarding NOLs should also be reviewed. He pointed to California’s legislation as an example, which suspends the use of NOLs for tax years 2020 through 2022 for taxpayers with net business income or modified adjusted gross income of $1 million or more. (For additional coverage, see our article in Tax Notes Today State.)

Explicit NOL Pricing?

Regarding pricing of NOLs in transactions since the CARES Act, Strong said that in his practice he hasn’t seen many deals that have expressly done that. 

Warnke said he hasn’t worked on many deals that are pricing in the NOLs or deals involving the sale or purchase of an NOL business. He noted that in the past, NOLs were either priced in upfront or paid for over time. But for those types of deals now, the uncertainty has likely put more pressure on paying for that attribute over time, Warnke said, adding that those transactions are a "nightmare.” 

Alan J. Schwartz of Holland & Knight LLP said his experience has been similar in that he hasn’t seen NOLs factored into deals other than high-level discussions and some diligence in calculating the significance of any NOLs.

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