The Brave New World of M&A and Tax Reform: What Has Changed and How to Improve Deal Values in Domestic Corporate Transactions

Dealmakers are living in a brave new world of tax rules now. Many describe the recent federal income tax legislation as historic—a once-in-a-generation event—but it would also be accurate to describe it as complex, with far-reaching strategic implications for organizations that transcend the tax function. M&A is no exception. Corporate purchasers and sellers in M&A deals may be positioned to take advantage of some of the recent tax changes to improve deal value, maximize income tax savings and minimize tax liabilities.
 
The changes are generally effective for tax years beginning after 2017. With tax reform of this magnitude, however, it is not possible to touch on all of them, so this article will focus on the five most significant changes influencing domestic M&A transactions involving corporations. It will not address the impact of changes on international income tax matters and cross-border M&A deals, or state and local tax implications.
 

Five key federal income tax changes affecting corporate M&A deals in the U.S.:

#1 - TAX RATE REDUCTIONS: Corporate tax rate reductions will impact transaction structures.
 
Key changes:

• The corporate income tax rate is permanently reduced from 35 percent to 21 percent.

• The highest individual income tax rate is reduced from 39.6 percent to 37 percent (but note that most individual provisions are set to expire in 2025).

• Owners of sole proprietorships and pass-through entities such as S corporations and partnerships who are allocated certain qualified income from their pass-through entities may obtain a deduction of up to 20 percent on this income, which effectively could reduce the highest income tax rate on this income to 29.6 percent (the deduction could land between zero and 20 percent depending on the circumstances).

• Individual tax rates on capital gains (20 percent), qualified dividend income (20 percent), and net investment income (3.8 percent) remain the same.

• The corporate alternative minimum tax is repealed, yet the ability to use minimum tax credit carry- forwards generated in 2017 and prior years has been preserved in a generous fashion. These carry- forwards may offset regular income tax liability for the years 2018 through 2020, and to the extent the credit carryforwards still exceed regular tax, 50 percent of the excess credit carryforwards are refundable for those years with the ability to obtain a 100 percent refund of whatever excess amount remains for 2021.

Observations:
Purchasers should consider the choice of entity to be used in planning and holding acquisitions, and compare the tax rates that apply to each entity option. For instance, if the corporate form is chosen, the net present value benefit derived from a tax shield from the amortization of a step-up in the tax basis of intangible assets should decrease. Also, the value of tax receivable arrangements for payments for its use of tax attributes acquired from the seller would diminish due to lower tax rates.
 
Both purchasers and sellers should consider the potential for entity rationalization as part of a strategy for an eventual sale.
 

#2 - LIMITATION ON INTEREST DEDUCTIONS: An interest deduction limitation change should influence the after-tax cost for debt-financed acquisitions of corporations. This tax rule change limits annual deductions for net business interest expense to 30 percent of the purchaser’s taxable income with adjustments.  
 
Key changes:

• The amount of adjusted taxable income approximates earnings before interest, taxes, depreciation and amortization (EBITDA) before 2022, and approximates earnings before interest and taxes (EBIT) after 2021.

• EBITDA or EBIT as shown on financial statements is not the same as the amount of the adjusted taxable income because of differences between financial statement accounting and tax accounting.

• Disallowed interest deductions may be carried forward indefinitely.

• The disallowed portion of interest expense that is carried forward would be subject to potential ownership change limitations on its future use.

• The limitation does not apply to businesses with $25 million or less of gross receipts or to certain businesses engaged in agriculture, real estate, or floor plan financing interest.

  
Observations:
The limitation of interest expense deductibility may increase taxes on corporations with substantial indebtedness or that make highly leveraged acquisitions. In an investment thesis, returns may be lower because this tax rule change could make the cost of debt more expensive on an after-tax basis. Thus, this limitation on interest deductibility could have an impact on the cost of capital. Consequently, there could be less use of leverage in some transactions. For example, if the purchaser is a private equity firm, this tax rule change might result in the use of more of its equity to finance the acquisition. This limitation on interest expense should be considered as part of the capitalization of a contemplated transaction and in modeling the value of the investment.
 

#3 - EXPENSING THE COST OF TANGIBLE ASSETS: Companies will be able to fully expense certain capital expenditures, including acquisitions of used property in 2018.
 
Key changes:

• For the next five years, an immediate expensing of 100 percent of the cost of certain depreciable assets acquired and placed in service (capex) during a tax year is permitted. The assets may be new or used.

• During the five years after 2022, the expensing percentage is decreased by 20 percent per year. Acquisitions that involve a plan for capex could benefit from this opportunity. Generally, the assets that qualify for expensing include equipment and other fixed assets with a tax life of 20 years or less.

• Assets that do not qualify include:

  • Intangible assets

  • Real estate (a new category of 15-year improvement property is intended to be eligible for expensing. A technical correction by Congress, however, is needed to fix this omission.)

  • Property located outside the U.S.

  • Related party assets, so the acquired assets must be first used by the purchaser

  • Underlying assets acquired in a transaction treated as a stock acquisition for tax purposes

Observations:
In planning a transaction, these rules may cause a purchaser to seek an asset acquisition as the assets acquired would be available for immediate and full expensing. This assumes the expensing results in an attractive net present value after other tax factors are considered. Of course, there are many non-tax factors to weigh in deciding on the form of a transaction. The chosen transaction structure itself may influence whether expensing is available. Due diligence should be performed as to the history and nature of the assets involved to ascertain whether they qualify for expensing.
 
A comparison of expensing to depreciating assets for income tax purposes should be considered in tax and valuation modeling. For example, the ability to elect out of full expensing is available because depreciation could be viable in certain situations. If the target company is expected to generate a net operating loss (NOL), the expensing amount should be reduced to the extent it creates the NOL. On the other hand, for target companies with plans for significant capex, the immediate tax deductions generated by the capex could make up for deductions lost due to interest expense limitations. Finally, this expensing benefit might be particularly suitable in a carve-out transaction or the acquisition of a closely held company that has pass-through income tax status.
 

#4 - CHANGES AS TO THE USE OF NOL CARRYFORWARDS: In a stock acquisition, the target company may possess NOL carryforwards. A purchaser may perceive this to be an asset to potentially reduce post-acquisition taxable income. The tax rules in effect for an NOL generated in 2017 and in prior years remain unchanged and are applicable to the carryforward of that NOL into 2018 and years following. Several changes are in effect, however, for the carryforward of NOL generated in 2018 and years following.
 
Key changes to the use of an NOL generated in 2018 and after:

• May not be carried back

• May be carried forward indefinitely

• Is limited to offset only 80 percent of taxable income in the future year of its use

Observations:
These rule changes may impact the value of a stock acquisition for both sellers and purchasers. Often, a seller may bargain to be reimbursed for tax deductions attributable to payments made by the target or seller for transaction costs. These reimbursements may be substantial and include debt refinancing costs, a portion of investment banking fees, and compensation payments such as stock option exercises, bonuses, severance and other items. For transactions occurring in 2018 and beyond, a purchaser or seller may no longer carry back deductions that could create an NOL in the year of the transaction for a tax refund. This NOL is available only to be carried forward subject to the changes highlighted above. The 80 percent limit on use could slow the pace of the absorption of the NOL carryforward. A potentially lengthy or unknown carryforward period may pose a practical issue as to the net present value of its use or for estimating a purchase price adjustment.
 
Other rules place potential limitations on the use of pre-transaction NOL carryforwards in the case of ownership changes. These ownership change limitation rules remain the same and continue to present their own challenges to derive benefits from pre-transaction NOL carryforwards. Without careful modeling, the recent changes highlighted above and the ownership change limitations as to NOL use, in combination, may pose an unexpected risk of erosion of valuable tax attributes.

 

#5 - PUBLIC COMPANY CHANGE OF CONTROL PAYMENTS FOR EXECUTIVES: The rule changes expand restrictions on the ability of a public company to deduct compensation of more than $1 million paid to each of certain top executives.
 
Key changes:

• The rule changes add the chief financial officer to the definition of an employee covered by the rules.

• The changes eliminate the exception for performance-based compensation, including stock options, from the definition of compensation subject to the $1 million deduction limitation. Since performance-based exceptions to this cap had been available in the past, some plans in existence in 2017 may be eligible to be grandfathered. If not, compensation related to stock option and bonus plans now are included in the determination of whether the $1 million cap has been exceeded.

• The definition of a public company has been expanded. It appears to include issuers of debt and equity, and there does not appear to be a requirement that the securities of the company be listed.  

Observations:
Many compensation plans contain change-of-control provisions that could result in substantial payments to the top executives of a public company. Limitations on the deductibility of compensation may come into play with a change of control and should be examined as part of the value of the transaction to both the seller and the buyer. Even if the stock of the company appears to be privately held, these restrictions unexpectedly may be applicable.  Also, the golden parachute rules remain unchanged for public and non-public companies. These limitations on deductibility and potential excise taxes on executives should be considered in modeling the value and cost of the transaction.
 

Summary

Many of the new tax changes will impact how domestic corporate deals are structured, valued, and financed. For example, the reduction in tax rates may affect the value of a transaction. For the purchaser, lower tax rates operate to reduce the net present value benefit of certain tax deductions used to create a tax shield after an asset transaction. The immediate expensing benefit, though, for tangible assets acquired in an asset transaction could significantly improve the net present value in such a transaction. This change may make asset deals more attractive for buyers, and potentially for sellers in that sellers may enjoy a lower tax rate on their gain in asset transactions.
 
Limitations on the deductibility of interest expense to 30 percent of an approximation of financial statement EBITDA could significantly impact how deals are financed. These limitations could increase the income tax liability of a post-transaction corporate entity in highly leveraged deals. In certain situations, the ability to currently deduct and not depreciate capex over the next five years may offset the loss of the interest expense benefits.  
 
The reduced corporate tax rates could lead to an increase in corporate M&A activity for two main reasons: First, lower corporate tax rates may produce more after-tax cash available for buyers to carry out acquisitions and encourage sellers to move forward with contemplated deals. Second, some deals that may have been on-hold due to the uncertainty of their tax consequences for either buyers or sellers before the tax changes were enacted may now be given the green light.
 
Still, the interaction of all the tax changes is more complex than ever. Careful planning and modeling is recommended to capture the value, and to understand the cost, of the tax changes related to M&A transactions.