How is the Tax Cuts and Jobs Act affecting M&A?

Certain corporate changes under the new Tax Cuts and Jobs Act are among the most sweeping enacted over the past 30 years. When evaluating the act's impact on mergers and acquisitions, corporate and pass-through entity provision changes must also be evaluated in the context of even more complex international ones that could affect a transaction. These shifts open up numerous possibilities, but are also fraught with ambiguity at times.

Domestic Tax Changes That Impact Mergers and Acquisitions

The basic impact of the tax changes is to shift the economics of different common deal structures, sometimes in unexpected ways. Other changes also create new structuring options depending upon the individual circumstances of the parties involved. Key changes are detailed below.

View transactions under a new 21 percent tax rate lens: One of the key highlights of the act is the lowering of the corporate income tax rate to 21 percent. Because a shareholder is subject to tax on a corporation's distribution of post-tax earnings (the so called "Double Tax") at 20 percent, the combined corporate double tax rate is now effectively 39.8 percent.

Meanwhile, capital gains rates were left unchanged, meaning that the corporate dividend and capital gains rates are still both 20 percent. Thus, a taxpayer will be indifferent between them based on tax considerations alone. Additionally, the corporate alternative minimum tax was also repealed, further lowering the tax paid by corporations. These reductions in rates do not sunset, unlike the cut in personal tax rates. While this supposed certainty looks meaningful, we are left guessing as to whether future administrations will be committed to these changes or if they will try to unwind them.

Write-downs: The act creates opportunities for accelerated expensing, including a 100 percent deduction for the cost of most tangible property and software the year it is placed in service. Previously owned property qualifies. The 100 percent write off on certain assets post transaction is compelling for many buyers, and will make Section 338(h)(10) elections, with their asset/stock sales, more attractive. However, goodwill and other intangibles are still subject to 15-year straight-line depreciation. Thus, purchase price allocations may be skewed by buyers toward tangible, depreciable property eligible for the 100 percent bonus depreciation, with sellers favoring those assets with the highest tax basis (and lowest taxable gain). Establishing allocations will be key in any purchase agreement. Overall, the industries that will utilize these accelerated write-downs may be limited as most are not capital-asset heavy, and rely on intangibles and good will for value.

It is also important to note that the value of the basis step up for items that are not eligible for full expensing are not less "valuable" since they are taxed at a lower corporate rate. This deduction is decreased beginning in 2023 but is slowly phased out each year, going to zero by 2027.

Net operating losses are now less valuable, especially if looking back: Net operating losses can now only be carried forward, though indefinitely, and are limited to an 80 percent offset against income. Such losses that occurred prior to the new law are still treated as they were under prior law, and are arguably more valuable to an acquirer. This change affects an acquirer's financial-statement impact from an acquisition, perhaps making the deal less accretive. It also limits their ability to write off deal expenses. This provision will now put pressure on buyers and sellers to "price" the value of tax attributes that can no longer be utilized by sellers.

Leverage is less attractive: Excess interest expense can now only be deducted up to 30 percent of "adjusted taxable income," which is similar to EBITDA until the end of 2021, then EBIT thereafter. No grandfathering exists for this new limitation. Thus, leverage has become relatively less attractive as the related expense deductibility is lessened, which might lead to new alternatives such as preferred stock, leases and derivatives becoming more advantageous. Deal multiples could contract, especially on a leveraged deal basis, as these structures are now less sustainable. Strategic buyers, not as dependent upon leverage, may as a result become more competitive.

Basic reorganization rules remain unchanged: The basic reorganization rules remain unchanged, including those for tax-free reorganizations, spin-offs and split-offs and liquidations or incorporations.

Partnerships and other pass-through entities are handled differently: Regarding partnerships and other pass-through entities (including most LLCs), the new Section 199A allows for a 20 percent deduction for "qualified business income," creating a 29.6 percent top tax rate on certain flow through businesses. Specified services businesses are excluded from this credit at specified income levels. This credit is an attempt to level the playing field -- tax rate wise -- between C corporations and flow-through entities, though practically speaking the calculations favor certain businesses over others. Additionally, the rules imposing a mandatory step down in basis on the transfer of an interest with a built in loss have been expanded.

International Tax Changes That Impact Mergers and Acquisitions

International tax changes were both substantial and substantive as the United States is now adopting a limited territorial system with respect to foreign subsidiaries. Foreign dividends paid to a 10 percent shareholder are now exempt from tax. This exclusion only extends to domestic C corporations and does not apply to pass-through entities or individuals, leading to some disparate results. Meanwhile, the Subpart F rules, applicable to taxpayers who own foreign subsidiaries, still apply. Changes in the attribution rules will now include more taxpayers under the international tax net, ensnaring taxpayers who own 10 percent of a foreign corporation by vote or value.

The type of payment and business matter: New taxes and exclusions also apply under the new law. The transition tax applies to all shareholders of foreign subsidiaries (including individuals, pass-through entities, corporations and trusts), and is a one-time tax on all deferred foreign income. GILTI, or global intangible low-taxed income, imposes a minimum tax, and is computed on an aggregate basis for all controlled foreign corporations of a U.S. shareholder. GILTI could also attach to any controlled foreign corporation with a low taxable basis in their tangible, depreciable assets. Essentially, the GILTI tax ends deferral of U.S. tax on foreign business income. On a positive note, the tax basis in tangible, depreciable assets does create a cushion against the GILTI tax.

Foreign derived intangible income, or FDII applies to domestic U.S. C corporations and some foreign corporations with U.S. operations to provide a reduced rate of tax of 13.125 percent on revenue from sales, royalties and services to foreign persons and entities outside of the United States. The base erosion anti-abuse tax imposes an additional tax to offset certain deductible payments to related foreign parties, but only impacts domestic corporations with at least $500 million in annual gross receipts (so has only a limited impact).

The exclusion of dividends by (certain) 10 percent shareholders means that U.S. entities may be able to more cheaply access cash on the balance sheets of foreign subsidiaries at a lower cost, though GILTI and other tax provisions might limit this possibility. Thus, offshore asset acquisition purchases can have an added benefit. Meanwhile, this dividend exemption does not apply to sales of stock of a foreign corporation, which leads to structural planning opportunities. The differing tax treatment of differing forms of international income impacts the value of various businesses.

Transition tax impacts both domestic and foreign deals: Strategic buyers will potentially have new large pools of repatriated overseas earnings, which need to be utilized for a business purpose (such as an acquisition) or distributed to shareholders. However, the one-time transition tax, owed by the shareholders not the entity, can be paid over eight years thus these related liabilities should be taken into account when establishing a purchase price. Each S corporation shareholder can elect to defer these payments indefinitely.

International transactions can ensnare the unwary into undesirable tax jurisdictions or tax rates: When consummating an international transaction, the complexity of the new rules might ensnare certain entities in an undesirable way, increasing the tax due on future earnings. Subpart F still must be considered when structuring international deals, and for similar reasons. The former use of "check and sell" may no longer work now that GILTI imposes a minimum tax across all owned entities, making less silo-ing of earnings possible.

Interest economics have changed for international deals: As U.S. deductibility for interest is limited in a way not so limited internationally, split facilities (part U.S. and part foreign) and foreign financing might become more common. However, Section 956 of the Internal Revenue Code was not repealed as expected, thus certain deemed "dividends" might be taxed at a full 21 percent rate, and without reduction by any available foreign tax credits. Therefore, credit agreements entered into by U.S. borrowers need carve-outs when controlled foreign corporations provide credit support.

Inversions get punished and disfavored: Under the new rules, inversions are discouraged. The individual shareholders of foreign acquirers who completed an inversion before the new law don't get the qualified dividend rate on dividends received from such a foreign corporation, and are instead taxed at the maximum individual rate. And, if the transition tax applies to a U.S. corporation that participates in an inversion after the act, the U.S. corporation's transition tax is computed at 35 percent, and an initial first year payment of the difference between this rate and the lower 8 and 15.5 percent rates earlier paid for the transition tax is due. BEAT can also apply in an adverse manner to post-tax act inversions.

Partnerships and Pass-Through Entities Have Gotten Even More Complicated: With respect to partnerships, the new rules filter through in an impactful way. The interest expense limitation applies at a partnership level. The transition tax applies to U.S. shareholders that are partnerships. And there is now a withholding tax on the disposition of a partnership interest by a non-U.S. person.

Conclusion

Mergers and acquisitions remain an exciting area, with structural options ever evolving. A shifting of rates and other financial factors definitely favor certain structures over others. There is a certain Wild West quality, especially on the international front, when the new rules are layered on top of existing legacy ones. As with most tax law changes, new rules mean expanded structuring options for transactions, enabling them to optimally pencil out financially for those hoping to close a deal. Using a very sophisticated tax advisor remains essential.