With recovery from the 2008 financial crisis taking hold and pent-up demand on both the buy and sell sides, cautious optimism marks today's global mergers and acquisitions (M&A) markets. Across the globe, deal activity is rising, although perhaps not as quickly as one might expect. Rising tax audit scrutiny of cross-border M&A structures and uncertainty over future international tax reforms are causing trepidation in the M&A markets. While activity is on the upswing, it seems unlikely to reach pre-2008 levels in the near term.
Compared to 2012, the first three quarters of 2013 saw strong M&A activity in both the volume and value of deals. But in the fourth quarter, the pace slowed significantly compared to the previous year, partly because 2012’s fourth quarter had seen accelerated deals due to a US tax rate change. The return to strength of the world’s stock markets may be another reason, as initial public offerings regained some luster for investors as an alternative exit route.
Some factors suggest that momentum will resume in 2014:
Within Europe, M&A activity is picking up, apart from the dip toward the end of 2013. Recovery is strongest in Germany while most Mediterranean economies continue to struggle. The exception is Spain, which is becoming relatively buoyant and is likely about to see some significant divestitures by Spanish private equity funds. Across Europe, strategic buyers are gaining market share over private funds and the size of deals is on a downward trend, opening opportunities for smaller players to participate in the market. While the attention of foreign investors has been shifting toward the Asia Pacific region (ASPAC), Europe is expected to continue to retain a solid share of global deal flows.
Among ASPAC countries, Australia, China and India continue to be major locations for M&A activity. Compared to recent years, India’s M&A growth has been tempered by domestic economic uncertainties, continuing changes to tax rules and aggressive tax audit practices. China’s M&A market growth remains solid, but regulatory hurdles and red tape have cooled foreign investors’ appetites. Australia’s M&A market has greatly improved, even as new thin capitalization rules make deals more expensive. Activity has been strong in the Australian infrastructure sector (particularly government privatizations of assets including ports and roads) and property sector (investors rebalancing their property portfolios), and, to a lesser extent, from private equity buyouts and exits.
In the United States, concerns that tax rates would rise in 2013 caused a flurry of activity in late 2012 as sellers sought to lock in lower tax rates. The acceleration of deals in 2012 led to a slump in early 2013. The US continues to attract interest from western Europe, Canada and Japan, and inbound investment from emerging market players in China and India is rising. New technologies, rising domestic taxes and increasing regulation are making it imperative for US middle market companies to pursue growth through cross-border expansion, contributing to higher deal volumes in this sector.
Around the world, many countries are working to increase tax revenue, shore up their tax bases and curb aggressively financed M&A transactions. The denial of deductions for interest has emerged as a common legislative means of eliminating the tax benefits of cross-border debt financing structures. Germany and Denmark were among the first countries to apply earnings stripping rules to deny tax deductions for interest paid on loans that were effectively taken up by companies to finance their own acquisition. Other countries have followed suit, such as Finland, or have introduced alternative legislation to combat excessive interest expense deductions.
As businesses return to profitability, tax authorities are turning their attention to the use of losses generated during the economic downturn. In particular, many countries have introduced restrictions on the ability of companies to offset their taxable profits with operating losses by introducing minimum taxation rules.
Reputational concerns are also dampening demand for tax-effective M&A deals. In Europe, regulators, the media and independent monitors are scrutinizing the tax contributions of corporations and wealthy individuals closely. Tax authorities are entering into more information exchange agreements and making greater use of agreements already in place.
As notions of tax morality spread from Europe to other regions, many companies are approaching tax matters more conservatively. Previously, reputational issues related to tax concerned only strategic buyers. Now, with increasing focus on tax transparency from regulators and other stakeholders, private equity buyers are paying more heed to reputational risks related to their tax affairs.
Perhaps the biggest tax development affecting global M&A activity – now and for years to come – is the Organisation for Economic Co-operation and Development’s (OECD) project to encourage global cooperation to address tax base erosion and profit shifting (BEPS). Under the BEPS Action Plan,1 one-half of the tax policy solutions on international taxation are slated to be announced in the fall of 2014, with the balance coming in the following year.
As countries may implement the BEPS recommendations, the current tax treatment of cross-border transactions and structures could change profoundly. Until the recommendations are known, potential buyers may steer clear of transactions involving sophisticated international tax planning structures. Even where such structures are onside with today’s tax legislation, it is difficult to predict whether they can be sustained over the longer term.
In addition to countries acting in concert in the context of the OECD’s work, some countries can be expected to take unilateral legislative action to address tax evasion and avoidance. For example, if the BEPS project does not produce results at a sufficient pace, the European Union has signaled that it will move ahead independently as it is with its proposal to amend the EU Parent-Subsidiary Directive to thwart tax planning involving hybrid instruments.
However, countries that are overly zealous in this regard risk deterring M&A activity. As noted, India’s aggressive stance toward offshore structures is casting a pall on what otherwise could be a vibrant market for M&A. Its continuing enforcement of taxation of indirect transfers of Indian investments in the post-Vodafone era, coupled with stricter foreign exchange approval regulations and proposed Companies Act changes that will increase governance requirements for Indian investments, make it more challenging to do M&A transactions in India.
Given current drives by governments to increase tax collections and uncertainty over future international tax reforms, sellers are advised to ensure they can demonstrate full tax compliance to potential buyers. Potential buyers should conduct thorough due diligence regarding their targets’ tax affairs and be sure to negotiate appropriate indemnities and warranties as part of any deals. With governments increasing their reliance on indirect taxes to raise revenue, it is also important for buyers to take a close look at a target’s compliance related to value added tax (VAT ) and other indirect taxes.
Once a deal has been made, companies should seek whatever tax certainty they can over their post-transaction integration plans. Companies can reduce their tax exposure by taking advantage of voluntary disclosure, horizontal monitoring and advance compliance programs and by locking in tax positions with tax authorities through tax rulings and advance pricing agreements.
In summary, M&A activity appears to be bouncing back after sustained global economic uncertainty, and M&A tax professionals with KPMG’s members firms are optimistic that M&A deal volumes will continue to increase. But intensifying scrutiny of M&A transactions from tax authorities and the potential for major international tax reforms will likely continue to affect deal flows. Governments are advised to monitor the impact of their tax policy and enforcement approach to ensure they strike an appropriate balance between collecting taxes and attracting new investment.
Arco Verhulst (KPMG in the Netherlands)
Vaughn Barber (KPMG China)
Christian Athanasoulas (KPMG in the US)
1 OECD (2013), Action Plan on Base Erosion and Profit Shifting, OECD Publishing.