In 2015, it was a bumper year for mergers and acquisitions (M&A), especially in the mid-market space. With the volume of activity similar to previous years, the value of activity shot up in many of the world’s markets, with standout performance in the US.
Recent years have seen a significant amount of exit activity among private equity funds, with a large number of initial public offerings, especially in the first 3 quarters of the year,as funds successfully sold off portfolio investments to reap substantial returns.Strategic buyers returned to the market in force in 2014 and into 2015. Following the lengthy post-financial crisisdownturn and ongoing uncertainty due to economic struggles on Europe, strategic buyers are getting back on their feet and their ability to price in synergies has made itharder for private equity funds to compete.The environment shows promise not seen since the pre-financial crisis markets of 2007, with private equity funds having lots of accumulated capital but difficulties in deployingit, as resurgent strategic buying keeps prices above the levels that institutional investors need for above-market returns.
This momentum is expected to continue to build in 2016, although markets will vary due to a number of factors:
—— While the US market is expected to continue to outpace other areas in terms of deal flows, interest rates in the country are inching up, increasing the cost of M&As financed with external debt.
—— Ongoing political uncertainty in Europe and Africa — due to the refugee crisis, geopolitical tensions, and fears of a UK exit from the European Union (EU), among other factors — may continue to dampen strategic buyers’ enthusiasm for deals in this region.
—— Markets in the Asia Pacific region vary widely and deal makers are watching China’s economic situation closely, but the outlook seems relatively bright for the region overall. Australia, China, India and Korea are showing particular strength in raising funds, and Singapore, Hong Kong and Sydney continue to develop as important hubs for facilitating deals in the region.
—— Although Brazil’s economy has slowed, venture capital and early stage activity continued to gain momentum across Latin America in the first half of 2015. Mexico and Argentina saw increased early stage investments as compared to the same period in 2014.
By sector, scientific advances and disruptive technologies are propelling significant M&A movement in the pharmaceutical, biotechnology, high technology and media industries. There is also activity among companies involved in infrastructure development, especially in Australia (e.g. energy and power generation) and Asia (e.g. water security). Depressed oil and commodity prices continue to challenge companies in the energy, natural resources and mining industries. As these companies focus more on their core businesses, assets arecoming available for good prices, opening opportunities for buyers looking to invest in these sectors.
Perhaps the biggest tax developments affecting crossborder M&As globally — now and for years to come — stem from the Organisation for Economic Co-operation and Development’s (OECD) project to encourage global cooperation to address tax base erosion and profit shifting (BEPS). In the fall of 2015, the G20 approved the OECD’s final guidance on domestic legislative and administrative changes to address all 15 points of Action Plan on BEPS.
Now companies with cross-border transactions and structures face a period of uncertainty as governments figure out how the guidance affects current rules, andthen work to design and enact domestic tax changes — a process that could take years. While these developments unfold, some potential buyers may avoid 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.
Already, the international drive to curb BEPS — both aspart of the OECD project and through countries’ unilateral moves — is altering the tax environment for cross-border M&As in important ways:
—— Focus on substance: Tax authorities are increasingly looking into whether there is sufficient business substance in offshore business structures, especially those involving low- or no-tax jurisdictions, and they are denying preferential rates for dividend and interest withholdings where insufficient substance exists. Patent box regimes for intellectual property holdings will likelycontinue to be available, but with changes to restrict patent box benefits to the claimant company’s contribution to the development of the IP in question (i.e. through theso-called ‘nexus’ approach).
—— Interest deductibility: 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 challenge tax deductions for interest paid on loans that were effectively taken up by companies to finance regulations, and other countries have followed suit, such as Finland.
—— Countries such as Sweden are tightening rules for interest on related-party debt by requiring the beneficial owner of the interest to be subject to a certain level of tax.
—— The UK and US, among others, are considering a proposed fixed ratio rule (FRR) to limit tax relief of net (including third-party) interest of 10–30 percent of net earnings before interest, dividends, taxes and amortization (most countries expect 20–30 percent), which will affect all international investors and especially highly leveraged groups.
—— Country-by-country reporting: Many countries have already mandated country-by-country reporting for 2016 tax periods, with the first sets of reports due in 2017. These reports require detailed disclosure by location of a company’s tax payments and related data. While the OECD has not proposed that the reports be made available for public scrutiny, the EU is consulting on this possibility as part of its tax transparency package. As a result, buyers could gain access to more detailed information about potential targets for due diligence purposes,and sellers should be mindful of the reputational implications of this increased transparency.
Within Europe, the European Commission’s (EC) investigations into the tax rulings of EU member states have caused some of the chill in local M&A markets. In October 2015, the EC determined that Luxembourg andthe Netherlands granted illegal state aid to a Luxembourg resident and a Dutch-resident company by granting a selective tax advantage. The EC ordered both countries to recover the alleged advantage from the taxpayers. Then in January 2016, the EC found that selective tax advantages granted by Belgium under its ‘excess profit’ tax scheme were also illegal under EU state aid rules, and at least 35 multinationals (700 million euros in total) who benefited must now return unpaid taxes to Belgium.
The EC’s rulings are having effects beyond the EU, and not just for those multinational companies caught up in the investigations. Significant concerns have been raised in the USSenate that US-based companies are being unfairly targeted by the EC’s investigations and the BEPS project more broadly.It remains to be seen whether the US will take a legislative oradministrative response. For example, the Internal Revenue Service could invoke a provision of the Internal Revenue Code that allows the US to double tax payments due from anothercountry that is seen as systematically discriminating against US companies on tax matters.
Meanwhile, in 2014 and 2015, the US saw a record number of cross-border M&A inversion transactions involving US companies becoming foreign corporations. The US Treasury Department issued a notice (Notice 2014–52) of its intent to issue regulations to take “targeted action to reduce the tax benefits of — and when possible, stop — corporatetax inversions.” In 2015, the Treasury Department issued an additional anti-inversion notice. Although the regulations described in these notices may make inversion transactions more difficult in some cases and reduce some of the tax benefits of these transactions, the inversion trend has continued into 2016.
In addition, in 2014 and 2015, a number of bills were introduced in the US Congress that would further restrict inversion transactions or limit their tax benefits. Due to lack of bipartisan support for such targeted approaches to inversion transactions, however, none of these proposals has so far been enacted into law. Many members of Congress think inversions should be addressed through broader US tax reform. Consideration by Congress of both broad reform of the international tax rules and thetargeted approaches is likely to continue, with the timing and outcome uncertain.
Given the current drives by governments to increase tax collections and the 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. The details and clauses of legal agreements should be planned in advance in order to avoid detrimental tax consequence, with special attention to clauses referring to price, contingent prices, liabilities, indemnification and warranties.
Consideration of BEPS exposures is especially important when completing tax due diligence reviews, definingtax indemnities, and undertaking acquisition integration planning. During the tax due diligence phase, it is also important to consider local country tax rulings obtained by the target company, if any, in various jurisdictions.
Once BEPS exposures are identified, it is important for both the acquiring company and target company to determine a course of action. One approach may be for the seller of the target company to give the acquiring company a purchase price reduction in anticipation that the acquirer will incur future ‘BEPS unwind costs’. Another approach may involve the target company addressing the BEPS exposures through pre-acquisition structuring. As a general matter, acquirers should consider any BEPS exposures specific to both thetarget and acquiring companies’ structures during the acquisition integration-planning phase.
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 has bounced back, especially in the US, after sustained global economic uncertainty.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 continue to influence deal flows.
Arco Verhulst (KPMG in the Netherlands)
Devon M Bodoh (KPMG in the US)
Angus Wilson (KPMG in the Australia)