United States (US) law regarding mergers and acquisitions (M&A) is extensive and complex.
United States (US) law regarding mergers and acquisitions (M&A) is extensive and complex. Guidance for applying the provisions of the Internal Revenue Code of 1986, as amended (Code), is provided by the federal government, generally by the Internal Revenue Service (IRS) in revenue rulings, revenue procedures, private letter rulings, announcements, notices andTreasury Department regulations, and also by the courts.
In structuring a transaction, the types of entities involved in the transaction generally help determine
the tax implications. Parties may structure a transaction in a non-taxable, partially taxable or fully taxable form.
A non-taxable corporate reorganization or corporate organization generally allows the acquiring corporation to take a carryover basis in the assets of the target entity. In certain instances, a partially taxable transaction allows the acquiring corporation to take a partial step-up in the assets acquired, rather than a carryover basis. A taxable asset or share purchase provides a basis step-up in the assets or shares acquired. Certain elections made for share purchases allow the taxpayer to treat a share purchase as an asset purchase and take a basis step-up in the acquired corporation’s assets.
Taxpayers generally are bound by the legal form they choose for the transaction.The particular legal structure selected by the taxpayer has substantivetax implications. Further, the IRS can challenge the tax characterization of the transaction on the basis that it does not clearly reflect the substance of the transaction.
This section summarizes US tax developments that occurred in 2016, 2017 and January 2018.
US tax reform
On 22 December 2017, the US President signed a new tax law (the 2017 Tax Law) that significantly affects US cross-border taxation. This new legislation is the most extensive rewrite of the US federal tax laws since the Tax Reform Act of 1986. The 2017 Tax Law, which affects both common US inbound and outbound structures, will have a significant impact on many foreign buyers of US companies. Most of the provisions of the 2017 Tax Law are effective 1 January 2018. Some provisions, however, have delayed or other effective dates.
The centerpiece of the new law is the permanent reduction in the corporate income tax rate from 35 percent to 21 percent. The rate reduction generally took effect on 1 January 2018.
Special rules apply for fiscal year corporate filers.
The 2017 Tax Law is highly complex in that it layers new law over years of existing US federal tax law as well as eliminates and modifies various sections of existing tax law. Shortly after the 2017 Tax Law was signed into law, the US Treasury Department (Treasury) and the IRS commenced what is expected to be a lengthy and time-consuming process of drafting interpretative regulations and guidance that address the legislation’s provisions. Generally,Treasury has 18 months to issue retroactive regulations addressing the 2017 Tax Law. Additionally, the US Congress may pass a ‘technical corrections’ bill that makes retroactive changes to the 2017 Tax Law.
The new law fundamentally changes the taxation of US multinational corporations and their foreign subsidiaries. US multinational corporations under the old law were subject to immediate and full US income taxation on all income from sources within and without the US. The earnings of foreign subsidiaries under the old law, however, were not subject to US income tax until the earnings were repatriated through dividend distributions. Prior to the act, an anti-deferral regime (subpart F) which dated back to 1962, applied to certain categories of foreign subsidiary earnings and taxed those earnings in the hands of the US corporate owners as if such amounts had been repatriated via dividend distribution.
By contrast, the earnings of foreign subsidiaries under the new law are either subject to immediate taxation under expanded anti-deferral provisions or are permanently exempt from US taxation. The new law generally retains the existing subpart F regime that applies to passive income and related- party sales and services income, and it creates a new, broad class of income (‘global intangible low-taxed income’ — GILTI) that is also deemed repatriated in the year earned and, thus, is also subject to immediate taxation. While GILTI is effectively taxed at a reduced rate, subpart F income is subject to tax at the full US rate.
To accomplish this shift to the new regime, the new law includes several key features, including:
Some of the stated goals in enacting the new tax law were simplification and a shift from a worldwide system of taxation to a territorial tax system (i.e. a tax system that taxes profits where they are earned). Whether the new law achieves these goals is debatable. The new tax law contains complex new provisions that will require significant reasoned analysis and judgment, as well as additional administrative guidance to properly implement. While it might be nominally accurate to state that the new tax system moves towards a territorial system — because certain profits earned by foreign subsidiaries are not subject to immediate taxation and will not be taxed when repatriated — the non-taxable profits are (in most situations) a small portion of the profit pool. Moreover, by expanding the anti-deferral regime to include GILTI (albeit at a reduced effective rate), the new tax law expands the base of cross-border income that is subject to immediate US income taxation.
Other key provisions of the new law are a reduced tax rate for a new class of income earned directly by US corporations (‘foreign-derived intangibles income’) and a new tax (the ‘base erosion and anti-abuse tax’ — BEAT) on deductible payments made by US corporations to related foreign persons.
Various provisions of the 2017 Tax law are discussed in further detail throughout this report. As a general matter, it is important to keep in mind that many of the 2017 Tax Law’s provisions will affect foreign buyers of US targets and, more generally, foreign multinationals that have significant US operations. In practice, some of the provisions will operate to increase US taxable income when applicable. Due to the significant changes, consideration of US tax reform developments is especially important when completing tax due diligence reviews, defining tax indemnities, and undertaking acquisition integration planning. From a tax due diligence perspective, areas of key focus from a US tax reform perspective include, for example, consideration of:
For those foreign companies with significant US operations that do not plan accordingly (e.g. through supply chain restructuring), the collective application of certain provisions of the 2017 Tax Law could result in an unfavorable impact on a foreign company’s global effective tax rate despite the US corporate tax rate reduction. To determine whether any particular company is a winner or loser under US tax reform, it
is essential to model the impact of the 2017 Tax Law’s relevant provisions (e.g. the provisions that limit interest deductions and seek to prevent US tax base erosion) using company specific facts.
The decision to acquire assets or stock is relevant in evaluating the potential tax exposures that a buyer may inherit from a target corporation. A buyer of assets generally does not inherit the US tax exposures of the target, except for certain successor liability for state and local tax purposes and certain state franchise taxes. Also, an acquisition of assets constituting a trade or business may result in amortizable goodwill for US tax purposes. However, there may be adverse tax consequences for the seller in an asset acquisition (e.g. depreciation recapture and double taxation resulting from the sale followed by distribution of the proceeds to foreign shareholders).
By contrast, in a stock acquisition, the target’s historical liabilities, including liabilities for unpaid US taxes, generally remain with the target (effectively decreasing the value of the buyer’s investment in the target’s shares). In negotiated acquisitions, it is usual and recommended that the seller allow the buyer to perform a due diligence review, which, at a minimum, should include review of:
Under US tax principles, the acquisition of assets or stock of a target may be structured such that gain or loss is not recognized in the exchange (tax-free reorganization). Such transactions allow the corporate structures to be rearranged from simple recapitalizations and contributions to complex mergers, acquisitions and consolidations.
Typically, a tax-free reorganization requires a substantial portion of the overall acquisition consideration to be in the form of stock of the acquiring corporation or a corporation that controls the acquiring corporation. However, for acquisitive asset reorganizations between corporations under common control, cash and/or other non-stock consideration may be used.
There may be restrictions on the disposal of stock received in a tax-free reorganization. The buyer generally inherits the tax basis and holding period of the target’s assets, as well as the target’s tax attributes. However, where certain built-in loss assets are imported into the US, the tax basis of such assets may be reduced to their fair market value.
In taxable transactions, the buyer generally receives a cost basis in the assets or stock, which may result in higher depreciation deductions (or immediate expensing for certain tangible assets under the 2017 Tax Law) for taxable asset acquisitions (assuming the acquired item has a built-in gain).
In certain types of taxable stock acquisitions, the buyer may elect to treat the stock purchase as a purchase of the assets (section 338 election discussed later — see this report’s information on purchase of shares). Generally, US states and local municipalities respect the federal tax law’s characterization of a transaction as a taxable or tax-free exchange.
Careful consideration must be given to cross-border acquisitions of stock or assets of a US target. Certain acquisitions may result in adverse tax consequences under the corporate inversion rules. Depending on the amount of shares of the foreign acquiring corporation issued to the US target shareholders, the foreign acquiring corporation may be treated as a US corporation for all US federal income tax purposes. In some cases, the US target may lose the ability to reduce any gain related to an inversion transaction by the US target’s tax attributes (e.g. NOLs and foreign tax credits — FTC).
Purchase of assets
In a taxable asset acquisition, the purchased assets have a new cost basis for the buyer (if not immediately expensed under the 2017 Tax Law). The seller recognizes gain (either capital or ordinary) on the amount that the purchase price exceeds its tax basis in the assets. An asset purchase generally provides the buyer with the opportunity to select the desired assets, leaving unwanted assets behind. While a section 338 election (described later) is treated as an asset purchase, it does not necessarily allow for the selective purchase of the target’s assets or avoidance of its liabilities.
An asset purchase may be recommended where a target has potential liabilities and/or such transaction structure helps facilitate the establishment of a tax-efficient structure post-acquisition. For example, under certain conditions, a tax basis step-up resulting from a transaction treated as an asset purchase can help mitigate exposure to the new so-called GILTI tax imposed by the 2017 Tax Law on a go-forward basis. For a discussion of the new GILTI provision, see ‘Integration planning for US target-owned intellectual property’ later in this report.
In a taxable acquisition of assets that constitute a trade or business, the buyer and seller are required to allocate the purchase price among the purchased assets using a residual approach among seven asset classes described in the regulations. The buyer and seller are bound by any agreed allocation of purchase price among the assets.
Contemporaneous third-party appraisals relating to asset values can be beneficial.
Depreciation and amortization
The purchase price allocated to certain tangible assets, such as inventory, property, plant and equipment, provides future tax deductions in the form of cost of sales or depreciation.
As stated earlier, in an asset acquisition, the buyer receives a cost basis in the assets acquired for tax purposes. Frequently, this results in a step-up in the depreciable basis of the assets but could result in a stepdown in basis where the asset’s fair market value is less than the seller’s tax basis.
Most tangible assets are depreciated over tax lives ranging from 3 to 10 years under accelerated tax depreciation methods, thus resulting in enhanced tax deductions.
Buildings are depreciable using a straight-line depreciation method generally over 39 years (27.5 years for residential buildings). Other assets, including depreciable land improvements and many non-building structures, may be assigned a recovery period of 15 to 25 years, with a less accelerated depreciation method.
In certain instances, section 179 allows taxpayers to elect to treat as a current expense the acquired cost of tangible property and computer software used in the active conduct of a trade or business. Under the 2017 Tax Law, the deductible section 179 expense limitation is generally 1 million US dollars (US$). This limitation, which is adjusted annually for inflation, is reduced dollar-for-dollar to the extent the total cost of section 179 property placed in service during the year exceeds US$2.5 million.
Separately from section 179, so-called ‘qualified property’ used in a taxpayer’s trade or business or for the production of income may be subject to an additional depreciation deduction (‘bonus depreciation’) in the first year the property is placed into service. The 2017 Tax Law expands bonus depreciation to include a 100 percent deduction for the cost of qualified property (generally tangible depreciable property with a depreciation life of less than 20 years) acquired from unrelated persons and placed in service after 27 September 2017, and before 1 January 2023. The 2017 Tax Law includes a 20 percent increment phase-down of the ‘bonus’ depreciation percentage for property acquired after 2022. Specifically,
the 2017 Tax Law allows businesses to expense 80 percent, 60 percent, 40 percent and 20 percent of the cost of property placed in service in 2023, 2024, 2025 and 2026, respectively. Under the 2017 Tax Law, bonus depreciation is completely phased out in 2027.
Unlike under prior law, the 2017 Tax Law does not limit bonus appreciation to ‘original use property’ that begins with the taxpayer. Specifically, under the 2017 Tax Law, both original- use and used tangible property that is ‘new’ to the taxpayer qualifies for bonus depreciation if certain conditions are met. This change governing immediate expensing provides an incentive for foreign buyers of asset-intensive US companies (e.g. manufacturing businesses) to structure business acquisitions as asset purchases or deemed asset purchases (e.g. section 338 elections) instead of stock purchases in those cases where the US target has significant assets that would qualify for 100 percent expensing. When applicable, the 100 percent bonus depreciation rule provides buyers of qualifying US assets with the opportunity to essentially deduct a portion of the purchase price allocable to qualifying tangible property.
Due to the enhanced bonus depreciation provision, it is also anticipated that a seller of a US target company may also be more willing to sell assets than before due to the US corporate tax rate reduction and 100 percent expensing for qualifying purchases of depreciable tangible property. Under the 2017 Tax Law, a C corporation that sells an asset and reinvests the proceeds into qualifying depreciable tangible property receives a cash tax benefit due to acceleration of deductions. Specifically, under the 2017 Tax Law, the net effect is a 21 percent tax on the gain realized on the sale, and a 21 percent deduction for the reinvested proceeds if the property qualifies for 100 percent expensing.
Bonus depreciation automatically applies to qualified property, unless a taxpayer elects to apply the general rules to the full basis. Specifically, under a separate election, a taxpayer can forego any bonus depreciation and accelerate the use of certain credit carryovers from earlier years. Where this
election is made, the taxpayer is required to use straight-line depreciation for all of its qualified property, with no bonus deduction.
Where both the section 179 expense and bonus depreciation are claimed for the same asset, the asset basis must first be reduced by the section 179 expense before applying the bonus depreciation rules.
Land is not depreciable for tax purposes. Also, accelerated depreciation, the section 179 deduction and bonus depreciation are unavailable for most assets considered predominantly used outside the US.
Generally, the capitalized cost of most acquired intangibles, including goodwill, going concern value and non-compete covenants, are amortizable over 15 years. A narrow exception — the so-called ‘anti-churning rules’ — exists for certain intangibles that were not previously amortizable, where they were held, used or acquired by the buyer (or related person) before the effective date.
Under the residual method of purchase price allocation, any premium paid that exceeds the aggregate fair market value of the acquired asset is characterized as an additional amount of goodwill and is eligible for the 15-year amortization.
Costs incurred in acquiring assets — tangible or intangible — are typically added to the purchase price and considered part of their basis, and they are depreciated or amortized along with the acquired asset. A taxpayer that produces or otherwise self-constructs tangible property may also need to allocate a portion of its indirect costs of production to basis; this can include interest expense incurred during the production period.
The seller’s NOLs, capital losses, tax credits and other tax attributes are not transferred to the buyer in a taxable asset acquisition. In certain circumstances where the target has substantial tax attributes, it may be beneficial to structure the transaction as a sale of its assets so that any gain recognized may be offset by the target’s tax attributes. Such a structure may also reduce the potential tax for the target’s stockholder(s) on a sale of its shares where accompanied by a section 338 or 336(e) election to treat a stock purchase as a purchase of its assets for tax purposes (assuming the transaction meets the requirements for such elections; see this report’s information on purchase of shares).
Value added tax
The US does not have a value added tax (VAT). Certain state and local jurisdictions impose sales and use taxes, gross receipts taxes and/or other transfer taxes.
The US does not impose stamp duty taxes at the federal level on transfers of tangible or intangible assets including stock, partnership interests and membership interests in limited liability companies (LLCs). Certain state and local jurisdictions impose sales and use tax on the sale of certain tangible assets; however, the buyer may be able to benefit from exemptions from sales and use tax where all or a substantial portion of the target’s assets are acquired through bulk sale and/or occasional sale provisions.
Typically, state or local transfer taxes are not applicable to the transfer of intangible assets, such as stock, partnership interests and LLC membership interests. However, the majority of states and certain local jurisdictions impose a tax on the actual transfer of real estate. In certain cases, some of these jurisdictions impose a tax on the transfer of a beneficial or controlling interest in real estate.
Purchase of shares
As stated earlier, in a stock acquisition, the target’s historical tax liabilities remain with target, which affects the value of the buyer’s investment in target stock. In addition, the target’s tax basis in its assets generally remains unchanged. The target continues to depreciate and amortize its assets over their remaining lives using the methods it previously used. Although the target retains its tax attributes in a
stock acquisition, its use of its NOLs and other favorable tax attributes may be limited where it experiences what is referred to as an ‘ownership change’ (see ‘Tax losses and other attributes’).
Additionally, costs incurred by the buyer and the target in connection with the stock acquisition are generally not deductible (but are capitalized into the basis of the shares acquired).
In a taxable purchase of the target stock, an election can be made to treat the purchase of stock as a purchase of the target’s assets, provided certain requirements are satisfied. The buyer, if eligible, can make either a unilateral election under section 338(g) (338(g) election) or, if available, a joint election (with the common parent of the consolidated group of which the target is a member or with shareholders of a target S corporation) under section 338(h)(10) (338(h)(10) election).
Alternatively, the seller and target can make a joint election, provided they satisfy the rules under section 336(e) (336(e) election). Similar to a section 338 election, the section 336(e) election treats a stock sale as a deemed asset sale for tax purposes, thereby providing the buyer a basis in the target’s assets equal to fair market value. Unlike the rules under section 338, however, the buyer does not have to be a corporation.
In certain circumstances involving a taxable stock sale between related parties, special rules (section 304) may re-characterize the sale as a redemption transaction in which a portion of the sale proceeds may be treated as a dividend to the seller. Whether the tax consequences of this recharacterization are adverse or beneficial depends on the facts. For example, if tax treaty benefits are not available, the dividend treatment may result in the imposition of US withholding tax (WHT) at a 30 percent rate on a portion of the sale proceeds paid by a US buyer to a foreign seller. On the other hand, the dividend treatment may be desirable on sales of foreign target stock by a US seller to a foreign buyer, both of which are controlled by a US parent corporation. In this case, the resulting deemed dividend from the foreign buyer and/or foreign target will generally be exempt from US federal income tax under the new participation exemption implemented by the 2017 Tax Law as long as certain conditions are met.
Tax indemnities and warranties
In a stock acquisition, the target’s historical tax liabilities remain with target. As such, it is important that the buyer procures representations and warranties from the seller (or its stockholders) in the stock purchase agreements to ensure that it is not exposed to any post-transaction liabilities (e.g. the new mandatory repatriation tax) arising from the target’s pre-transaction activities. Where significant sums are at issue, the buyer generally performs a due diligence review of the target’s tax affairs. Generally, the buyer seeks tax indemnifications for a period through at least the expiration of the statute of limitations, including extensions. The indemnity clauses sometimes include a cap on the indemnifying party’s liability or specify a dollar amount that must be reached before indemnification occurs. Please note that KPMG LLP in the US cannot and does not provide legal advice. The purpose of this paragraph is to provide general information on tax indemnities and warranties that needs to be addressed and tailored by the client’s legal counsel to the client’s facts and circumstances.
Tax losses and other attributes
The 2017 Tax Law modifies the rules that govern the utilization of net operating losses (NOLs). Effective for losses arising in tax years beginning after 31 December 2017, NOL deductions for a given year are generally limited to 80 percent of a corporation’s taxable income. Under the 2017 Tax Law, NOLs are generally no longer eligible for carryback. Unlike under prior law, however, the 2017 Tax Law provides for the indefinite carryforward of NOLs arising in tax years ending after 31 December 2017. Prior law generally provided a 2-year carryback and 20-year carryforward for NOLs.
As a result of the new 80 percent limitation and other changes, corporations now need to track NOLs arising in tax years beginning on or before 31 December 2017, separately from NOLs arising after 31 December 2017. Utilization of NOLs arising in years beginning before 31 December 2017, are not subject to the new 80 percent limitation and continue to be subject to the 20-year expiration rule imposed by prior law.
Where capital losses are concerned, the 2017 Tax Law does not appear to limit the 3-year capital loss carryback allowed for corporations or impose a limitation on the utilization of capital loss carryovers.
Section 382 imposes one of the most significant limitations on the utilization of target’s NOLs (as well as capital losses and credits). Section 382 generally applies where a target that is a loss corporation undergoes an ‘ownership change’. Generally, an ownership change occurs when more than 50 percent of the beneficial stock ownership of a loss corporation has changed hands over a prescribed period (generally 3 years).
The annual limitation on the amount of post-change taxable income that may be offset with pre-change NOLs is generally equal to the adjusted equity value of the loss corporation multiplied by a long-term tax-exempt rate established by the IRS. The adjusted equity value used in calculating the annual limitation is generally the equity value of the loss corporation immediately before the ownership change, subject to certain potential downward adjustments. Common such adjustments include acquisition debt pushed down to the loss corporation and certain capital contributions to the loss corporation within the 2-year period prior to the ownership change.
Similar to section 382, it is important to note that section 383 also seeks to restrict monetization of a loss corporation’s tax attributes by another profitable corporation.
In addition to changing the NOL rules, the 2017 Tax Law also repealed the US corporate alternative minimum tax (AMT) regime for tax years beginning after 31 December 2017. Excess AMT credits that have not yet been claimed are generally refundable up to fifty percent through 2021; after 2021, any remaining AMT credit is fully refundable. As a practical matter, utilizing excess AMT credits and generating cash refunds as a result of such credits may be difficult for some taxpayers that face a 383 limitation.
Crystallization of tax charges
We will describe below consequences of a member of a consolidated group leaving such group.
A corporation’s departure from a consolidated group is subject to the complex regulations that apply to US consolidated groups. Very generally, one consequence of a corporation’s departure from a consolidated group is the acceleration of any deferred items from transactions between the departing corporation and other members of the consolidated group. For example, gain on the sale of an item of property by one member of a consolidated group (S) to another consolidated group member (B) will generally be deferred under the consolidated return regulations until that property is transferred out of the consolidated group. If, however, either S or B leaves the consolidated group, S’s deferred gain will be accelerated and includible in taxable income (if S is the departing member, the deferred gain will be taken into account by S immediately before S leaves the consolidated group).
There is an exception to this acceleration of deferred items for certain cases in which the entire consolidated group having the deferred items is acquired by another consolidated group.
Within a consolidated group, it is possible for a company (S) to have a negative tax basis in the shares of another company (B). This is referred to as an excess loss account and can arise as a result of debt leveraged distributions (e.g. B borrows in order to fund a dividend distribution) or debt leveraged generation of losses (e.g. B borrows and spends the proceeds on operating its business). Like the deferred intercompany items previously discussed, immediately before either B or S leaves the consolidated group, any excess loss account must be recognized as taxable income. There is an exception to this excess loss account recognition for certain cases in which the entire consolidated group having the excess loss account(s) is acquired by another consolidated group.
The departure of a corporation from a consolidated group raises numerous issues besides the acceleration of deferred items described above. For example, when a corporation ceases to be a member of a consolidated group during the tax year, consideration must be given to the allocation of income, gain, loss, deduction, credit, and potentially other attributes between the departing corporation and the consolidated group. The consolidated return regulations also contain complex rules that may reduce or eliminate loss realized (and/or certain tax attributes) on the departure of a consolidated group member. In addition, note that the departing corporation is potentially liable for the consolidated group’s entire tax liability for each year in which the departing corporation was a member of the consolidated group (even for a day), including the year in which the subsidiary leaves the consolidated group.
In certain circumstances, the seller may prefer to realize part of the value of its investment in the target through a pre-sale dividend. This may be attractive where the dividend is subject to tax at a rate that is lower than the tax rate on capital gains.
Generally, for corporations, dividends and capital gains are subject to tax at the same federal corporate tax rate of 21 percent. However, depending on the ownership interest in the subsidiary, a seller may be entitled to various amounts of dividend-received deduction (DRD) on dividends received from a US subsidiary if certain conditions are met. However, certain dividends may also result in reducing the tax basis of the target’s stock by the amount of the DRD.
An individual is generally taxed on capital gains and dividends from domestic corporations and certain foreign corporations based on their overall income tax bracket.
See below for long-term capital gains rates for tax years beginning after 31 December 2017. Qualified dividends are generally taxed at the general long-term capital gains rate.
Individuals are not entitled to DRDs on dividends. Thus, the tax effect of a pre-sale dividend may depend on the recipient‘s circumstances. Each case must be examined on its facts. In certain circumstances, proceeds of pre-sale redemptions of target stock may also be treated as a dividend by the recipient stockholder (see ‘Equity’).
|Tax bracket||Long-term capital gains and dividend tax rate|
|10 and 12 percent||0 Percent|
|22, 24, 32 and 35 percent||15 Percent|
|37 percent||20 Percent|
Source: Internal Revenue Code
The US does not impose a federal stamp duty tax. Certain states may impose a tax on the transfer of a controlling interest in the ownership of a company, which generally applies only to certain assets, including real property and certain leases of real property.
Generally, a clearance from the IRS is not required prior to engaging in an acquisition of stock or assets. A taxpayer can request a private letter ruling, which is a written determination issued to a taxpayer by the IRS national office in response to a written inquiry about the tax consequences of the contemplated transactions.
Although it provides a measure of certainty on the tax consequences, the ruling process can be protracted and
time-consuming and may require substantial expenditures on professional fees. Thus, the benefits of a ruling request should be carefully considered beforehand.
Private letter rulings are taxpayer-specific and can only be relied on by the taxpayers to whom they are issued. Pursuant to section 6110(k)(3), such items cannot be used or cited as precedent. Nonetheless, such rulings can provide useful information about how the IRS may view certain issues.
A particular type of entity may be better suited for a transaction because of its potential tax treatment. Previously, companies were subject to a generally cumbersome determination process to establish entity classification.
However, the IRS and Treasury issued regulations that allow certain eligible entities to elect to be treated as a corporation or a partnership (where the entity has more than one owner) or as a corporation or disregarded entity (where the entity has only one owner). Rules governing the default classification of domestic entities are also provided under these regulations.
A similar approach is available for classifying eligible foreign business organizations, provided such entities are not included in a prescribed list of entities that are per se corporations (i.e. always treated as corporations).
Taxpayers are advised to consider their choice of entity carefully, particularly when changing the classification of an existing entity. For example, where an association that is taxable as a corporation elects to be classified as a partnership, the election is treated as a complete liquidation of the existing corporation and the formation of a new partnership. The election could thus constitute a material realization event that might entail substantial adverse immediate or future US tax consequences.
Local holding company
A US incorporated corporation is often used as a holding company and/or acquisition vehicle for the acquisition of a US target or a group of assets. Under the 2017 Tax Law, a corporation is now generally subject to an entity-level federal corporate income tax rate of 21 percent (lower taxable income amounts may be subject to lower rate brackets), plus any applicable state and/or local taxes.
Despite the entity-level tax, a corporation may be a useful vehicle to achieve US tax consolidation to offset income with losses between the target group members and the buyer, subject to certain limitations (see ‘Group relief/consolidation’). Moreover, a corporation may be used to push down acquisition debt so that interest may offset the income from the underlying companies or assets. However, as noted earlier, a debt pushdown may limit the use of a target’s pre- acquisition losses under the section 382 regime (see ‘Tax losses and other attributes’).
Where a non-US person is a shareholder in a corporation, consideration should also be given to the Foreign Investment Real Property Tax Act (FIRPTA) (see next section).
Foreign parent company
Where a foreign corporation is directly engaged in business in the US through a US branch (or owns an interest in a fiscally transparent entity that conducts business in the US), it may be subject to net basis US taxation at the 21 percent corporate rate on income that is effectively connected to the US business (but only in the case of an entity entitled to benefits under a tax treaty, if that income is attributable to a US permanent establishment). The US also imposes additional tax at a 30 percent rate on branch profits deemed remitted overseas (subject to tax treaty rate reductions or exemptions). In addition, the foreign corporation will generally be subject to tax return filing obligations in the US.
Alternatively, a foreign corporation may be used as a vehicle to purchase US target stock, since foreign owners are generally not taxed on the corporate earnings of a US subsidiary corporation. However, dividends or interest from a US target remitted to a foreign corporation may be subject to US WHT at a 30 percent rate (which may be reduced under a tax treaty). Thus, careful consideration may be required where, for example, distributions from a US target are required to service debt of the foreign corporation (e.g. holding the US target through an intermediate holding company, as discussed later in this report).
Generally, the foreign corporation’s sale of US target stock should not be subject to US taxation unless the US target was a US real property holding corporation (USRPHC) at any time during a specified measuring period. This would be the case where the fair market value of the target’s US real property interests was at least 50 percent of the fair market value of its global real property interests plus certain other property used in its business during that specified measuring period. The specified measuring period generally is the shorter of the 5-year period preceding the sale or other disposition and the foreign corporation’s holding period for the stock.
A foreign seller of USRPHC stock may be subject to US income tax on the gain at standard corporate tax rates (generally 21 percent) and a 15 percent US WHT on the amount realized, including assumption of debt (the WHT is creditable against the tax on the gain). In addition, a sale of USRPHC stock gives rise to US tax return filing obligations.
Non-resident intermediate holding company
An acquisition of the stock of a US target may be structured through a holding company resident in a jurisdiction that has an income tax treaty with the US (an intermediate company) potentially to benefit from favorable US and foreign tax treaty WHT rates.
However, the benefits of the structure may be limited under anti-treaty shopping provisions found in most US treaties or under the US federal tax rules (e.g. Code, regulations).
Multiple buyers may use a joint venture vehicle to purchase a US target or US assets. A joint venture may be organized either as a corporation or a fiscally transparent entity (a flow-
through venture), such as a partnership or LLC. A joint venture corporation may face issues similar to those described earlier (see ‘Local holding company’).
A flow-through venture generally is not subject to US income tax at the entity level (except in some states). Instead, its owners are taxed directly on their proportionate share of the flow-through venture’s earnings, whether or not distributed. Where the flow-through venture conducts business in the US, the foreign owners may be subject to net basis US taxation on their share of its earnings, as well as US WHT and US tax return filing obligations.
Generally, a buyer (or an acquisition vehicle) finances the acquisition of a US target with its own cash, issuance of debt or equity or a combination of both. The capital structure is critical due to the potential deductibility of debt interest. Certain US tax reform developments raise tax exposure concerns for a number of common US inbound acquisition financing structures (e.g. US inbound acquisition financing structures involving Luxembourg entities). The new Section 385 Regulations (see 'Deductibility of interest') also raise various considerations for US inbound acquisition financing.
Buyers of US target companies should carefully consider both US tax reform developments and recommendations from the Organisation for Economic Co-operation and Development (OECD) to counter base erosion and profit shifting (BEPS), as well as the new Section 385 Regulations when deciding on what acquisition funding structure to use.
An issuer of debt may be able to deduct interest against its taxable income (see 'Deductibility of interest’), whereas dividends on stock are non-deductible. Additionally, debt repayment may allow for tax-free repatriation of cash, whereas certain stock redemptions may be treated as dividends and taxed as ordinary income to the stockholder. Similar to dividends, interest may be subject to US WHT.
The debt placement and its collateral security should be carefully considered to help ensure that the debt resides in entities that are likely to be able to offset interest deductions against future profits. The debt should be adequately collateralized to help ensure that the debt will be respected as a genuine indebtedness. Moreover, the US debtor may recognize current income where the debt is secured by a pledge of stock or assets of controlled foreign companies (CFC). See ‘Foreign investments of a US target company’.
Deductibility of interest
Interest paid or accrued during a taxable year on a genuine indebtedness of the taxpayer generally is allowed as a tax deduction during that taxable year, subject to several exceptions, some of which are described below.
For interest to be deductible, the instrument (e.g. notes) must be treated for US tax purposes as debt and not as equity. The characterization of an instrument is largely based on facts, judicial principles and IRS guidance. Although a brief list of factors cannot be considered complete, some of the major considerations in the debt-equity characterization include:
Shareholder loans must reflect arm’s length terms to avoid being treated as equity. Where a debtor has limited
capability to service bank debt, its guarantor may be treated as the primary borrower. As a result, the interest accrued by the debtor may be re-characterized as a non-deductible dividend to the guarantor. This may entail additional US WHT consequences where the guarantor is a foreign person.
Interest deductions may be limited for certain types of acquisition indebtedness where interest paid or incurred by a corporation during the taxable year exceeds US$5 million, subject to certain adjustments. However, this provision generally should not apply if the debt is not subordinated or convertible.
A US debtor’s ability to deduct interest on debt extended or guaranteed by a related foreign person may be further limited under the earnings-stripping rules. For taxable years beginning after 31 December 2017, the 2017 Tax Law substantially amends the earnings-stripping provision provided by section 163(j) of the Code (the section 163(j) earnings-stripping provision) to generally disallow US tax deductions for ‘all’
net business interest expense of any taxpayer in excess of 30 percent of a business’s ‘adjusted taxable income’ (ATI). If certain conditions are met, the section 163(j) earnings- stripping provision can result in disallowance of interest expense deductions regardless of a taxpayer’s business form and whether the interest is owed to a related or third party.
For purposes of the section 163(j) earnings-stripping provision, business interest of a corporation includes any interest paid or accrued on indebtedness properly allocable to a trade or business. Under the 2017 Tax Law, disallowed interest expense can be carried forward indefinitely to subsequent taxable years. During the tax due diligence phase, a buyer of a company that has a disallowed interest expense carryforward should consider the extent to which section 382 imposes limitations on the utilization of this tax attribute.
Historically, the section 163(j) earnings-stripping provision only applied to limit interest deductions on foreign ‘related-party’ borrowings and/or borrowings guaranteed by a related party to 50 percent of earnings before interest, taxes, depreciation and amortization (EBITDA). The 2017 Tax Law provides no grandfathering rule for debt existing before 2018.
Depending on a US target’s facts, the new interest expense limitations under the section 163(j) earnings-stripping provision (and certain other new provisions — e.g. the new hybrid mismatch rule) could result in increased taxable income for US target. During the tax due diligence phase, it is important to evaluate a US target company’s US and global debt levels and to test US target’s section 163(j) deductibility threshold. This analysis will help the foreign buyer determine potential US tax impact of existing debt levels, new debt and
refinancings. This analysis will also help foreign buyer evaluate the viability of alternative tax planning options for financing the acquisition of a US target company. Depending on the facts and circumstances, some planning opportunities to mitigate the impact of interest deduction limitations under revised section 163(j) may exist.
For testing purposes, the section 163(j) earnings-stripping provision is performed at the level of the tax filing entity.
The conference report for the 2017 Tax Law states that the section 163(j) limitation should be applied ‘after’ other interest disallowance, deferral, capitalization or other limitation provisions. Similar to NOLs, utilization of a US target’s disallowed interest expense carryforwards is subject to limitations following a change of control.
As a general matter, foreign companies with highly leveraged US operations should consider whether an excess interest situation currently exists or might exist in the foreseeable future. During the tax due diligence phase, a foreign buyer should consider undertaking this same inquiry for potential US target companies as well. If an excess interest situation does exist, it may make sense for the foreign company to explore ways to shift debt burden from the United States to an overseas affiliate that has sufficient debt capacity under local country rules. Also, other planning opportunities for further consideration may also exist. For example, by agreeing to a higher cost of goods sold (COGS) from suppliers in exchange for 90 days of trade credits (as opposed to borrowing in order to finance COGS on a real-time basis), it might be possible to convert interest expense that would otherwise be disallowed as a deduction under the section 163(j) earnings-stripping provision into a deductible business expense. (Before undertaking any COGS planning, it is important to consider whether such planning could give rise to unanticipated US trade and customs costs).
As of January 2018, it is unclear whether a corporation can treat interest expense that was deferred and carried forward under the legacy section 163(j) earnings-stripping provision as business interest paid or accrued in a tax year beginning after 2017. Foreign buyers of US target companies should keep
this uncertainty in mind when evaluating during the tax due diligence phase whether it will be able to utilize in the future a US target’s disallowed interest expense carryforwards for tax years 2017 and before (if any).
In addition to the limitations discussed above, other limitations apply to interest on debt owed to foreign related parties and to certain types of discounted securities. For example, in October 2016, Treasury released final and temporary regulations that seek to prevent companies from eroding the US tax base via deductible intercompany loans (the Final 385 Regulations). As a general matter, the Final 385 Regulations restrict the tax benefit of using intercompany debt in M&A transactions that involve foreign entity acquisitions of US target companies. Due to the nature of how the Final 385 Regulations operate, these regulations can impact transaction structuring, tax due diligence and general tax planning.
The cornerstones of the Final 385 Regulations involve recast and documentation rules (hereafter, the Section 385 Recast Rule and the Section 385 Documentation Rules, respectively). Unless an exception applies, the general rule of the Section 385 Recast Rule treats a debt instrument issued by a US corporation to a related party after 4 April 2016, as equity if the debt instrument was issued:
The Section 385 Recast Rule also provides a so-called funding rule that treats a debt instrument issued by a US corporation to a related party after 4 April 2016, as stock if it is issued for property (e.g. cash) and with a principal purpose of funding one of the transactions listed above. To prevent recast of a debt instrument as equity under this funding rule, it is critical that the borrower refrain from the following activities during the 36-month period before and after the loan issuance:
As for the 385 Documentation Rules (which are not yet effective as of January 2018), these rules generally require a US company to satisfy specific documentation and financial due diligence standards for:
For example, written documentation must establish:
Failure to comply with the 385 Documentation Rules (once, and if, they become effective) may result in intercompany debt being recharacterized as stock for US federal income tax purposes. As previously noted, unlike the 385 Recast Rules, the 385 Documentation Rules are not yet effective as of January 2018. As of January 2018, the 385 Documentation Rules are scheduled to apply to interests issued or deemed issued on or after 1 January 2019. As of January 2018, it is not clear whether Treasury will withdraw all or parts of the controversial Section 385 Regulations. Due to the 2017 Tax Law’s changes to the earnings-stripping rules and certain other changes, there appears to be significantly less need for the Section 385 Regulations.
Though the 385 Documentation and Recast Rules are primarily relevant to foreign-parented multinationals that own or acquire US corporations (or to buyers of such foreign- parented multinational groups), these rules can also apply to:
For debt issued before 4 April 2016, the Section 385 Regulations do not apply, provided that the debt was not modified after 4 April 2016.
As a general matter, foreign parent entities (whether top-tier parents or intermediate parents) that have US subsidiaries should review their intercompany debt for section 385 compliance. To the extent that debt will be affected by the Section 385 Regulations, the effective tax rate of the international group could be effected. For taxpayers to whom the 385 Recast Rules apply — principally foreign multinationals — it is important that appropriate processes (i.e. internal tracking systems) be in place in order to track covered debt issuances and de-funding transactions, and to prevent unintended recasts. For potential acquisition targets, enhanced tax due diligence may be necessary to determine:
As a general matter, the following implications (among others) can arise if debt is recast as equity under the 385 Recast Rule:
As for the 385 Documentation Rules, compliance with these rules will, once (and if) they go into effect, become a standard part of M&A tax due diligence and transaction planning for US target companies.
Withholding tax on debt and methods to reduce or eliminate it
The US imposes a 30 percent US WHT on interest payments to non-US lenders unless a statutory exception or favorable US treaty rate applies. Further, structures that interpose corporate lenders in more favorable tax treaty jurisdictions may not benefit from a reduced WHT because of the conduit financing regulations of section 1.881-3 and anti-treaty shopping provisions in most US treaties. (See ‘Non-resident intermediate holding company’).
No US WHT is imposed on portfolio interest. Portfolio interest constitutes interest on debt held by a foreign person that is not a bank and owns less than 10 percent (by vote) of the US debtor (including options, convertible debt, etc., on an as- converted basis).
Generally, no US WHT is imposed on interest accruals until the US debtor pays the interest or the foreign person sells the debt instrument. Thus, US WHT on interest may be deferred on zero coupon bonds or debt issued at a discount, subject to certain limitations discussed below (see ‘Discounted securities’).
Checklist for debt funding
The acquisition of a US target may be financed by issuing common or preferred equity. Distributions may be classified as dividends where paid out of the US target’s current or accumulated earnings and profits (E&P; similar to retained earnings). Distributions in excess of E&P are treated as the tax-free recovery of tax basis in the stock (determined on a shares-by-share basis). Distributions exceeding both E&P and stock basis are treated as capital gains to the holder.
US issuers of stock interests generally are not entitled to any deductions for dividends paid or accrued on the stock. Generally, US individual stockholders are subject to tax on dividends from a US target based on their overall income tax bracket (see ‘Pre-sale dividends’ for the applicable tax rates). Stockholders who are US corporations are subject to tax at the 21 percent rate applicable to corporations, but they are entitled to DRDs when received from US corporations depending on their ownership interest (see ‘Pre-sale dividends’).
Generally, dividends paid to a foreign shareholder are subject to US WHT at 30 percent unless eligible for favorable WHT rates under a US treaty. The WHT rules provide limited relief for US issuers that have no current or accumulated E&P at the time of the distribution and anticipate none during the tax year. Such a US issuer may elect out of the WHT obligation where, based on reasonable estimates, the distributions are not paid out of E&P.
Generally, no dividend should arise unless the issuer of the stock declares a dividend or the parties are required currently to accrue the redemption premium on the stock under certain circumstances. Of course, US WHT is also imposed on US-source constructive (i.e. deemed paid) dividends. For example, where a subsidiary sells an asset to its parent below the asset’s fair market value, the excess of the fair market value over the price paid by the parent could be treated as a constructive dividend.
Generally, gains from stock sales (including redemptions) are treated as capital gains and are not subject to US WHT (but see the discussion of FIRPTA earlier in this report).
Certain stock redemptions may be treated as giving rise to distributions (potentially treated as dividends) where the stockholder still holds a significant amount of stock in the corporation post-redemption of either the same class or another class(es). Accordingly, the redemption may result in ordinary income for the holder that is subject to US WHT. See this report’s sections on ‘Purchase of assets’ and ‘Purchase of shares’ for discussion of certain tax-free reorganizations.
Hybrid instruments and entities
Instruments (or transactions) may be treated as indebtedness (or a financing transaction) of the US issuer, while receiving equity treatment under the local (foreign) laws of the counterparty. This differing treatment may result in an interest deduction for the US party while the foreign party benefits from the participation exemption or FTCs that reduce its taxes under local law. Alternatively, an instrument could be treated as equity for US tax purposes and as debt for foreign tax purposes.
Similarly, an entity may be treated as a corporation for US tax purposes and a transparent entity for foreign tax purposes (or vice versa). Under certain circumstances, this differing treatment can give rise to ‘stateless income’ (income that is taxed nowhere).
As noted in ‘Recent developments’, certain provisions of the 2017 Tax Law seek to discourage use of hybrid entities and instruments that give rise to stateless income. Specifically, the 2017 Tax Law contains a new ‘hybrid mismatch rule’ that generally disallows deductions for related-party interest or royalties paid or accrued in connection with certain hybrid transactions or by, or to, hybrid entities if (i) the related party does not have a corresponding income inclusion under local tax law; or (ii) such related party is allowed a deduction with respect to the payment under local tax law. This provision, which incorporates the concepts of the OECD BEPS Action 2, applies to tax years beginning after 31 December 2017.
For purposes of this hybrid mismatch rule, a hybrid transaction includes any transaction or instrument under which one or more payments are treated as interest or royalties for US federal income tax purposes but are not treated as such under the local tax law of the recipient. A hybrid entity is one that is treated as fiscally transparent for US federal income tax purposes (e.g. a disregarded entity or partnership) but not for purposes of the foreign country of which the entity is resident or is subject to tax (hybrid entity), or an entity that is treated as fiscally transparent for foreign tax law purposes but not for US federal income tax purposes (reverse hybrid entity). The 2017 Tax Law provides broad regulatory authority for Treasury and the IRS to subject additional transactions to this new hybrid mismatch rule.
The hybrid mismatch rule eliminates the US tax benefits of some hybrid structures that foreign multinationals have commonly used in the past to finance US operations. Foreign multinationals should consider revisiting their US inbound financing structures in view of the new hybrid mismatch rule and also consider this rule when determining the acquisition funding structure for US target companies.
Buyers of US target companies should also carefully consider the OECD BEPS recommendations concerning hybrids during the tax due diligence phase and before implementing any structures concerning acquisition finance planning and/or acquisition integration planning. Where hybrid instruments and entities are concerned, a number of jurisdictions (e.g.the Netherlands) have already implemented some of the OECD’s BEPS recommendations that undo some of the tax benefits of hybrid structures commonly implemented by US multinationals, and several other jurisdictions have proposed adopting the OECD recommendations. It is important to keep this in mind when acquiring a US multinational that has significant operations in such jurisdictions.
In addition to the new hybrid mismatch rule, the 2017 Tax Law also precludes CFC hybrid dividends from qualifying for the DRD. The 2017 Tax Law broadly defines the term ‘hybrid dividend’ to mean a payment for which a CFC receives a deduction or other tax benefit in a foreign country. The 2017 Tax Law generally treats hybrid dividends between tiered CFCs as subpart F income. Despite this subpart F income treatment, the 2017 Tax Law does not allow utilization of foreign tax credits resulting from hybrid dividends.
A US issuer may issue debt instruments at a discount to increase the demand for its debt instruments. The issuer and the holder are required currently to accrue deductions and income for the original issue discount (OID) accruing over the term. However, a US issuer may not deduct OID on a debt instrument held by a related foreign person unless the issuer actually paid the OID.
A corporate issuer’s deduction for the accrued OID may be limited (or even disallowed) where the debt instrument is treated as an applicable high yield discount obligation (AHYDO). In that case, the deduction is permanently disallowed for some or all of the OID if the yield on the instrument exceeds the applicable federal rate (for the month of issuance) plus 600 basis points. Any remaining OID is only deductible when paid.
In certain acquisitions, the parties may agree that the payment of a part of the purchase price should be made conditional on the target meeting pre-established financial performance goals after the closing (earn-out). Where the goals are not met, the buyer can be relieved of some or all of its payment obligations. An earn-out may be treated as either the payment of the contingent purchase price or ordinary employee compensation (where the seller is also an employee of the business). Buyers generally prefer to treat the earn-out as compensation for services, so they can deduct such payments from income.
In an asset acquisition, the buyer may capitalize the earn-out payment into the assets acquired but only in the year such earn-out amounts are actually paid. Such capitalized earn-out amounts should be depreciated/amortized over the remaining depreciable/amortizable life of the applicable assets. In a stock acquisition, the earn-out generally adds to the buyer’s basis in the target stock. Interest may be imputed on deferred earn- out payments unless the agreement specifically provides for interest.
Documentation of each step in the transaction and the potential tax consequences is recommended. Taxpayers generally are bound by the form they choose for a transaction, which may have material tax consequences. However, the government may challenge the characterization of a transaction on the basis that it does not reflect its substance. Thus, once parties have agreed on the form of a transaction, they are well advised to document the intent, including the applicable Code sections. Parties should also maintain documentation of negotiations and appraisals for purposes of allocating the purchase price among assets.
Contemporaneous documentation of the nature of transaction costs should also be obtained. Although the parties to a transaction generally cannot dictate the tax results through the contract, documentation of the parties’ intent can be helpful should the IRS challenge the characterization of the transaction.
Concerns of the seller
Generally, the seller’s tax position influences the structure of the transaction. The seller may prefer to receive a portion of the value of the target in the form of a pre-sale dividend for ordinary income treatment or to take advantage of DRDs. A sale of target stock generally results in a capital gain, except in certain related-party transactions (see ‘Purchase of shares’) or on certain sales of shares of a CFC. In addition, a foreign seller of a USRPHC may be subject to tax and withholding based on FIRPTA, as discussed earlier in this report.
A sale of assets could also result in capital gains treatment except for depreciation recapture, which may have ordinary income treatment. Where the seller has no tax attributes to absorb the gain from asset sales, gains may be deferred where the transaction qualifies as a like-kind exchange, in which the seller exchanges property for like-kind replacement property (e.g. exchange of real estate). As previously mentioned, it seems likely that the seller of a US target company may be more willing to sell assets than before ue to the US corporate tax rate reduction and 100 percent expensing for qualifying purchases of depreciable tangible property. Under the 2017 Tax Law, a C corporation that sells an asset and reinvests the proceeds into qualifying depreciable tangible property receives a cash tax benefit due to acceleration of deductions.
Alternatively, the transaction may be structured as a tax-free separation of two or more existing active trades or businesses formerly operated, directly or indirectly, by a single corporation for the preceding 5 years (spin-off). Stringent requirements must be satisfied for the separation to be treated as a tax-free spin-off.
Company law and accounting
This discussion is a high-level summary of certain accounting considerations associated with business combinations and non-controlling interests.
Accounting Standards Codification (ASC) Topic 805, Business Combinations (ASC 805) and ASC Subtopic 810-10, Consolidations — Overall (ASC 810-10) require most identifiable assets acquired, liabilities assumed and non-controlling interest in the acquiree to be recorded at ‘fair value’ in a business combination and require non-controlling interests to be reported as a component of equity.
ASC 805-10-20 defines a ‘business combination’ as a transaction or other event in which an entity (the acquirer) obtains control of one or more businesses (the acquiree or acquirees). A business combination may occur even where control is not obtained by purchasing equity interests or net assets, as in the case of control obtained by contract alone. This can occur, for example, when a minority shareholder’s substantive participating rights expire and the investor holding the majority voting interest gains control of the investee.
ASC 805-10-55-3A defines a business as an integrated set of activities and assets that is capable of being conducted and managed to provide a return in the form of dividends, lower costs, or other economic benefit directly to investors or other owners, members or participants.
On 5 January 2017, the Financial Accounting Standards Board (FASB) issued Accounting Standard Update (ASU) No. 2017- 01, Clarifying the Definition of a Business (ASU 2017-01), which provides a new framework for determining whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. Under ASU 2017-01, an integrated set of activities and assets is a business if it has, at a minimum, an input and a substantive process that together significantly contribute to the ability to create outputs.The ASU creates a screening test that reduces the population of transactions that an entity needs to analyze to determine whether there is an input and a substantive process. ASU 2017-01 is effective for public business entities for annual and interim periods in fiscal years beginning after 15 December 2017 (i.e. 1 January 2018 for public companies with a calendar year-end). For all other entities, it is effective for annual periods in fiscal years beginning after 15 December 2018, and interim periods in fiscal years beginning after 15 December 2019. An entity may adopt the ASU early and apply it to transactions that have not yet been reported in financial statements that have been issued or made available for issuance.
Business combinations are accounted for by applying the acquisition method. Companies applying this method must:
ASC 805 allows for a measurement period for the acquirer to obtain the information necessary to enable it to complete the accounting for a business combination. Until necessary information can be obtained, and for no longer than 1 year after the acquisition date, the acquirer reports provisional amounts for the assets, liabilities, equity interests or items of consideration for which the accounting is incomplete.
A company that obtains control but acquires less than 100 percent of an acquiree records 100 percent of the acquiree’s assets (including goodwill), liabilities and non- controlling interests, measured at fair value with few exceptions, at the acquisition date.
ASC 810-10 specifies that non-controlling interests are treated as a separate component of equity, not as a liability or other item outside of equity. Because non-controlling interests are an element of equity, increases and decreases in the parent’s ownership interest that leave control intact are accounted for as equity transactions (i.e. as increases or decreases in ownership) rather than as step acquisitions or dilution gains or losses.
The carrying amount of the non-controlling interests is adjusted to reflect the change in ownership interests.
Any difference between (i) the fair value of the consideration received or paid and (ii) the amount by which the non- controlling interest is adjusted is recognized directly in equity attributable to the parent (i.e. additional paid-in capital).
A transaction that results in the loss of control generates a gain or loss comprising a realized portion related to the portion sold and an unrealized portion on the retained non-controlling interest, if any, that is re-measured to fair value. Similarly, a transaction that results in the gain of control could result in a gain or loss on previously held equity interests in the investee since the acquirer would account for the transaction by applying the acquisition method on that date.
Affiliated US corporations may elect to file consolidated federal income tax returns as members of a consolidated group.
Generally, an affiliated group consists of chains of 80 percent- owned (by vote and value) corporate subsidiaries (members) having a common parent that owns such chains directly or indirectly.
The profits of one member may be offset against the current losses of another member. In most cases, gains or losses from transactions between members are deferred until the participants cease to be members of the consolidated group or otherwise cease to exist. Complex rules may limit the use of losses arising from the sale of stock of a member to unrelated third parties (i.e. unified loss rules).
Following an acquisition of a target, all transactions between the buyer and the target must be consistent with arm’s-length standards. If related parties fail to conduct transactions at arm’s length, the IRS may reallocate gross income, credits, deductions or allowances between the participants to
prevent tax avoidance or to reflect income arising from such transactions. As stated earlier, such transactions may include loans, sales of goods, leases or licenses. Contemporaneous documentation must be maintained to support intercompany transfer pricing policies.
Generally, the NOLs of a dual resident corporation (DRC) and a net loss attributable to a separate unit cannot be used to offset the taxable income of a US affiliate or the domestic corporation that owns the separate unit. Any such loss is a dual consolidated loss (DCL) subject to regulations contained in Treas. Reg. 1.1503(d)-1 through 8.
A DRC is a domestic corporation subject to income tax in a foreign country on a worldwide income basis or as a resident of the foreign country. A separate unit is a foreign branch or a hybrid entity (i.e. an entity not subject to tax in the US but subject to tax in a foreign country at the entity level) that is either directly owned by a domestic corporation or indirectly owned by a domestic corporation through a partnership, trust or disregarded entity.
Limited use of a DCL may be possible where the consolidated group or domestic corporation (in the case of a stand-alone domestic corporation) files a special election that ensures that amounts deducted in computing the DCL will not be used to offset the income of a foreign person.
Foreign investments of a US target company
Often, a US target owns shares of one or more foreign corporations. As discussed above, the 2017 Tax Law makes fundamental changes to the taxation of US multinationals and their foreign subsidiaries. Under the old law, the earnings of foreign subsidiaries generally were not subject to US income tax until the earnings were repatriated through dividend distributions. Foreign subsidiary earnings generally were subject to immediate US taxation only if the earnings were subject to the US subpart F anti-deferral rules. Under the new law, the earnings of foreign subsidiaries are either subject to immediate taxation under expanded anti-deferral provisions or permanently exempt from US taxation. The new law generally retains the existing subpart F regime, and it creates a new, broad class of income ('global intangible low-taxed income' or 'GILTI') that is also subject to immediate taxation. Under a new participation exemption system, earnings of foreign subsidiaries that are not subject to tax under the subpart F or GILTI regimes generally are exempt from US tax when distributed to a US shareholder as a dividend. In many cases, however, most foreign subsidiary earnings will be subject to tax either as subpart F income or GILTI.
Foreign buyers of US companies should carefully consider the subpart F and GILTI rules when undertaking acquisition integration planning for US targets that have foreign subsidiaries. As indicated above, when applicable, the subpart F rules accelerate US taxation of certain income (subpart F income) earned by a CFC. For purposes of the subpart F rules, a CFC is any foreign corporation more than 50 percent of whose stock (by vote or value) is owned by US shareholders (as defined below) on any day during the taxable year of the foreign corporation. Subpart F income generally includes passive income (e.g. dividends, interest, royalties, rents, annuities, gains from sales of property), and related-party sales and services income. Under the subpart F rules, subpart F income earned by a CFC may be currently included in the income of a US target that is a ‘US shareholder’ of the CFC, even if the CFC has not distributed the income.
The 2017 Tax Law expands the reach of the subpart F rules through the following changes:
As indicated above, the 2017 Tax Law introduces a new anti- deferral regime that requires a US shareholder of a CFC to include its GILTI in income. Most foreign subsidiary earnings that had been eligible for deferral under the old law are now subject to immediate US income taxation under the new GILTI provision. Corporate shareholders are allowed a deduction equal to 50 percent of GILTI for 2018 through 2025, which will be decreased to 37.5 percent beginning in 2026. As a result, the effective tax rate on GILTI for a US corporate shareholder is 10.5 percent prior to 2026, and 13.125 percent after 2026.
A US corporation’s GILTI deduction, however, may be limited when its GILTI and foreign-derived intangible income amounts (discussed below) exceed the corporation’s taxable income.
In general, GILTI is the excess of all of the US corporation’s net income over a deemed return on the CFC’s tangible assets (10 percent of depreciated tax basis). In many situations, most of a CFC’s gross income that is not subject to current taxation under the existing subpart F regime will be subject to immediate taxation as GILTI. The generally small sliver of income represented by the permitted return on tangible assets is not subject to US taxation when earned by the foreign subsidiary and, as discussed above, is eligible for a 100 percent dividends received deduction (DRD). A credit is also allowed for 80 percent of foreign taxes paid.
Although lowering the US statutory rate from 35 percent to 21 percent presumably reduces incentives to shift profits outside the US, the GILTI provision reflects a concern that a shift to a territorial tax system could exacerbate those incentives because any profits shifted offshore would be permanently exempt from US tax. The inclusion of GILTI in a US shareholder’s income is intended to reduce those incentives by ensuring at least a minimal rate of tax, at least on those earnings of CFCs that exceed the permitted return on tangible assets.
The foreign earnings of a CFC that are not subject to tax under the subpart F or GILTI regimes generally are exempt from US taxation. Under the 2017 Tax Law’s participation exemption regime, a US target corporation is allowed a 100 percent DRD on dividends received from a foreign subsidiary, subject to certain conditions being met. As a general matter, the 100 percent DRD is only available to US C corporations and is limited to the foreign-source portion of dividends received from a foreign corporation in which the US corporation is a US shareholder (i.e. the US corporation owns 10 percent or more of the vote or value of the foreign corporation’s stock).
In addition to the subpart F and GILTI regimes, the US tax code also contains anti-deferral rules that govern passive foreign investment companies (the so-called ‘PFIC’ regime). A US target may be subject to taxation and interest charges resulting from owning stock in a PFIC. A PFIC is any foreign corporation (that is not a CFC) that satisfies either of the following income or asset tests:
A US target owning PFIC stock is subject to a tax and interest charge on gains from the disposal of PFIC stock or receipt of an excess distribution from a PFIC. To avoid the PFIC tax regime, the US target may elect to treat the foreign corporation as a qualified electing fund (QEF election), with the US target being currently taxed on the QEF’s earnings and capital gain, or elect to recognize the built-in gain in the PFIC stock under a mark-to-market election.
During the acquisition planning phase, foreign buyers of US multinationals should consider whether it may be beneficial for the US target company to undertake any pre-acquisition restructuring that involves moving foreign subsidiaries of the US target out from under the US target. Any pre-acquisition restructuring will require the cooperation of the seller. Failure to undertake timely out-from-under planning to unwind such a ‘sandwich structure’ can indirectly expose the foreign buyer to additional US taxes (and, therefore, a higher global effective tax rate) due to application of the subpart F, GILTI, and/or PFIC rules. If out-from-under planning is not undertaken prior to the acquisition, then the foreign buyer should consider out-from-under planning as part of its overall post-acquisition integration planning initiative for US target.
From a tax due diligence perspective, foreign buyers of US target companies should also confirm with the seller whether the US target filed all required Forms 5471, Information Return of US Persons with Respect to Certain Foreign Corporations, with respect to its CFCs. To provide a little background, the United States generally requires that ‘US shareholders’ of a CFC file with their US federal income tax returns a Form 5471 for each CFC.1 On Form 5471, a US shareholder reports (among other things):
During the tax due diligence phase, it is very important that a foreign buyer of a US target company consider whether the US target appropriately prepared and filed any required Forms 5471. In addition to penalties, the failure to file a Form 5471 or substantially complete the Form 5471 may cause the US target’s statute of limitations (typically 3 years) to be extended indefinitely.
Integration planning for US target-owned intellectual property
Acquisition integration planning often includes identifying alternatives for the tax-efficient transfer of target company IP to the buyer’s existing IP holding company structure.
Following the 2017 Tax Law and other recent changes to the US Treasury regulations, a US corporation will be subject to US taxation on any transfer of IP to a foreign corporation.
This includes a transfer of goodwill, going concern value, or workforce in place.2 The 2017 Tax Law also contains provisions that are either intended to reduce the incentives for a company to reduce its US tax base (e.g. the GILTI and BEAT provisions, as discussed in this report or to encourage IP shifts into the United States (e.g. the so-called FDII regime, discussed in more detail below).
As a complement to the new GILTI regime that imposes a minimum tax on excess returns earned by a CFC, the 2017 Tax Law provides a 13.125 percent effective tax rate (increasing to 16.406 percent in 2026) on ‘foreign-derived intangible income’ (FDII) earned directly by a US corporation from foreign sales, leases, licenses, and services to unrelated foreign persons. Presumably, the goal of the FDII provision is to provide an incentive for US companies to locate productive assets in the United States, rather than offshore.
As in the GILTI regime, the reduced effective tax rates for FDII are achieved through a special deduction by the US corporation. At a high level, a US corporation’s FDII is its net income from export activities reduced by a fixed 10 percent return on its depreciable assets used to generate the export income. A US corporation’s FDII deduction may be limited, however, when its GILTI and FDII amounts exceed the corporation’s taxable income.
Together with the reduced US corporate tax rate of 21 percent and the GILTI regime, the FDII regime generally makes the US, as compared to before, a more attractive option for the establishment of an export base and may reduce the incentives for US companies to transfer or keep IP offshore.
The table below summarizes the impact of the GILTI and FDII provisions on US effective tax rates. The effective tax rates noted in this table take into account the new US corporate tax rate of 21 percent and, in the case of the effective tax rate noted for GILTI, an 80 percent foreign tax credit. The rates also rely on several assumptions that may not be true in many cases. For example, these rates assume that the US taxpayer in question has sufficient income to take the full GILTI deduction which may not be true due to current year losses or NOL carryforwards. As of January 2018, several European countries have expressed their intentions to challenge the FDII regime. Representatives from these countries claim that the FDII regime is not in line with the international norms on patent boxes and violates international trade rules on export subsidies.3 As of January 2018, the long-term viability of the FDII regime appears uncertain.
|GILTI||2025||2026 and after|
|Deduction||50 percent||37.5 percent|
|Effective US tax rate||10.5 percent||13.125 percent|
|Minimum foreign tax rate at which US residual tax = 04||13.125 percent||16.406 percent|
|Deduction||37.5 percent||21.875 percent|
|Effective US tax rate||13.125 percent||16.406 percent|
As previously noted, the 2017 Tax Law eliminates the so- called goodwill exception that many companies previously relied upon to tax efficiently integrate target company IP with buyer’s existing IP holding company structure. To effect this change, the 2017 Tax Law broadens the definition of ‘intangible property’ by amending section 936(h)(3)(B) to say the following, among other things, constitute ‘intangible property’:
The 2017 Tax Law’s broader definition of intangible property, which is in line with the OECD’s definition of intangible, is intended to prevent the use of intangible property transfers to shift income between related parties, and more specifically, to make it more difficult for a US person to make an outbound transfer of intangible property without incurring tax.
Finally, in addition to the provisions discussed above, it is important that foreign buyers of US target companies consider the 2017 Tax Law’s hybrid mismatch rule and base erosion anti-avoidance tax (BEAT) provision before implementing any transfers of IP owned by a US target company or its subsidiaries. As previously mentioned, the hybrid mismatch rule generally disallows deductions for related-party interest or royalties paid or accrued in connection with certain hybrid transactions or by, or to, hybrid entities if (i) the related party does not have a corresponding income inclusion under local tax law; or (ii) such related party is allowed a deduction with respect to the payment under local tax law. For additional details regarding the hybrid mismatch rule, see ‘Hybrid instruments and entities’.
Very generally, the BEAT is an additional tax that applies to large corporations that reduce their US tax liabilities below a certain threshold by making deductible payments (e.g.
interest and royalties) to related foreign entities. If applicable, a US corporation will have a BEAT liability in addition to its regular income tax liability.
The BEAT generally applies to corporations that are not S corporations, RICs, or REITs, are part of a group with at least US$500 million of annual domestic gross receipts (over a 3-year averaging period), and that have a ‘base erosion percentage’ of 3 percent or higher (2 percent for certain banks and securities dealers). The base erosion percentage generally is determined by dividing deductions attributable to payments to related foreign persons by the total amount of the corporation’s deductions for the year.
Corporations that meet the US$500 million gross receipts test and the base erosion percentage are required to run a separate set of calculations to determine whether they are subject to a BEAT liability. The BEAT regime generally requires a taxpayer to recompute its taxable income as if it had not made any base erosion payments and then multiplies that ‘modified taxable income’ amount by the applicable BEAT tax rate. The taxpayer generally will have a BEAT liability to the extent that amount exceeds the taxpayer’s post-credit regular tax liability (the BEAT rules provide preferential treatment for four types of tax credits).
The BEAT tax rate generally is 5 percent for 2018, 10 percent for 2019–2025, and 12.5 percent after 2025.The BEAT rate is 1 percent higher for banks and registered securities dealers. Due to the new BEAT regime, many foreign multinationals that receive substantial royalty, interest or service payments from US subsidiaries could see an increase in their effective tax rate. Companies subject to the BEAT may need to consider supply chain restructuring if the BEAT gives rise to an unmanageable cost that detrimentally impacts the company’s competitiveness. For some companies, such restructurin to address BEAT exposures may include, for example, converting a service fee procurement company structure into a buy-sell structure and/or transferring customer contracts to foreign subsidiaries. The restructuring options chosen will depend on each taxpayer’s particular facts, circumstances, and operational goals. During the tax due diligence phase, foreign buyers of US target companies should consider the extent to which a target company’s intercompany transactions are subject to the new BEAT regime. Unlike the GILTI regime, the BEAT applies to all US taxpayers that satisfy the US$500 million threshold test regardless of whether part of a US or non-US group.
Other acquisition integration planning considerations from a value chain perspective
Most of the 2017 Tax Law’s international tax provisions apply equally to US and foreign multinationals that have US operations. For example, depicted below is a common structure (Diagram 1) that may no longer be optimal due to US tax reform developments (in the diagram below, LRD is a limited risk distributor). When performing tax due diligence, acquiring companies should carefully consider whether the target’s structure is detrimentally impacted by US tax reform developments.
Considerations from an OECD BEPS initiative perspective
It is important that foreign buyers of US companies consider not only US tax reform developments but also global BEPS developments when planning the acquisition of a US company. Consideration of country-specific BEPS developments is especially important when completing tax due diligence reviews, defining tax indemnities, and undertaking acquisition integration planning. As of January
2018, the US has implemented some but not all of the OCED BEPS recommendations. Even if the US implements no additional OECD BEPS recommendations in the future, it
is important that foreign buyers of US companies consider BEPS issues when planning the acquisition of a US company due to the following reasons:
Where acquisition financing is concerned, certain OECD BEPS recommendations raise tax exposure concerns for a number of common US inbound acquisition financing structures (e.g. US inbound acquisition financing structures involving Luxembourg entities).
From a tax due diligence perspective, areas of key focus from a BEPS perspective include, for example, consideration of whether the US target company has any structures in place that include: hybrid entities (e.g. an entity that is treated as a corporation for US tax purposes but as a disregarded entity for foreign tax purposes), hybrid instruments (e.g. an instrument that is treated as debt in the payor jurisdiction and equity
in the recipient jurisdiction), hybrid transfers (e.g. a repo transaction treated as a secured financing in one jurisdiction and as a sale and repurchase in another), principal companies, limited risk distributors, commissionaires, and IP license and/ or cost sharing arrangements. As it concerns identifying BEPS exposures during the tax due diligence phase, other important considerations also include consideration of local country tax rulings obtained by the target company, if any, in various jurisdictions. In the current environment, structures thatinclude elements such as those just listed and/or local country tax rulings present the risk of increased audit scrutiny and tax authority challenges.
Once BEPS exposures are identified, it is important for both the acquiring company and target company to determine a course of action. One possible approach may be for the seller of the target company to give the acquiring company a purchase price reduction in anticipation that the buyer will incur future ‘BEPS unwind costs’. Alternatively, another approach may involve the target company addressing the BEPS exposures through pre-acquisition structuring. As a general matter, buyers should consider any BEPS exposures specific to both the target and acquiring companies’ structures during the acquisition integration planning phase.
As previously discussed, various provisions of the 2017 Tax Law (e.g. the new hybrid mismatch rule) incorporate certain OECD BEPS recommendations. Also, noteworthy, the updated US model income tax treaty released in 2016 (the 2016 Model Treaty) includes some BEPS-like provisions. For example, the 2016 Model Treaty includes provisions that would deny treaty benefits on deductible payments of mobile income made to related persons where that income benefits from low or no taxation under a preferential tax regime.
Net investment income tax
Section 1411 imposes a 3.8 percent tax on net investment income (NII) of individuals, estates and trusts with gross income above a specified threshold. The NII tax does not apply to S or C corporations, partnerships (but may apply to their owners), non-resident aliens, tax-exempt trusts (e.g. charitable trusts), and trusts that are not classified as trusts under the Code (e.g. REITs).
In the case of an individual, the NII tax is applied on the lesser of the NII or the excess of gross income thresholds as follows:
|Filing status||Threshold amount|
|Married, filing jointly or a surviving spouse||US$250,000|
|Married, filing separately||US$125,000|
Source: Code section 1411(b)
NII includes three major categories of income:
The NII tax is computed on Form 8960, Net Investment Income Tax — Individuals, Estates, and Trusts. Individuals report this tax on Form 1040, US Individual Income Tax Return. Estates and trusts report this tax on Form 1041, US Income Tax Return for Estates and Trusts.
The 2017 Tax Law leaves the 3.8 percent NII tax in place.
Foreign AccountTax Compliance Act
The Foreign Account Tax Compliance Act (FATCA) was enacted into law to address tax evasion by US taxpayers that hold unreported assets in non-US financial accounts and undisclosed interests in foreign entities. Generally, FATCA affects three groups:
FFIs are required to identify their US account holders, obtain and track those account holders’ tax information, and report it annually to the IRS (or to local authorities for FFIs operating in jurisdictions that have signed a Model 1 Intergovernmental Agreement). NFFEs are generally required to identify and disclose their substantial US owners, unless they qualify for an exception (e.g. where the NFFE is an ‘Active NFFE’).
FATCA applies a 30 percent tax (effectively a penalty) that is enforced by withholding agents, who must generally withhold 30 percent from certain payments of US-source fixed, determinable, annual or periodical income (FDAP) made to noncompliant entities. Payments of gross proceeds from the disposition of property that give rise to US-source dividends and interest that are paid to noncompliant entities are also subject to the 30 percent withholding tax for dispositions occurring after 31 December 2018.
The 30 percent withholding tax may be eliminated in several ways. The simplest way is for the payee to be a type of entity that is not subject to withholding and for such payee to provide a properly completed withholding certification (e.g. Form W-8BEN-E, Certificate of Status of Beneficial Owner for United States Tax Withholding and Reporting (Entities)), to the withholding agent identifying itself as an FATCA compliant entity (e.g. a participating FFI or active NFFE).
FATCA exempts certain payments from withholding (e.g. so- called ‘non-financial payments’). In this case, the withholding agent must independently determine whether the payment otherwise subject to withholding qualifies for an exception.
FATCA imposes secondary liability on withholding agents for failure to properly withhold.
The payment of US-source FDAP to a non-US person must be reported on Form 1042-S, Foreign Person’s US Source Income Subject to Withholding, and Form 1042, Annual Withholding Tax Return for US Source Income of Foreign Persons.
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