By Aman Badyal
Though the recently enacted tax reform package known as the Tax Cuts and Jobs Act (the “Act”) does not revise the rules applicable to corporate reorganizations, it does have significant implications for corporate mergers and acquisitions (M&A) in the United States.
This article focuses on four specific changes to the Internal Revenue Code that could have the most significant impact on M&A transactions.
The entire purchase price of certain assets can be expensed if the assets are placed in service before 2022. Starting in 2023, the deduction will be reduced by 20% per year. That is, in 2023, 80% of the cost of qualifying assets can be expensed immediately, 60% can be expensed for assets acquired in 2024 and so on.
As the new expensing provision applies to both new and used assets, acquirers will be further motivated to structure acquisitions as asset purchases (or deemed asset purchases) rather than stock purchases. However, due to the reduced value of NOLs (see below), buyers should weigh the advantages of expensing the purchase price versus depreciating the asset over a number of years.
A net operating loss (NOL) exists when a business reports deductions that exceed its taxable revenue. Under prior law, taxpayers could carry back an NOL to the two prior tax years and create a tax refund. An NOL could also be carried forward for 20 years.
The new law prohibits an NOL from being carried back. Although NOLs can now be carried forward indefinitely, the Act caps the amount which can be applied to any taxable year to an amount equal to 80% of the taxpayer’s taxable income for such year. The new rule applies to NOLs that arise in tax years that begin on or after January 1, 2018.
Under prior law, M&A transaction related expenses would often create an NOL for the tax period ending on the date of the transaction, which would generate a tax refund for the seller. This refund was often the subject of negotiations.
As any NOLs must now be carried forward, the resulting tax benefits will carry over to future tax years. The parties to the transaction should weigh the benefit of this future tax benefit when negotiating the purchase price.
Businesses with average annual gross receipts of greater than $25 million dollars face a cap on the amount of deductible interest expense. The maximum interest expense deduction under the new law is 30% of the taxpayer’s adjusted taxable income. Until January 1, 2022, “adjusted taxable income” will essentially mean EBITDA (and EBIT thereafter).
This cap on interest expense deduction will apply regardless of when the underlying debt was incurred. Any interest paid in excess of the maximum can be carried forward indefinitely.
As this new limitation on interest expenses is unfavorable to businesses that rely heavily on debt, highly leveraged businesses and leveraged acquisitions may be less attractive in the M&A landscape.
The new law imposes a transition tax on untaxed foreign earnings of foreign subsidiaries. The transition tax is a one-time mandatory tax assessment, but it may be paid in installments over eight years. Buyers must ensure they engage in appropriate due diligence to discover any such liabilities of an acquisition target. If an acquisition target has any such liability, buyers should consider those obligations when negotiating a purchase price. Buyers will also need to confirm that the target’s transition tax liability was properly computed.
Buyers, sellers, and their respective advisors must be keenly aware of how the Act could influence the economics of M&A transactions in their pipeline. We will continue to monitor developments in this area. Should you have any questions or desire further insight, feel free to contact one of the members of our Tax Department:
DISCLAIMER: This article is not intended to provide legal advice, and no legal or business decision should be made based on its contents.