The Future Lawyer Weekly Briefing – W/C 8th April 2024

M&A Tax: An Aspiring Lawyer’s Guide to Tax

A series introducing law students to the real world of tax.

Saving on corporate tax is one of the main motivations behind executing a merger and acquisition (M&A). Whether an M&A should go ahead can come down to tax considerations, making M&A tax a profitable area for law firms.  

Tax-Driven M&A Strategies

In 2015, driven by tax considerations, Pfizer attempted to acquire Allergan for $160 billion. The acquisition would reduce Pfizer’s global tax rate by 7%, saving it at least $3.4 billion in tax bills in 2015 alone.  

Facing regulatory scrutiny on the attempted tax inversion, Pfizer called off the deal. However, transfer pricing (the strategy above, explained in a previous article) is merely one of the tax-driven M&A strategies corporations pursue to mitigate their tax burdens.  

Acquisition of loss-makers 

Since companies are taxed on the profits they make, reducing taxable profits reduces tax liabilities. So, an acquirer could buy a loss-making company to offset its taxable income, subject to statutory limits. 

For instance, behind the narrative of creating the world’s only integrated sustainable energy company, the Tesla-SolarCity deal was partially driven by reduction in taxable income thanks to SolarCity’s financial strain.  

Tax deductible depreciation  

In short, this is when extra depreciation (i.e., the cost of using assets) reduces taxable income. Normally, the tax rules on how much depreciation can be charged leave relatively little wiggle room for the creative tax lawyer.  

However, when a target is acquired, the parties must reassess its assets to “fair value”, a number that might have little to do with the real value of the assets. The higher the fair value, the more depreciation expense charged, the less the tax bill.  

For instance, General Motors’ $2.6 billion buyout of Electronic Data Systems involved a $2 billion write-up of the latter’s assets. Thanks to the new fair value, General Motors was able to claim a $400 million annual tax deduction.  

Increased leverage and tax gain

In simple terms, this sort of tax gain occurs when an M&A results in the new entity being able to borrow more money and thus reducing taxable income with interest payments on those borrowings. That is, by increasing leverage, the debt-financed new corporate entity lowers its tax burdens via interest deductions.  

Suppose two companies, A and B, can each borrow two times against their equities. A and B each pay £10 million in interest. As separate entities, A and B pay £20 million in interest. By merging as one corporate entity, they can borrow, say, four times against their combined equity. Effectively, then, the new entity can pay twice the interest on its debt, i.e., £40 million. As a result, the new entity can reduce its tax bills by £20 million.  

For instance, in 2015, the Kraft-Heinz merger allowed the combined entity to leverage its larger equity base to secure more debt. The merger’s financing structure was designed to optimise the combined company’s capital structure and tax efficiency. 

These strategies and case studies show that, even in deals that are primarily driven by long-term strategic alignment, tax remains a compelling factor in M&A decisions.  

Tax Considerations 

Once a deal is underway, tax considerations still play a pivotal role in shaping the structure, financing, and overall strategy of the transaction. Intertwined with commercial and legal considerations, these tax factors directly influence the success of the deals.  

Deal Structure 

The choice between an asset purchase and equity purchase significantly impacts tax outcomes. An asset purchase allows the buyer to step up the acquired assets’ basis to their current market value, potentially leading to future tax deductions via depreciation. Conversely, a stock purchase does not allow such a step-up, reducing the deal’s attractiveness from a tax perspective.  

Tax Attributes 

The target company’s tax attributes, such as net operating losses or tax deductibles, are crucial. These attributes provide valuable tax benefits post-acquisition but are subject to limitations and restrictions under tax law, directly influencing the deal’s valuation. 

Method of Financing 

The financing method—whether through cash, debt, or stock—carries distinct tax implications. Debt financing, for example, may offer tax advantages through interest deductibility, thereby influencing the acquisition’s cost-effectiveness and structure. 

Jurisdiction 

Cross-border M&As introduce complex tax considerations, including double taxation and the application of international treaties. The jurisdictions involved can significantly affect the deal’s tax efficiency, requiring careful planning and understanding of multiple tax regimes. 

Law Firms’ Involvement

In addition to advising on the considerations above, law firms guide companies and private equity house on the following:  

Tax indemnities

Law firms sweep tax landmines during the due diligence process. They negotiate tax indemnities within the purchase agreement to protect buyers from unforeseen tax liabilities associated with the pre-acquisition activities of the target company. The process involves detailed analysis of the target’s tax compliance history, contingent tax liabilities, and the structuring of indemnity clauses to cover potential tax exposures. 

Regulatory approval of tax deductions  

To secure regulatory approval for tax deductions and other benefits post-M&A, law firms ensure that the deal structure follows local and international tax laws and regulations. They apply for tax rulings and argue for the deductibility of expenses such as interest and advisory fees, thereby maximising the tax efficiency of the transaction. 

Article by David Zheng