Don’t Let Tax Issues Dictate Your Business Growth Plan

Sound business planning often requires both organic and inorganic investment, each bringing opportunities and risks – including tax risks. Inorganic investment often involves acquiring a business that has potential tax liability exposures from prior transactions and/or tax return positions that are inherited by the acquiror. Organic investment often involves complex transactions to combine or separate business assets and/or functions, the tax treatment of which is often subject to uncertainty. While comprehensive due diligence and tax planning can address some of these risks, typically there are significant tax risks resulting from inorganic and organic transactions that cannot be fully mitigated by planning alone.

Successfully navigating the inherent tax risks in both organic and inorganic investments and maximizing tax opportunities requires a deep knowledge of the applicable tax law. However, knowledge of the tax law alone is insufficient to mitigate many of the risks identified or to take full advantage of opportunities. In such cases, a keen eye for risk mitigation solutions is needed. Historically, businesses have relied upon a combination of in-house tax professionals and outside advisors to identify and quantify potential tax risks and opportunities. Although there may be deep tax technical and transactional expertise within these groups of professionals, they typically lack experience designing risk mitigation strategies such as tax insurance. As discussed below, a combination of tax planning, advisory and tax exposure mitigation perspectives will lead to more optimal outcomes in organic and inorganic transactions.

Inorganic Investments

In an acquisition, an identified tax exposure may result in a contentious negotiation that can cause friction between the buying and selling teams from the outset or, in an extreme case, put the closing at risk. Depending upon the nature of the particular tax exposures, the prospective buyer may attempt to negotiate an adjustment to the proposed purchase price or exclude the value of a tax asset from its purchase price calculation. However, when compared to the cost of transferring this risk to one or more insurers, both of these approaches are highly inefficient, as can be seen from the illustrations below.

Illustration 1: A $50 million tax exposure is identified on a $500 million business due to the target historically operating a potential permanent establishment in France. The prospective buyer may attempt to reduce the proposed purchase price by some or all of the $50 million exposure, often agreeing to adjustment equal to half of the exposure.

Illustration 2: A target has a net operating loss carryforward of $50 million for which there is risk that the losses would not be respected by a taxing authority because they were generated as a result of interest deductions on related-party debt. The acquirer in this case often excludes the tax affected value (e.g., 21% * $50m = $10.5m) of the asset from its purchase price calculation.

Reducing the offer price by over $10 million for each of these $50 million tax exposures will produce a noncompetitive bid as compared to seeking a more efficient tax insurance solution.

Organic Investments

Organic expansion often involves transactions that look similar to inorganic activity such as a sale or transfer of a business or assets or a merger of legal entities, but takes place between commonly owned parties. As with the process for inorganic expansion, tax risks in such transactions could involve divergent views on the value of a business or asset being transferred, uncertain application of complex tax laws or treaties, or uncertainty about how future events may impact the present-day tax treatment of the transaction. The decision whether to execute the organic transaction often hinges on the ability to successfully mitigate the tax risks identified in a more comprehensive manner than can be accomplished through tax advisory services alone.

Mitigating Tax Risks

Many of the most efficient and creative solutions to tax risks identified on internal and inorganic transactions have been developed and negotiated by former tax advisors, who are applying their advisory experience to design tax and transaction insurance solutions. Businesses have become comfortable using these bespoke and creative tax solutions both within and outside of M&A activity, and have recently applied tax insurance to unlock spinoff activity, reallocate millions of dollars of funds from overfunded benefits plans, reduce the balance sheet impact of tax reserves, among other common tax risks.

Although the availability and pricing of tax insurance varies by issue, jurisdiction and other factors, the cost for insurance, which is often under 5% of the exposure being mitigated, is far below the 21% or higher purchase price adjustments described above for an inorganic transaction. For organic transactions, tax insurance can often be the catalyst that allows for execution where a risk was identified that prevented a key stakeholder (e.g., CFO, General Counsel) from approving the transaction. The decision to forego an organic transaction supported by sound business planning because of one or more identified tax risk should not be made before first exploring an insurance solution. Failure to consider tax insurance solutions to known tax risks on an inorganic transaction will often lead to a noncompetitive bid or a decision to walk away from the transaction altogether, despite the acquisition otherwise being a sound business decision.

Tax exposures identified with respect to inorganic and organic transactions can disrupt sound business strategy, and cause parties to engage in economically inefficient behavior. Through a better understanding of the availability and breadth of tax insurance solutions, in-house professionals and their advisors can reduce tax friction and execute transactions with greater tax certainty.