July 31, 2019
The sweeping US tax overhaul that has been in effect for well over a year was intended to simplify America’s tax code. It has prompted businesses to factor the changes into their growth strategies and scenario planning, particularly in light of ongoing trade tensions. But the 2017 tax reform act continues to be a complex law to digest, requiring specialists to manage ongoing developments around key areas, including: tax implications on tariffs, employee compensation, state tax laws, and capital availability.
Uncertainties around these areas likely will linger for some time, and how dealmakers respond going forward could impact the quality and value of their next deal. For instance, many consumer market companies today are evaluating their supply chains and pricing approaches to be cost-effective and tax-efficient. As they contemplate relocating sourcing, manufacturing and distribution, they will need to consider carefully the law’s international provisions, including the global intangible low-taxed income (GILTI), the base erosion and anti-abuse tax (BEAT), and the foreign derived intangible income (FDII) deduction. Moreover, it will be critical to examine pitfalls around interest limitations while leveraging tax reform’s opportunities at the federal, state and local levels.
Tax reform complicates the consequences of tariffs
Last year, the United States and China imposed punitive tariffs on one another. Although they currently have paused further escalation of the ongoing trade conflict, uncertainties persist. US tariffs on $250 billion worth of Chinese goods remain in place, as well as Chinese retaliatory tariffs on US exports. Tax reform could further complicate the impacts of tariffs, particularly as they relate to GILTI and BEAT. Many taxpayers are trying to ease the impacts of these provisions while also trying to reduce the fallout from tariffs. However, these dual efforts have countervailing objectives and therefore may carry unintended consequences.
To mitigate BEAT, for instance, some taxpayers are turning to transfer pricing or re-assessing if BEAT-affected payments are cost of goods sold (COGS). Consequently, these measures could attract greater scrutiny and possibly tariff costs if COGS increase. Meanwhile, efforts to lessen the impacts from tariffs – such as dividing goods purchase prices between product values and payments for services – inadvertently may create BEAT implications.
Tax reform and tariffs are prompting businesses to revisit broken and outdated models and processes. Specifically, tax reform provides businesses with an opportunity to develop strategies aimed at mitigating or even avoiding tariffs. The rules around tax and tariffs are linked in a variety of ways, so it will be imperative to combine a deep understanding of the US customs and US income tax landscapes to develop an overall strategy going forward.
Tax reform impacts employee compensation
Tax reform also means public companies are now limited to $1 million a year in deductions for compensation paid to their CEOs, CFOs, and three highest-paid officers on their proxy statements. Once the $1 million limit per covered employee is reached, all other compensation, including performance bonuses, options, equity and deferred compensation, is no longer deductible.
These changes could have broad implications on M&A deals, especially as they relate to talent retention and recruitment. In transactions with a public company target, it will be important for buyers to assess how the new rules could impact the target’s future compensation costs for its top executives. Consideration also should be given to whether changes to grandfathered arrangements triggered by the transaction will cause these arrangements to become subject to, and nondeductible under the new rules. The target and buyer also will need to evaluate which deductions are limited for purposes of the target’s final tax return and buyer’s post-closing return.
There is also uncertainty regarding tax treatment of public companies that are taken private. More guidance is needed from the IRS to understand whether such firms will continue to be subject to deduction limitations and whether the target’s covered employees will become covered employees of the buyer.
State governments are navigating gray areas, too
From a state perspective, the tax landscape is not any clearer. Tax reform has created challenges for governments trying to bridge differences between the federal law and rules at home. States have taken a cautious view in enacting federal tax reform – balancing both budgetary costs and benefits with any administrative complexity related to their decision to conform. As states catch up, it remains to be seen whether and how they will apply certain areas of tax reform and how key provisions of the law could impact M&A prospectively. Three key areas will be worth watching: interest limitations, immediate expensing and repatriation.
- Interest limitations: Firms will need to consider additional costs, as companies can only deduct interest expense of up to 30 percent of earnings before interest, taxes, depreciation and amortization (EBITDA). The interest limitation is expected to tighten further in 2022, when deductibility will be capped at 30 percent of their earnings before interest and taxes but after depreciation and amortization expenses. The question now is how states plan to apply this provision of the law. Depending on the state, calculating the interest deduction under EBITDA could vary depending on a state’s filing methodology (e.g., separate versus combined).Limitations on deductibility of interest could have an impact on tax payments and the availability of cash to make payments to investors. As a result, a state’s application of the interest limitation provision could impact how much companies are able to pay on their investments, particularly when it comes to private equity firms and leveraged buyouts. Given the uncertainties, it will be important for companies to consider the risks and explore ways to mitigate them going forward.
- Immediate expensing: Tax reform allowed dealmakers to immediately write off the costs of tangible assets for federal purposes instead of waiting months or years for them to depreciate. Moreover, the law widened the range of assets eligible for the tax benefit to include certain types of content, such as film, television and live theatrical productions.This provision has created a meaningful cash tax benefit for buyers, but many states have decoupled from this rule. Accordingly, buyers will need to account for this lack of benefit in their models. Moreover, where a state has adopted full expensing, care will be required to determine if any differences between the federal and state rules could apply, potentially resulting in benefits (e.g., purchases of foreign assets).
- Repatriation: Foreign earnings previously taxed under the federal toll charge in Section 965 may be repatriated by U.S. shareholders in a tax-free manner. However, not every state has adopted the inclusion of such foreign earnings in their tax base and similarly, not every state has adopted the exclusions and deductions offered under federal tax law to such foreign earnings. Moreover, as some states do not offer full dividends received deductions that are offered for federal income tax purposes, there could be a state income tax cost to repatriation that should be considered, which could make returning cash to investors more costly.
Capital is readily available for M&A?
Despite the uncertainties, dealmakers will continue enjoying unparalleled access to capital, thanks partly to tax reform. Even though the legislation has not directly driven many more M&A deals, a mix of corporate tax savings and repatriation means that the law provides another source of cash in an already liquid market for investment and M&A.
For the first time since the financial crisis in 2008, companies in the S&P 1500 repurchased more than $800 billion of shares in 2018 – a level that surpassed business spending on new or upgraded plant and equipment. The wave of repurchases was largely driven by big companies across various industries, particularly large firms within the telecommunications, media and technology sectors, according to a PwC analysis. This suggests that capital available for M&A could very well expand, since funds for repurchases could easily be redirected toward acquisitions as opportunities present themselves. The key is to generate sufficient returns on those deals, leveraging the current tax and tariff landscape with a coherent strategy.
The market for deals likely will remain active the rest of this year, especially with the US economy remaining resilient. Whenever a recession does arrive, we expect a decoupling of the M&A environment from the overall economy, with high levels of capital helping maintain a steady pace of deals.
Navigating through the complexities around tax reform will be key. Already, the US Treasury and the IRS have issued a fair amount of regulations and guidance, but uncertainties remain as to how the rules will apply and whether some regulations are being implemented the way the law intended. While many are still only proposals and subject to change, dealmakers will need to track them closely and incorporate their implications on transactions.
Explore the regulatory changes shaping deals in the New Deal Frontier.