Baird's Initial Thoughts on Implications for Corporate, Cross-Border, and Financial Sponsor Deal Activity
This article summarizes the impact of recently enacted U.S. tax reform, also known as the Tax Cut and Jobs Act (TCJA), on the M&A market along several dimensions. We expect that TCJA could have meaningful effects on M&A activity, both in the U.S. and internationally, based on reductions in tax rates, changes to tax deduction timing and limits, and greater flexibility in using offshore cash.
Before delving into the impact of U.S. tax changes on different types of companies and deals, we note a few points that are relevant to many M&A situations:
- Passage of TCJA benefits M&A activity by eliminating uncertainty regarding the level of future tax rates for acquirors and targets, as the lack of clarity in the preceding months about the nature and timing of tax reform may have caused some deal-makers to move to the sidelines temporarily
- For tax years beginning in 2018, statutory corporate income tax rates decline to 21% from 35%, while the corporate alternative minimum tax has been repealed. Reduced tax rates inherently increase target company values by providing a larger share of profits to owners.
- TCJA allows companies to expense 100% of expenditures on new and used qualified property (i.e., tangible property with a recovery period of up to 20 years, plus computer software) acquired and placed in service from September 28, 2017 through the end of 2022. By lowering near-term tax obligations through higher year-one deductibility for acquired asset costs, this provision makes the economics of some prospective acquisitions more viable for buyers, especially in manufacturing or other equipment-intensive industries, even when sellers negotiate for their share of raised tax shield values via higher sale prices.
Impact on Corporate M&A Activity
Several aspects of tax reform are most applicable to deal-making involving corporations as acquirors and sellers:
- Corporates that experience lower effective tax rates will have more cash to spend on M&A. The benefits of increased financial firepower are less significant for larger cash-rich corporates that already have ample access to low-cost capital.
- More than $2 trillion in cash that has been held offshore by U.S.-based companies to defer further taxation on unremitted earnings must be repatriated over a period of up to eight years and taxed at a 15.5% rate. While 90%+ of cash repatriated during 2004’s tax holiday was returned to shareholders through stock repurchases and dividends, the current appeal of buybacks may be reduced for companies with elevated stock valuations.
- Corporate divestiture activity should increase under the new tax system, adding to the supply of available targets. Under the previous tax regime, corporates were often hesitant to execute divestitures of certain non-core assets due to high tax rates and the impact of divesting assets with low tax bases. These companies should be more open to selling parts of the business due to lower taxes on resulting gains. Divesting companies are also positioned to secure higher after-tax values by negotiating sale prices that reflect a portion of the increased tax shield now available to buyers (as noted above).
- Regarding immediate expensing of the costs of acquired qualified property, public companies must weigh the tax benefits of deducting these costs in year one versus the investor reaction to acquisition announcement guidance for lower EPS accretion (or possibly dilution) in the near term due to accelerated depreciation practices. Companies could respond by using longer-term forecasts for accretion and projected rate of return metrics to convey the planned economic benefits of acquisitions.
Effect on Cross-Border M&A
New tax laws will have varying impact on the level of M&A activity between U.S.-based companies and firms in other geographic markets:
- Under the previous tax regime, U.S. companies frequently spent cash that was trapped offshore to acquire targets based in foreign markets. Repatriated cash can now be more readily used for other purposes, including domestic acquisitions.
- U.S. acquirors should have a larger appetite for overseas targets due to their enhanced ability to generate cash that can be allocated broadly. Foreign subsidiaries of U.S. companies will primarily be taxed by the countries in which profits are produced, with any additional tax impact related to new provisions intended to prevent multinationals from excessively shifting profits to lower-tax jurisdictions. In addition, U.S. companies can fully deduct foreign-source dividends received through ownership of 10%+ of an overseas corporation for at least one year.
- As noted above, lower tax rates and immediate cost expensing could increase the prospective valuations of U.S.-based companies. Due to this factor, price-conscious acquirors across markets may be more inclined to pursue targets located in other countries.
- TCJA also contains provisions designed to deter inversion transactions.
- New limits on interest expense deductibility (detailed just below) reduce the incentive to allocate debt to a U.S. business involved in a cross-border transaction.
Impact on Financial Sponsor M&A
Certain tax reform provisions are particularly relevant to M&A conducted by private equity firms:
- For most companies, tax reform limits the deductibility of net interest expense on all debt outstanding at the start of 2018 to 30% of adjusted taxable income, which is similar to EBITDA through 2021 and EBIT thereafter. The deductibility cap increases the cost of capital for acquisitions reliant on a meaningful degree of debt financing, as is the case for many sponsor purchases. This could make private equity firms less competitive with cash-rich strategics in pursuing some targets, especially if interest rates in the leveraged finance markets rise significantly from historically low levels. In addition, targets with large cyclical fluctuations in EBITDA levels could draw less attention from sponsors.
- Factors likely to mitigate the impact of reduced deductibility include the unlimited ability to carry forward disallowed interest expense. Furthermore, a sponsor survey conducted by PitchBook after TCJA’s passage revealed that over two-thirds of respondents expect to use more equity in deals during 2018 than in 2017.
- Other provisions of tax reform noted above should help financial sponsors make the math work on planned purchases (albeit at potentially lower return thresholds), including improved bottom lines for targets due to lower tax rates, plus the ability to step up and expense some costs immediately under certain transaction structures (as discussed below). These positive cash flow features are likely to be at least partly reflected in target valuations.
- While carried interest will continue to be treated as a capital gain, the minimum hold period to qualify for long-term capital gains treatment was raised from one year to three years. We believe this provision could cause sponsors to retain certain portfolio companies producing strong results rather than exiting prior to the end of the new minimum hold period.
- The American Investment Council, a leading private equity lobbying group, described TCJA as a “net positive for private equity” in a statement released after its passage.
Additional Provisions Affecting M&A
On top of the changes reviewed above, other elements of tax reform could affect the nature and timing of M&A transactions:
- Given the increased present value of the depreciation tax shield under TCJA, more transactions could be structured as actual or deemed asset purchases, such as through a Section 338(h)(10) election, in order for acquired asset values to be stepped up for tax purposes as a means of maximizing this benefit.
- Target valuations should take into account new limits on net operating losses arising in tax years beginning in 2018, as these NOLs are capped at 80% of taxable income and cannot be carried back to earlier years. Such restrictions are particularly relevant due to provisions related to immediate capital expensing, which increases the likelihood of NOLs being incurred in any year with large capital expenditure write-offs.
- While NOLs can be now carried forward indefinitely, lower corporate tax rates reduce the value of future and previously incurred NOLs as well as other tax shields. This dynamic will diminish the extent to which selling shareholders are compensated for these tax attributes.
- Changes to certain provisions in later years could influence behavior once these changes are closer to the horizon. For example, the 30% limit on deductibility for interest expense transitions from being tied to EBITDA through 2021 to being based on EBIT (often a much lower value) in 2022, which could cause companies to shift as much depreciation and amortization expense as possible into 2021 from future years in order to create capacity for post-2021 interest expense deductions. Levels of qualified property cost depreciation will also change, as the 100% expensing allowed through 2022 will phase down by 20% per year from 2023 through 2026, which could make acquisitions of tangible asset intensive businesses particularly attractive in 2021.
- Moderately lower individual tax rates might spark incremental M&A activity, as individuals may be more willing to sell LLCs or S corporations due to reduced taxes on gains. On the other hand, non-corporate taxpayers are now able to deduct 20% of qualified business income earned via such a flow-through entity during 2018-2025, providing added incentive to retain the business due to a much lower effective tax rate on such income.
While not covering all ramifications of TCJA on individual M&A transactions, the information and analysis presented above conveys the substantial and wide-ranging impact of tax reform on M&A activity. The influence of TCJA may become more apparent later in 2018, after companies have had additional time to evaluate and adjust to the new provisions. The tax implications for individual M&A deals depend on the entity choices of the parties involved and the structure of the transaction, and are therefore best discussed directly with tax and M&A advisors.