Trump’s tax cuts and the impact on US M&A
April 2018 | COVER STORY | MERGERS & ACQUISITIONS
Financier Worldwide Magazine
April 2018 Issue
While president Trump’s first 12 months in office were not short on incident – think travel bans, Russian probes, the Mexico-US border wall, fake news, sex scandals, federal firings and divisive tweets, among many others – they were short on genuine achievement.
Yet the finals days of 2017 did see the under-fire president chalk up what many consider to be the only bona fide success of his administration so far: the first major overhaul of the US federal income tax system in more than 30 years, the Tax Cuts and Jobs Act (TCJA).
The TCJA, according to the US Senate Committee on Finance, “overhauls America’s tax code to deliver historic tax relief for workers, families and job creators, and revitalize our nation’s economy. By lowering taxes across the board and eliminating costly special-interest tax breaks, the TCJA will help create more jobs, increase paychecks, and make the tax code simpler and fairer for Americans of all walks of life”.
Drilling down to how the legislation applies to businesses in particular, the Committee advises that the TCJA: (i) lowers what was the highest corporate tax rate in the industrialised world to 21 percent – down from 35 percent – the largest reduction in corporate tax rate in US history: (ii) modernises the US international tax system so that global US businesses will no longer be held back by an outdated ‘worldwide’ tax system that results in double taxation for many US job creators; and (iii) makes it easier for US businesses to bring home foreign earnings to invest in growing jobs and pay cheques in local communities.
Furthermore, the non-partisan Congressional Budget Office (CBO) has reported that businesses will receive an estimated $320bn in benefits due to the corporate tax cuts under the TCJA.
“The tax reforms have led, and are leading, to a massive degree of cash repatriation,” observes Stephen Amdur, a partner at Pillsbury Winthrop Shaw Pittman LLP. “While the implications of the influx of cash into US corporates are still developing, we are already seeing an increase in dividends and share buybacks, and we expect an increase in US mergers & acquisitions (M&A) to follow. The cash infusion may prove irresistible to M&A teams that now have access to funds that were previously tied up overseas.”
Duly signed into law on 22 December 2017, the TCJA has dramatically altered the US tax landscape and has numerous beneficiaries, the US M&A industry among them. Indeed, some commentators foresee the tax reforms facilitating a record US deal count in 2018-2019.
“The US tax reform enactment has the potential to support an uptick in US M&A activity,” says Patrik Kerler, head of M&A at KPMG Switzerland. “A key driver is that before reform, many US multinational corporations held significant earnings – estimated in the billions of dollars – that have effectively been trapped offshore due to the incremental US tax that would be paid if and when the earnings were repatriated to the US. With the new mandatory repatriation provisions, US multinational corporations will repatriate cash back to the US and use it, in part, to fund acquisitions.”
In the view of Jonathan L. Corsico, a corporate partner at Gibson, Dunn & Crutcher LLP, there is no question that the tax reforms will lead to an increase in M&A, with more cash available and company valuations positively impacted. “Many companies have additional cash reserves in their arsenal if they want to buy and many companies are now worth more if they want to sell,” he explains. “It is a positive mix for the M&A market.”
Resoundingly negative was the impact of the previously imposed 35 percent corporate tax rate on the disposition of assets. “Corporates had structured around this burdensome tax by pursuing tax-free options such as spin-offs, split-ups and the like,” recalls Steven Einstein, vice chairman of Equiteq. “M&A activity was generally stifled by the high tax cost that had been imposed prior to the newly-enacted legislation. By virtue of lowering this tax penalty to 21 percent, the markets are poised to experience a resurgence of M&A divestiture activity.”
If so, this resurgent activity may then morph into something more, with some quarters suggesting an M&A binge is on the way. However, these predictions may be premature. “I am not sure if there is going to be an M&A binge, but there will certainly be additional deals on the table that were not previously attractive,” suggests Mr Corsico. “Tax reform creates opportunities that did not exist before.”
Structure and finance issues
The TCJA will undoubtedly have a major impact on how M&A transactions are structured and financed in the months and years ahead. Two provisions of the new tax law – the ability to expense the cost of tangible property and the limitation on the deductibility of business interest – are particularly relevant, according to Stanley S. Jutkowitz, senior counsel at Seyfarth Shaw LLP.
“The ability to expense the cost of tangible property – including both new and used property – as well as computer software, will mitigate in favour of asset acquisitions rather than stock acquisitions, especially in situations where a buyer can obtain a step-up in basis of a target’s assets,” explains Mr Jutkowitz. “Under the tax law, for the next three years deductions for business interest will be limited to 30 percent of earnings before interest, tax, depreciation and amortisation (EBITDA). This means buyers will have to calibrate the amount of debt used in M&A transactions to fall within this limit. This, in turn, may result in more use of preferred equity than, for example, subordinated debt.”
In terms of M&A transactions involving multinational corporations, significant structural and financial changes are pretty much inevitable. “Previously, many multinational corporations took great pains to structure their operations so that earnings were realised in non-US, meaning lower tax, jurisdictions,” says Mr Corsico. “The gains to be had from this type of structuring were sometimes so great that it drove M&A. However, with tax reform, it is now more difficult to achieve tax benefits from this type of structuring activity. Similarly, deals that were previously attractive because of their ability to shift earnings abroad are now less attractive.”
Others take the view that the TCJA has many far-reaching implications for transaction structuring that are not yet fully understood. “There may be increased attractiveness of cash transactions for buyers as a result of greater cash availability, from repatriation, and enhanced deductibility for the purchase price paid for certain asset acquisitions,” suggests Stephen Arcano, a partner at Skadden, Arps, Slate, Meagher & Flom LLP. “At the same time, we expect that transaction structure and form of consideration will continue to be driven by the perceived desirability by the parties of cash vs. stock as consideration, and the relative cost and benefit calculus comparing the differing impact on benefits to sellers and buyers.”
Sectors and industries
With some of the offshore cash repatriated by US companies earmarked toward growing their businesses through strategic M&A, a number of sectors and industries are set to benefit from the injection of capital.
“A large portion of the cash reserves held offshore by US companies is attributable to companies in the pharmaceuticals and technology sectors, and this additional liquidity may fuel additional activity in those sectors,” points out Thomas W. Greenberg, a partner at Skadden, Arps, Slate, Meagher & Flom LLP. “M&A in the industrial sector may benefit from the provisions of the TCJA allowing acquirers to immediately depreciate 100 percent of the cost of acquired tangible personal property assets. In addition, businesses with large US-based revenues may become more attractive given the lower income tax rates.”
For the life sciences sector, the corporate tax rate reduction may affect the number of tax inversion deals. “It is quite possible that we will see more M&A activity in sectors which have seen a number of tax inversion deals attempted in recent years, for example when Pfizer attempted to buy Allergan in late 2015 for $183.7bn,” suggests Elizabeth Lim, Americas research editor and senior analyst at Mergermarket. “With the corporate tax rate significantly reduced, this would for the most part discourage such inversion deals from taking place, which was part of the reason for the tax reforms in the first place,” she adds.
Another sector to keep an eye on is energy. “The energy industry pays some of the highest rates of tax, so the cut in the corporate tax rate will make companies in this space more attractive targets,” says Andrew J. Sherman, a partner at Seyfarth Shaw LLP. “A more important factor is the ability to expense the cost of tangible personal property. The energy sector is incredibly capital intensive, so this new write off will allow the sector to make capital expenditures at a lower cost.”
“The reforms affect all sectors and industries so every company will need to re-evaluate their M&A strategies, investment decisions and supply chains in light of the tax reforms,” says Mr Kerler. “That said, companies in certain industries, such as life sciences and technology, represent a significant amount of the offshore earnings that are deemed repatriated and can now be funneled toward deals.”
Another intriguing aspect of the tax reforms is the extent to which they could make US businesses and assets targets for non-US acquirers. With a lower corporate tax rate set to increase the value of many US companies, the case for non-US acquirer interest is persuasive.
According to Mr Arcano, US-based businesses may become more attractive to non-US acquirers as a result of lower US corporate tax rates. “However, the TCJA includes several provisions that will likely increase the burdens on non-US headed multinational corporate groups investing in the US,” he explains. “These include base erosion anti-avoidance tax (BEAT) rules limiting the benefits of paying interest and royalties to offshore affiliates, as well as significantly expanded controlled foreign corporation (CFC) rules that make it more difficult to engage in post-acquisition integration planning involving the US target’s non-US subsidiaries.”
However, Mr Jutkowitz suggests that all that glitters is not gold. “Potential buyers have to look carefully,” he advises. “There are numerous pitfalls in the new tax laws that could mitigate the positive impact of a lower tax rate and both domestic and international efforts to avoid shifting of income from higher to lower tax jurisdictions.”
Transitioning with caveats
Although the text of the TCJA is likely to be modified by the Department of the Treasury (USDT) and the Internal Revenue Service (IRS) over the coming months, for the moment, M&A practitioners appear to be adapting fairly comfortably to the new regime, albeit with caveats.
“This is the most significant change in US tax since 1986,” asserts Mr Kerler. “While one of the articulated goals of the tax legislation was simplification, as it relates to multinational businesses the rules have become more complicated. M&A professionals in the deal space need to educate themselves on the provisions and recognise that everything – deal models, structures, financing, integration planning and more – all need to be revisited in this new environment.”
Given their complexity, M&A dealmakers would also do well to engage with advisers and regulators at an early stage when factoring the tax reforms into their transaction plans and execution. “The tax package was complicated and it will take time for even tax professionals to get a full picture of all its repercussions,” says Ms Lim. “Further, with increased competition on the horizon for high-value assets, it behoves dealmakers to do their homework as early and as thoroughly as possible to eliminate potential issues further down the road.”
Clearly, for many M&A professionals, the transition to the TCJA regime is very much a case of out with the old, in with the new. “The changes to the tax laws should cause M&A professionals to leave the old playbook on the shelf and look at potential deals with a fresh set of eyes to find the best opportunities, and to determine how best to maximise advantages and minimise detriments of the new tax regime,” says Mr Sherman.
“The complexity and extensive scope of the recently enacted US tax legislation will be studied by legal, accounting, private equity and investment banking professionals for some time to come,” adds Mr Einstein. “In light of these changes, it is imperative that deal professionals become wholly conversant with the legislation so that they can optimally address the new M&A opportunities the legislation presents.”
In the months since its enactment, the TCJA has generally been met with an enthusiastic response. And while it may not lead to an M&A binge, the legislation, in conjunction with rising confidence beget by a strong US economy, has laid the groundwork for dealmakers to cut themselves a hefty slice of the M&A action to come.
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