Capturing the tax value in M&A transactions: The first 90 days—and beyond

Most middle market private equity and strategic investors understand that tax due diligence, structuring and advisory are crucial to identifying opportunities and protecting against risk in a business transaction. Significant time is often spent by the deal team and advisors in negotiating and papering key tax-related deal terms. However, getting to the closing of an acquisition is just the beginning.

The same is true of buy-side tax considerations. Failure to engage proper advice, fulfill obligations and execute with respect to taxes can have meaningful economic consequences. So how can buyers ensure they realize the benefits for which they have negotiated?

While not an all-inclusive checklist, the following are some areas in which buyers often need to consider taxes:

Final closing statement

In middle market M&A deals, a your-watch, my-watch construct is commonly used with respect to income taxes. Generally, this means a seller will be economically responsible for income taxes attributable to pre-closing activities, and the buyer is responsible for income taxes attributable to post-closing activities.

While the mechanisms through which this concept is implemented vary, deals are often negotiated so that sellers bear the economics of pre-closing income taxes through inclusion in indebtedness, with no additional adjustments after the final closing statement is agreed to. Put another way, the final closing statement is the buyer’s final proverbial bite of the apple for making sure the seller bears the cost of pre-closing income taxes.

In a typical transaction, the final closing statement is due 60 to 120 days after closing. In our experience, the tax component of indebtedness can sometimes be an afterthought, as the focus is on financial accounting. While in some instances the income tax accrual can be straightforward, in many circumstances meaningful work may need to be done to determine a proper accrual.

Key questions and issues requiring careful review and analysis may include:

• Does the income tax accrual need to be calculated and reviewed for multiple periods? Depending on when a transaction closes relative to tax filing dates, there may be more than one tax year for which final calculations and return filings need to be made.
• Are all the correct state and local jurisdictions included in the accrual? While a purchase agreement will often place some restrictions around the inclusion of new jurisdictions, it should be considered whether changes to the company’s nexus footprint require additional filings. A buyer should also make sure state and local calculations are being made with an appropriate level of detail.
• If the company is utilizing net operating losses in the accrual calculation, has the appropriate analysis and documentation under section 382 been performed?
• Have transaction expense deductions, including compensatory payments, been properly analyzed for deductibility and the timing of same?
• If the company has non-U.S. operations and filing obligations, have those items been properly considered in the accrual?
• Some items may be included in a tax accrual for purposes of indebtedness that don’t actually appear on a pre-closing tax return. Common examples are the tax impact of pre-closing deferred revenue, and an imputed global intangible low-taxed income (GILTI) amount on pre-closing controlled foreign corporation earnings.

The issues that need to be addressed in order to properly calculate taxes in indebtedness can be complex, and require lead time to address. It is important to involve professionals with the requisite expertise well before the delivery of the statement to the seller counterparties. Company management may lack the expertise to handle these calculations, and may have close relationships with sellers or be sellers themselves. The company’s existing tax provider may similarly lack sophistication, or otherwise have relationships that may color the positions they take.

Other mechanisms for payment of pre-closing taxes

In many middle market M&A transactions, there are other mechanisms for seller payment of pre-closing taxes, other than inclusion in indebtedness. They may include an obligation to pay the taxes as returns are filed, tax indemnification, and recourse to representations and warranties insurance.

Still, in these instances, buyers should seek to make sure an appropriate accrual for income taxes is included in closing indebtedness. Doing so ensures that items covered by inclusion in indebtedness, and not in the other mechanisms, are captured (overlap may not be one-to-one). Also, that takes some pressure off chasing sellers for payments post-closing. The latter is especially important if the buyer does not have access to escrowed funds and has concerns about the seller’s creditworthiness.

Voluntary disclosures

While performing tax due diligence, buyers frequently uncover historical state income tax and sales and use tax liabilities. A common way to resolve these issues and put the company in compliance is through voluntary disclosure agreements (VDAs). Though the process may vary, a VDA typically involves approaching a state to register for the tax, file returns, and pay back taxes and interest for a specified period.

An informed buyer often will want to negotiate the ability to file VDAs post-closing, as well as the seller’s responsibility for funding the pre-closing tax liabilities associated with the same. The seller’s economic responsibility may be structured in various ways, including an up-front reduction to purchase price via inclusion in indebtedness, or as an indemnification obligation (potentially accompanied by escrowed funds). When negotiating the amount of exposure, buyers should also be mindful of the advisor costs to prepare, submit and see VDAs through to resolution.

From a seller’s perspective, a VDA may be agreeable in that it can help:

• Put a limit on potential historical exposure by limiting the look-back period
• Potentially reduce penalties and interest

Where a buyer plans to file VDAs post-closing, it is advisable to begin the process as soon as possible, for several reasons:

• Delays in initiating the process can cause tax liabilities to continue to compound. Such liabilities may fall outside the scope of negotiated seller responsibility.

• Indemnification provisions often have a limited survival period, and escrowed funds will have a release date. VDAs can take a significant amount of time to complete (e.g., between six months to more than a year) depending on the responsiveness of a state’s revenue department. It is critical to have matters settled in advance of the related escrow release.

• Sellers may negotiate participation rights in the VDA process. This can cause the process to drag out further as it creates another layer of review discussion. 

It should also be noted that not all liabilities are eligible for VDA treatment, so careful consideration in both negotiating the purchase agreement and taking action post-closing is critical.

Several states have provisions limiting the applicability of a VDA if, for example, a taxpayer once paid the tax at issue and then stopped paying such tax, or if a taxpayer previously faced an audit by the state. In addition, certain states (e.g., Ohio with respect to its Commercial Activity Tax) have imposed greater burdens on private equity groups that may own other businesses with in-state operations that need to be included in a VDA, increasing both the exposure subject to VDA liability as well as professional costs to administer such process.

Purchase price allocations

Depending on the tax structure of the transaction, a purchase price allocation (PPA) may be required for tax purposes. While PPAs are required for all true acquisitions of assets, they are also required for certain equity acquisitions, including (but not limited to) the acquisition of LLC units when the target is disregarded for tax purposes, the acquisition of partnership interests with certain tax elections in place, and the acquisition of stock where a section 336 or 338 election is made.

While not required, it is very common for a buyer and seller to agree to an allocation of purchase price in the purchase agreement. In such cases, the purchase agreement will assign one party the responsibility of preparing the PPA and providing it to the other party for their review.

It is crucial for buyers to understand their responsibilities under the purchase agreement and the requisite due dates. In our experience, the initial draft of the PPA is required to be prepared and shared with the other party between 30 and 120 days following closing, depending on the specifics of the transaction and the negotiations of buyer and seller.

It is important to note that the tax PPA is different than the opening balance sheet work and/or purchase accounting that may be required for financial reporting purposes. While conceptually similar, the tax rules are different from generally accepted accounting principles (GAAP), sometimes significantly so, and the tax PPA is nearly always different than the allocation done under Accounting Standards Codification 805.

We have seen buyers mistakenly conflate the two and attempt to use the GAAP purchase accounting to satisfy the tax PPA obligation. This can lead to delays and inaccurate tax returns, and may even mean the contractual deadlines outlined in the purchase agreement are missed.

In most cases, a buyer and seller have conflicting interests when it comes to the tax PPA (i.e., a favorable allocation for the seller would be detrimental to the buyer, and vice versa). Therefore, it is critical that buyers understand their responsibilities with respect to the tax PPA and are ready to prepare and/or review the tax PPA at the appropriate time. Being unprepared could lead to being in breach of contract or allowing the other party to control the allocation.

Pre-closing and straddle tax return review

The rights and responsibilities for the preparation and review of tax returns are often addressed in the purchase agreement. Understanding who is responsible for the preparation of returns, what rights a buyer has with respect to seller-prepared returns (or vice versa), and the relevant due dates are critical.

Often, when sellers are provided a broad indemnification for pre-closing taxes, sellers will control the preparation of pre-closing tax returns. However, even in instances when buyers have a strong indemnification for pre-closing taxes and are comfortable in their ability to collect on the same if triggered, tax returns for pre-closing periods can still have an impact on post-closing tax positions.

One such example is tax accounting methods. If a target company is employing an incorrect method of accounting for an item (such as revenue or expense recognition), this accounting method will typically persist until the company files for an accounting method change with the IRS.

For example, if before closing the company has been recognizing an item of expense earlier than permitted by tax law, fixing this issue by filing an accounting method after closing will result in relatively higher taxable income (and tax) post-closing as a result of the section 481(a) adjustment. Tax liability would have effectively shifted from the pre-closing period to the post-closing period, and it may not be covered by a standard your-watch, my-watch construct unless specifically negotiated.

If an item like this is identified in due diligence, a buyer may negotiate a requirement that the target company files for an accounting method change effective in a pre-closing period, along with an election to accelerate any unfavorable adjustment into the pre-closing period. In these instances, the buyer should also negotiate control over the preparation and filing of the election, or, at a minimum, strong review rights for ample time and opportunity to make sure the election is being properly made. Even so, it will be critical to monitor progress so that disputes can be resolved well in advance of the filing deadline.

Other items on pre-closing returns that can affect post-closing periods include elections and the impact of tax positions on tax basis going forward. Additionally, even if there are no future impacts and pre-closing taxes are fully indemnified, aggressive or incorrect positions taken by the company can create ASC 740 impacts to financial statements and create a significant amount of time and effort to explain or rectify later.

Technology, process and integration

The closing of a transaction can be a good time to evaluate the company’s practices and procedures around taxes. For example, the buyer may consider replacing the incumbent tax provider, simplifying the legal entity structure, implementing a technology solution for sales taxes, assessing the company’s ability to generate timely information for tax reporting, and more. A buy-side transaction advisor likely has insight on these types of items that can be leveraged.

For add-on transactions, understanding how the company’s tax function fits into that of the platform, and what is redundant, is important. Finally, for financial sponsors the new investment should be understood with respect to its impact on fund level and limited partner tax reporting.

Working together

A buy-side transaction advisor should use the knowledge gained in due diligence and purchase agreement negotiation to help their client understand the key action items and milestones rolling into the preparation of the closing statement and beyond. For the buyer, it is important to engage on these items early, understand how they fit into broader context, and provide their advisor the opportunity and support advisors need to deliver their full value.

In instances when it is expected the incumbent tax provider for the target will be replaced, it is important that a new firm be introduced and integrated early on. Alternatively, if the incumbent is retained, other advisors assisting with post-closing work should be introduced and integrated as soon as possible in order to clarify roles and responsibilities, and make sure action items are timely met.

Buyers often may be focused on opening balance sheet, auditor selection, and other finance and operational matters. Ignoring tax in the near-term post-closing can compound issues and cause unexpected value erosion.

Ultimately, making sure the tax value and risk mitigation negotiated for in the purchase agreement is a shared responsibility between client and advisors. Only through proactively working together can a positive outcome be secured.