How Will the New Tax Law Affect M&A?

After months of protracted wrangling, Congress delivered major tax reform with the passage of the “Tax Cuts and Jobs Act” (“Act”). Effective at the start of 2018, the Act includes tax breaks for individuals, as well as a massive tax cut for corporations and qualifying pass-through entities.

There are always plenty of business and financial reasons for companies to be bought, sold, or reorganized.   Though the changes to the tax code do not cause mergers and acquisitions, when taxes are reduced, companies, business owners, and investors keep more of their earned income and profits. Thus, with more after-tax dollars to spend, buyers are more likely to deploy capital. Likewise, as the tax on certain sellers is reduced, those sellers have greater incentive to sell. With that in mind, here’s a look at how some of the new rules under the Act may impact the M&A landscape.

The Good News

How to Spend the Tax Cuts: Employee Raises or Corporate Acquisitions?  The Act’s greatest boon for corporations was the reduction of corporate tax rates from 35% to 21%. Prior to the enactment of the bill, the financial press was rife with stories speculating that the corporate tax “savings” would be devoted to stock buy-backs and corporate acquisitions. However, shortly after the tax break was announced, several corporations announced raises or bonuses for workers.

Despite these high-profile reports of benefits to employees, it is still likely that the tax cuts will spur more corporate acquisitions by using a substantial portion of their tax savings.

The tax cuts were not limited to C Corporations. The Act provides a 20% tax deduction on individual business owners of qualifying pass-through entities (including S corporations, limited liability companies and partnerships).  The deduction cannot exceed the greater of: (i) 50% of wages of the business, or (ii) 25% of wages plus 2.5% of the original cost of certain depreciable assets. This deduction phases out for owners of pass-through entities in certain services businesses such as accountants and lawyers. Questions remain about who will qualify for the pass-through entity deduction. Exploring those questions is beyond the scope of this article. Suffice it to say, pass-through companies that qualify for the deduction will have more after-tax dollars available for future acquisitions.

Lower Tax on Sales of Corporate Subsidiaries. Unlike individuals, corporations do not have a rate differential between capital gains and ordinary income. By reducing top corporate rates from 35% to 21%, corporations will face lower tax on the disposition of subsidiaries, divisions, or assets.  The corporate rate reduction may facilitate more corporate liquidations because the tax cuts increase the after-tax proceeds from such dispositions.

Repatriation of Offshore Funds.  Prior to the Act, U.S. businesses were taxed on their worldwide income. As a result, multinational corporations developed elaborate corporate structures to defer or avoid U.S. taxation.  Some companies went so far as to re-domicile their worldwide headquarters so that their parent company was no longer a U.S. resident company. The Act moves toward a “territorial system” where U.S. companies will be taxed on their U.S.-source income only. To transition to this new model, U.S. corporations will be taxed at 15.5% on cash holdings repatriated from foreign holdings to the United States, and 8% of earnings held offshore in illiquid assets. This repatriation tax compares to the 35% rate that would have previously applied. As further “incentive” to actually repatriate the dollars, the U.S. corporations will be deemed to repatriate the tax over a period of up to eight years, whether or not the taxpayer returns capital to the United States. It is anticipated that some $2-3 trillion dollars will be returned to the United States as a result. With more capital state-side, multinational strategic buyers are likely to make capital investments in and strategic acquisitions of domestic companies.

Expensing of Acquired Capital Assets. The Act allows the immediate 100% write-off of the cost of depreciable capital assets, including depreciable assets acquired from a third party.  The ability to immediately deduct the purchase price allocated to capital equipment will encourage acquisitions of capital-intensive businesses to be structured as asset purchases rather than stock purchases. On balance, expensing of capital assets should stimulate more acquisition activity.

The Bad News (Which Isn’t All that Bad)

Interest Deductibility.  The Act limits business interest deductions to 30% of the taxpayer’s EBITDA. The cap on interest expense deductions is unwelcome news for mezzanine lenders, could hamper leveraged buyouts, and will limit the financing options for buyers and sellers.

Carried Interest Rules. After much ballyhoo about ending the carried interest “loop hole”, the Act now requires a carried interest to be held for three years to qualify for long term capital gain rates. Gains from disposing of carried interests that do not qualify for a long-term capital gain will be taxed at short term capital gain rates. The longer holding period requirement will have a direct impact on hedge funds which tend to have short hold periods. However, most private equity investments are held for 3-5 years, if not longer. As a result, the longer holding period may not have much impact on traditional private equity investors.

All things being equal…

All signs point to the Act stimulating M&A activity.  Thanks to tax “savings”, strategic buyers and multinational corporations will have more available cash to utilize on acquisitions.  Private equity firms may experience more competition from strategic buyers chasing deals. However, PE-backed companies will benefit from the corporate tax cuts too as tax savings will flow to the private equity investors.

 

Doug McCullough, Partner | McCullough Sudan PLLC | mccullough@dealfirm.com

Spread the word. Share this post!