On September 27, 2017, the White House and Republican congressional leadership released a nine-page outline (the Framework) summarizing the current legislative effort on comprehensive tax reform. The Framework offers few surprises and leaves critical details open, but it is likely to be the starting point as Congress addresses federal tax reform issues in the coming months. It remains to be seen which provisions proposed in the Framework will actually become new law and in what form they will be adopted. Regardless, adoption of several of the key provisions, like a corporate tax rate cut, will have a significant impact on M&A activity. In addition, there are also many less obvious provisions that may indirectly, but powerfully, affect the M&A market if adopted. This memorandum outlines some of the key areas with which the M&A market will be particularly concerned.
Corporate Rate Cut and Individual Rate Cut
A reduction in the corporate income tax rate is expected to have a positive impact on M&A activity. Lower tax rates will induce many corporations that were worried about a high tax bill to be more willing to sell assets or subsidiaries to a prospective buyer. Lower tax rates for corporations may also make corporations more useful as an acquisition vehicle, as compared to partnerships or LLCs, depending on how the pass-through tax rate changes are finalized, as discussed below.
Lower individual rates may also spark additional M&A activity, particularly for individual sellers of LLCs or S corporations. Finally, the potential consideration of measures to reduce the double taxation of corporate earnings (an area of particular interest to Senate Finance Committee Chairman Orrin Hatch, who has been developing a corporate integration proposal) could further reduce corporate tax burdens and increase corporate M&A activity.
However, we note that until an actual rate cut is passed, M&A activity may be chilled in the short term because parties will be hesitant to trigger a tax bill today that could be lower tomorrow if they wait.
The current proposal contains unspecified limits on deductions for net interest expense. Debt plays a large role in M&A transactions and the loss of interest deductions would make companies think differently about how they structure M&A. This proposal would especially impact M&A structuring in the private equity sector where leverage is critical to any acquisition transaction. Restricting interest deductions also could make acquisitions of US companies by foreign buyers somewhat less attractive because of a reduced ability to leverage (either with third-party debt or intercompany debt) the US target. Interestingly, the current proposal only applies limitations to C Corporations, with the applicability of such limitations to non-corporate taxpayers remaining subject to further consideration. Any difference in such treatment between corporations and partnerships may drive decision making regarding the type of ownership structures used in M&A. Further, unlike the immediate expensing provisions (described below), nondeductible interest may result in an increase in a C corporation’s effective tax rate for financial statement reporting purposes as the nondeductible interest expense is permanently denied. Finally, it is interesting to note that some taxpayers might favor incurring debt prior to the passage of any tax reform in case existing debt is “grandfathered” thus preserving interest deductibility.
Immediate Expensing of Capital Expenditures
The Framework contemplates full deductions for the cost of certain capital expenses by businesses made after September 27, 2017, for a five-year period. The change to expensing of capital investments will impact the economics of M&A, particularly if the treatment is extended to goodwill and other intangible assets. The effect of this change will likely be greatest for privately held companies, as public companies may be more likely to view full expensing as providing only a timing, and not a permanent financial statement, impact.
Pass-Through Tax Rate
The pass-through tax rate (sole proprietorships and entities treated as S Corporations or partnerships) would be reduced to 25 percent, with unspecified restrictions to limit use of the pass-through rate to avoid the top individual rate. Many companies in the private equity and healthcare areas purchase interests in small and family owned businesses and these changes could lead to very different results for such businesses than the current treatment. It is not clear from the Framework whether sellers of pass-throughs would be able to avail themselves of the lower pass-through tax rate on ordinary (as opposed to capital) gain recognized on the disposition of a business, or instead whether the higher individual rates would apply in this scenario.
The proposal does not include any mention of changes to the taxation of carried interest, which is of particular interest to private equity and other investment funds. Some politicians have intimated that any new legislation should include some carried interest changes. Whether it is added to the current proposal remains to be seen, but this may be dependent on the desire or need for bipartisan support and whether carried interest provisions would be viewed as raising a material amount of revenue as part of the overall package.
The Framework would exempt from tax 100 percent of dividends received from foreign subsidiaries, defined as being companies in which a US parent owns at least 10 percent of the stock (Territorial System). In order to protect the US tax base, the Territorial System would be backstopped by an unspecified reduced tax rate on foreign profits of US multinationals. There would be a transition tax (to be paid over a several year period) on currently accumulated foreign earnings under a deemed-repatriation model, employing a bifurcated rate (higher rate for earnings considered as held in the form of cash or cash equivalents), with rates and other details unspecified. M&A deals are often structured with tax-efficient repatriation or integration in mind; changes to our international tax system (e.g., territorial) could drastically change how parties structure transactions or integrations. The parties will have to change how they typically deal with cash trapped in foreign subsidiaries. In addition, companies may desire that targets restructure themselves to take advantage of the new treatment of foreign subsidiaries under a territorial system. Careful planning may be required for foreign subsidiary earnings that could potentially be subject to the reduced tax rate. It is important to note that changes in the rules regarding foreign earnings will likely impact the collateral packages when financing transactions and may affect pricing. Finally, many companies consider the cost of repatriating cash to the United States (e.g., to be used for stock buybacks or for other corporate purposes) when considering a disposition of foreign operations; making repatriation of cash tax-free for US tax purposes may make currently cost-prohibitive dispositions more likely to occur.
Observations and Likely Next Steps
The Framework is a very high-level outline with few details. Further, it can be expected that the political process will result in many changes before final legislation is enacted and, indeed, it is possible that, in the current political climate, no significant tax reform legislation will be adopted. The congressional tax-writing committees will be working hard during the coming weeks (and possibly months) in developing detailed legislative language to implement the Framework’s high-level concepts. Reports indicate that the House Ways and Means Committee plans to mark-up tax reform legislation by the end of October, with the goal of passage of a tax reform bill in mid-November, followed by approval by the Senate, and the hope of signing final legislation by year-end—though this timing is both aggressive and non-binding. As the details are filled in, hard choices will have to be made in order to fit a tax reform package within any realistic budget parameters, and many technical, timing and transitional issues will have to be addressed.
McDermott’s Corporate and Tax teams are closely monitoring activity in this area and are advising clients on potential impacts and planning responses. We will continue to provide general tax reform updates as circumstances warrant as well as more detailed examinations of specific aspects of tax reform.