From the IFRS Institute - May 31, 2018
Lower tax rates and cash repatriation are designed to significantly increase liquidity levels in the United States and provide additional flexibility for companies to engage in M&A transactions. New tax rules, such as the 100 percent bonus tax depreciation on capex, may encourage structuring investments in new ways to take advantage of the deductions. Meanwhile, companies have recomputed their current and deferred tax positions and revised their tax planning forecasting models and strategies for the new tax rules.
All of this may affect how investors approach target valuations and engage in due diligence work. Acquirers reporting under IFRS need to carefully assess each aspect of the tax law changes, and grasp new accounting complexities arising from the tax treatment of M&A transactions compared with IFRS.
H.R. 1, previously known as the Tax Cuts and Jobs Act (the Act), was enacted on December 22, 2017. In just the last few months, the Act has had a significant effect on the amount, type, structure and modeling of M&A transactions. M&A activity announced by US acquirers in the first two months of 2018 was at the highest dollar volume since the first two months of 2000, reported to the Wall Street Journal1. According to Phil Cioffi, US national leader for KPMG’s M&A tax practice, “the administration’s focus on deregulation, coupled with the new tax laws, and healthy growth rates indicate that M&A activity will remain robust in the near future.”
Changing M&A landscape and forthcoming new accounting rules
The Act includes numerous changes that will significantly impact M&A activity. The centerpiece of the new law is the permanent reduction in the corporate income tax rate from 35 percent to 21 percent. This is expected to position the United States as a more attractive jurisdiction for inbound M&A activity and may also increase the value of US-domiciled businesses.
The Act also taxes historical tax-deferred offshore earnings at reduced rates and generally allows future offshore earnings to be repatriated free of US federal income tax. This may increase the amount of corporate cash available for M&A transactions.
Last, many international provisions of the Act may cause companies to reevaluate their overseas holdings, supply chain arrangements, and arrangements with foreign affiliates. As part of this strategic evaluation, companies may decide not only to reorganize parts of their businesses, but also to consider both acquisitions and disposals to optimize their global competitiveness.
Meanwhile, asset acquisition and business combination accounting remain largely unchanged under IFRS. However, the IASB has been rethinking its definition of a business and is expected to issue revised guidance soon, not identical to but along the same lines as the amendments issued by the FASB in 20172. In addition, the IASB is considering the accounting for transactions under common control and a discussion paper (the first step in the process) is expected in 2019. The new definition of a business in particular could mean that fewer transactions are business acquisitions under IFRS. It may involve new judgments in an area that has long been challenging, in particular for sectors such as pharmaceuticals, technology and real estate.
More deals and new structures and financing coupled with changes in tax law and accounting rules create a challenging environment for IFRS preparers. Here we summarize the provisions of the Act most significant to M&A activities, as well as some of the relevant accounting considerations.
Sell vs. spin
Prior to the Act, gains on the sale of a business or business assets were taxed at 35 percent (plus any state and local taxes) for corporations. Therefore, many preferred structuring deals as tax-free transactions, such as spinoffs3, to achieve their goal of separating business lines. The Act reduces the corporate tax rate to 21 percent, which may encourage corporations to sell, rather than spin off, unwanted businesses and raise cash. In addition, corporations have the ability to immediately deduct certain capital expenditures for tax purposes (see below). Gains on the sale of assets can therefore potentially be offset with current deductions, thereby creating new M&A opportunities.
A change in intent may have accounting implications for the classification, presentation and measurement of any noncurrent assets or disposal groups held for sale in accordance with IFRS 54.
Capex expensing – 100 percent ‘bonus’ tax depreciation
The Act allows taxpayers to immediately deduct 100 percent of the cost of tangible property that would otherwise have a tax depreciable life of 20 years or less. This generally includes most machines, automobiles, trucks, airplanes, power plants, pipelines, cell towers and utility and telecommunication network equipment.
Under previous law, only the taxpayer that originally placed the property into service (generally the first owner) was eligible for the bonus tax depreciation (the ‘original use’ requirement). The Act expands bonus-eligible assets to include both original use assets and certain used assets that are acquired by purchase from an unrelated party (as defined under tax law).
|The 100 percent bonus tax depreciation applies to assets acquired and placed in service from September 28, 2017 until December 31, 2022. Beginning in 2023, the bonus depreciation percentage decreases annually by 20 percent until it is eliminated in 2027. This provision can significantly increase the tax benefit of purchasing rather than leasing certain assets.|
The bonus tax depreciation is not limited to asset deals, but also applies to stock deals subject to a Section 338(h)(10) election, making this election more attractive to buyers.
|The Section 338(h)(10) election, also available under prior tax law, allows the parties to treat the purchase and sale of the stock of a target corporation as a deemed asset sale under certain conditions. In this case, the 100 percent bonus tax depreciation is unavailable for goodwill and other intangible assets, which remain amortizable on a straight-line basis over 15 years for tax purposes.|
Therefore, while the acquisition may qualify as a business combination for accounting purposes under IFRS 35, the involved parties can treat the transaction as an asset purchase and sale for tax income purposes. This accounting treatment may be different from the tax treatment, creating the need to account for deferred taxes. For example, the buyer may initially calculate the tax and accounting goodwill differently because of the treatment of acquisition costs. The tax and accounting will also likely evolve differently. This is because tax goodwill is systematically amortized for tax purposes while the accounting goodwill is only tested for impairment. The reverse situation may also arise, where the acquisition does not qualify as a business combination for accounting purposes. In that case, no accounting goodwill is recognized irrespective of the tax treatment.
Basis differences may exist at the acquisition date between the tax and book value of the assets acquired and liabilities assumed; however, those differences generally are exempt from deferred tax recognition.
Limitations on the deductibility of interest
Section 163(j) of the Act limits the ability of a borrower to deduct net interest expense in excess of 30 percent of ‘adjusted taxable income’.
|Adjusted taxable income is generally defined as taxable income with interest, depreciation and amortization added back (i.e. similar to EBITDA). After 2021, only interest will be added back to the definition of adjusted taxable income (i.e. similar to EBIT). Adjusted taxable income is based on taxable income, not GAAP, IFRS or book income, and therefore for this purpose EBITDA and EBIT are tax, not GAAP or IFRS numbers.|
Disallowed interest expense is carried forward indefinitely and may be used in future years to the extent that net interest expense does not exceed 30 percent of adjusted taxable income. However, such carryforwards are potentially subject to limitation if there is an ownership change.
The interest expense limitation may create additional deferred tax assets that will need to be assessed for recoverability under IAS 126 The limits might restrict a company’s ability to recognize deferred tax assets for interest deductions carried forward from previous periods.
It is also expected that the new interest deduction limitation could provide incentives for many companies to raise capital through means other than debt – e.g. through leases, derivatives or equity issuances. It could also impact leveraged buyouts, both future deals and deals that already have closed. Further, the effect may be felt more at companies with higher leverage levels, or if interest rates rise. It may also lead companies to shift debt to non-US jurisdictions to maintain interest deductibility on a global basis.
From an accounting perspective, modifications to existing debt agreements typically create issues over whether or when it is appropriate to derecognize the financial liability and how to account for past and new debt issuance costs under IFRS 97 Previous debt versus equity classification assessments may also need to be revised under IAS 328.
Other key changes with potential accounting impact
The Act includes a number of additional key provisions that affect the income tax positions of potential targets – e.g. NOL (net operating loss) limitations, AMT (alternative minimum tax) credits, deemed repatriation tax liability. This will potentially affect M&A valuations, negotiations of reimbursement rights, and consequently the accounting allocation of the transaction price to the identifiable assets acquired and liabilities assumed.
On a go-forward basis, it is crucial that acquirers analyze and quantify a target’s tax assets and liabilities and further tax exposures, as part of their standard procedures of tax structuring and diligence. Anyone acquiring US corporations with foreign subsidiaries should be mindful of the target’s potentially significant US deferred tax liability, payment of which may be accelerated in connection with post-acquisition integration transactions.
Read more in KPMG’s analysis, The new tax legislation: Impact on M&A.
1 Tax Cuts Fuel Biggest Merger Spree Since 2000, The Wall Street Journal, March 6, 2018
2 Read more about the FASB’s amendments in KPMG’s Issues In-Depth
3 A spinoff (or demerger) occurs when a parent distributes its ownership interest in a subsidiary and loses control as a result
4 IFRS 5, Non-current Assets Held for Sale and Discontinued Operations
5 IFRS 3, Business Combinations
6 IAS 12, Income Taxes
7 IFRS 9, Financial Instruments
8 IAS 32, Financial Instruments: Presentation