2013 - Issue 18—With the private equity world's focus on cash flow and EBITDA, the lens through which portfolio companies are viewed from both a business and operations perspective provides some insight into tax-related matters that are of particular significance and importance to portfolio companies throughout their investment lifecycle. In this week's edition of Tax Advisor Weekly, we consider some key initial post-acquisition tax-related matters, as well as some that are presented later in the investment cycle.
As we discuss many of these tax issues, one thing that becomes evident is the importance of engaging an ongoing tax advisor who can provide both sophisticated and cost-effective tax compliance, reporting and planning services.
Initial Portfolio Company Post-Acquisition Period
A portfolio company's post-acquisition period is often one of considerable change, including changes in company leadership and management oversight, strategy, revenue and cost management, and plans for growth and expansion. But this period frequently also presents new and complex tax and tax accounting issues.
The ability to identify tax savings and tax efficiencies can have a meaningful impact on the value of the business, something that can assist the company not only in achieving its growth goals but also in achieving a desirable exit for the private equity sponsor and its investors.
Tax Accounting, Reporting and Compliance Matters
One of the first items to be addressed from a tax and financial reporting perspective is dealing with the tax accounting aspects of the acquisition. In preparing the initial post-acquisition period financial statements, it is critical to get the tax aspects of purchase price accounting and the income tax provision correct from the outset. This includes obtaining a thorough understanding of the transaction itself and its treatment from both an accounting and tax perspective. The purchase price accounting will be driven by the nature of the transaction for tax purposes, such as whether it is a taxable or non-taxable deal, the type of entity (C corporation, S corporation or partnership) or assets that were acquired, and whether the acquisition was structured as a stock, an asset or a stock treated as an asset acquisition for tax purposes. The treatment of the transaction will dictate whether carryover or step-up in tax basis is applicable and whether historical tax attributes survive and exposures are inherited.
The purchase price allocation is an important component of the transaction. Usually, the purchaser and seller have different goals and conflicting interests from a tax perspective. Even though the final allocation is something that should have been agreed upon as part of the transaction, there are times when post-acquisition allocation inconsistencies arise between the buyer and seller (aside from differences that could exist because of working capital adjustments, etc.). Keep this in mind in purchase accounting, and be sure to review and understand the terms of the purchase agreement, the valuation report and any other materials that cover purchase price allocation.
In addition, depending on the treatment of the transaction for tax purposes, there are numerous other items that are critical to determine and understand as you assess the company's tax position and posture following the transaction, and as you prepare the purchase pricing accounting, including:
- The company's tax attributes that survive the transaction and the extent to which they are available or limited going forward (e.g., net operating losses, AMT credit carryforwards, etc.);
- The existence and impact of earnouts, contingent consideration, liabilities, transaction costs or other items that might impact the purchase price from a tax perspective;
- All book purchase accounting entries;
- The book valuation and purchase price allocation;
- The tax valuation and purchase price allocation for asset deals or deemed asset deals (see the Peco Foods, Inc. & Subsidiaries v. Commissioner case);
- The existence of a bargain purchase;
- The amount and treatment of transaction costs from a book and tax perspective;
- Built-in gains and losses;
- Tax exposures required to reported in accordance with ASC 740 (formerly known as FIN 48); and
- Tax indemnification and tax-sharing arrangements.
The importance of getting the purchase price accounting and initial (as well as subsequent) income tax accounting correct is highlighted by the fact that one of the leading causes of financial statement restatements and material weaknesses is related to income tax accounting matters, with purchase pricing accounting being one of the more complex aspects of income tax accounting. Also, be sure to request a copy of the tax due-diligence report, if privy to that information, as these reports typically identify areas that could be of concern.
Beyond the initial purchase price accounting and financial statement reporting matters, it is important to address tax compliance matters, including the filing of appropriate tax forms, elections and statements related to the transaction (e.g., Internal Revenue Code (IRC) Section 338 election, IRC Section 754 election, Form 8023, Form 8594, etc.) on a timely basis. It is also important to deal with post-acquisition filing requirements and any appropriate elections that must be made with these filings (e.g., election to amortize start-up costs, recurring item exception, etc.).
Tax Planning Matters
In addition to dealing with the more compliance-oriented matters, tax planning opportunities should not be neglected, particularly given private equity's focus on cash flow. Cash tax savings opportunities can not only improve cash flow but also increase the value of the business itself through the increase in EBITDA, an important factor when the private equity fund is selling the portfolio company on the basis of a multiple of EBITDA. Some key tax matters include:
- Entity rationalization (review of legal entities for opportunities to streamline corporate structure and potentially decrease tax compliance and maintenance costs);
- Selection of accounting methods and changes;
- Acceleration of bad debt deductions;
- Establishment of appropriate transfer pricing (e.g., in relation to management fees or other charges between related parties) and related documentation;
- Identification of research & development (R&D) credits and other federal or state credits and incentives;
- Assessment of applicability of the domestic manufacturing deduction (IRC Section 199);
- Consideration of state tax planning (e.g., state nexus, filing methodologies, etc.); and
- Consideration of foreign/international tax matters and planning.
Portfolio Company Post-Acquisition and Pre-Exit Period
Typically, in line with private equity investment strategy, following the initial post-acquisition period, we see aggressive growth plans for the portfolio companies. This can be accomplished either through organic growth or strategic acquisitions. In either case, such growth presents tax issues ranging from the structuring of such acquisitions to the implications of such acquisitions on the company's tax footprint.
As the company's tax footprint grows, close attention should be paid to potentially triggering taxable presence in new jurisdictions, for both state and foreign tax jurisdictional purposes, and to new state or foreign tax filing requirements. In addition, strategic tax planning should be considered to maximize the tax efficiency of the company's growing business operations — for everything from tax structuring and identifying local jurisdiction tax incentives or holidays, to ensuring that appropriate transfer pricing arrangements are established.
A portfolio company's post-acquisition period can be one of growth and expansion. But in some cases, particularly given the anemic economic growth over the last few years, financial difficulties are sometime encountered. As a result, portfolio companies may be forced to renegotiate the terms of their debt. Although such "restructurings" or "modifications" may appear routine, they can have significant and unintended tax consequences that should be analyzed. The basic rule is that if a debt modification is found to be "significant," it is treated as a deemed exchange and is thus a taxable event for both the issuer/debtor and holder/lender. In other words, the debt is treated as if it has been cancelled in exchange for the new restructured debt. In general, a taxpayer may be required to recognize cancellation of indebtedness income (COD) on the cancellation or repurchase of its debt for less than its face amount. Under IRC Section 108, there are a number of exceptions to the taxation of COD income. For example, if the debtor is insolvent, the COD income is not taxable to the extent of the debtor's insolvency; however, the debtor must reduce certain tax attributes.
Alvarez & Marsal Taxand Says:
For private equity portfolio companies, the immediate post-acquisition period and the rest of the investment lifecycle can be dynamic and challenging, not only from a business perspective but also from a tax perspective. With the many business changes occurring during this period, whether during times of economic growth and expansion or times of struggle, there are many tax-related obstacles and opportunities to be considered. Therefore, as portfolio companies and their investors navigate the investment lifecycle, it is important to ensure that appropriate attention is given to tax-related items. In the end, they can have a meaningful impact on a portfolio company's EBITDA and corresponding valuation multiple upon exit.
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