There has been a clear shift in the traditional investment appraisal and due diligence techniques in the world of mergers and acquisitions (M&A) in recent years. Returns are becoming increasingly driven by operational improvement rather than financial engineering. As a result, tax efficient supply chain planning (TESCP) is playing an increasingly significant role in M&A transactions, especially where the benefits are realised within a short time frame.
The benefits of introducing TESCP techniques are considerable. Besides increasing the after-tax return of the integrated group, the payback period would be enhanced, a united approach to the market is possible and anticipated fiscal results can be delivered. Consequently, we are steadily increasing the use of TESCP “Benefits Analysis” for our clients during the due diligence stage of a transaction. This action is reinforced by the fact that a reduction in cash tax payable of £100 through TESCP would require an equivalent revenue enhancement or cost savings of £135 to achieve the same cash saving.1
TESCP involves the centralisation of functions, assets and risks. As multinationals seek to become more global or regional, adopting a business model that involves centralising key functions, assets and risks drive costs out of the business, while simultaneously creating operating efficiencies (see diagram below). The result is the realisation of significant above-the-line savings. By locating the “principal” company in a tax-efficient location, tax arbitrage can also be achieved.
Key areas where TESCP can add substantial value include:
• Consignment manufacturing
• Limited risk distribution
• Centralised procurement
• Intellectual property planning
• Centralisation of management
We will focus on TESCP opportunities in the following circumstances:
• Corporate-to-Corporate deals
• Private Equity (PE) deals
• Leveraged buyouts
• Asset acquisitions
When assessing the merits of a target, it is critical to understand its operating model / supply chain. Post-merger integration is one of the most disruptive aspects of any M&A transaction; hence it is critical to understand the challenges that lie ahead when integrating the businesses as integration costs can be substantial. Such costs could influence whether the target is, in fact, a viable investment. Conversely, in a competitive transaction, a potential purchaser who is able to quantify potential savings would be in an advantageous position.
If both the target and the acquirer have a decentralised supply chain, there are opportunities to assess (preferably at the start of the due diligence phase) the potential benefits of creating a centralised operating model (similar to diagram). Such benefits will therefore be assessed at the after-tax level. In our experience, subject to the current tax profile of both parties, the tax savings alone may pay back the cost of integration and implementation of the new supply chain within two to three years.
It is important to note that implementing TESCP – while simultaneously undertaking post-merger integration – provides a substantial business case for change that reduces the risk of successful challenge by Revenue authorities. TESCP should also be assessed where the acquirer has an existing tax efficient supply chain model and the target operates a decentralised model (for example, Kraft and Cadbury) and vice versa. Once again, the potential benefits could be significant and, therefore, influence the investment decision process.
Private Equity Deals
In the past, when undertaking investment decisions, the PE houses and their advisors often paid little attention to the benefits of TESCP (focusing instead on supply chain and SGA savings, excluding tax arbitrage). This was primarily due to the perception that the implementation process of a centralised structure was lengthy and the benefits would take a long time to crystallise – two factors typically not attractive to PE houses. Now that they may be holding on to their portfolio companies for a longer period of time and the myth of lengthy implementations has been busted, TESCP forms a critical part of the assessment process in the PE world.
A critical aspect of a leveraged buyout is to achieve a tax shield for the interest on acquisition debt. In the current environment, this is becoming increasingly difficult as many Revenue authorities are restricting the ability to perfect debt “push-down.” TESCP can provide an alternative or complimentary strategy if the centralisation of functions occurred in (or just moving some “profit-generating assets” or activities to) a company in which there are excess tax losses due to unutilised interest expenses.
When considering particular targets, there is an opportunity to assess how best to structure “profit-generating” assets such as intellectual property (IP), commonly owned and managed in centralised locations. These include Switzerland, Luxembourg, Ireland and the Netherlands. The UK – with the introduction of the Patent Box rules – is striving to become more competitive; however, the consensus is that the proposed CFC rules (as currently written) somewhat hampers true competitiveness.
There are numerous tax considerations when undertaking TESCP. First and foremost, it is clear that any reorganisation must be undertaken in a substantive manner – TESCP is not brass plate tax planning.
Post-merger integration provides a clear business case for such reorganisations. Revenue authorities will focus on the following areas of challenge – exit charges, valuations (e.g., IP), CFC considerations and transfer pricing. All of these involve detailed technical analysis, but it may transpire that these issues are less risky than achieving benefits by way of debt “push-down” in a particular territory.
When undertaking M&A due diligence, it is essential to consider the benefits that TESCP may return. Coupled with traditional planning techniques, TESCP maximises shareholder return and significantly reduces investment payback. The key part is ensuring TESCP forms a critical part of the investment decision process. With the current crackdown on one-off tax planning solutions, a commercially based TESCP strategy remains one of the only viable means of achieving tax efficiency.
1 Based on the UK corporation tax rate of 26 per cent, the grossed up value is equal to 100/0.74.
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