Avoiding Unexpected Tax Implications in Mergers and Acquisitions

By James DeLeo, MBA, CPA/MST & Kelly Berardi, JD, LL.M.
Gray, Gray & Gray, LLP

One of the most important aspects of any M&A deal is the tax planning. While experienced dealmakers know to expect certain tax consequences, there are often unexpected tax implications that can arise. These unexpected tax bills can have a significant impact on the value of the deal and the financial well-being of the companies involved.

There are several common unexpected tax implications in M&A deals. Some of the most common include:

• Hidden liabilities: When one company acquires another, they could assume all the acquired company’s liabilities, including tax liabilities. These liabilities may not be readily apparent during due diligence, and they can come as a nasty surprise after the deal closes. For example, the acquired company may have been underreporting its income or may have accrued taxes that it has not yet paid.
• Transfer pricing: Transfer pricing is the practice of setting prices for goods and services that are transferred between related entities. In an M&A deal, the two companies involved may become related entities. This can create transfer pricing challenges, as tax authorities may scrutinize the prices charged for goods and services between the two companies. If the prices are deemed to be unreasonable, the companies could face significant tax liabilities.
• Tax accounting differences: Companies may use different methods of accounting for tax purposes. When two companies with different tax accounting methods merge, it can create accounting challenges. These challenges can lead to unexpected tax liabilities, as the companies may have to adjust their financial statements to comply with the same accounting methods.
• Changes in tax laws: The tax laws are constantly changing. This can create uncertainty for M&A deals, as it is difficult to predict how changes in the tax laws will impact the deal. For example, a change in the tax law on depreciation could have a significant impact on the value of the acquired company’s assets.

Delving Deeper: Hidden Tax Traps in M&A Deals

Let’s look at specific areas ripe for hidden tax traps, along with strategies to navigate them.

Intangible Assets: Valuation Pitfalls:

Beyond physical assets, intellectual property (IP) and other intangibles like goodwill can hold significant value in M&A deals. However, their valuation and subsequent tax treatment can be fraught with complications.

• Valuation Disagreements: Determining the fair market value of intangibles is subjective, creating potential tax disputes. The acquiring company might value the acquired IP high for tax deduction purposes, while the tax authority might disagree, leading to adjustments and increased tax liabilities.
• Amortization Issues: Intangible assets are typically amortized over a period of 15 years for tax purposes (although a different period for GAAP). But determining the useful life of complex intangible assets requires careful consideration. Factors such as technological advancements, market demand, and the asset’s susceptibility to obsolescence play a key role. For example, a software algorithm might have a shorter useful life if it is likely to be quickly superseded by newer technologies. The useful life is estimated based on these factors and the period over which the asset is expected to contribute to the company’s revenue generation. This estimation influences the annual amortization expense, thus impacting the company’s financial statements and tax obligations. Regular reassessment of the useful life is also necessary to align with changing circumstances and ensure accurate financial reporting.
• Transfer Pricing and Intangibles: When IP is transferred between related entities within the merged company, transfer pricing becomes crucial. Setting prices below market value could be seen as tax avoidance, leading to hefty penalties. Conversely, overpricing could raise the acquiring company’s taxable income.

Employee Benefits and Liabilities:

M&A deals frequently involve inheriting the acquired company’s workforce and their associated benefits. This can lead to unforeseen tax burdens down the line.

• Stock Options and Deferred Compensation: If the acquired company has granted stock options or deferred compensation plans to its employees, the acquiring company inherits the tax implications. Unexpected tax adjustments might arise upon vesting or payout, depending on how these plans are integrated into the new entity. In some cases, a deferred compensation plan may be paid out prior to closing.
• Employee Benefit Plans: Existing pension plans, healthcare plans, and other employee benefits in the acquired company might not align with the acquiring company’s programs. Restructuring or integrating these plans can trigger unexpected tax consequences, such as early termination fees or changes in deductibility of contributions.
• Post-Acquisition Workforce Restructuring: Downsizing or restructuring the combined workforce after an M&A deal can lead to severance packages and employee stock option terminations. Tax implications surrounding these actions, such as deductibility of severance costs and taxability of option terminations, need careful consideration.

State and Local Tax (SALT) Liabilities:

SALT liabilities can significantly affect the overall cost of the acquisition and may introduce complications that could delay or derail the deal. Each state and locality has its own set of rules and rates, which can vary widely. SALT considerations include, but are not limited to:

• Income and franchise taxes
• Sales and use taxes
• Property taxes
• Payroll taxes

To avoid complications it is necessary to review the target company’s compliance with SALT obligations, identifying any unpaid taxes, and understanding the nexus the company has established in various jurisdictions. Additionally, assessing the applicability of any tax incentives or credits that could be transferred upon acquisition is important.

Strategies to mitigate SALT liabilities include negotiating the purchase agreement to specifically address and allocate responsibility for past, present, and future tax liabilities. It’s also advisable to consider structuring the deal in a way that optimizes tax efficiency, possibly through asset purchases rather than stock purchases, where applicable.

International Tax Considerations:

Cross-border M&A deals add another layer of complexity with diverse tax regimes and treaty interpretations.

• Foreign Tax Credits and Double Taxation: The acquiring company might be able to claim foreign tax credits for taxes paid by the acquired company’s foreign subsidiaries. However, navigating complex tax treaties and ensuring proper documentation to utilize these credits requires careful planning.
• Transfer Pricing in a Global Context: Transfer pricing becomes even more critical in international M&A deals, as goods and services may be transferred across borders within the merged entity. Mispricing by even small margins can lead to significant tax liabilities in different jurisdictions.
• Exit Strategies and Withholding Taxes: Planning for potential future exits from foreign subsidiaries acquired in the M&A deal is crucial. Depending on the exit strategy and the specific tax regime, significant withholding taxes on dividends or capital gains could be triggered.

Mitigation Strategies and Tools

While unexpected tax implications are a reality in M&A deals, proactive mitigation strategies can minimize their impact.

• Experienced Team Composition: M&A deals are complex, and it is important to seek professional advice from experienced tax advisors. Assembling a team with expertise in M&A tax, transfer pricing, and international tax is vital to navigate the complexities and risks involved.
• Comprehensive Due Diligence: In-depth financial and tax due diligence is essential to uncover hidden liabilities and potential tax risks. This includes reviewing tax returns, transfer pricing policies, and employee benefit plans.
• Modeling and Scenario Planning: Utilizing tax modeling tools to simulate different deal structures and scenarios can help predict potential tax liabilities and identify optimal approaches.
• Voluntary Disclosure Agreements (VDA): A VDA, prepared in advance, can help a deal go through by limiting the look-back period on state and local taxes (typically to three to five years), or reduces (or eliminates) penalties for the look-back period.
• Structure the deal carefully: The structure of the M&A deal can have a significant impact on the tax consequences. Tax advisors can help to structure the deal in a way that minimizes the tax liability.
• Post-Merger Integration Planning: Early planning for integrating tax systems, accounting methodologies, and transfer pricing policies across the merged entities can help avoid future tax headaches.
• Stay up to date on tax law changes: Tax laws are constantly changing, and it is important to stay up to date on the latest iterations. This will help you to identify potential tax risks and develop strategies to mitigate those risks.

Unforeseen tax implications are not deal-breakers in M&A, but ignoring them can be costly. By understanding the potential pitfalls, proactively mitigating risks, and seeking expert guidance, companies can navigate the complex tax landscape of M&A deals and secure a successful and tax-efficient outcome. Remember, tax is a dynamic field, and staying updated on evolving regulations and case law is crucial for informed decision-making throughout the M&A process.