Back to Taxes Committee publications

Marina Vishnepolskaya
Esq, New York
mv@mvesq.com

 

Report on a conference session at the ninth annual IBA Finance & Capital Markets Tax Conference

Tuesday 21 January 2020

 

Session chair

Jodi Schwartz  Wachtell Lipton Rosen & Katz, New York

 

Speakers

Lodewijk Berger  Jones Day, Amsterdam
Sean Finn  Latham & Watkins, London
Reto Heuberger  Homberger, Zurich; Vice Chair, IBA Taxes Committee
Michael Lane  Slaughter & May, London
Sara Zablotney  Kirkland Ellis, New York

 

The panel hosted an interactive discussion on tax issues and recent developments in cross-border mergers and acquisitions (M&A).

 

Choice of jurisdiction for holding companies

First, the panellists discussed issues in choice of jurisdiction for a holding company in an M&A deal, in light of recent tax developments in the European Union, the United Kingdom and the United States. Sara Zablotney discussed the reduction in the US federal corporate income tax rate from 35 per cent to 21 per cent under the 2017 tax reform.

Zablotney suggested that, given the significantly lower tax rate, the US is back in the conversation on choice of jurisdiction. In particular, companies seeking to finance an acquisition of an entity with a substantial US presence with debt may prefer US borrowing. However, deals require exhaustive modelling to assess potential tax consequences. In particular, companies should assess the implications of two provisions in the 2017 tax reform: a federal ‘global minimum’ income tax on global intangible low-taxed income (GILTI) and the base erosion and anti-abuse tax (BEAT).

Michael Lane discussed tax issues in choosing the UK as the home jurisdiction for an M&A deal. He said there were a series of migrations out of the UK in 2008 but the UK then made its corporate tax system more attractive with new Controlled Foreign Corporation (CFC) rules and a dividend exemption for both foreign and domestic dividends. That legislation, coupled with no dividend withholding tax, a participation exemption for capital gains and the benefits under the bilateral US-UK tax treaty led to the UK being on par with Ireland and the Netherlands as an attractive holding company location. In 2010, the individual income tax top rate was raised to 50 per cent for a while, which prompted directors to rethink where they wanted to be based, showing that choice of jurisdiction was not all about the corporate tax rules.

Reto Heuberger discussed the tax consequences of domiciling a holding company in Switzerland. Switzerland has abolished the cantonal tax privileges, including the holding company privilege, under pressure from the Organisation for Economic Co-operation and Development (OCED) and the EU. However, dividend income on investment of at least ten per cent by vote or CHf 1m by value and capital gains from the sale of equity investments of at least ten per cent are still effectively exempt from taxation. In addition, Switzerland does not apply any CFC rules. If there is no pressure from the OECD to amend the rules, Switzerland is not expected to introduce any CFC rules, added Heuberger.

There also is a unilateral exemption for permanent establishment (PE) income in Switzerland. Tax advisers previously had promoted a US-financed limited liability company (LLC) without an active trade or business, resulting in absence of a PE, but Swiss tax authorities shut it down.

In addition, Heuberger discussed the possibility of structuring around a dividend withholding tax. In a private equity context, funds may invest through a holding company in Switzerland, but stricter requirements apply. Additional paid-in capital in the form of foreign contributions may be distributed free of withholding tax. On distribution to shareholders, contributions may be distributed first, then profits. This rule was changed for public companies, which distribute profit and contributions in a 50/50 ratio. The amended rule is not applicable to contributions from abroad, resulting in dividends remaining free of withholding tax.

Sean Finn discussed foreign considerations for inbound investments and establishing corporate headquarters in the UK. Finn mentioned the favourable capital gains regime and raised the issue of stamp duties, but said the tax did not, in his experience, act as a deterrent for a UK holding company. Finn also discussed the impact of Brexit, which may place a UK holding company at a disadvantage, due to uncertainty in the tax rules following separation from the EU.

Currently, EU members are subject to agreements governed by EU law. Once the UK leaves the EU, relationships with remaining EU members may change. For example, under an EU directive, in a parent-subsidiary structure there is no withholding between EU-based parents and subsidiaries. In contrast, in reliance on certain UK bilateral treaties with Italy or Germany, withholding is reduced to only five per cent. As a result of Brexit, assuming no implementation of an arrangement equivalent to the EU directive, reduced withholding renders the UK a less favourable holding company jurisdiction compared to its EU counterparts. Advisers would need to heed to issue spotting and plugging problems with domestic law.

In addition, Finn addressed limitation on benefits (LOB) provisions in bilateral tax treaties. By example, a UK company that formed a German subsidiary, which in turn established a US subsidiary, may not rely on the ‘equivalent beneficiaries’ provision in the LOB article of the US-German bilateral tax treaty upon exit of the UK from the EU. The LOB clause would not apply because equivalent beneficiaries must be members of the EU. Upon Brexit, a UK holding company would not be established in a jurisdiction that is an EU member. The example was an illustration of a deal structure that may play out after Brexit.

Lodewijk Berger explained the basic participation exemption regime in the Netherlands. Dutch tax authorities are subject to both international and domestic pressure to address anti-abuse concerns. After the Netherlands endorsed the EU Anti-Tax Avoidance Directive (ATAD), it passed a new CFC rule that applies to subsidiaries in blacklisted jurisdictions. There was a proposal to abolish withholding tax on outbound dividends that would make Dutch companies more attractive from a tax standpoint, but the government withdrew the proposal due to significant public backlash. Dutch tax law provides for full capital gains and dividends exemptions on meeting certain light requirements. There is a Dutch CFC rule.

Berger also reviewed the salient holdings in the Danish beneficial ownership cases, which addressed dividend and interest withholding. He noted the cases were a surprise for the Danish tax community, despite similar jurisprudence in Spain and Italy. In the case law, taxpayers used substance-light holding companies. Danish tax authorities began denying benefits to holding and finance companies, finding no business purpose for these companies to be part of the holding company structure. In the case law, the EU court established a higher bar to qualify for the tax benefits. Based on the Danish court jurisprudence, traditional practices with respect to substance that rely on local service providers would not work.

In similar circumstances, an Italian court did not allow a group to use same-country presence to justify a Luxembourg company if the company itself lacked substance. In general, for benefits to apply, the jurisdiction has to be natural to investment.

M&A transactions

The panel proceeded to review various factors to take into account in M&A transactions.

First, the panellists addressed the choice between a merger of equals and a takeover. In the US, alternatives for tax deferral depend on US ownership. The mix of consideration is another factor; structuring for tax deferral where the ratio of cash to equity is higher may not be possible. However, in public company transactions, the market does not necessarily demand tax-free treatment for shareholders receiving equity. In particular, tax deferral is not so important when shareholders receive cash or liquid stock.

In addition, many shareholders of US public companies are tax-indifferent persons, such as pension plans or tax-exempt organisations. Nonetheless, shareholders have initiated lawsuits in Delaware courts in respect of certain corporate inversions, alleging directors breached their fiduciary duties to the shareholders by failing to disclose adequately taxation risks in transactions to shareholders (amongst other things).

In the UK, the market expectation is that any non-cash transaction will be structured to give shareholders rollover treatment and avoid a dry tax charge. Lane mentioned that Royal Dutch Shell’s dual-headed structure was unified in 2004. Under the unified structure, UK shareholders in the UK PLC obtained rollover, but that was not possible on the Dutch side. A small number of UK shareholders in the Dutch NV went to court to argue, unsuccessfully, for rollover treatment.

The case illustrated a potential impact of Brexit on tax consequences of non-cash transactions in the UK. UK legislation provides for tax-free dividend demergers only where both the demerging and demerged companies are resident in an EU Member State. Under prior legislation, the demerging and demerged entities were required to be UK residents. However, some argued this approach was anti-European. Thus, laws were amended to expand residency to EU Member States. Post-Brexit, the UK is not a member of the EU and it remains to be seen whether the residency requirement will be narrowed to the UK or expanded. Expanding jurisdiction of entities in a demerger, for example, US subsidiaries of UK PLCs, would facilitate structuring such non-cash transactions. Conversely, in certain jurisdictions, such as the Netherlands and Germany, corporate shareholders only get rollover into shares of a company resident in an EU Member State.

Zablotney added that pension funds in the US may be large shareholders and, as tax-indifferent parties, may influence decision-making on tax consequences of a transaction. From a US perspective, another factor in structuring for a tax-free reorganisation is the tension between potential current taxation for shareholders or optimising the combined entity’s post-transaction tax profile. For instance, a tax election for a deemed asset sale under section 338(g) of the US Internal Revenue Code, which results in a taxable transaction, may be useful from GILTI perspective but requires analysis.

Schwartz noted that, in the case of a CFC, a deemed asset sale election may produce a different result from a stock sale. US tax advisers have to run extensive modeling to assess potential tax consequences. In addition, squeeze-out rules under applicable state corporate law must be taken into account in structuring a transaction. For example, a Dutch asset sale to squeeze out minority shareholders is not desirable for a US CFC because of the timing of income inclusions.

From a Swiss perspective, Heuberger said, virtually all deals are share exchange deals. There is no capital gains tax for private individuals and the participation exemptions apply to corporate shareholders selling at least ten per cent company shares. There is rollover for non-ten-per-cent shareholders in case of share-for-share exchanges. Deals include a market-value reserve for foreign capital contributions. These contributions may be distributed without imposition of a withholding tax. In a recent deal, a US$19bn reserve for capital contributions was created.

Zablotney described US ‘double dummy’ or ‘top hat’ transactions as means to accomplish a 'merger of equals'. A newly formed TopCo forms two subsidiaries, BidCo 1 and BidCo 2. Each of BidCo 1 and BidCo 2, respectively, acquires one of the two combining corporations for a mix of cash and TopCo stock. Heuberger noted that the squeeze-out threshold in Switzerland is 90 per cent, so deals are structured as takeovers. Schwartz commented that, in the US, an activist shareholder such as a hedge fund may purchase shares to prevent the company from reaching the squeeze-out threshold.

Cross-border deals

The panel continued with a discussion of cross-border deals. Zablotney introduced the issue of purchase price allocation. In the US, the parties do not need to agree on the allocations, as long as the fact that an agreement was not reached is indicated on the parties’ respective US tax returns. This result may be preferable, so that each party may follow its own Generally Accepted Accounting Principles (GAAP) accounting valuation. Thus, each party would not need to establish any book-tax differences on its respective financial statement, which the party would need to disclose on its US tax return. Parties may reach significant carve-out deals in which GAAP financials match allocations, instead of filing a book-tax form with a return.

Lane noted that it is customary in the UK to agree on value allocations in asset purchase agreements and for both sides to be required to adhere to the agreed values. It can be possible to depart from the commercial or accounting values in certain circumstances by election – for example, for tax depreciation for fixtures – but both buyer and seller have to sign the election, by which they both are bound. Finn added, in documents, parties agree to allocation, either at or after closing. Coming up with an allocation could be a real issue.

Zablotney commented that, in the US, parties could insert their preferred effort standard in the deal documents to agree on an allocation prior to closing date where required by law. In addition, purchase price adjustments may require an initial or subsequent determination of purchase price allocation post closing.

Heuberger mentioned a recent case where it was agreed that, if the buyer disagreed with the valuation of a certain target company by more than ten per cent, the parties would hire an expert. Zablotney added that, for this purpose, due to transfer pricing considerations, parties would not want to share the information on either side of the deal.

Due diligence

The panel culminated with a discussion of due diligence issues when evaluating a target company. Lane noted that the issue of withholding taxes in respect of indirect capital gains first came to prominence in the Vodafone case, where the Indian tax authority argued that Vodafone should have made a withholding in respect of the seller’s capital gain when making an indirect Indian acquisition. However, such withholding issues were becoming more common in other jurisdictions, such as China. In response, the parties may keep a portion of the purchase price in escrow until determination of withholding obligations.

The withholding issue also is common in reorganisations, in which there is no ultimate change in ownership. Lane gave an example he had seen recently of the proposed transfer, within a group, of a Dutch company owning an Indian subgroup, where a straight transfer of the Dutch company would have triggered an Indian tax charge. It may be possible to mitigate such taxes by putting enough non-Indian assets in the non-resident company that it falls below the threshold (50 per cent by value) to be treated as an Indian company. Another withholding trap is real estate transfer taxes, particularly in Australia and Germany. These jurisdictions can look through any level of corporate ownership and treat an upstairs share sale as an indirect transfer of land at the lowest tier of ownership and within scope of the withholding tax charge.

Finn noted that dealing with withholding tax is not just a risk allocation issue. On most deals, seller would accept that capital gains tax is its responsibility. However, complexities in arrangements may arise. For example:

• the seller may take a position of no withholding;

• between signing and closing, the seller or purchaser could change;

• new laws may be introduced; or

• new facts could come to light.

Indirect transfer taxes quickly could become a significant issue. Withholding tax is an increasing issue when tax authority views may be prone to change.

Lane explained how attitudes to tax rulings have changed in due diligence. Until recently, a tax ruling issued to a target group for a finance structure was seen as giving comfort and certainty. Now, the ruling could be treated as state aid, raising the issue of whether additional protection should be sought. It is common in share sales governed by UK law to include representations to the effect that no member of the target group has received anything which might be considered as unlawful state aid.

Lane explained further that covenants or indemnities might not fully protect the buyer, given the long time limits for state aid claims and uncertain effects of various recovery methods. The EU Commission has ten years from when the aid was given to launch an enquiry. Additionally, depending on the method a Member State uses to effect recovery, the recovery might constitute a ‘tax’ for purposes of the particular indemnity.

For example, Lane said, the EU Commission decided the UK’s CFC finance company partial exemption constituted unlawful state aid, at least in part. The UK is currently considering interim recovery among various recovery methods in respect of the decision. HM Revenue & Customs (HMRC)’s preference is to issue normal assessments, or discovery assessments, where possible. In such a case, the assessed amounts would constitute a tax.

However, when HMRC is out of time to issue assessments, it invites taxpayers to enter into voluntary contractual agreements to pay over unlawful aid received. Failure to enter into an agreement would result in HMRC either seeking recovery through the High Courts or, possibly, via a special legislative measure. The status of the amounts recovered through methods other than timely assessments as a ‘tax’ is unclear.

Heuberger discussed the effect of the sixth EU Directive on Administrative Compliance (DAC 6) requirements on due diligence for Swiss companies with group companies in the EU. In a recent deal, parties struck out a representation and a warranty for DAC 6 compliance in light of regulations expected to be implemented. Switzerland is not part of the EU, and when a Swiss company sells EU subsidiaries, Swiss advisers rely on their EU colleagues on state aid issues. In the Netherlands, deals include arrangements with respect to the sharing of transfer pricing documents, but sellers are not keen to share country-by-country reports and master files, potentially subjecting determinations to debate.

Finn commented further that for DAC 6 noncompliance, penalties are significant in Poland but nominally they are not a tax. However, penalties are linked to non-compliance. The issue is therefore whether the penalties may be described as a tax in the deal documents. Zablotney noted that, in the US, parties sometimes use a broader ‘penalties, additions to tax’ language to address similar characterisation issues.

Jodi noted that, in the US, whether an amount is a tax is an issue in private equity deals relying on representation and warranty insurance. EU deals also rely on representation and warranty insurance. Zablotney noted further that, in the US, insurance is standard in private equity deals. Parties often obtain a synthetic pre-closing indemnity subject to exclusions for known items and standard exclusions, such as transfer pricing or tax attribute carry-forwards. Separate insurance can be taken out for items discovered in diligence. There is uncertainty regarding the tax consequences of receipt of insurance proceeds.

Jodi explained that items included in a due diligence report are not insured. In the US, insurance gross-ups may be used to compensate a party for the tax cost of receiving insurance proceeds. Insurance proceeds may be taxable in relevant state or local jurisdictions, unlike an indemnity from seller, which may be viewed as an adjustment to purchase price.

Heuberger commented that insurance is standard in Swiss private equity deals but there is lack of clarity on how insurance proceeds are taxed. A tax indemnity paid by seller to buyer typically is treated as an adjustment to purchase price. A payment for damages typically is taxable income. Either tax treatment could apply, depending on the facts and circumstances.

Lane noted insurance is generally used for unexpected liabilities. Tax indemnities traditionally have been seen as dollar-for-dollar underwriting of the tax provisions used to price the deal. In contrast, corporate warranties were for items for which claims were not expected. Therefore, warranty and indemnity insurance was a better fit for unexpected claims for breach of corporate warranties, rather than for expected dollar-for-dollar tax indemnities. Hence there will be a carve-out for disclosed matters, which would not normally operate to limit an indemnity.

Such policies entered the UK market via private equity. Traditionally, private equity houses would refuse to give much in the way of warranty and indemnity protection. The funds argued that their business models required sales proceeds to be distributed up to their investors straightaway. The best a purchaser from a private equity seller could generally hope for was limited protection given by management. Insured warranties and indemnities represented an improvement on that position. But, until recently, the insurance did not apply against a full tax indemnity from a good corporate credit.

Zablotney noted that, in transactions that are carve-outs from US consolidated groups, the seller would be unlikely to provide information to the insurer. The insurer would require the seller to cover all pre-closing tax risks of the carved-out business. Thus, at least partial indemnities are more common in US carve-out deals. Finn referred to an OECD study, pursuant to which deal insurance appears to have increased from 13 per cent to 65 per cent in recent years. Berger noted, importantly, due diligence reports have a clearly defined scope and do not make general references to out-of-scope risk factors that have not been diligenced. Otherwise, such references may trigger the known-issues exclusions of the insurance.

 

Back to Taxes Committee publications