Mergers and acquisitions are complex transactions that are highly impacted by legal, financial, and tax factors, each of which can lead to deal failure. For instance, the complex tax landscape and particularly changes in tax laws were a reason for the Pfizer and Allergan $160 billion deal withdrawal in 2016.
In this article, we focus on the tax aspects of mergers and acquisitions to learn how taxation works in M&A and what the tax implications of mergers and acquisitions are.
How do taxes work in M&A?
Mergers and acquisitions tax issues are one of the top concerns both for a target company and an acquiring company. This is because an inadequate approach to tax regulations can lead to expensive consequences.
For instance, the acquiring company’s taxable income may be highly affected depending on how the transaction is structured. The deal structure, whether an asset purchase or a stock purchase, determines how tax liabilities are allocated and whether financial benefits can be maximized.
During the deal, a buyer and seller should consider the following aspects regarding taxes:
- Tax basis
This refers to the original cost of an asset or stock, which is used to determine capital gains or losses.
- Fair market value
This is the price at which the assets or business are valued, impacting the tax cost for both parties.
- Purchase price allocation
This is about allocating the purchase price to different asset classes, influencing tax consequences for both deal sides.
Learn about different legal aspects of mergers and acquisitions in our dedicated article.
Generally, an M&A deal can be a tax-free reorganization under IRC Section 368 for federal income tax purposes or a taxable transaction under the principles of IRC Section 1001.
Types of M&A transactions and their tax implications
Now, let’s take a closer look at the two main types of M&A transactions and what tax implications they bring.
Stock purchase
In a stock purchase, the buyer purchases the target’s shares or ownership interest directly from its shareholders. The buyer gains ownership of the target company, including its assets, liabilities (undisclosed and unknown), and ongoing operations.
- Buyer’s tax implications
The buyer doesn’t receive a step-up in the tax basis of the company’s assets, meaning the tax basis remains the same as it was for the seller. Depreciation or amortization is based on the original cost, not the purchase price, which could reduce potential tax benefits for the buyer.
- Seller’s tax implications
The seller typically pays capital gains tax on the difference between the cost basis of the shares and the purchase price. The capital gains tax rate is generally lower than the ordinary income tax rate, especially if the shares were held long-term.
Asset purchase
In an asset purchase, the buyer purchases specific assets (and possibly liabilities) of the target company, rather than its stock. This allows the buyer to selectively acquire desired assets and leave unwanted liabilities behind.
- Buyer’s tax implications
The buyer can step up the tax basis of the acquired assets to their fair market value at the time of the purchase. This allows for higher depreciation and amortization deductions in the future, potentially reducing taxable income. This is particularly beneficial for assets with shorter depreciation schedules.
- Seller’s tax implications
The selling company may face double taxation if it’s structured as a C-corporation (meaning it’s taxed separately from its owners). First, the company pays tax on any gain from selling the assets. Then, if the proceeds are distributed to shareholders, the shareholders pay tax on the distribution. For S-corporations (permitted to pass taxable income, credits, deductions, and losses directly to shareholders) and other pass-through entities, the tax is typically only at the shareholder level.
Learn more about stock vs. asset acquisition differences in our dedicated article.
Capital gains and income tax considerations
M&A transactions often result in capital gains or income taxes for the seller, depending on how the transaction is structured. These taxes can substantially impact the deal’s overall tax cost.
- Capital gains tax
These taxes apply to the sale of capital assets, such as stock or property, when sold for more than their original purchase price (tax basis). Long-term capital gains (for assets held over a year) fall under favorable tax treatment and are typically taxed at 15% or 20%, depending on income brackets. Short-term capital gains are taxed at ordinary income tax rates (generally from 10% to 37%).
- Income tax
These taxes apply to the sale of non-capital assets, such as inventory or receivables, which are taxed as ordinary income. Income tax rates are typically higher than capital gains rates, so sellers often prefer structuring deals to qualify for capital gains treatment to reduce their tax burden.
International M&A: cross-border tax implications
Understanding cross-border tax issues is critical for companies that are engaged in international M&A transactions.
These are the key things to consider:
- Foreign tax credits and double taxation
Companies may be taxed in both the target’s and buyer’s jurisdictions. Tax treaties between countries can help mitigate this issue by offering credits or exemptions.
- Transfer pricing
Related parties in different countries must adhere to transfer pricing rules to avoid being penalized by tax authorities. Transactions must be valued at fair market value.
- Tax residency
Companies must determine in what jurisdiction the income will be taxed based on residency and sourcing rules.
- Exit strategies and withholding taxes
Withholding taxes on capital gains or dividends could be triggered, depending on the company’s exit strategy and current tax landscape. That’s why it’s important to plan potential foreign exits in advance.
Net operating losses and deferred tax assets
Net operating losses (NOLs) and deferred tax assets are tax considerations in mergers and acquisitions that both deal sides should take into account.
- Net operating losses
NOLs occur when a company’s allowable tax deductions are greater than its taxable income within a certain period. This situation results in a negative taxable income, meaning the company has not generated sufficient revenue to cover its expenses. NOLs can be used to offset future taxation of the deal.
- Deferred tax assets
Deferred tax assets arise from temporary differences between the tax basis of an asset or liability and its reported amount in the financial statements, resulting in future tax benefits. For instance, a company may recognize a tax expense that will not result in an actual tax payment until a future date. Depending on the methods of tax accounting in mergers and acquisitions, deferred taxes are held differently.
Structuring M&A deals for tax efficiency
Choosing the right corporate tax structure for a deal can significantly impact the overall value of the transaction. Additionally, by engaging tax consultants, companies can develop strategies to minimize tax liabilities and ensure M&A tax compliance with federal laws. These are things to consider in tax planning for mergers and acquisitions to maximize tax efficiency:
- Asset purchase or stock purchase
In general, buyers prefer asset purchases to benefit from the step-up in tax basis. However, sellers may push for stock sales to avoid double taxation.
- Debt financing
Interest payments on acquisition-related debt can be deductible, lowering the overall tax cost of the transaction.
- Tax incentives
The U.S. tax laws provide several incentives, such as research and development (R&D) credits, that can reduce tax liabilities.
Common pitfalls in M&A tax planning
Even with careful planning, M&A deals still often face certain tax challenges, among other merger and acquisition risks. Below are some common pitfalls that companies should be aware of in terms of taxes:
- Insufficient tax due diligence
In the M&A deal process, companies often focus on financial aspects during due diligence, overlooking a potential hidden tax liability in the target. This way, tax liabilities, such as unpaid tax debts, incorrect tax positions, or ongoing disputes with tax authorities, can remain with the buyer after the transaction, especially in stock purchases.
- Wrong choice of transaction type
Companies sometimes misclassify transactions or fail to understand the full impact of the chosen structure (asset or stock purchase). For example, treating a transaction as an asset purchase may benefit the buyer. But at the same time, it can trigger a higher tax burden for the seller.
- Overestimated tax benefits
The company’s tax anticipations from M&A can be too optimistic. The acquiring company may face limitations on how much of the target’s NOLs can be used post-transaction, as per rules like IRC Section 382. Moreover, some transaction costs may not be deductible or may only be capitalized. This, in turn, can significantly impact deal profitability.
- Incorrect purchase price allocation
Companies sometimes misallocate the purchase price across different assets which can lead to higher taxes paid by both the buyer and the seller. That’s why the involvement of professional tax consultants is desirable to mitigate such a risk.
- Ignorance of international tax attributes
In cross-border M&A, companies may underestimate the complexity of international tax rules, such as transfer pricing or withholding taxes. And failing to properly plan for these complexities can result in double taxation, penalties, or inefficient use of tax treaties.
Key takeaways
- Tax implications in M&A are an important aspect to consider since taxes can heavily influence deal outcomes and costs for both the buyer and the seller.
- Tax consequences of the deal can be different depending on the structure: an asset purchase or a stock purchase.
- Cross-border M&A deals present unique tax challenges, such as double taxation, transfer pricing rules, and withholding taxes.
- Common tax pitfalls include insufficient due diligence, misclassification of transaction types, incorrect purchase price allocation, ignorance of international tax attributes, and overestimated tax benefits.
