How The U.S. Tax Reform Will Impact Technology M&A
Technology companies are likely still trying to work out if the long-awaited U.S. tax reform was an early Christmas present or a stocking full of coal. The answer is more of the former than the latter. The same seems to be the case for technology-related M&A. One early indicator is the recent SAP – Callidus deal.
In his excellent analysis of the tax reform’s effect on the technology industry, David Yasukochi, Tax Office Managing Partner at BDO USA and co-leader of BDO’s Technology and Life Sciences practice, maps out some of the changes the tax reform brings with it.
I spoke to him about several subjects relating to how the tax reform affects technology M&A and the way deal structures could change.
On deal activity
Jakob Sand: One point that has been getting a lot of attention is that the reform could incentivise U.S. technology companies – and other multinationals - to repatriate some of their funds. The big tech companies alone have approximately $500 billion in cash and cash equivalents overseas. Part of that cash could go towards acquisitions, which is why some analysts predict that 2018 could see increased American M&A activity. I may be donning the suit of the devil’s advocate here, but I do not necessarily think that the uptake will be as large as some analysts seem to think. I do believe that there could be an uptake in M&A on the heels of the tax reform, but the fact is that there is no shortage of cash, or investor interest, in the technology sector at the moment. So extra cash could potentially oversaturate the market, driving up valuations to unrealistic heights. What is your take on that?
David Yasukochi: As it pertains to the impact of the repatriation provision, I would tend to agree with that point. Private equity investors, for example, have been saying for years that there is a lot of dry powder sitting on the side lines. So I don’t think the freeing up of cash through the repatriation provision necessarily moves the needle by itself. If we were to take a lesson from history, the main effect of repatriation will likely be large-scale buyback of shares, similar to what we saw in 2004 when there was a tax holiday encouraging repatriations from abroad; although the recent Apple announcement that it will reinvest $350 billion in the U.S., as well as similar announcements from others, signal that companies may be a little more nuanced in this regard.
However, on the other hand, there is no doubt that the reduction of the corporate tax rate, which was the primary focus of this legislation, will have a real, beneficial impact to companies, and in so doing, enhance their attractiveness as M&A targets. In one fell swoop, the tax law has significantly enhanced after-tax earnings and cash flow.
One impact of this phenomenon is that it makes U.S. companies more attractive targets for cross-border acquisition or expansion. The U.S. economy is growing, and now you can operate in a country where the corporate tax rate becomes comparable to other developed markets at 21%. This is an opportunity that can’t be ignored and may spur even wider growth of the U.S. economy – at least that’s the hope.
On tax reform details
Jakob Sand: When there are major changes to legislation and regulations, markets and companies need time to fully assess their effect – and take them into account when it comes to their future actions. While repatriation has gotten a lot of attention, it is far from the only major change. Areas like the ‘GILTI tax’ (Global intangible low-tax income), ‘BEAT tax’ (Base erosion avoidance tax) and the FDII (Foreign derived intangible income) all impact technology companies. The American IRS has already made several announcements and released guidelines and guidance to clear up some of the potential grey areas where companies may still be unsure how to interpret the reform. What do you see as some of the biggest changes, and what uncertainties surround them?
David Yasukochi: While there has been some guidance already, it, for the most part, has been limited to the transition tax (which imposes a reduced tax on historical foreign earnings of foreign subsidiaries) so far. This will definitely be a busy year for the IRS and beyond.
I would start with the so-called ‘GILTI’ tax. It establishes a way for the US to tax what the U.S. Treasury has labelled ‘cash boxes’; arrangements where profits are earned in countries with low or no income taxes, for example, the Cayman Islands. If the Cayman Islands chooses not to tax that income, the U.S. now has a way of taxing it through the GILTI tax, which may be imposed on foreign subsidiaries of U.S. taxpayers whose earnings are in excess of a formulaic routine return. However, already companies are trying to figure out how to avoid the GILTI tax. And where there’s that kind of activity, there is sure to be a lot of attention by the IRS to combat that.
Another one is the FDII tax. It stipulates that to the extent that U.S. companies derive excess returns from sales overseas, that income qualifies for a preferential tax rate, similar to patent boxes and innovation boxes in Europe. It could very well impact technology companies, which are generally global in scale. Again, there are details that remain unclear, and the methodologies permitted to isolate qualifying income is likely to be complex.
Thirdly there is the BEAT Tax. This potentially imposes additional tax on otherwise deductible payments made to foreign related parties. Importantly, it does not apply to payments for goods. However, if you have a global supply chain extensively comprised of related parties, and perhaps, for example, pay royalties and interest to those overseas parties, it could have a significant impact. Because the tax does not apply to goods, there may be differences in opinion as to what payments are properly includible in cost of goods sold.
With all of these new tax provisions, many technology companies are facing a big challenge: mining data and gathering support to comply with the new rules. That is something that I anticipate that we will busy working with clients on.
On potential changes to deal structures
Jakob Sand: The tax reform is also likely to influence deal structures in the technology industry. It also heralds changes for buyers, including companies, venture capitalists and private equity funds. For example, we could see a slowdown in the buyout market, as it often relies heavily on debt in relation to making investments. There are also some pieces of the tax reform that make partnership deals less attractive than they have been in recent years. In your view, what are a couple of the biggest changes we will see?
David Yasukochi: One would be the newly imposed interest expense limitations. We now have a provision that says that there is a ceiling to deductible interest expense essentially equal to 30% of EBITDA. In coming years (after 2021), that changes to 30% of EBIT. Two things spring to mind in relation to that change. One is that a lot of private equity financed portfolio companies are going to hit that ceiling. Secondly, the switch to EBIT is going to hit many more companies very hard. One could easily see that changing the debt to equity mix. It could also make buyers walk away from deals they previously would have considered.
Finally, there is now a large tax rate disparity between C corporations and pass-through entities like S corporations and partnerships (where the tax liability is borne directly by the owners). Over time, U.S. buyers have become more comfortable with pass-throughs - and even favoured – over C corporations. Pass-throughs have a single level of tax, making them more tax efficient where there may be regular distributions of cash from the targets, or in the event of a future sale of assets (generally beneficial to other buyers, making those companies more attractive). However, to the extent those buyers are comprised of U.S. individuals, there is now a 16% tax rate differential between federal corporate and individual tax rates (although a new 20% deduction applicable to qualified business income of pass-throughs can reduce that gap to around 8.6%). That’s a large enough difference to make these buyers consider a change in taxable structure. So, going forward after the tax reform, I think we are going to see more and more deals structured as acquisitions of C corporations, because it can ensure a much better cash flow in some situations.