Tax compliance for acquisitions: Prepare before purchasing
Fears of a “double-dip” recession in 2012 may have subsided, but the
overall economic forecast remains uncertain. Therefore, companies are
looking beyond organic, internal growth to external growth sources to
bolster company performance.
A recent study by The Boston Consulting Group (BCG) touted the power
of acquisitions for growth during turbulent economic times. The study
found a positive correlation between mergers and acquisitions by
companies during economic downturns and superior shareholder returns
for those companies (“The Power of Diversified Companies During
Crises,” Jan. 25, 2012, available at tinyurl.com/7tl8a3c; free
registration required). The BCG noted that “[merger-and-acquisition
activity] executed during downturns, when GDP growth is below its
long-term average of 3 percent, tends to produce substantially higher
long-term shareholder returns than deals done in economic upturns.”
The BCG also noted that “[o]verall, the outperformers conducted 2.2
times as many acquisitions as the underperformers.”
Although acquisitions can be important to strategic growth during
times of economic uncertainty, the execution of an acquisition can be
challenging, especially regarding tax compliance. Within each key
component of an acquisition (due diligence, integration,
accounting/financial reporting, and post-acquisition compliance),
certain tax concerns, if not identified early and properly addressed,
can significantly impair the successful execution of the overall
combination.
DUE DILIGENCE
It is critical that an acquiring company understand the tax
implications of an acquisition before attempting to structure the
transaction. If the transaction is structured as a stock acquisition,
the acquiring company has limited opportunity to mitigate associated
tax liabilities other than through contractual indemnifications. This
is because the acquiring company assumes all liabilities regardless of
whether they are recorded on the target company’s books. On the other
hand, if the transaction is structured as an asset acquisition, the
acquiring company can attempt to exclude associated tax liabilities
from the purchase. Where tax exposures may be assumed, it is important
that the acquiring company begin due-diligence efforts early, because
identifying and quantifying the breadth of such tax liabilities may
prove challenging.
One of the most challenging aspects of assessing tax liabilities is
the time required to identify them. Typically, such identification
requires obtaining supporting documentation for all open tax years,
which initially may include prior-year tax returns, tax provisions,
and adoption- and subsequent-year support of FASB Accounting Standards
Codification (ASC) Subtopic 740-10 (previously FIN 48), Accounting
for Uncertainty in Income Taxes. Moreover, if the target
company has made any prior acquisitions, similar data for the acquired
companies will be required. In many cases, this data must be tracked
down via old databases, multiple binders, and off-site storage
centers, which typically requires significant time. In some cases,
authorization may be required from one or more tax service providers,
which also may delay the identification process.
Once the tax liabilities have been identified, the next challenge is
quantifying such amounts. Considerable analysis of prior-year data
typically is involved in quantifying tax liabilities, and that also
often requires considerable time. Year over year, for all open tax
years, return and provision data must be analyzed to evaluate whether
unidentified tax liabilities exist.
Following are examples of challenging tax liabilities to identify
and quantify as part of due diligence that companies should prepare
for early and investigate thoroughly:
Target acquisitions. The target company previously
may have acquired one or more companies and may be carrying tax
attributes, reserves, etc., from those companies on its books. It is
important to review these amounts thoroughly for accuracy and
assurance that the target has properly identified and recorded these
items. If these items have not been properly identified either by the
target company or as part of the due-diligence process, additional tax
liabilities may arise.
Additionally, the misapplication of such tax attribute limitations
as the “SRLY” (separate return limitation year) rules, Sec. 382/383
change-of-control limitations, and unified-loss rules set forth in
Regs. Sec. 1.1502-36 could result in additional tax liabilities from
tax attributes the target used that may have been limited or even
never allowed. Some states follow federal tax attribute limitations,
potentially resulting in further tax liabilities. Foreign tax
attributes may carry their own limitations as well.
ASC 740-10 reserves. Ideally, the target’s
adoption of ASC 740-10 and subsequent quarterly/annual updates should
have uncovered any material income tax uncertainties from a federal,
state, and foreign income tax perspective. But again, as part of
uncovering tax liabilities within the due-diligence process, the
acquiring company should review existing reserves for accuracy and
determine whether additional reserves are necessary. As some time may
have passed since companies adopted ASC 740-10, underlying studies and
supporting analyses may require updating. Areas likely needing updated
analyses include state nexus, tax attribute limitation, tax credits,
permanent establishment, and transfer pricing.
In addition, other taxes not covered by ASC 740-10 (e.g., sales/use,
payroll, property, franchise, and value-added tax) should be reviewed
as well for potential additional tax liabilities. Even if a target
company has large losses, significant tax liabilities may be found in
foreign taxes and these non-income-based taxes.
Ongoing tax audits. Another potential source of
tax liabilities is ongoing federal, state, or foreign target company
tax audits. The resolution of such audits could mean a substantial tax
liability in the future. Therefore, it is important that the acquiring
company protect itself contractually from tax liabilities arising from
ongoing audits or at least factor the estimated tax liabilities into
valuing the target company.
INTEGRATION
As with due diligence, the integration process necessary for a
successful acquisition can be mired in tax-related concerns.
Typically, the most challenging tax concern during this acquisition
stage is the propensity to contain such efforts solely within the tax
department when, in reality, tax effects ripple throughout many
departments.
Following are key departments, beyond core tax, that should be
included in the integration process, along with the potential tax
implications if excluded:
Legal. It is critical that the legal department be
involved in the tax aspects of integration to assist in creating a
tax-efficient, post-acquisition organizational structure. The legal
department can help achieve an organizational structure that provides
optimal tax and treasury results. Such reorganization may include
eliminating or merging subsidiaries in the same jurisdictions to
prevent duplicative filing requirements and general complexity but
should be weighed against the potential loss of tax attributes from
the eliminated subsidiary. In addition, the target company may bring
new intercompany synergies that create improved transfer-pricing
opportunities and minimize foreign withholding taxes. It also is
important that the legal department be involved with respect to the
situs of intellectual property, which can significantly affect future
income and withholding tax liabilities.
Information technology. An acquisition can present
a significant administrative burden for the tax function if the
information technology (IT) department is not involved early in the
integration process. A typical example is a target company that
previously changed its tax-related IT systems. Key data necessary for
ongoing target tax compliance may be lost if the old IT systems are
not identified and preserved. Another example is a target company’s
using multiple IT systems for assessing various tax liabilities, such
as income, sales/use, and payroll taxes. It is important that each
tax-related IT system of the target be identified and incorporated
into the acquiring company’s systems. Overlooking any of these
tax-related systems may result in miscalculation of tax liabilities
and a need to re-create supporting documentation.
Human resources. It also is important that human
resources be included in acquisition integration efforts because of
the effect payroll has on the tax function. State filing requirements
and apportioned income are based in part on the location of payroll.
Therefore, upon combination of the companies, payroll effects should
be evaluated to determine whether they give rise to or eliminate state
filing requirements, as well as their impact on state-apportioned
income. Similarly, the foreign tax implications from integrating
payroll also should be considered with respect to additional or
eliminated filing requirements, as well as their impact on foreign tax
liabilities.
ACCOUNTING / FINANCIAL REPORTING
An otherwise successful acquisition can be complicated by the
related tax purchase accounting requirements. The complexity stems
primarily from the existing purchase accounting rules that could
produce results that may seem counterintuitive and therefore may be
misapplied, with significant financial statement implications for the
acquiring company.
Following are some of the more challenging purchase accounting rules
that could significantly affect the acquiring company’s financial
statements.
Release of VA for the acquirer’s DTAs. The
purchase accounting rules for release of valuation allowance (VA) for
the acquiring company’s deferred tax assets (DTAs) in conjunction with
an acquisition may seem counterintuitive. The rules require that such
release be reflected in the acquirer’s income tax expense, rather than
as part of purchase accounting. These rules may result in increased
earnings volatility for the acquiring company, which must now reflect
acquisitions-related events within its own financial statements
instead of absorbing acquisitions-related tax impacts separately
within purchase accounting.
In practice, this rule means that the establishment on the books of
the acquired entity of deferred tax liabilities (DTLs) related to
non-goodwill intangibles generated as part of the acquisition could
have the effect of releasing VA on the books of the acquiring company,
with the offset being that an income tax benefit is recorded. If the
acquired entity is in a net DTL position after all purchase accounting
adjustments are recorded (often because of significant amounts of
non-goodwill intangibles), the corresponding income tax benefit
associated with the release of VA on the acquirer’s books may also be
significant. The rules on this are rather complex, and, as such, a
substantial amount of analysis should be performed to ensure they are
being applied properly.
Release of VA related to acquired DTA subsequent to
acquisition. Similar to the release of VA for the
acquirer’s DTA in conjunction with an acquisition, the purchase
accounting rules for a VA release related to acquired DTA subsequent
to the acquisition also may seem counterintuitive. Under these rules,
again, the release of a VA is generally reflected in income tax
expense instead of as part of purchase accounting, and may result in
earnings volatility. An exception to this rule is for the release of
VA within the measurement period (within one year after the
acquisition date, during which a company may adjust the provisional
amounts recognized for a business combination) resulting from new
information about facts and circumstances that existed at the
acquisition date. In this instance, the release of VA is properly
reflected within purchase accounting.
Subsequent accounting for uncertain tax positions assumed in an
acquisition. As with the previous two purchase
accounting rules, uncertain tax positions assumed in an acquisition
also may produce unexpected results, as they require subsequent tax
reserve adjustments that do not qualify as measurement-period
adjustments to be accounted for outside purchase accounting. The
result of the application of these rules, again, is potentially an
increase in earnings volatility.
POST-ACQUISITION COMPLIANCE
Although it is relatively well understood that short-period federal,
state, and foreign income tax returns will often be required for the
target from the beginning of the target’s tax year through the
acquisition date, navigating the completion of such returns may prove
challenging. Therefore, this process should be started as early as
possible.
Determine the preparer. This may seem obvious,
but, in practice it can pose many hurdles. Several tax service
providers may be involved, all with the capacity to prepare such
returns. For simplicity, the short-period returns are often prepared
by the same tax service provider used to prepare the target’s
prior-year returns, even if ultimately the surviving company tax
function is covered by a different tax service provider. Conversely,
as a new preparer is generally used in post-acquisition periods, the
surviving company may want to integrate the target’s data as soon as
possible and begin by processing these returns.
Maintain prior preparer relationship. Regardless
of which tax preparer ultimately completes the target’s short-period
returns, it is important that relationships be maintained throughout
the transition process. While most information should be obtained in
the due-diligence process, the surviving company may still be somewhat
dependent on the target’s preparer for obtaining tax return
preparation data, gaining access to prior-year supporting data,
understanding current- and prior-year tax positions taken, and better
understanding the target company in general. Without this information,
the time and effort involved in understanding and re-creating
necessary target data can be daunting.
Understand due-diligence results. Before preparing
and filing the short-period returns, it is important to review the
results of due diligence to ensure noted tax exposures have been
addressed, tax attribute carryforwards have been perfected, and
jurisdictions where filing obligations were found to exist (and those
where final returns are applicable) are identified.
Ensure acquisition-related issues are addressed.
Target company short-period returns should be evaluated to make sure
they address acquisition-related issues. A common acquisition-related
issue with these returns is whether Sec. 382/383 tax attribute
limitations prevent using target company tax attributes due to the
target company’s change of control triggered by the acquisition. The
change of control may also trigger Sec. 280G “golden parachute”
provisions, under which a target company’s change-in-control payments
to an executive might be partly nondeductible (and for which the
executive could incur a nondeductible 20% excise tax under Sec. 4999).
It also is important to understand what transaction-related costs may
be deducted by the target company, which can be a complex analysis.
Finally, it should be verified that statements required by the unique
issues created by an acquisition are included in the target company’s
short-period return.
LAYING THE GROUNDWORK
During uncertain economic times, acquisitions are an excellent way
to bolster company growth. But executing a successful acquisition is
not easy, especially when it comes to tax considerations. The most
potentially detrimental tax considerations are typically the most
commonly overlooked or delayed until after the acquisition. Careful
tax planning far in advance of a contemplated acquisition will help to
mitigate these issues and ensure an overall successful acquisition.
EXECUTIVE SUMMARY
Companies can grow through merger and acquisition
even in periods of economic uncertainty, but to do so successfully,
they must plan and manage tax and other aspects of the transition
through due diligence, integration, proper accounting and financial
reporting, and tax compliance.
During the due-diligence process, an acquiring
company should scrutinize tax attributes from any previous
acquisitions, reserves for uncertain tax positions, and any ongoing
tax audits of the target company.
In the integration phase, the company should keep taxes in
mind as it combines not only the target’s and its own tax
departments, but their legal, information technology, and human
resources departments as well.
Accounting and financial reporting issues deserving special
care include proper recording of the release of valuation
allowance for the acquirer’s deferred tax assets and of any acquired
uncertain tax positions.
After an acquisition, a company benefits from
continuity between previous and successive tax preparers, addressing
any issues revealed during due diligence, and evaluating the target’s
short-period returns for tax attribute limitations and other
tax-related implications of the change in control.
Douglas M. Sayuk (
doug@cliftondouglas.com
), Matthew H. Fricke (
matt@cliftondouglas.com
), and Raymond J. Naughtin (
ray@cliftondouglas.com
) are partners, and Shamen R. Dugger (
shamen@cliftondouglas.com
) is a director, all of Clifton Douglas LLP in San Jose, Calif.
To comment on this article or to suggest an idea for another
article, contact Paul Bonner, senior editor, at
pbonner@aicpa.org
or 919-402-4434.
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