Armanino Blog

Buyers Look Closely at Taxes in M&A

March 28, 2019

Tax planning is always important. When you’re exiting a business, it becomes crucial. As part of mergers and acquisitions (M&A) due diligence proceedings, potential buyers will thoroughly examine a target’s tax positions, reserves and accruals. You should address known issues with these tax items before pursuing the sale of your business.

Transfer Pricing

Transfer pricing — the pricing of goods, services and intangibles between related parties — is one of the most contested areas of taxation between buyers and sellers, as well as between taxpayers and governments. Taxpayers hope to minimize the amount of taxes they pay, but governments are looking to collect as much as they are entitled to. A company’s transfer pricing policies will determine how revenue is sourced among its related entities located all over the globe, enabling them to find that happy medium with all jurisdictions involved.

When reviewing a seller’s transfer pricing documents, purchasers will look at two things: (1) whether the right amount of tax has been paid to each jurisdiction, and (2) where the intellectual property of the business is owned. Buyers want to ensure that they can exploit the intellectual property after acquisition. If the intellectual property that the target uses to generate revenue is owned by a related entity in a different jurisdiction, the buyer might not be able to benefit from that revenue post-acquisition. Pre- and post-acquisition planning is crucial to make sure the intangibles are in the appropriate jurisdiction to benefit the acquirer.

Quality of NOLs

The U.S. Tax Code limits how an entity can use the business losses that it generates. Disallowed business losses can be carried forward to future years as net operating losses, or NOLs. These NOLs are recorded as assets on the books because they can be used to offset future tax liabilities. Such NOLs are enticing to the buyer and can increase the purchase price significantly.

Unfortunately, the tax code limits how useful these NOLs will be post-acquisition. When a change in ownership occurs, Section 382 may restrict the use of the NOLs. By having a Section 382 analysis conducted, the seller can help the purchaser validate the quality of the target entity’s NOLs so they can assign appropriate value.

State Taxes

A purchase price can easily degrade if the target does not address its state tax issues. Sellers need to consider each state’s unique taxes, including those on income, property, sales and use, gross receipts, inheritance and payroll. Buyers will look at the following issues before entering into a transaction:

  • Nexus: Nexus, or the minimum connection a business must have before it is required to file taxes in a particular jurisdiction, is not the same in every state. And in the wake of South Dakota v. Wayfair, Inc., a number of states have enacted economic nexus provisions, which require sales and use tax collection for out-of-state sellers that exceed a certain monetary threshold or number of transactions in their states. One misunderstood law could mean losing thousands of dollars in penalties and interest.
  • Apportionment: Allocating an entity’s sales among its active jurisdictions can be trickier than it sounds. One state may source sales using a market-based approach, and another may source based on where the work is performed. Mistakes in apportionment can generate penalties and interest, and they can have a ripple effect into other states as well.
  • State-specific adjustments: Not all states mimic the federal government’s choices, so state-specific tax return adjustments are required. Since the Tax Cuts and Jobs Act (TCJA) was passed at the end of 2017, there are even more federal tax deductions that states may choose to disallow on their own returns.

Buyers may have a different risk tolerance than their targets, so sellers should prepare to be questioned about their state tax practices and positions.

Research and Development Tax Credits

The TCJA made the research and development (R&D) tax credit available to more taxpayers than ever before. Buyers will want to know that their target can support their R&D credit claims. The information required to support the claims is extensive, and it would be difficult for the buyers to prove pre-acquisition claims without adequate documentation.

Buyers may also want to verify that reserves have been set aside in case the IRS uncovers an issue or disallows a portion of the credit. Targets that have reserves for these tax credits will look more attractive to the buyer.

Beyond Taxes

Taxes are not the only things you should concern yourself with leading up to the sale of your business. You should also evaluate your financial reporting team, consider an audit, address contract noncompliance, and perhaps most importantly, consider whether the timing of the transaction is optimal. You should have all your bases covered so that when it’s time to pull the trigger, you feel confident that you made the right decision.

March 28, 2019

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