Tax planning and risk mitigation strategies are often reactive for growing businesses, with potential exposures addressed only after being identified rather than before they arise. For many technology and manufacturing companies, for example, early tax planning can preserve valuable attributes like R&D credits and net operating losses and can establish and protect millions of dollars in qualified small business stock exclusions for founders and early investors. For growing private equity platform companies, early planning can involve managing a global workforce or setting intercompany and transfer-pricing policies to both capture benefits and manage tax risk.
As the value of tax attributes and tax payments grows, so do the risks associated with potential audits of the tax positions taken and potentially not taken. These risks often go unidentified until a business is positioned for sale and subject to tax due diligence, at which point the range of available fixes narrows fast.
Target tax exposures identified pre-closing can be addressed in several ways. Historically, specific tax indemnities were provided by Sellers, often backstopped by extended escrow periods. The proliferation of representations and warranties insurance (“RWI”) replaced some tax indemnities, but RWI coverage typically excludes known tax risks, leaving material gaps in tax coverage for the Buyer. Adjustments to the offering price, filing voluntary disclosure agreements or pre-signing purchase price adjustment negotiations are other commonly considered tax risk mitigation tools, but the economic toll of the these strategies is typically several multiples of the cost of tax insurance.
Tax insurance is often available to transfer the exposure to the insurance markets, but Buyers often do not possess sufficient information and supporting documentation to obtain a tax insurance policy pre-signing. In addition, Buyers often delay raising a potential tax exposure until the eve of signing to maximize negotiation leverage, which forecloses the option of a pre-signing tax insurance policy charged to the Seller. Symphony Tax bridged this information gap for one client by working with the Seller to obtain the necessary facts and supporting documentation to obtain a tax insurance quote for the Buyer, allowing the Buyer to adjust the purchase price by the estimated cost of the policy pre-signing, then underwrite and bind the policy post-close.
Whether addressing a Target company risk that was identified but not mitigated pre-closing, or a risk arising from post-close transactions or operations, the company’s tax function and its leadership need to view tax risk mitigation strategically. Some identified risks are best avoided altogether, either by restructuring the transaction steps or reconsidering implementing the transactions giving rise to the risk. Other tax risks are outweighed by the benefits, whether that means acquiring the Target business despite the presence of tax risks or engaging in post-close activity that generates tolerable but unavoidable tax risk.
Viewing tax risk mitigation strategically means measuring:
- the worst-case scenario cash tax exposure to the company if the risk materializes,
- the impact on liquidity if reserves or escrows need to be established or maintained,
- reputational and economic risk to the company if an aggressive tax position becomes public knowledge, and
- the cost-benefit analysis of transferring the risk to a third party via tax insurance
It is uncommon for a tax issue to scuttle an otherwise opportunistic acquisition of a business, and frequently buyers ignore or postpone addressing Target tax concerns to facilitate signing and closing. Examples of tax issues that are identified during tax due diligence but are often left to be addressed post-close include, but are not limited to, the following:
| Common Target Tax Exposures | Description |
| The quantity and availability of tax attributes (e.g., NOLs, R&D credits, FTCs) | Questions or concerns with respect to losses generated from business activities or excess tax deductions, the calculation of R&D credits, and the basketing of foreign tax credits. |
| Concerns about the Target’s S corp election or transactions that impact S corp status | Most tax due diligence teams examining S corp Targets identify potential concerns with the Target’s S corp status, either because of a failure to produce the original S election form, or because transactions in the past raise concerns about the creation of a second class of stock. |
| The tax treatment of prior Target transactions | There is a wide variety of historic Target transactions and tax positions that could give rise to concerns, including the treatment of transfer-pricing and other related-party transactions, internal restructurings, and IP generation and ownership. |
| Tax treaty benefits and other cross-border activity of the Target | Frequently, tax due diligence teams identify risks related to reduced withholding taxes under tax treaties, permanent establishment risks, and local country non-US exposures such as indirect capital gains tax, stamp duty, and real estate transfer tax. |
Many of these risks can be mitigated by a tax insurance policy or economically addressed through less efficient means such as purchase price adjustments or indemnities. For example, Buyers often pull the tax-effected value of net operating losses or R&D credits out of their bid model, because of perceived risks associated with their calculation or availability. In a competitive process, that adjustment is typically 4 to 5 times as large as it would have been to obtain a tax insurance policy and adjust the bid price by the cost of the insurance instead.
Pros and Cons of Addressing Tax Risk Post-Close
Waiting until after closing to mitigate tax risks such as these eliminates the ability to push the mitigation cost to the Seller and narrows the options available to the Buyer. Options such as pre-closing restructuring of the transaction, carving out and leaving troubling assets or legal entities with the Seller, or purchasing tax insurance and allocating some or all the cost to the Seller, become unavailable post-closing. However, not only is tax insurance still available to the Buyer post-close, but it might be easier to obtain because the Buyer will have much greater access to Target information and documentation and will be on a less compressed timetable. Symphony Tax works with both Buyers and Sellers and their advisors to design the most cost-efficient and timely solution for either side of the table.
Post-Close Activities Create Tax Risk
In addition to tax risks identified but not mitigated pre-closing, there are many post-closing activities that can give rise to new tax exposures or exacerbate existing ones. In the context of a bolt-on acquisition (i.e., an acquisition of stock or assets by an existing portfolio company), there are often post-close integration transactions to move assets, operations and/or intellectual property into or around the platform legal entity structure. In a large platform or bolt-on acquisition, there may be unwanted assets or businesses that are carved out and sold after closing, potentially requiring internal transfers of assets to organize the business for sale, and/or complexities associated with calculating the tax basis of the disposed assets.
Around closing and often after, businesses recapitalize equity or restructure outstanding indebtedness, which can create unintended taxable income and interest deduction limitation concerns. For multinational businesses or ones that operate in many US states, there could also be the introduction or changes to transfer pricing policies, cost-sharing arrangements or centralized IP ownership that can generate material tax exposures.
Attention to taxes at the portfolio company level is often limited to compliance and reporting, especially for early-stage businesses that typically do not have sufficient taxable income to support strategic tax planning. However, most established businesses and those approaching exit will often benefit from strategic tax planning, which invites the potential creation of risks and exposures. If the intended transactions or restructurings generate economic or operational benefits that outweigh the perceived tax risks, strong consideration should be given to implementation of those transactions. If there is hesitation to incur those tax risks by the company or its owners, tax insurance is often available to protect against a challenge to the intended outcome.
In addition to mitigating risk, insurance and other financing alternatives can address liquidity concerns that arise in connection with establishing or maintaining indemnities and escrows. Capital that is reserved to cover potential future tax indemnities is effectively unusable for extended periods of time, creating liquidity shortfalls that can hamper business operations or growth. Often a tax insurance policy or similar financial product can be designed that will reimburse the obligor upon the payment of an indemnity, thereby allowing the obligor to reserve little to no long-term capital to support these obligations. For example, tax insurance can often be purchased to provide reimbursement if an indemnity payment becomes due in the future, typically when the indemnity relates to a potential tax exposure for which tax insurance could have been acquired by the party at risk. Similar insurance and financial products are often available to free up escrowed or reserved capital when there are material doubts that one or more payments will become due.
Conclusion
Tax risks and opportunities are not simply a compliance issue. The timing of tax risk identification materially impacts the mitigation tools available, which can have an enormous impact on strategic tax planning. Some risks are best avoided altogether; others are outweighed by the benefits of the underlying transaction. Either way, potential tax exposures need to be evaluated, quantified, and managed deliberately, not absorbed or self-insured by default.
Symphony Tax can help identify these risks and structure the solution, whether that is tax insurance, a financing solution, or suggested alternative transaction structures or mitigation strategies. If any of the scenarios above reflect a live matter, or one that surfaced on a transaction that has recently closed, we welcome the conversation.
Doug Brody
President, Symphony Tax
(516) 316-1184
dbrody@symphonyrisk.com