D. Tax Accounting and Reporting Objection
i. General Discussion
There are two basic types of taxable acquisitions: asset deals and stock deals.
The first type of taxable transaction, collectively referred to as “Asset Deals,” involves:
- an acquisition by the buyer of the assets of a target company,
- an acquisition by the buyer of the stock of a target company accounted for as an acquisition of assets pursuant to an election under section 338(h)(10) of the Internal Revenue Code , or
- a forward triangular merger of a subsidiary of the buyer and the target in which the target company is merged out of existence and which is accounted for as a purchase of assets of the target.
The use of limited liability companies (“LLCs”) as business entities has increased in recent years, and a correspondingly increasing number of targets doing business as LLCs have appeared in M&A transactions. LLCs generally use a pass-through entity status for tax purposes, unless they are covered by an election to be treated as an association taxable as a corporation. In the case of an LLC as selling or target entity, the result of the purchase of all of the ownership interests in the entity is generally treated the same as a purchase of the assets of the entity for tax purposes. Revenue Ruling 99-6, Situation 2, provides that the purchase of all of the equity or membership interests in a target LLC by a buyer is treated the same as the sale by the former owners of all of the assets of the entity to the buyer — equivalent to a 338(h)(10) election for LLCs.
The second type of taxable transaction involves a purchase by the buyer of the stock of the target company (without a section 338(h)(10) election) or a reverse triangular merger of a subsidiary of the buyer and the target in which the target company is the survivor (collectively, “Stock Deals”).
ii. General Tax Accounting Rules
A pre-closing event or negative condition that would constitute a breach of a representation by the seller may in real terms constitute an unfavorable occurrence for the buyer. But that does not mean that a buyer’s outlay to address the event or negative condition, in and of itself, will generate an expense that can currently be deducted by the buyer for federal income tax purposes. Certain post-closing expenditures, i.e. Rectifying Expenditures, by the buyer or a buyer subsidiary that are incurred to correct negative events or conditions that occurred prior to the closing, such as the misrepresented quantity or usable condition of inventory or machinery and equipment, would probably have to be capitalized by the buyer and would therefore not be immediately deductible. Accordingly, those Rectifying Expenditures would not give rise to an immediate “tax benefit” that could be viewed as a potential tax “windfall” which is the very basis of the “fairness” argument.
Further, even if the rectification of the misrepresented pre-closing event or condition does give rise to an otherwise legitimate deductible expense, it does not necessarily follow that the expense would be deductible by the buyer (or the target in the case of a Stock Deal). For an expense to be deductible as a trade or business expense by a taxpayer it must be an ordinary and necessary expense of that taxpayer’s trade or business. If the expense was incurred in some other taxpayer’s (i.e., the seller) trade or business it will generally not be deductible by a different taxpayer (e.g., the buyer) but may continue to be deductible by the first taxpayer (i.e., the seller). Also, for an expense in respect of a liability to be deductible by an accrual basis taxpayer generally all the events needed to establish liability must have occurred, the liability must be fixed and determinable, and economic performance (which generally means payment by the taxpayer) must have occurred with respect to the expenditure by the end of year in which the deduction would be claimed (or in certain cases shortly after the end of that year). If the buyer merely pays a liability properly attributable to the seller that does not provide any assurance that the buyer will be entitled to a deduction for that expense.
The task then is to apply these general tax accounting rules to the types of taxable transactions described above: Asset Deals and Stock Deals.
iii. Asset Deals
Where the buyer or the buyer’s subsidiary takes title to the assets of the purchased business and there is a breach of a seller’s representation to the buyer and as a result the buyer becomes subject to a liability or negative condition, the question is whether the Rectifying Expenditure in undoing the damage occasioned by such liability or negative condition is properly deductible by either the buyer or the seller. For an expenditure to be deductible by a taxpayer under the accrual method of accounting, it must meet three conditions:
- it must be an ordinary and necessary expense of the taxpayer’s trade or business;
- the liability must be fixed and determinable; and
- economic performance (which generally means payment) by the taxpayer must have occurred with respect to the expenditure.
All three conditions must generally be met before the end of the taxable period of the taxpayer claiming the deduction. If the misrepresentation by the seller concerns a liability or negative condition that was not fixed and determinable on or prior to the closing, even if it could not have been deducted by the seller prior to the closing, the Rectifying Expenditure by the buyer in respect of the liability or condition does not necessarily convert to one that could be deducted as an expense by the buyer. In such a case the Rectifying Expenditure is really more akin to a liability that the buyer assumed as part of the purchase and should more properly be treated as part of the purchase price. Under existing authority it is generally accepted that any liability – even a contingent liability – that is assumed by the buyer in the purchase of the assets of a business must be capitalized into the cost of the acquisition and that liability may not be deducted by the buyer. If a liability was a contingent liability at the closing and did not become fixed and determinable until after the closing, that liability could still not be deducted by the buyer. The fact that the buyer will be precluded from claiming a deduction for an assumed liability will be the result whether the assumed liability is fixed and determinable or is contingent, whether it is identified or not identified, or whether the liability is known or unknown at the time it is assumed.
Thus, in an Asset Deal, there is no merit from a tax point of view to a seller’s argument that a buyer will have a potential tax windfall from a Rectifying Expenditure that should be reflected as a reduction of seller’s indemnity payment. Asset Deals do not give rise to a viable tax benefit offset (referred to hereinafter as “Viable TBO”)
iv. Stock Deals
1. Free-Standing and Not Pass-Through
In a taxable Stock Deal, the target company remains in existence as a separate entity following the closing and if it is an accrual basis taxpayer, it should generally retain the ability to deduct a Rectifying Expenditure that was necessitated by and arose from the circumstances underlying a breach of representation. This is the case whether the liability was a fixed and determinable liability that was properly accrued prior to the closing or was a contingent liability that was properly accrued after the closing. A Stock Deal does not involve the disqualifying element of a “new” or different taxpayer trying to claim a deduction that is attributable to another taxpayer’s trade or business, which was the critical problem in an Asset Deal. Thus, in taxable Stock Deals there might be a potentially Viable TBO.
However, if the target company was a member of the seller’s affiliated group and was included on the consolidated return filed by that group prior to the Stock Deal, the target company may still be precluded from deducting after the closing a Rectifying Expenditure. Preclusion would be the result if the deduction was or should have been properly accrued for tax purposes prior to the closing. If that deduction was or should have been properly accrued for tax purposes prior to the closing it should be claimed on a consolidated return for that prior period and it should not be available to the target company following the closing. As in the case of an Asset Deal, there is no prospect for a Viable TBO if target was not a free-standing taxpayer.
The result would be similar if the target prior to the closing was a corporation covered by an S election (or if it was a pass-through entity not covered by an election to be treated as an association taxable as a corporation). Under the S corporation rules, the income items and deductions of an S corporation that appear on its return for a particular year pass through to the stockholders of the corporation at that time and would not thereafter appear on any subsequent return filed by the corporation. In other words, deductions that were or should have been properly accrued prior to the closing may not be available to the target company after the closing if the target company was covered by a consolidated return through the closing or if it was covered by an S election through the closing. The result is similar if the target was a limited liability company or other entity which is subject to “pass through” taxation. These Stock Deals involving pass-through targets do not present the possibility for a Viable TBO.
It may be observed that such Stock Deals where the target has been in a consolidated group or the target is a pass-through have a disqualifying feature that is shared with Asset Deals: the presence of an additional or different taxpayer entity (the consolidated group or the owners of the pass-through) which is entitled to claim the deduction.
2. Code Sections 382 and 383
Even if the target was a C corporation through the closing and was not included on a consolidated return covering the seller’s affiliated group (i.e., it was free-standing), the target’s ability to claim a tax-saving deduction could be also reduced or eliminated by operation of the net operating loss carryover and the built-in loss rules of section 382 and section 383 of the Internal Revenue Code (“Built-in Loss Rules”). These rules restrict the ability of a target corporation, in any year after there has been a prohibited change in the ownership of the target, to utilize net operating losses and built-in losses that were in place at the time of the change in ownership. A prohibited change in ownership will generally occur if over any three-year period there is a shift in the ownership of more than 50% of the outstanding stock of the target corporation, and the Section 382 rules apply once that threshold has been exceeded.
The Built-in Loss Rules in general restrict – on an annual basis after the prohibited change in ownership (i.e., the closing) – the target’s ability to utilize those net operating loss carryovers and built-in losses that were in place at the closing to the value of the target at the time of the change in ownership times the long term tax-exempt interest rate. In December of 2020 the long term tax exempt rate was 0.99%. Using that rate, if a target was acquired in December of 2020 for $5,000,000, the annual limitation on utilizing those losses constituting Rectifying Expenditures would only be $49,500.
The authors believe (admittedly without the support of empirical data) that the vast majority of merger and acquisitions that take place each year in the United States, and certainly almost all of the deals covered by the Latest ABA Study, involve the single year transfer of more than 50% ownership of target enterprises. Accordingly, the Built-in Loss Rules would minimize the potential tax benefits alleged by sellers to be available to most buyers of C corporation targets depending on the value of the target at the time of the closing.
3. Summary of Stock Deal Issues
In short, the argument that a foundational “windfall” would give rise to a Viable TBO (even if it was available) would only be available to a buyer or a buyer subsidiary in a taxable Stock Deal if the target meets two conditions:
- the target had been prior to the closing a “free standing” individually taxed entity (i.e., not part of seller’s consolidated group); and
- the target is a C corporation (or an LLC covered by an election to be treated as an association taxable as a corporation and not covered by an S election).
If the target does not meet that two-part test, then the Rectifying Expenditure as to the buyer will be treated as part of the purchase price or it will be treated as an expense properly allocated to another taxpayer.And even if the target is a free-standing C corporation, any deduction opportunity would also be severely limited by the Built-in Loss Rules discussed above. If the target was an S corporation or other pass-through entity such as a limited liability company (which is taxed as a partnership) or a partnership, any deduction constituting a Rectifying Expenditure which is actually attributable to a period prior to the closing would be allocated to the equity owners of that entity and would not be available to buyer. Thus, in the case of taxable Stock Deals the potential of a tax benefit windfall to the buyer would not materialize. Overall, a Viable TBO mechanism which is intended to achieve the “fairness” arguably sought by sellers would fail.
3. How Are Actual Deals Being Done?
In the several ABA Studies published by the ABA M&A Committee over the past decade, TBO provisions in deal documents appeared in many instances although there has been a clear declining trend since 2011 when TBO provisions appeared in a slight majority of deals studied. As mentioned earlier, 41 of the 151 deals covered by the Latest ABA Study in 2019 contained pro-seller TBO provisions – just over 27%. Of those 41 deals, 3 were tax free reorganizations in which TBO provisions could be viable from a tax point of view, but which would nevertheless be subject to the other objections outlined earlier in this article including the Built-in Loss Rules which severely restrict tax savings that an indemnifying seller would seek to exploit. Of the remaining 38 deals, 10 were Asset Deals for tax purposes which as argued above do not present Viable TBO situations. All the remaining 28 deals were Stock Deals which included potentially Viable TBO provisions, but only if the target were free-standing and taxed as a C corporation.
Given the inherent complexity of taxation in general, it could reasonably be expected that contractual provisions regarding TBO would likewise tend to be extensive and complex. In fact, the TBO provisions in the documents in question in the Latest ABA Study were brief and relatively simple. There follow several representative examples of TBO provisions which run the gamut from simple to detailed to very detailed.
“The amount of any and all Losses shall be determined net of …any Tax benefits realizable by or accruing to the Purchaser Indemnitees with respect to such Losses.”
“Without limiting the effect of any other limitation contained in this Section … for purposes of computing the amount of any Damages incurred by the Indemnified Party under this Section … there shall be deducted an amount equal to the amount of any Tax benefit actually realized within two (2) years of such Damages in connection with such Damages, as determined on a ‘with and without’ basis.”
“The amount of indemnification claims hereunder will be net of any tax benefits realized within three (3) taxable years by the Indemnified Party in connection with such claims.”
- More detailed
“The amount of any Buyer Indemnified Losses shall be reduced by the amount of any Tax Benefit directly or indirectly available to the Buyer Indemnitee relating thereto. For purposes of this Section …a ‘Tax benefit’ shall mean a reduction in the Buyer Indemnitee’s Tax (calculated net of any Tax detriment resulting from the receipt of any indemnification payment, including the present value of any Tax detriment resulting from the loss of any depreciation and amortization deductions over time, calculated using a discount rate of 3.5%) arising out of any Damages that create a Tax deduction, credit or other tax benefit.”
- Very detailed
Indemnity payment regarding Losses “shall be reduced to reflect any Tax Benefit actually realized in the year in which the indemnity payment is required to be made or in any prior year by Buyer …. Tax Benefit means any deduction, amortization, amortization, exclusion from income or other allowance that actually reduces in cash the of Tax that Buyer … would have been required to pay (or actually increased the amount of the Tax refund to which Buyer… would have been entitled in the absence of the item giving rise to the claim….For purposes of this section … Buyer …. shall be deemed to use all other deductions, amortizations exclusions from income or other allowances …prior to the use of ‘Tax Benefits’….”
C. Calculation of Tax Benefit Amount
All of the TBO provisions require a calculation of the amount of the tax benefit offset. Those provisions effectively call for subtracting the amount of actual tax paid by the buyer from the amount of tax which would have been paid without including the tax-reducing item (sometimes referred to as the “with and without” method). A variation on the with and without method seen in a few of the deals studied calls for subtracting the amount of actual tax paid by the buyer from the amount that would have been paid if the tax-reducing item is the last item included (sometimes referred to as the “last in” method). It is unclear whether there is any real difference in result under the two methods.
D. When Must Tax Saving Be Actually Realized by Buyer?
Most of the 28 Stock Deals studied specify a period of time during which the tax benefit or savings must be actually received or realized by the buyer in order to reduce an indemnity payment. Where a time period is specified, it is usually expressed in tax years measured from the date of incurrence of the damages underlying the breach of representation. Additional periods of one, two or even three years are specified. It should be noted that the limiting effects of the Built-in Loss Rules (currently about 1% per year) combined with the specified short periods which tax savings must be realized by the buyer in Viable TBO provisions greatly reduces to minimal percentages any possible reduction of sellers’ indemnity obligation.
E. Mandate on Buyer to Seek Tax Benefits; Mitigation
Most of the TBO provisions refer to tax savings or tax benefits “actually” received or realized (some say “in cash”) by the buyer. None of the TBO provisions expressly compel the buyer to seek tax savings or benefits.
Even the stand-alone express general mitigation obligation contractually imposed on buyers (found in 18 of the 28 Stock Deals with TBO provisions) do not obligate the buyer to seek tax benefits. Those stand-alone general mitigation provisions do not mention tax issues at all. Furthermore, almost all such mitigation provisions address the “gross” losses or damages, but not the “net” indemnification payment. Such contractual mitigation provisions do not by their terms extend to the attainment of tax advantages favoring the seller.
It is worth noting that another pro-seller provision analogous to TBO often seen in M&A documentation reduces the indemnity payment a seller must pay by any insurance recovery received or receivable by the buyer on account of the circumstances underlying the breach of representation. Such insurance provisions are found in all 28 Stock Deals in the Latest ABA Study. Unlike the silence of the language of TBO provisions, the insurance offset provisions frequently do expressly require the seller to seek recovery under available insurance. The implication would be that such an affirmative duty would not apply in the case of TBO when the two offset provisions appear in the same document.
F. What Role Does Seller Have in Buyer’s Tax Strategy?
None of the 28 Stock Deals with potentially Viable TBO provisions give seller any a priori role in the preparation of the buyer’s tax returns or the selection of the buyer’s tax reporting strategy. It appears, appropriately so, that in the first instance the buyer has total control of its tax reporting and filing. However, there should clearly be litigable potential for the seller to inquire as to the existence of tax savings even in the absence of contractual provisions to that effect. In a dispute over indemnification and TBO there could be significant risk to buyer that a court would grant a seller some right of discovery taking into account mitigation obligations, either common law or contractual.
G. Lack of Buyer Protection
None of the 28 Stock Deals in question contained any provisions that would protect an indemnified buyer if TBO issues were in play. There were no provisions protecting the confidentiality of buyer’s tax reporting. Further, there was no express provision leaving all tax reporting decisions to the exclusive discretion of the buyer. It is left unsaid what happens if the buyer is forced to litigate an indemnity claim. If the buyer’s indemnity claim resulted in litigation it would expose the buyer’s tax returns and its reporting positions to scrutiny and disclosure. The buyer could also be forced to show that it has not been unreasonable in declining to adopt tax positions advocated by the seller. Would the buyer’s tax returns and the testimony of its tax advisors be part of the public record in the case or could they be sealed? Would the buyer be forced to adopt tax positions advocated by the seller and adopted by the court even though buyer’s tax advisors recommended against adopting those positions? What assurance would the buyer have that the seller would be willing or able to defend a buyer which adopted those seller-friendly positions if a taxing authority later questioned those positions? Such critical questions are not addressed whatsoever in any of the TBO provisions in any of the deals in question. The risks and uncertainties could very well chill the inclination of buyers to seek redress through indemnification for obvious breaches of representations.
H. Procedural Shortcomings
What is missing from all the TBO provisions in all 41 deals covered in the Latest ABA Study is any treatment of the mechanics of implementing an adjustment of the payment under a TBO scheme other than in many of the deals which require buyer to refund a portion of a tax saving subsequent to receiving an unadjusted indemnity payment. Since there is no express requirement that the buyer seek tax benefit or tax savings, and since any tax benefit or tax saving would ordinarily occur well after the buyer successfully sought an unadjusted indemnification payment from the seller it would seem that it is up to the seller to proactively monitor the activity of the buyer and query the buyer about tax benefits subsequent to the indemnity payment. Perhaps there is an implied duty (good faith and fair dealing) on the part of the buyer to keep the seller informed, but no explicit provision to that effect is found in any of the documents. In any event, the absence of treatment of the mechanics suggests that the sellers who extract a TBO provision from the buyer are not trying very hard to provide for a truly functioning and effective provision that will provide a possible advantage. It may be that sellers are satisfied with extracting from buyers a provision that might inhibit a buyer from seeking redress through indemnification than in actually seeking workable reduced indemnification liability.
I. Do the 28 Stock Deals Pass the Free-Standing C Corp Test?
The ultimate test of the viability of TBO provisions in a Stock Deal is whether the target company is a free-standing taxpayer and is treated for tax purposes as a C corporation. The authors are not aware of any publicly available databases that would answer either of those questions. However, in some cases the documents themselves contain indications of status in whereas clauses, representations and warranties, and certain other provisions. On that basis the authors conclude that all 10 Asset Deals and at least 5 of the Stock Deals would actually fail the free-standing C corporation test. Accordingly, in 18% of all Stock Deals in the Latest ABA Study the TBO provisions are just not viable from a tax point of view.
Earlier in this article it is suggested that the traditional limitations on indemnification payments such as baskets, caps and short survival periods foster peace, clarity, finality and closure between buyer and seller. That is not true of TBO provisions. TBO provisions actually greatly prolong the period of hostility between buyer and seller, and give rise to numerous additional issues and grounds for dispute. It appears obvious that many M&A practitioners do not understand the tax law and the practical consequences (especially to the buyer) in negotiating TBO provisions in deal documents. Seller-side practitioners can be excused for blindly advocating for TBO provisions along with all other obstacles to indemnification by buyer. The same can’t be said for buyers. The acceptance by buyers of such TBO provisions, without at the least insisting on measures to protect the buyer, suggests a lack of vigilance or failure to perceive the dangers.
When approximately 36% of all of the deals in the Latest ABA Study cannot possibly have the desired result under applicable tax law, and when the remaining 64% can only have an absurdly small percentage desired result under applicable tax law (i.e., the Built-in Loss Rules), it is time that the TBO concept is abandoned in all M&A transactions. It is the view of the authors, for all the reasons set forth in this article, that TBO provisions do not belong in M&A transactions.