Massumi + Consoli LLP: Looking Back and Looking Ahead
The Federal Income Tax Impact of 2017 TCJA, 2020 CARES Act and “Build Back Better” Proposals on Middle Market Private Equity M&A Transactions
Ten months into Joe Biden’s presidency, with a current, slight majority in the House and Senate U.S. Democrats appear primed to enact federal income tax reform (even if ultimately modest) in order to fund infrastructure, healthcare, education and climate packages promised on the campaign trail. In light of the tax law changes set out by the Biden administration’s “Build Back Better” proposals, this article provides a brief summary of (i) certain tax changes previously enacted with the Tax Cuts and Jobs Act of 2017 (the “TCJA”), the Coronavirus Aid, Relief and Economic Security Act of 2020 (the “CARES Act”) and (ii) tax law changes being proposed under the Biden administration’s American Jobs Plan, American Families Plan and other proposals (and the House Ways and Means Committee’s September 2021 reconciliation bill legislation tax plan (the “HWM Plan”)) and their impact on private equity M&A transactions, especially negotiations between buyers and sellers and tax structuring considerations.
Tax Rates
The headline of the TCJA’s corporate tax changes, of course, was the reduction of the corporate income tax rate from 35% to 21%[1], creating a combined effective income tax rate to shareholders of 37% on corporate earnings (i.e. 21% corporate income tax rate and 20% qualified dividends/capital gains rate, ignoring state rates and the Medicare net investment income tax) – although in many cases the qualified dividends/capital gains component of the combined effective income tax rate can be deferred until shareholders ultimately exit the investment in the business. For equityowners of “pass-through” companies (partnerships, S corporations, sole proprietorships, etc.), in an effort to somewhat maintain parity with businesses in C corporation form, the TCJA introduced the Section 199A deduction for qualified businesses (any trade or business except one involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, dealing in certain assets or any trade or business where the principal asset is the reputation or skill of one or more of its employees), which, when taking into account the reduced highest individual income tax rate from 39.6% to 37%, effectively reduced the combined effective income tax rate to equityholders to 29.6% (subject to limitations).
Historically, many private equity sponsors have preferred to keep their portfolio companies in “pass-through” form for a variety of reasons, including the potential for a realized value on exit. This higher value could take the form of a strategic or sponsor buyer paying a higher sales price due to the buyer’s ability to take depreciation and amortization deductions in respect of the asset-level tax basis step up enjoyed by such buyer or could take the form of entry into a tax receivables agreement in an exit through an “UP-C” initial public offering or sale to a special purpose acquisition vehicle.[2] Additionally, some sponsors simply preferred the lower effective income tax rate (eliminating the two layers of tax caused by owning the portfolio company through a C corporation). However, as a result of the TCJA’s reduced corporate income tax rate, private equity sponsors engaged in middle market M&A transactions involving the majority stake purchase of a “pass-through” target company have found more difficult the decision whether to leave the target company in “pass-through” form (and selectively “block” for investors who specifically needed it) or to acquire the target company with a C corporation tax structure, especially considering the complexity involved in maintaining a “pass-through” structure (negotiating tax distributions and potentially controversial taxable income allocations, to name two complications). To further complicate matters, the Biden administration’s American Jobs Plan and American Families Plan would increase the highest individual ordinary income tax rate back to 39.6%, eliminate the preferential capital gains/qualified dividends rate altogether for taxpayers earning more than $1 million, and increase the highest corporate income tax rate to 28%, while the HWM Plan would increase the highest individual ordinary income tax rate back to 39.6%, increase the highest long-term capital gains tax rate to 25%, increase the highest corporate income tax rate to 26.5% (and introduce graduated rates for corporations, generally)[3] and cap the Section 199A deduction for qualified business income at $2 million per individual taxpayer. Any number of these changes would, once again, cause private equity sponsors to rethink their tax structuring preferences and return modeling in buy side M&A transactions.
Carried Interest
In a first major attempt to address the oft-criticized “carried interest” capital gains arrangements enjoyed by general partners of private equity funds and hedge funds, the TCJA introduced Section 1061’s three year holding period requirement (rather than the traditional one year holding period requirement) in order for investment proceeds received in respect of an “applicable partnership interest” (i.e. a “carried interest” arrangement) to be eligible for the preferential long-term capital gains rate. The highly technical rules in the statute (and in the final regulations thereunder issued by Treasury in January 2021) caused private equity sponsors and their teams of tax advisors headaches in seeking structures that successfully address, or at least mitigate, the longer holding period requirement, analyzing the impact of the risk of the higher tax rate to the general partner given the expected life of any applicable investment and/or determining whether to hold the investment longer in order to meet the holding period. In the end, while some have been implemented to varying degrees of success, many of the clever structuring exercises were abandoned due to complexity, risks of conflicts of interest with limited partners of the funds[4] or lack of confidence in the tax substance of the arrangements.
The Biden administration’s American Families Plan proposes to eliminate “carried interest” eligibility for the preferential long-term capital gains rate altogether for general partners and investment managers whose taxable income exceeded $400,000. The HWM Plan would instead increase the three-year holding period requirement to five years for such high earning general partners and investment managers. While not an outright elimination, this proposal does send the minimum holding period requirement much closer to, and in many cases longer than, the median life of the typical middle market private equity portfolio company acquisition, which would in effect likely dramatically increase the number of private equity sponsors needing to seriously consider the impact of the higher tax rate on their investments.
Corporate Net Operating Losses
Often, in private M&A transactions involving the majority stake sale of a C corporation target company, sellers will seek to include in the purchase agreement a provision designed to compensate the sellers for any net operating losses, tax credits or other similar tax assets that the target company has generated prior to the closing of the transaction, as well as any transaction-related tax deductions recognized by the target company (e.g. resulting from expenses incurred by the target company in pursuing the transaction – transaction bonuses, banker fees, debt payoff, etc.), and that may be available for use by the target company in realizing cash tax savings in post-closing tax periods to the buyer’s benefit. These provisions could take the form of a purchase price increase by way of a hard-coded amount (i.e. estimated at time of signing and not subject to later adjustment) or a formulaic determination (i.e. determined at closing using agreed assumptions) (in either case, a “Tax Benefit Purchase Price Increase Provision”), or, more typically these provisions could take the form of a covenant for the buyer to make post-closing payments to the seller as and when the target company utilizes the tax assets post-closing in generating cash tax savings on a with and without basis (a “Go-Forward Tax Benefit Payment Provision”). Often a Go-Forward Tax Benefit Payment Provision would be, at buyer’s request, limited by a survival period, a maximum cash payment amount or other limitations.
Additionally, sellers will seek to include a provision that requires the buyer to make post-closing payments to the sellers based on the amount of any tax refunds received by the target company that relate to taxes paid prior to closing (a “Tax Refund Payment Provision”). In protecting such Tax Refund Payment Provisions, sellers would include a covenant in the purchase agreement requiring buyer to cause the target company to carry back any net operating losses or other tax assets generated prior to closing to the greatest extent possible.
The TCJA introduced a handful of income tax law changes that had an unanticipated impact on these and similar provisions. First, as a result of the TCJA corporate taxpayers were no longer able to carry back net operating losses.[5] Instead all net operating losses were required to be carried forward until the first available year with otherwise net positive taxable income. As a result, tax refunds that sellers would have otherwise expected the target company to receive after closing were no longer available, making Tax Refund Payment Provisions less valuable to sellers. Second, as a result of the TCJA the carryforward of net operating losses was made subject to an 80% limitation[6], elongating the time in which a Go-Forward Tax Benefit Payment Provision would yield any cash tax savings payable to the sellers (and, if the Go-Forward Tax Benefit Payment Provision was subject to a survival period in the purchase agreement, then potentially reducing its overall potential payout altogether), making such Go-Forward Tax Benefit Payment provision less valuable to sellers. On the flip side if a purchase agreement included a Tax Benefit Purchase Price Increase Provision, then such 80% net operating loss limitation may have had the retroactive result that the buyer overpaid the sellers for the expected tax benefits.
Further complicating matters, with a goal of providing tax relief to American businesses during the midst of the COVID-19 pandemic, the CARES Act reinstated the ability for corporate taxpayers to carry back (to the five preceding tax years) net operating losses generated in the 2018, 2019 and 2020 tax years. Suddenly, a company that may have been in a positive taxpaying position in past years was able to immediately monetize net operating losses (rather than wait for future profitable tax years), and if such company were a target in an M&A transaction in the interim, such event had the potential to cause the buyer to make cash payments to the sellers under a Tax Refund Payment Provision even though the buyer may have paid additional purchase price in respect of those net operating losses in a Tax Benefit Purchase Price Increase Provision. As a result, buyers and sellers found themselves scrambling to see what they owed or were owed under purchase agreements in respect of Tax Refund Payment Provisions and what types of efforts standards such agreements included in respect of any requirement to affirmatively monetize net operating losses under the reinstated carryback rules. Needless to say, contractual disputes were numerous.
Bonus Depreciation
The TCJA greatly expanded the impact of bonus depreciation (an income tax deduction determined based on a percentage of a qualifying asset’s adjusted basis, in the year that the asset is “placed in service”). Assets eligible for bonus depreciation include vehicles, furniture, manufacturing equipment, heavy machinery and computer software, among other things. Prior to the TCJA bonus depreciation took the form of an immediate deduction of 50% of an asset’s tax basis in the year it was “placed in service”. The TCJA temporarily increased the deductible amount to 100% of the value of assets acquired and placed in service after September 27, 2017, and before January 1, 2023. Beginning in 2023, the amount deductible will decrease by 20 percentage points each year until 2027. Significantly, the TCJA expanded the availability of the bonus depreciation deduction from new assets placed in service to used assets acquired by a business and placed in service, including, crucially, assets acquired in M&A transactions taking the form of an asset purchase or the equivalent for income tax purposes (including acquisitions of “pass through” target companies).
Private equity sponsor buyers in M&A transactions have always valued (and specifically structured for) asset-level tax basis step up (the so-called “tax shield”). The freshly acquired asset tax basis can be monetized over time through depreciation and amortization income tax deductions, on a 15-year ratable schedule for goodwill and intangibles at the slowest, and 3-, 5- and 7-year MACRS depreciation and immediate bonus depreciation for certain hard assets at the fastest. The TCJA’s bonus depreciation changes made these “tax shield” structures even more powerful for buyers in private M&A transactions due to the immediate expensing deductions, especially in respect of portfolio companies heavy in fixed assets. In turn, buyers have become in theory more willing to pay larger purchase prices when considering the increased value of the “tax shield”, while simultaneously more likely to fight with sellers over purchase price allocations among assets.[7]
The Biden administration does not propose to make changes to the bonus depreciation rules (however, the proposed 15% minimum corporate tax rate on book income in the Biden administration’s American Jobs Plan could have the effect of reducing the usefulness of bonus depreciation to some corporate taxpayers).
Debt Service Interest Expense Deductions
After the TCJA, businesses are limited in the amount of interest expense deductions that can be utilized to offset taxable income – from 2018 through 2021 the interest deductions are limited to 30% of “adjusted taxable income” (a term that effectively amounts to the business’ EBITDA) and for tax years after 2021, amortization and depreciation allowances are removed from the determination of “adjusted taxable income” (such that the term effectively amounts to the business’ EBIT). The CARES Act increased the 30% EBITDA limit to 50% for tax years 2019 and 2020. Many middle market private equity M&A transactions rely on acquisition debt placed on the target company in order to finance some portion of the transaction – in fact many sponsors rely heavily on acquisition debt regularly in order to maximize return on investments to their limited partner investors. However, overall these TCJA provisions capping interest tax deductions have had the effect of reducing the tax benefit impact of leveraged buyouts in the private equity M&A market, putting pressure on some sponsors to place more equity in each deal, calling on co-investors to take on equity instead of some portion of the debt financing or finding other sources of financing that don’t technically fall within the scope of these interest expense limitation rules.
Neither the Biden administration nor the HWM Plan proposes any major changes to these interest expense deduction rules.[8]
Notes
[1] A goal of the TCJA was to make the United States a more competitive corporate tax jurisdiction with the rest of the OECD member countries and reduce incentives for U.S. multinational companies to shift profits overseas. It aimed to do so by: reducing the corporate income tax rate from 35% to 21%, moving to a territorial tax system (by introduction of the full dividends received deduction for major corporate shareholders of controlled foreign corporations), introducing the “global intangible low tax income” tax regime (“GILTI”) requiring a minimum worldwide combined effective tax rate imposed on U.S. multinational companies of between 10.5% and 13.125%[1] in respect of earnings that exceed a 10% return on the company’s invested foreign assets, introducing the “base erosion and anti-abuse tax” regime (“BEAT”) imposing on large companies a minimum 10% tax on net income without regard to certain related party payments to offshore subsidiaries designed to disincentivize shifting profits overseas, introducing a special low 13.125% effective tax rate[1] (implemented with a special tax deduction) on “foreign derived intangible income” (“FDII”) designed to incentivize U.S. multinational companies to onshore intellectual property and similar assets (and the profits in connection therewith), and finally imposing on U.S. shareholders of controlled foreign corporations a one-time transition tax toll charge on all as-of-yet untaxed foreign earnings. Regarding these international tax provisions, the Biden administration’s “Made in America” tax plan would increase the corporate income tax rate to 28% (and set a minimum 15% corporate income tax rate on book income for corporations with more than $2 billion in net income), repeal the special FDII tax deduction, and increase the GILTI regime’s minimum worldwide combined effective tax rate imposed on U.S. multinational companies to 21%. Slightly less harsh, the HWM Plan would increase the GILTI regime’s minimum worldwide combined effective tax rate imposed on U.S. multinational companies to 16.5625%, would increase and would increase the FDII effective tax rate to 20.7% and would gradually increase the BEAT tax rate to 15% by 2026.
[2] Often, when a private company in “pass-through” form is planning to initiate an initial public offering or engage in a transaction with a special purpose acquisition company, the transaction will take the form of an umbrella partnership C corporation structure (an “UP-C”) whereby the company becomes a partnership operating subsidiary (i.e. the umbrella partnership) of the public company (i.e. the C corporation). This type of transaction maximizes asset-level tax basis step up to the public company. In such transactions, the pre-closing equityholders of the company typically negotiate for entry into a “tax receivables agreement”, generally requiring the public company to make payments over time equal to 85% of each cash tax dollar saved by the public company due to the depreciation and amortization deductions taken by the public company in respect of the asset-level tax basis step up.
[3] Additionally, on October 26, 2021, Senators Elizabeth Warren, D-Mass., Angus King, I-Maine, and Ron Wyden, D-Ore. Introduced a plan for a corporate minimum tax rate of 15% for corporations publicly reporting profits in excess of $1 billion for three straight years.
[4] A general partner, now incentivized to hold the investment for the minimum three years, may be at odds with its limited partners in a situation where there is clear evidence the investment could be monetized at a considerable profit prior to year three.
[5] This provision was temporarily suspended by the CARES Act for net operating losses generated in 2018, 2019 and 2020.
[6] In any given tax year, the corporate taxpayer may utilize a net operating loss carryforward deduction only against up to 80% of the net taxable income for such tax year.
[7] Generally, to sellers, the portion of purchase price allocated to fixed assets results in larger amounts of gain taxable at ordinary income tax rates due to the requirement to recapture depreciation and amortization deductions taken on the sellers’ watch.
[8] There are however some proposals regarding how the current rule operates in respect of partnerships and proposals regarding limitations on interest expense deductions for U.S. multinational companies to the extent that interest expense incurred by the U.S. parent company is attributable to its foreign subsidiary operations.
