We are nearing the end of 2014 and it has certainly been an eventful year. This month’s article reflects the need for reputational risk to govern tax policy in the area of corporate acquisitions, and summarises some of the issues analysed at the IBSA conference last week at the Mandarin Oriental Hyde Park hotel, here in London. My article should be a sobering warning to all professional advisers involved in international business structuring, as well as IFS clients who may be considering making corporate acquisitions, or perhaps disposing of their own businesses.
I will be discussing this further in a webinar to be held on 10th December 2014 at 12.00. To dial in to this webinar, which is free, please (click here].
On a related topic, I will be moderating the next discussion group of the IBSA to be held on Wednesday 14th January. All IBSA members are invited to attend the discussion group entitled ‘Corporate Finance: Public vs Private Equity’.
I don’t know how many of you are following me on Twitter in my guise as Chairman of the IBSA – @RoySaundersIBSA – but please excuse me for not tweeting more! Or perhaps it is a mercy that my social media hasn’t become your anti-social media. But I always like to read comments from those of you who take the time to respond to these newsletters, so please don’t hesitate to send me a ‘tweet’ to roy@interfis.com.
In case December runs away with itself and I don’t get another opportunity to send you another missive, please accept this one as my best wishes to all of you for a happy Christmas and a successful year end, but above all a healthy 2015.
With kind regards
Roy
A Review of 2014 – Corporate Acquisitions and BEPS
Corporate acquisitions have returned with a vengeance in 2014 – the greatest number of deals since 2007. This is partly because the US and UK economies have recovered, partly because larger companies have amassed significant amounts of cash in the downturn and are now turning their attention to acquisitions, and although banks are still hesitant to lend again, interest rates are low and therefore money, when available, is cheap.
Perhaps the most significant phenomenon in 2014 has been the US corporate inversion, where the acquisition of a non-US company enables the US company to become a subsidiary of the non-US company where tax rates are lower, such as the UK and Ireland. But it is not only the higher tax rates in the US which are relevant, it is primarily the territorial approach of countries such as the UK and Ireland, as opposed to the worldwide approach in the US, which has triggered these inversions. The key sectors to see movement have been in pharmaceuticals and healthcare, energy and power and industrial chemicals.
Therefore, one of the driving forces in US corporate inversions is that overseas earnings, which have attracted low rates of tax, cannot be brought back to the US without significant additional US tax under their worldwide system of taxation. US tax reform is unlikely in the short term, so the US is adopting a sticky plaster policy of trying to make inversions more difficult, partly through moral persuasion and particularly where the foreign parent company has limited substance. Indeed, this may be where foreign jurisdictions themselves may help the US in demanding substantial management activities to ensure local tax residence. In the meantime, perhaps the US could adopt a semi-amnesty policy of reducing the US corporate tax rate on foreign earnings to say 10%, without a full scale tax reform programme being required.
Outside of the US, acquisitions have been prevalent within the EU countries, either through traditional take-overs or through cross border mergers. The former is fairly quick but requires minority shareholders to relinquish their shares, a protection more often afforded within Continental EU countries than in the UK. Mergers in the UK are less common and may require court approval, hence taking more time but with greater certainty as regards minority shareholders.
All corporate acquisitions, whatever their nature, have to factor in the significant costs involved, including transfer taxes and professional fees. It is clearly beneficial if the eventual holding company has a territorial approach in its tax system, whilst companies being acquired should preserve any tax losses and avoid potential tax claw-backs. The shareholders have to ensure that any paper for paper exchanges do not trigger a capital gains tax liability, but a deferral until the new shares are eventually sold. From a regulatory point of view, corporate acquisitions need to ensure that Competition and Markets Authority clearance is obtained if there is any potential that consumers will be harmed by take-overs or merger arrangements.
Private equity deals involved in corporate acquisitions are necessarily more short term in nature than longer term cross border mergers. They also feature a high degree of leverage, and may involve structures which may be perceived as embodying aggressive tax planning. Thus thin capitalisation issues may create challenges for interest deductibility, and the creation of holding companies whose substance may be questioned is more likely to come under attack by tax administrations. For example, Luxembourg holding companies have been used extensively in such deals involving hybrid instruments such as PECs (Participating Equity Certificates), treated as interest in Luxembourg but equity in, for example, the US.
The OECD in its BEPS initiative would wish to attack such structures in three ways: firstly, negating the tax benefits to be derived from hybrid instruments under Article 2 of BEPS; secondly, denying treaty access to a Luxembourg entity without the required degree of substance recognised by other countries under Article 6 of BEPS; and thirdly attacking Luxembourg itself for granting what the OECD considers State Aid to finance companies through their practice of beneficial tax rulings. Indeed, the OECD has attacked Malta and Ireland for similar State Aid practices involving financing and intellectual property licensing structures.
It appears that a whistle blower in Luxembourg has leaked that 548 tax rulings are currently being investigated by the European Commission involving Luxembourg companies created by entities in the US, Japan, China, Russia, Brazil, and many other countries, particularly in the EU. It remains to be seen whether the accusations of State Aid will be upheld by the Courts, and yet further if any claims may be made against the companies involved to repay the tax benefits obtained. And what happens in the event that a company benefiting from such tax rulings has since been acquired by another, and where tax indemnities have been entered into by the vendor shareholders?
If monies have been placed into escrow accounts to cover such tax indemnities, claims may be easy to satisfy. But the consequences of State Aid being upheld could create huge ripple effects in terms of claims, perhaps against the advisers themselves who have been instrumental in obtaining these beneficial tax rulings.
What is clear is that the BEPS initiative is changing the way international business structures are being implemented. The first and foremost requirement is that any entity within a corporate structure has to have the relevant degree of substance to ensure it is tax resident in the particular country, and that it merits access to double tax treaty arrangements. Aggressive tax planning in the form of hybrid instruments, for example, are to be avoided, and inter-company arrangements have to clearly demonstrate the arm’s length principle of transfer pricing. Indeed, country by country reporting, as recommended in Article 13 of BEPS, will provide transparency to tax administrations so that they can easily identify exceptional profits in jurisdictions which may suggest tax benefits and lack of required substance.
Ultimately, companies will consider the reputational risk of transgressing the recommendations inherent in the new era of BEPS, rather than the benefits to be obtained from tax mitigation. There will therefore be a continual conflict at Board level between corporate governance involving reputational risk, and the financial requirements of maximising shareholder value. This does not mean, however, that the minimisation of tax costs isn’t a fundamental consideration when developing the growth of a company, or becoming involved in corporate acquisitions, and certainly the avoidance of double taxation is a fundamental requirement. Nowhere is this more obvious than in emerging markets, where the risks at all levels are considerably higher than in developed markets.
In countries such as China, Korea, Africa and India, tax risks are at best uncertain, as has been demonstrated in the Vodafone case in India and the Lone Star case in Korea. These countries prefer to levy taxes according to what they consider the source of income or gains, as opposed to the perceived tax residence of the recipient entity. Where other countries impose tax on the residence basis of taxation, there may be instances where tax liabilities in these emerging markets cannot be credited against tax liabilities elsewhere.
Bilateral investment treaties may be useful in protecting investors in these regions from governmental actions such as expropriation of assets, although their practical effect may be somewhat theoretical, but they do little to address the issue of potential double taxation. What is of greater effect is to maintain assets outside of the relevant country where possible. These assets may be cash assets, but are also likely to be intellectual property required for the development of any local projects. Although BEPS addresses the issue of transfer pricing of such intangible rights, their foreign ownership not only allows protection of such rights but may enable an element of double taxation to be avoided.
Thus although 2014 may have witnessed a resurgence of the mega deals and generally witnessed more corporate acquisitions than in the previous 6 years, it may be remembered more as the year in which the emphasis companies and their professional advisers place on tax mitigation has changed in the light of the BEPS initiative. Reputational risk is seen as a much higher priority than tax savings, and international business structuring consultants must reflect carefully before advising on corporate arrangements. This is true whatever their professional discipline, be they lawyers, accountants, tax practitioners, private equity managers, or corporate finance specialists. With the threat of more State Aid investigations, 2015 will be an interesting year for all of us.