PitchBook reported the largest amount of US merger and acquisition (M&A) activity in recent years from 2015 through 2017.
At $1.99 trillion, $2.13 trillion, and $1.67 trillion in 2015, 2016, and 2017, respectively, these years have edged out even 2007—the previous peak before the financial crisis. The number of companies sitting on large amounts of cash and privy to low interest rates have most experts expecting the deal-making to continue through 2018 and beyond.
With rapidly changing technologies shaping the business landscape, it’s unsurprising technology companies are fueling a significant portion of this growth.
Preparing for M&A Activity
The objectives for technology companies looking to participate in the M&A boom are to increase value and drive growth. However, many technology companies are unprepared for the rigors of a transaction—including the scrutiny that occurs during due diligence.
Conventional wisdom is that economics should drive transactions and taxes should be considered only after the economics. However, it’s important to understand how and why tax considerations impact transaction value as well.
Target companies that aren’t adequately prepared to address the common tax issues that arise during due diligence to the satisfaction of a prospective buyer may discover those issues can result in reduced valuations—sometimes even scuttling the deal.
Beyond potentially saving a transaction, the benefit of identifying these issues is that wherever there’s a tax-related risk, there’s usually a corresponding opportunity.
State Income-Tax Issues
One of the first questions a buyer’s due-diligence team asks is whether the target company is filing tax state and local returns in all states in which it should be filing. Almost always, the conclusion is that it isn’t, creating some level of exposure to state income taxes.
Even development-stage companies are often very active in several states because of efforts to expand or develop markets. Each state has different rules for determining whether a company’s activities cause it to have nexus, resulting in many companies unknowingly creating tax exposure in multiple states.
A development-stage technology company might believe its exposure to state income taxes is minimal due to recurring losses, but there are many potential pitfalls in the quagmire of state income taxes.
- Gross-receipts taxes—Washington, Nevada, and Ohio
- Margin taxes—Texas
- Capital or net-worth taxes—Tennessee and Georgia
These taxes aren’t based on a measure of net income because no state wants to miss out on tax revenue. As a result, states show a lot of creativity in expanding their tax base. For example, some states have adopted economic nexus standards that create a filing obligation whenever revenue is generated in the state.
Inconsistent sourcing rules also have the potential to source revenue to one state even though it’s already sourced to another state. The result of these rules is that without proper planning, a company may be taxed twice on the same dollar.
Other traps include the effects of compounding seemingly immaterial annual-minimum taxes over multiple years because all years for which returns haven’t been filed remain open to taxation.
How It Applies to Due Diligence
Constantly changing state rules add more pressure, making it nearly impossible for a company to stay abreast of the rules and avoid significant exposure without the assistance of a skilled advisor. In this regard, companies are well served—especially if an acquisition, and subsequently a due-diligence review, are on the horizon—by taking the following steps:
- Limiting their tax exposure
- Arbitraging the disparities in a state’s inconsistencies
- Maintaining their preparedness to answer a buyer’s questions—including how their state-tax exposure is quantified and contained
The sales-tax landscape has changed dramatically over the past decade. Before the information revolution, sales tax was largely limited to the sale of tangible goods. Now—in response to the new information economy as well as the twin threats of a shrinking tax base and declining tax revenue—taxing jurisdictions are scrambling to adopt rules that broaden the base of goods and services to which sales tax applies.
Each taxing jurisdiction has a different agenda and enacts laws it believes will further extend its reach and increase revenue—laws that are often at direct odds with competing tax jurisdictions. Additionally, these laws often don’t keep pace with the rapidly changing technological environment.
Defining Sales Tax in the Information Economy
The question used to be whether sales tax applied to software—determining whether software was a tangible good, in other words. Several years ago, consumers bought prepackaged software programs on a tangible medium, such as a CD, at a retail store.
Now, consumers download apps onto handheld devices or access remote servers to store information. The question has evolved to ask how sales tax applies to the following items:
- Software licenses
- Software as a service (SaaS)
- Cloud services
- Infrastructure as a service (IaaS)
- Platform as a service (PaaS)
- Data processing or information services
- Any combination of tangible goods bundled with software or services
The result is an incredibly diverse—and extremely complex—array of sales-tax rules.
How Sales Tax is Assessed
Even small technology companies with limited sales can reach many jurisdictions because of the internet. These companies can, and often do, trigger significant sales-tax obligations.
Unlike income taxes, which are usually assessed on a measure of taxable income, sales tax is assessed on gross receipts with rates as high as 8% or 9%. In most cases, these obligations are borne by the consumer. If the seller or provider doesn’t withhold and remit sales tax, however, they can be liable to the taxing jurisdiction.
A combination of uncollected sales tax, penalties, and interest can materialize into a large liability for technology companies of any size.
State and Local Tax-Agency Audits
State and local tax agencies are becoming more aggressive in their audits. These agencies are also enhancing their ability to detect non-filers through the use of technology, including machine-learning processes and programs that allow them to cross-reference federal- and state-agency databases, such as:
- Secretary of state
- Employment security
- Employee’s personal-income-tax withholding registrations
A common technique for determining non-filers is auditing an out-of-state business’s customers. An auditor may first review invoices that didn’t include sales tax. Then, depending on the results, he or she may send a notice and nexus questionnaire to the out-of-state business to inquire as to whether it should be charging sales tax.
How It Applies to Due Diligence
A common question asked during due diligence in any transaction scenario is what the target company’s exposure to sales tax is. In other words, what activities may be subject to sales tax, and in which jurisdictions does the company have exposure?
Too often, the answer is that the company hasn’t thoroughly assessed its exposure and as a result has a significant unreported liability. Additionally, because the company often has never filed in a particular jurisdiction to which it has an obligation, the tax jurisdiction may be able to look at all prior years with no protection provided by a statute of limitations.
The end result is invariably a decrease in the company’s value, resulting from the outstanding tax liabilities and penalties that may be assessed. In these situations, the best a company can hope for is a reduction in purchase price or for amounts to be held back in escrow to cover future assessments. The worst-case scenario—and an unfortunately common one—is that the prospective buyer determines the risk is prohibitive and the deal is withdrawn.
In the increasingly global economy, most companies have cross-border transactions—whether they’re with customers, vendors, development partners, or employees. The increase in cross-border-capital flows means companies are also engaging in international transactions at an earlier stage, which makes it important to understand how a company’s global operations may impact a transaction.
Criteria for Filing International Tax Forms
Companies with operations outside the United States must assess whether they meet the following criteria:
- US compliance is up to date, including relevant international disclosures
- Foreign filing obligations are complete and accurate
The United States imposes strict penalties for failure to file certain information forms and returns—$10,000 penalty per failure to file Form 5471, for example—and other nations are following suit.
Shifting International-Tax Rules
In recent years, the global Organisation for Economic Cooperation and Development’s Base Erosion and Profit Shifting initiative has changed long-established rules regarding international transactions and what countries deem acceptable. As a result, many local taxing authorities are more frequently reviewing and challenging tax filings. They’re also increasing the required compliance documentation, making it more difficult for taxpayers to stay on top of their filing requirements.
The growing concern that cross-border transactions may lead to the potential manipulation and evasion of taxes has led to taxing authorities taking the following steps to enforce compliance:
- Requiring increased levels of transparency into foreign-held assets and operations
- Imposing severe penalties for willful noncompliance and inaccuracy
Developing an International Tax Strategy
The challenges multinational enterprises face are similar to the compliance burden associated with multistate law because of differing incentives and rules. In the competition for tax revenue, some countries offer favorable tax incentives, advanced transfer-pricing agreements for reduced corporate income-tax rates, or increased R&D credits.
Exploiting these favorable tax jurisdictions may require transferring appreciated intellectual and intangible property, R&D engineers, and other items of economic substance into the jurisdiction.
A company operating across borders needs a strategy to manage both its transfer pricing and its intangible assets because both are issues frequently uncovered during the due-diligence process.
More generally, some common pitfalls that may be discovered during the tax-diligence process for multinational technology companies include the following:
- Failure to properly report related-party transactions or foreign-held assets
- Exposure to value-added taxes or other indirect taxes
- Failure to report and withhold on cross-border payments
- Inability to support intercompany pricing and transactions with contemporaneous documentation, including transfer-pricing documentation and intercompany service or license agreements
- Not meeting specific requirements to qualify for local tax incentives or reduced income-tax rate
- Creation of unintended permanent establishment or taxable presence, either directly or through agents in the foreign jurisdiction
- US taxation of foreign operations through Subpart F or the newly implemented global intangible low-taxed income tax
- Mismanagement of foreign tax credits, resulting in double taxation
Companies that don’t have the appropriate procedures in place to comply with international tax complexities may find potential buyers will identify these areas during due diligence and ask for a reduction to the purchase price or require additional escrow holdbacks for potential exposure.
R&D Tax-Credit Issues
Several taxing jurisdictions, including the United States and a significant number of states, provide R&D tax credits as an incentive for companies to invest in the development of new, improved, or innovative technologies. Of course, this is exactly what technology companies do—they research and innovate.
There are very specific rules for what constitutes a qualifying activity for purposes of claiming R&D credits, as well as which costs qualify. Because the credits are lucrative and the determination of whether a technology is innovative enough to qualify for them is subjective, taxing authorities approach claims for research credits skeptically.
Most research credits are available only to offset taxes, although some are refundable. However, if a company can’t use the credit in the year it’s generated, most credits are available to be carried forward for future tax years—with some limitations—even if the company has a new owner in that future year.
Supporting an R&D Tax Credit Claim
Sustaining an R&D credit requires companies to maintain contemporaneous documentation to support that the activity qualifies and that there’s a connection between the qualified activity and the actual cost.
It’s this process—cataloging and retaining the contemporaneous documentation and establishing the connection between the activity and its cost—that most technology companies struggle with.
How It Applies to Due Diligence
Because development-stage technology companies often don’t expect to be able to immediately monetize credits, they often forgo or delay putting effort into processes that assist in identifying and qualifying activities and maintaining contemporaneous documentation.
This decision can materially alter a company’s value for shareholders in a subsequent transaction. Without adequate support, a buyer will view research credits skeptically. As a result, a buyer will substantially discount the value of the federal and state research credits, denying the selling shareholders the full benefit of the research credits they paid to create.
Proactively implementing practical procedures that allow a company to identify, collect, and maintain appropriate documentation to support future claims for credits can be a small price to pay to safeguard the monetary benefit of those credits in a transaction.
Identifying Transaction Costs
When a company is involved in a transaction—whether a merger, acquisition, or leveraged buyout—it can incur significant costs. For example, companies routinely engage law firms, accounting firms, financial-advisory firms, and investment bankers as part of a transaction. The deductibility of these costs may vary depending on the following factors:
- Nature of the cost
- When the cost was incurred
- Transaction structure
The tax treatment of transaction costs has been and continues to be a challenging and controversial area, and although the IRS has provided a significant amount of guidance and safe harbor provisions, these rules are still misapplied and underdocumented.
In general, transaction-related costs must be capitalized; however, there are several exceptions to this general rule that allow for the current deduction or amortization of certain costs. The most common transaction costs include the following:
- Success-based fees
- Debt-financing costs
- Legal and accounting fees
- Costs of terminating or abandoning a transaction
Bonus payments, options, and accelerated management incentive equity plans also often generate significant tax deductions upon a transaction’s closing.
How It Applies to Due Diligence
Sale and purchase agreements often contain provisions addressing who’s responsible for paying transaction expenses—generally the seller. In many cases, because sellers are paying for these expenses, they’re in turn negotiating for an increased purchase price attributable to the tax savings or benefits derived by the buyer.
Quantifying these benefits, understanding whether they can be carried back or forward, and projecting when they can be realized is a significant hurdle in most transactions. Being able to answer these questions, however, is important to ensure a fair transaction price.
Choosing the Right Accounting Methods
Technology companies must consider various accounting elections and methods to help mitigate tax risks and capitalize on opportunities. These elections include the following:
- Methods for recovering assets, such as bonus depreciation or amortization
- Capitalization policies
- Accounting methods around revenue recognition
- Inventory accounting
- Prepaids and accruals
- Consolidated tax-return elections
- Adoption of fiscal year-ends
Some of these elections need to be made in the first year of business or at the outset of a new category of transactions. Any failure to make elections or adopt proper accounting methods in a timely fashion can create significant—and costly—future tax exposures. At best, their correction can be time consuming and expensive.
How It Applies to Due Diligence
A due-diligence review can often uncover a seller’s inadvertent adoption of improper tax-accounting methods. In a stock transaction, for example, a buyer either assumes exposure or incurs significant future costs to take corrective action.
Timing differences and issues related to the above scenario are often viewed by a buyer as permanent because they accelerate income-tax payments. This makes obtaining a clear understanding of any tax exposures prior to negotiating a sale agreement important for deciding tax representations, warranties, and covenants.
Additionally, many sale agreements contain purchase-price adjustment provisions related to a seller’s working capital and whether it exceeds or falls short of a negotiated, normalized level of working capital at close. Sale agreements may also include certain tax accounts in the computation of this working capital, such as:
- Operating-type taxes, including sales and use tax as well as payroll
- Income taxes, although these generally exclude deferred taxes
Sellers can benefit from understanding their estimated tax position through the date of close and whether they have the appropriate level of reserves to cover any known exposure.
Understanding Limitations on Tax-Attribute Carryovers
Development-stage technology companies almost always have a need for more capital and often participate in several rounds of financing. These rounds of financing—and the consequent stock issuance—create owner shifts in which the founders are diluted by new investors.
These companies often also generate significant tax attributes that can’t be monetized and must be carried forward. The tax attributes include net operating losses (NOLs) and tax credits, such as the research tax credit.
To a buyer, these attributes represent real value—and from a seller’s perspective, they should be included in the determination of an enterprise’s value. Internal Revenue Code Section 382, however, imposes limitations on the use of these carryovers if the owner shifts are enough to trigger an ownership change.
Tax-Attribute Carryover Limitations
Prior to 1986, a corporation could effectively sell tax-attribute carryovers, and buyers lined up to purchase a company for the sole purpose of acquiring its tax attributes. The Tax Reform Act of 1986 effectively ended the trafficking of NOLs and other tax attributes by limiting a buyer’s ability to use the tax attributes acquired from a seller on a time-value-of-money basis relative to the value of the company.
These limitations are triggered by a change-in-control event—a time when more than 50% of the ownership of a company’s stock changes, relative to a rolling three-year window. These ownership changes are common during a technology company’s development stage because it constantly recapitalizes.
The provisions require extremely detailed and complex computations to determine whether and when a change has occurred. If it’s determined a change has occurred, the provisions provide for another set of rules to determine the limitation on the annual usage of the tax attributes—known as the Section 382 limitation.
How It Applies to Due Diligence
Often, Section 382 limitations become a hotly contested issue when negotiating enterprise value. Early identification and planning to ascertain asset value can often lead to an increased value for the company upon sale.
Because of their inherent complexity and the time-consuming and expensive nature of their implementation, however, many early-stage companies defer performing an analysis until they believe they may start to use their attributes.
For this reason—and because many early-stage companies don’t anticipate the near-term need to use the attributes—the proper monitoring and tracking of ownership changes is often neglected.
Unfortunately, during tax diligence one of a buyer’s first areas of focus is determining the value, if any, associated with any tax-attribute carryovers. When no analysis has been performed by a seller, the buyer may either do a high-level analysis using buyer-favorable assumptions or simply presume there’s no value to the tax attributes.
This is why companies contemplating a transaction or liquidity event can benefit from proactively performing a high-level analysis. This analysis can help companies understand the value of NOLs and other tax attributes so they can monetize these attributes during negotiations—ultimately increasing the purchase price of the asset.
How Transaction Structure Affects Purchase Price
Although many venture-backed and start-up companies continue to organize as corporations, many entities are also formed as LLCs and S corporations. These latter structures may allow a buyer to purchase a company’s stock while obtaining a step up in tax basis for the entire purchase price. This step up can then be deducted generally over 15 years for tax purposes.
Private-equity investors and strategic acquirers often find this scenario attractive, resulting in an increased purchase price—if effectively negotiated. This may entail understanding purchase-price allocation considerations for the business assets as well as modeling the tax benefits to the buyer. This often requires careful presale structuring.
Along with potential attribute limitations, ownership changes can result in certain unfavorable tax consequences, such as:
- Accelerated income
- Inadvertent termination of a partnership or favorable accounting methods
- Exposure to transfer-, sales-, and property-tax reassessments
Preparing for Due-Diligence Pitfalls
It’s prudent for technology companies to anticipate scrutiny from others—either a taxing jurisdiction, such as the IRS, or a prospective buyer. Not being prepared can have numerous consequences, such as:
- Potential historical federal and state tax issues identified during the due-diligence process that could result in tax exposure
- Severe fines and penalties that may be imposed by a tax authority, potentially indemnifying the potential buyer
- The loss of legitimate tax deductions, credits, and other tax attributes
- Reduction of a company’s valuation
Through a comprehensive review, companies can increase the value ascribed to their tax attributes—credits and tax losses, for example—when negotiating their overall company value. A review can also lower a company’s chances of failing to meet the due-diligence standards or risk tolerance of a prospective buyer.
Proactive and Ongoing Tax Planning
With careful and proactive tax planning, many of the common pitfalls can be limited or avoided altogether—enabling higher valuations to be sustained. This is accomplished through organizing tax documentation and knowing what to expect throughout the diligence process, especially if multiple potential buyers are involved.
Additionally, companies can enhance the perception of their internal tax function and its compliance and reporting processes. By being proactive prior to signing a letter of intent, companies can also decrease their administrative burden during the tax-diligence process.
We’re Here to Help
If your technology company is considering M&A activity and would like to understand the tax considerations, our team can help. Contact your Moss Adams professional or reach out to a tax partner who specializes in working with technology companies.