Dealogic reported $1.58 trillion of M&A activity in the United States for 2014. That’s the largest amount for M&A activity in recent years, edging out even 2007 (one year before the financial crisis). Because companies are sitting on large amounts of cash and interest rates are low, most experts expect the deal making to continue through 2015. With rapidly changing technologies shaping the business landscape, it’s no wonder technology companies are fueling a significant portion of the growth.
For technology companies looking to participate in the M&A boom, the objective is to maximize value. Unfortunately, many technology companies are unprepared for the rigors of a transaction, including the scrutiny that occurs during due diligence. This can result in lower valuations or even a failed deal. Conventional wisdom is that economics should drive the transaction and taxes should be considered only after the economics—but can tax considerations impact transaction value? The simple answer is yes.
Let’s look at some of the tax issues that commonly come up in due diligence. For target companies not adequately prepared to address these issues to the satisfaction of the prospective buyer, these issues almost always result in reduced valuations and sometimes can even scuttle the deal. The corollary is that where there’s a tax-related risk, there’s usually—with a small investment up front—a corresponding opportunity.
State Income Tax
One of the first questions asked by a buyer’s due diligence team is whether the company is filing tax returns in all states in which it should be filing. Almost always, the conclusion is that the company isn’t filing in all states in which it should and there’s some level of exposure to state income taxes. In their efforts to expand or develop markets, even development-stage companies are often very active in several states. Each state has different rules for determining whether a company’s activities cause it to have nexus in the state, and many companies unknowingly create 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 in the quagmire of state income taxes, there any many traps and pitfalls.
Some of the more common traps include states that tax gross receipts (such as Washington and Texas) and states that have occupancy taxes (Ohio), capital taxes (Tennessee), or franchise taxes (Delaware and California). Note that these taxes aren’t based on a measure of income: No state wants to be on the short end of tax revenues, and as a result they show a lot of creativity in expanding their tax base. For example, some states have adopted economic nexus standards, in which a filing obligation is created merely by having revenue generated in the state. Other times, inconsistent sourcing rules will source revenue to one state that is already sourced to another state. The obvious result is that, without proper planning, a company may be subject to tax twice on the same dollar—the cardinal sin in taxation.
Other traps include the effects of compounding seemingly immaterial annual minimum taxes over multiple years, since all years remain open to taxation. If no return is filed, the statute remains open indefinitely.
If these pitfalls weren’t enough, there’s the added pressure of state rules constantly changing—making it nearly impossible for a company to stay abreast of the rules and avoid significant exposure without the assistance of a skilled advisor. The key is to limit the exposure or even arbitrage the disparities in the state’s inconsistencies and then to be prepared to answer the buyer’s questions, with exposures quantified and contained.
Over the past decade, the sales tax landscape has also changed dramatically. Before the information revolution, sales tax was largely limited to the sale of tangible goods. As our economy has transformed into an information economy—and in response to the threat of shrinking tax bases and declining tax revenues—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 maximize its reach and revenues (often at direct odds with competing tax jurisdictions). Further, the laws each taxing jurisdiction passes often don’t keep pace with the rapidly changing technological environment.
The question used to be whether sales tax applied to software—or, in other words, “Is software a tangible good?” Several years ago, we used to buy prepackaged software programs at a retail store. Now we download apps on our handheld devices or access remote servers to store information. The question has evolved to “How does sales tax apply to software licenses, software as a service (SaaS), cloud services or infrastructure as a service (IaaS), platform as a service (PaaS), any type of data processing or information services, or any combination of tangible goods bundled with software or services?” The result is an incredible diversity of extremely complex sales tax rules.
Even a very small technology company, whose limited sales can reach many jurisdictions thanks to the Internet, can (and often does) trigger significant sales tax obligations. Unlike income taxes, which are usually assessed on a measure of taxable income (as noted above), sales tax is assessed on gross receipts, and rates can be as high as 8 or 9 percent. In most cases, sales tax obligations are borne by the consumer, but if the seller or provider doesn’t withhold and remit sales tax, the seller or provider can also be liable to the taxing jurisdiction.
In a transaction scenario, a favorite question asked in due diligence is “What is the company’s exposure to sales tax?” 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. Moreover, 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 without any statute of limitations providing protection to the company. The end result is invariably a decrease in the value of the company. In such a situation, the best the company might hope for is a reduction in purchase price or amounts held back in escrow to cover future assessments. The worst case scenario—and unfortunately a common one—is that the prospective buyer determines the risk to be prohibitive and the deal is withdrawn.
In our global economy, what company doesn’t have at least some number of cross-border transactions, whether it’s transactions with customers, vendors, development partners, or employees? When preparing for the sale of a company, it’s important to understand how the global operations of your business may impact a transaction.
If your company has operations outside the United States, you need not only to assess whether the foreign compliance is up to date but consider whether your domestic filing obligations are complete and accurate. Over the years, taxpayers have proven very creative in the management of their worldwide tax obligations, and taxing jurisdictions are finding it increasingly difficult to enforce compliance. As a result, these taxing jurisdictions (and particularly the United States) have come up with an almost overwhelming set of rules that need to be navigated carefully. Because of the concern over cross-border transactions and the manipulation of taxes, tax jurisdictions are enforcing compliance by requiring increased levels of transparency into foreign-held assets and operations and imposing severe penalties for noncompliance.
Applying ideas and concepts similar to those noted above in the context of multistate tax, now imagine managing tax obligations in an international context. International taxation is extremely diverse: Development-stage technology companies are often faced with tax obligations that have nothing to do with income and sometimes little to do with economics. In the competition for tax revenues, some countries offer extremely favorable tax holidays or agreements for reduced rates or other incentives. Exploiting these favorable jurisdictions often requires moving appreciating intellectual property and other intangible assets, manufacturing capabilities, research and development, and other items of economic substance into specific countries.
Migrating these assets when they are mature is prohibitive from a tax perspective, so the idea is to move them before they are mature. Development-stage technology companies often have the right profile for these strategies, but their implementation requires a lot of careful planning and structuring. However, in a due diligence scenario, these structures are often frowned upon as too complex and difficult to integrate into a buyer’s existing strategy and profile. Further, maintaining such a complex structure can be expensive as well as time- and talent-consuming. The result is that they’re often neglected, which can cause significant risks and exposures.
More generally speaking, some common pitfalls in the international context include:
- Failures in compliance regarding properly reporting transactions or foreign-held assets
- Exposure to value-added taxes
- Failure to disclose and withhold on cross-border payments
- Inability to support intercompany pricing and transactions with contemporaneous documentation, including transfer pricing studies and third-party comparables
- Not meeting the specific requirement to qualify for tax holidays or reduced tax rates
- Mismanaging foreign tax credits (resulting in double taxation)
- The inability to repatriate cash for domestic needs without severe tax consequences
Companies without appropriate procedures in place to comply with the international complexities inherent in a global business may find that potential buyers identify these areas as reduction to purchase price or require additional escrow holdbacks for potential exposure.
Research and Development Tax Credit
Several taxing jurisdictions (including the United States and a significant number of states) provide tax credits as an incentive for companies to invest in the development of new or improved and innovative technologies. Of course, this is exactly what technology companies do—research and innovate.
There are very specific rules around what constitutes a qualifying activity for purposes of claiming research credits as well as around which costs actually qualify. Because the credits are lucrative and the determination of whether a technology is innovative enough is subjective, taxing authorities approach claims for research credits skeptically. Sustaining a credit requires companies to maintain contemporaneous documentation that supports that the activity qualifies and also supports 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 the cost—that most technology companies struggle with. Most research credits are available only to offset taxes (although some are refundable); however, if a company isn’t able to utilize the credit in the year 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.
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. Although this isn’t an unusual decision, it can be one that will materially alter the value for the shareholders in a subsequent transaction. Absent adequate support, a buyer will also view research credits skeptically. As a result, a buyer will substantially discount the value of the federal and state research credits, thereby denying the selling shareholders the full benefit of the research credits they paid to create. Implementing practical procedures up front that will allow a company to at least identify, collect, and maintain appropriate documentation to support future claims for credits can be a small price to pay to ensure the monetary benefit of the credits in a transaction.
When a company is involved in a transaction, be it a merger, acquisition, or leveraged buyout, it can often incur significant costs. Companies routinely engage law firms, accounting firms, financial advisory firms, and investment bankers as part of the transaction. The deductibility of these transaction costs may vary depending on the nature of the cost, when it was incurred, and the structure of the transaction. It’s important to understand the related financial reporting guidance to correctly compute the required book-tax adjustments.
The tax treatment of transaction costs has been and continues to be a challenging and controversial area. 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. Though the IRS has provided a significant amount of guidance, these rules are still misapplied and underdocumented. The most frequent transaction costs incurred include success-based fees, debt financing costs, legal and accounting fees, and costs of terminating or abandoning a transaction.
Technology companies must consider myriad elections to minimize tax risks and maximize opportunities. Some of the many elections to be considered include:
- Methods for recovering assets (bonus depreciation, amortization)
- Capitalization policies
- Accounting methods around revenue recognition
- Accounting for inventory
- 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. Failure to make elections or adopt proper accounting methods in a timely fashion can create significant tax exposures later on. Even at best, correcting a failure to make an election or an improper election can be time-consuming and expensive. Unfortunately, buyer due diligence frequently uncovers a seller’s often-inadvertent adoption of improper tax accounting methods. In a stock transaction, a buyer is either assuming the exposure or will have to incur significant future costs to take corrective action.
Limitation on Tax Attribute Carryovers
Development-stage technology companies are almost always looking for capital and will often participate in several rounds of financing. The issuance of stock in a financing creates ownership shifts in which the founders are diluted in favor of the new investors. Development-stage technology companies are often also generating significant tax attributes that cannot currently be monetized and must be carried forward. These tax attributes include net operating losses and credits (like the research credit). To a buyer, these attributes represent real value—and, of course, from the seller’s perspective, they should be included in a determination of the enterprise’s value. Note that Internal Revenue Code Section 382 imposes some limitations on these carryovers.
Prior to 1986 a corporation could effectively sell these 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 net operating losses and other tax attributes. The legislation put limits on a buyer’s ability to utilize the tax attributes acquired from a seller on a time-value-of-money basis relative to the value of the company. These limitation provisions are triggered by a change-in-control event—a time when more than 50 percent of the ownership of the company’s stock changes, relative to a rolling three-year window. These ownership changes are common during a technology company’s development stage, since it constantly recapitalizes. The provisions require extremely detailed and complex computations to determine whether and when a change has occurred. If it is determined that a change has in fact occurred, the provisions provide for another complex set of rules to determine the limitation (known as the Section 382 limitation) of the tax attributes.
Because these provisions are complex, implementing them properly can be very expensive. For this reason—and because many early-stage companies don’t anticipate the near-term need to utilize the attributes—the proper monitoring and tracking of ownership changes is often neglected. Unfortunately, during tax diligence, one of the buyer’s first areas of focus is determining the value, if any, associated with the tax attribute carryovers. Where no analysis has been performed by seller, the buyer may do a high-level analysis using buyer-favorable assumptions or, just as commonly, presume that there’s no value to the tax attributes. Often the Section 382 limitation becomes a hotly contested issue when negotiating enterprise value. Sorting this out can require frantic, last-minute, and very expensive calculations by the seller and its tax advisor to justify value and get the buyer to agree.
Along with potential limitations on attributes, ownership changes can also result in other unfavorable tax consequences, such as accelerated income, inadvertent termination of a partnership or favorable accounting methods, exposure to transfer taxes, sales taxes, and property tax reassessments.
Preparing for Pitfalls
It’s prudent for technology companies to anticipate scrutiny from others—either from a taxing jurisdiction (such as the IRS) or from a prospective buyer. The effects of not being prepared for having your books and records scrutinized by a trained eye can are many: First, severe fines and penalties may be imposed by a tax authority. Second, you may lose legitimate tax deductions, credits, and other tax attributes. Third, you may find your company’s valuation reduced. And, finally, your company may fail to meet the due diligence standards or risk tolerance of a prospective buyer. On the other hand, with careful and proactive tax planning and the anticipation of a future transaction, many of these pitfalls can be limited or avoided altogether—and higher valuations can be sustained.
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: