How tax impacts the determination of the purchase price in M&A transactions

In M&A transactions, purchase price determination and tax considerations closely interact. Our EY expert outlines what must be considered in the tax due diligence, the deal negotiations, and the preparation of the completion accounts from a tax perspective.

In brief

• Tax considerations are relevant across the purchase price calculation mechanism, from net debt to the relevant (tax) assets.
• Including tax risks as “debt” or “debt-like” items in the equity bridge shifts the risk to the seller. An alternative may be (special) tax indemnities at the cost of the counterparty risk for the buyer and limitations regarding seeking W&I indemnity coverage.
• Similar considerations apply to tax receivables and assets. If not included as an asset in the equity bride, buyer and seller often agree on a tax refund concept ("pay-as-you-go" approach).

One of the core elements of any M&A transaction is the purchase price calculation. Besides other complexities, determining the purchase price has a close and multi-layered interplay with tax in general and, specifically, tax due diligence findings. This article provides an overview of the various tax impacts on purchase price mechanisms. Although the following focuses on closing account transactions, similar considerations may apply to locked-box deals.

The basics

Commonly, the purchase price calculation's starting point is the enterprise value based on a multiple of the (adjusted) EBIDTA ("headline price"). From there, the equity value is calculated by adding/deducting net debt, net working capital adjustments, CAPEX underspend as well as other relevant items (the "equity bridge"). Within net debt, there is no clear-cut definition for "debt" and "debt-like-items". Rather, the items included are determined in the deal negotiations and – frequently – discussed all over again when preparing the completion accounts. Nevertheless, there is a “common understanding” in practice that "debt" and "debt-like-items" are broader than just indebtedness:

Example Case – Acquisition of the (fictional) Red Group

In the tax due diligence (TDD) for the Red Group, the buyer's advisors flagged the following tax findings/considerations:

1. WHT litigation: The tax authorities pursue tax proceedings against one of Red Group’s entities for not deducting applicable withholding taxes. There is a 60% chance that the tax authorities will successfully claim EUR 30m in taxes and a 30% chance for another EUR 10m.
2. Transfer pricing: Red Group has no transfer pricing study in place, and several intragroup service agreements exist between entities in different jurisdictions. The chance that the related risk materializes is low, but the impact may be up to EUR 20m in additional taxes.
3. Deferred tax asset: One of Red Group's entities has net operating losses (NOLs) of EUR 50m, resulting in a deferred tax asset of EUR 10m under IFRS. The NOLs survive the change in ownership and are expected to be utilizable against future taxable profits based on the business forecast.
4. VAT receivable: One Red Group entity has an input VAT receivable in the amount of EUR 45m. The respective years are currently under audit.

Tax risks and liabilities

Common tax-related debt-like items

Often accepted as tax-related “debt” or “debt-like” are items such as the accrued corporate income tax liability until closing or tax liabilities triggered by specific actions of the seller (such as social security contributions on a special “deal bonus” to the management).

From a buyer's perspective, the preferred approach is to also include tax risks (such as the transfer pricing exposure and tax litigation risk in the example) as debt-like items. This shifts the risk to the seller:

Example case: If Red Group’s CHF 40m WHT litigation risk (TDD item 1) is considered a debt-like item in the equity bridge, there is a 40% chance for the EUR 30m and a 70% for the EUR 10m that the respective deduction is ultimately unjustified and the buyer “underpaid” by some amount for the target group.

Tax may represent not only a risk for an unwelcome invoice from the tax authorities but also a limitation for the buyer to freely use the target's funds post-closing ("trapped cash"). Examples are situations where it is not possible to distribute excess cash without withholding tax leakage or where tax-related limitations apply (such as under the Swiss indirect partial liquidation doctrine).

In the sellers' market of the last years, adding tax risk as debt-like items to the equity bridge proved difficult, especially in auction processes.

A common alternative to a debt-like item for tax risks is adding a (special) tax indemnity, not being subject to a de-minimis or basket amount. As a result, the seller avoids suffering a (potentially unjustified) purchase price reduction. In turn, this approach creates a counterparty risk for the buyer relating to enforcing its indemnity claims.

Example case: The seller and buyer may agree on a (special) tax indemnity covering the EUR 20m transfer pricing risk (TDD item 2) rather than including the low-risk tax item as a “debt” or “debt-like”-item in the equity bridge (transfer pricing risks are typically not covered under W&I insurance).

The debt-like item vs. (special) tax indemnity conundrum even accentuates in deals where the seller's liability under the transaction agreement is limited to a pro memoria amount due to W&I insurance. As W&I insurance policies regularly exclude certain risks from coverage (e.g., “known” risks or certain common carve-outs), the buyer's options are to include them as debt-like items in the equity bridge or to simply take the risk. 

Tax receivables and assets

Besides tax risks and liabilities, also tax receivables present difficult negotiation points in M&A practice. Here, the interests are inverse: the seller tries to negotiate any tax receivables as cash-like items into the purchase price calculation, while the buyer is inclined to challenge their value, enforceability, and the possibility of utilizing them going forward.

The most common examples of tax receivables are excessive income tax prepayments, deferred tax assets (primarily from net loss carryforwards), and input VAT claims, often from intragroup asset deals not structured as a transfer as a going concern (“TOGC”).

By adding tax receivables to the equity bridge, the buyer economically “prepays” at closing for a potentially uncertain asset:

Example case:

Since the deferred tax assets (TDD item 3) consist of NOLs, the value mainly depends upon the future profitability of the respective Red Group entity. Within the boundaries of transfer pricing, the buyer may be able to allocate profits and implement reorganization for using the NOL.

As regards the VAT receivable (TDD item 4), the tax authorities may conclude in the audit that Red Group’s entitlement is lower than accounted for in the books of the respective entity (or even nil). Also relevant are the timing and the necessary filings for a refund or use of the tax receivable. In these respects, there are quite significant differences between jurisdictions and tax authorities.