Investing Abroad, a Few Tax Considerations
International Mergers and Acquisitions are mainly driven by strategic growth and financial objectives. Legal structuring is key to the protection of the interests of the respective parties: the Buyer, the Seller and the Banks involved. Tax also generally emerges rapidly as a key issue. For the Buyer, structuring an acquisition tax-efficiently may reduce the effective cost of the acquisition and the effective average tax rate of the group, allow tax neutral repatriation of cash and be the first step to a tax efficient exit strategy. For the Seller, the challenge is to obtain the highest price at a minimum tax cost. In a fast-moving international tax environment with a global increase of taxes and tightening of anti-abuse mechanisms, certainty and efficient tax planning are key and challenging objectives to international players. This article discusses the main tax issues of international acquisitions by adopting a comparative approach.
When considering an acquisition abroad, tax considerations are often amongst the main concerns. In the acquisition phase, several arbitrations may take place, including, for instance, (i) acquisition of a company (“share deal”) versus acquisition of the assets (“asset deal”), (ii) investing directly from the headquarter country or through domestic or foreign entities and (iii) financing the acquisition with debt versus equity.
An efficient tax planning strategy addresses tax issues as a whole at every stage including: (i) acquisition (ii), post-acquisition restructurings and (iii) exit strategies.
This article sets out the main tax issues that an investor may consider when considering investing abroad. It does not address real estate investments.
1. Acquisition phase
1.1. Share deal or asset deal?
Share deal versus asset deal is not only a tax question. The legal implications are also very different. With a share deal resulting in the acquisition of a Target Company, the Buyer inherits current and potential liabilities, which should normally not be the case with an acquisition of assets.
The tax treatment is different for the Seller and for the Buyer.
Transfer taxes generally apply upon the sale and generally are much higher on an asset acquisition (especially where the assets include goodwill and real estate). This is particularly the case in European countries such as Belgium, Germany, France and Spain but also outside Europe, notably in Australia, the United States and Japan.
Provided that the Target Company is not a real estate company, the acquisition of its shares should therefore usually be less costly for transaction tax purposes. The saving generally benefits the Buyer, who is likely to be the taxpayer unless the parties agree otherwise.
For the Buyer, share deals may also be favored where the Target Company has significant net operating losses (N.O.Ls) to carry-forward that can be offset against the future taxable income of the Target Company. This, however, implies that the country where the Target Company is established does not provide limitations in the use of NOLs in the event of a change of control, as Belgium, Germany, Italy, Spain the United States do. Many countries have introduced or are contemplating to the introduction of limitations on the availability of NOLs in order to secure a minimum level of taxation of companies and prevent abuses of companies with tax losses. For instance, the French Finance Bill for 2013 provides that NOLs may be carried forward against only the first million of profit and 50% of the excess over this. Also, NOLs are more likely to be unavailable where business restructurings occur within the company.
Capital Gains Tax for the Seller
The Seller may prefer a share deal since capital gains tax on the sale of shares or substantial shareholdings is generally subject to lower taxation (with the possible benefit of tax exemptions if the shares are held in a holding company). Numerous countries (throughout Europe but also outside Europe) provide for a participation-exemption regime that gives exemption or near exemption from taxation of gains arising on the sale of shareholdings, although the regimes generally require a minimum holding period as well as a minimum participation stake.
In the case of a sale of assets, ordinary income tax or standard corporate income tax is likely to apply on gains generated by the sale, with no reduction in the rates applying. The taxable gain will frequently correspond to the sales price where the assets were generated by the Seller from nothing. However, if the selling entity has NOLs available to be offset against that taxable gain, the transaction may prove tax-neutral for the Seller.
Acquiring shares also presents some disadvantages for the Buyer. The value of the assets owned by the company is not stepped-up in value in the books of the Target Company upon its sale. The base cost of the assets for tax purposes will remain the same despite the payment by the Buyer of a price reflecting – to some extent - the fair market value of the assets at the time of his purchase of the Target Company. Therefore, tax attributes attached to the payment of sales price may not be claimed on the underlying assets acquired.
The original base cost of the assets held by the Target Company will not change as a result of its acquisition. Tax depreciations will be limited to that base cost and any future capital gains on them will be determined on that historic base cost – which is lower than the value given to the assets for the purpose of determining the acquisition price paid by the Buyer for the Target Company. Therefore latent tax liabilities adhering to the assets will survive the deal and effectively pass into the hands of the Buyer.
Also, and as already pointed out, aside from tax, the Target Company’s debts will continue to exist and the Buyer will effectively inherit its legal, employment and contractual liabilities.
Therefore, while the Seller may favor an asset deal, the Buyer will generally prefer an asset deal.
If sufficient contractual protection is obtained, a share deal may still be considered, with the Buyer generally claiming the indirect benefit – reflected in a reduced acquisition price – of the tax saving achieved by the Buyer in the course of the negotiations.
Obviously, depending upon the assets or business acquired, a share deal may be the only option for business reasons. This is the case with, for instance, Leveraged Buy Outs (LBOs), where investment funds or investors are interested in a company rather than in the underlying assets.
1.2. Direct or indirect investment?
Whatever the deal (asset or share purchase), the Buyer should hold shares in the legal entity carrying out the business (whether it is newly incorporated on an asset deal or acquired from the Seller).
The next question is whether the shares should be held directly by the Buyer “mother company” or through an intermediate entity. Intermediate holding companies may be set up by a group to segregate its domestic assets from its international assets (or the US assets from the assets located in the rest of the world) for instance. Other groups may structure the chain of ownership of their subsidiaries in accordance with the nature of their products or activities. However, in this article, only tax aspects of the ownership are taken into consideration.
Deduction of the acquisition interest charge
If the acquisition is debt-financed, the incorporation of an Acquisition Company in the country of the Target Company may allow the two companies to file a consolidated tax return so that the interest charge incurred by the Acquisition Company may be deducted from the profit of the Target Company. Tax grouping or tax consolidation provisions exist in various distinct forms in numerous jurisdictions, including the United States, Australia, Japan, France1 and Germany. The scope of such provisions is however generally restricted to domestic subsidiaries that are wholly owned (or almost wholly owned) by the consolidating parent entity.
Where a jurisdiction does not provide for such tax grouping, it may alternatively be possible to obtain consolidation through a merger between the Target and the Acquisition Companies under a tax neutrality or deferral regime. However, this route may be challenged by the tax authorities of some countries (such as France or Poland) if they consider the merger to be purely tax driven.
In addition, several countries that are confronted with significant budget deficits tend to restrict the tax benefits of the use of debts in challenging their nature (debt may be reclassified into deemed equity) and/or limiting the deduction of the related interest charge. For example, France introduced a recent provision limiting the deductibility of the interest charge in a context of debt financed acquisition of a company2. Interest may be disallowed if the Acquisition Company cannot show that it takes all decisions relating to the acquisition and that it actually plays its role of controlling shareholder of the newly acquired subsidiary. This limitation is intended to prevent foreign groups from deducting interest in France by establishing an indebted Acquisition Company with no real substance i.e., with the effective decision-taking process abroad. The limitation proves to be discriminatory. The limitation may not apply to French based groups where the decision-taking process test is not met at the level of the Acquisition Company but in France within an affiliate company. This safe harbor rule is obviously not available to foreign controlled French Acquisition Companies.
Holding, repatriation and reinvestment
A holding company (hereafter “Holdco”) may also provide a wide range of tax benefits in addition to consolidation reliefs. Dividends from the newly acquired Target Company and received by Holdco may be tax-exempt. One of the critical aims of a foreign group is to be able to repatriate profits from the newly acquired Target Company at no tax cost (i.e., no withholding tax) in the jurisdiction of the distributing company or at the level of intermediate holding companies (which is generally achieved by using participation exemption regimes).
The withholding tax on dividends that is generally due in the jurisdiction of the distributing company on outbound dividends may be reduced or cancelled by virtue of a tax treaty between the jurisdiction of establishment of the distributing Target Company and of Holdco or by virtue of domestic/European law within a European context.
With the exemption of the dividend in the country of Holdco, the application of the withholding tax in the source country, i.e., the country of the Target Company, may result in a non-recoverable final cost3.
The location of Holdco is therefore critical to reduce those so-called “cross border costs”. However, anti-abuse principles exist to prevent treaty shopping or the use of “mail box companies” for avoidance purposes. The company should therefore have corporate and operational substance and should be regarded as the beneficial owner of the dividend. Back-to-back arrangements are therefore prohibited.
Holdco must therefore be used as an actual holding company, monitoring (and having the resources to monitor) its investments. Use of a Holdco may allow a group to reinvest the tax-exempt proceeds (dividends, gains) without repatriating them to the ultimate headquarter jurisdiction. This intermediate step with no repatriation may result in tax savings in the headquarter country, for example, in the US which generally taxes foreign income of subsidiaries on a deferred basis i.e., upon repatriation.
In the European Union, Holdcos are generally located in Luxembourg, Belgium, Netherlands, or Spain.
1.3. Debt or equity financing?
An acquisition may be financed by equity or debt. Equity gives rise to non-deductible dividends. Debt gives rise to deductible interest charges. The lending may be extended by a bank or a related party of the Buyer (a finance company or regular company of the group).
Generally, Buyers resort to debt for leveraging purposes and on some occasions for tax planning purposes. With a related party debt, a group may strip earnings of the indebted company tax free (due to deductibility at the level of the indebted company and low taxation at the level of the lending related party).
However, jurisdictions have anti-abuse mechanisms generally known as “thin capitalization rules” or “earnings-stripping regulation”.
The most common limitation concerns the thin capitalization rules, whereby deduction of interest may be disallowed if a required debt-to-equity ratio is exceeded (along with other tests). This approach is adopted by several countries, including the United States4, France5, Belgium and Australia (although these jurisdictions generally limit its scope to related-party debt and, as the case may be, to third party debt guaranteed by a related party). Another method consists of the application of an overall ceiling of deduction of net financial expenses determined by reference to the company’s EBITDA.
For example, Germany and Italy apply a global limit on deduction of 30% of the EBITDA. The same limitation was also very recently introduced in Spain and France under the newly adopted Finance Bill. French indebted companies whose net interest charge exceeds EUR 3 million may deduct from their taxable profit only 85% of their whole interest charge (effective for financial years started after December 31st, 2012) and 75% (effective for financial years starting on or after January 1st, 2014)6. Such a limitation applies on the excess interest charge irrespective of as to whether it is paid to a third party (such as a Bank) or to a related party. This German inspired limitation sometimes referred as “tax barrier” may appear as the ultimate tool for tax administrations to prevent the erosion of the country’s tax base. In France, it applies to interest charges which were considered as deductible under the existing anti-abuse mechanisms (under sections 212 and 209 –IX of the French tax code as seen previously).
On the other hand, the limitation increases the cost of capital for companies, which may prove detrimental to investments.
Therefore, leveraging an acquisition locally requires investigation of the potential limitations on deductibility of interest.
Consolidation of the Target Company’s income and the acquiring company losses may be achieved through group tax consolidation regimes or merger of the indebted Acquisition Company or Holdco and the Target Company.
The efficiency of a debt-financed acquisition is further enhanced where the interest can be paid gross (with no withholding tax) to a related party located in a low tax jurisdiction.
A number of jurisdictions provide for a zero withholding tax on interest unless, such as in France, interest is paid to a creditor established in a non-cooperative territory or jurisdiction for tax purposes7. Also, numerous international tax treaties provide for a zero rate on interest.
Once the acquisition structure is set, the next question is whether the structure suitable for the acquisition will remain tax-efficient once the acquisition is completed.
2. Post-Acquisition Phase
In this phase, the main concerns of the foreign investor are to reduce the tax burden of the Target Company and to achieve a seamless repatriation of profits.
2.1. Alleviating the tax burden of the Target Company
Post-acquisition restructuring may be considered to achieve better tax planning at the level of the Target Company and of the group of the Buyer.
The use of debt through consolidation and merger is discussed above but other, more operational, restructurings may be investigated.
Determination of a new transfer pricing methodology (regarding transactions between groups companies world-wide) within the course of the reorganization with the Buyer group may give rise to savings.
Transfer pricing aims to define the pricing policies for intra-group or related party transactions within the group. Prices and terms of should be fixed on an arm’s length basis i.e., under market conditions. However, numerous transactions like these will have no comparable with third party transactions. Groups will therefore resort to methodologies recommended as the OECD or set out in domestic law, as they are in the US8. Reorganizing the manner in which the group operates in reallocating risks and functions between entities and countries may prove tax-efficient.
Location of the intangibles must also often be addressed. Many countries provide for reduced rates of taxation for income deriving from intangibles. They include Luxembourg, the Netherlands and more recently the UK with the so-called “patent box” regime. Ireland and Switzerland are also attractive jurisdictions as they offer a low corporate tax rate and benefit from a strong tax treaty network under which corresponding incomes may be redistributed tax free to foreign shareholders.
The structure and quantum of intra-group services such as management fees, royalties, research and development and cash pooling should also be reviewed and where necessary changed to reflect the new situation following the acquisition. This may translate into overall tax savings subject to a detailed and careful transfer pricing policy.
2.2. Repatriation Strategy
As discussed above, one of the key tax issues is how to achieve repatriation of cash from the Target Company while limiting cross-border costs, which usually take the form of withholding taxes. The use of an intermediate Holdco is one answer. Debt and intra-group services may be another. Deductibility of these payments would however require that the debt be genuine (and the interest not excessive) or the services rendered be effective, useful to the business of the Target Company and that the level of fee paid be commensurate with the services rendered.
Service fees are generally not taxable in the source country and royalties may also be paid gross under several tax treaties and under European law subject to certain conditions.
3. Exit Strategy
The structuring of the acquisition has a critical impact on the exit phase.
Where the acquisition has been completed through a Holdco under a participation exemption regime, the capital gain realised upon the disposal of the shares of the Target Company may be exempt at the level of Holdco. In France, for instance, the current rate of taxation is 4% (subject to a two year holding requirement and a 5% minimum interest).
Taxation in the country where the Target Company that is to be sold is established should also be addressed. In general, tax treaties – where applicable – attribute the right to tax the gain on a sale of the Target Company to the country of residence of Holdco only. Alternatively, they may provide that where Holdco owns a substantial shareholding (generally 25% or more of the Target Company), the country of residence of the Target Company may also levy tax. Care should therefore be taken in the choice of location of Holdco, even if under European case law the tax exemption of capital gains applicable to domestic Holding companies under local participation exemption regimes, must be extended to European based Holdcos. For example, the tax treaty between France and Spain, provides that the residence country of Holdco (say Spain for instance) is attributed the right to the gain on disposal of shares issued by the other treaty country (say France in our example).
France is denied to right to levy tax unless Holdco owns directly or indirectly 25% or more in the French company9. In such a situation, the Spanish Holdco benefits in France of the same tax benefits that would have been applicable if Holdco would have been established in France (with the exemption regime on substantial shareholdings10)11.
The sale proceeds finally need to be repatriated to the group without any tax costs. This requires that the dividend distributions from the holding company to the group do not trigger any withholding tax and if not, that the liquidation of the holding company may be completed without any adverse tax consequences or withholding taxation on the gain upon liquidation (as is notably the case in Luxembourg).
Efficient international investment requires that the parties address taxation and tax planning not only in the country of the Target Company and of the Buyer but also on a cross-border scale in order to understand the overall tax treatment of an investment and to take benefit of reliefs and planning opportunities. Players in the M&A field (such as groups, banks, investment funds) are more and more confronted to a complex and changing tax environment in the structuring of their investments. The tax cost of transactions globally increases. Tax authorities are generally more “aggressive” also on an international scale with a growing trend of criminalization of tax law. In such a context, Players in this market increasingly demand greater tax certainty as to their costs and exposure in international deals.
1. Sec 223 A of the French Tax Code
2. Sec 209-IX of the French Tax Code
3. However, France recently introduced a 3% tax on distributions from French companies or after-tax profit of French based branches of foreign companies (section 235 ter ZCA of the French tax code). The tax is designed as a special contribution due by the French distributing company (or branch) and may not be reduced by international tax treaties or EU law aimed at reducing or suppressing distribution costs. Companies subject to standard corporate income tax (“CIT”) at 34.43% will suffer an effective CIT at 36.4% in case of distribution of all the profits. In case of intermediate French companies in the chain of ownership, the cascading effect should prove detrimental (unless subsequent distributions are made within a fiscal unity).
4. Sec 163(j) of the internal Revenue Code
5. Sec 212 of the French Tax Code
6. Sec 212 bis of the French Tax Code
7. Sec 125 A III of the French Tax Code
8. Sec 482 of the Internal Revenue Code
9. Article 13 2. A)
10. Sec 219, I-a-quinquies of the French Tax Code
11. Sec 244 bis B of the French Tax Code / BOI 4 B-1-08. Extension of the tax benefits to Companies established in a Member State of the European Union or with a country of the European Economic Area having signed with France a qualifying tax treaty.