Tax planning considerations in merger and acquisitions

Mergers & acquisitions —a snapshot Changing the way you think about tomorrow’s deals Stay ahead of the accounting and reporting standards for M&A1

June 8, 2017

What's inside Tax advantages of an alliance ................................ 2 Formation ........................... 3 Ongoing ................................ 4 Exit ........................................ 4 In summary ............................... 4

Alliances: Think about taxes for each stage of the alliance Tax benefits can be a critical, motivating factor for entering into an alliance rather than an alternative structure. Tax attributes available with an alliance formation can create advantages over traditional M&A transactions. For example, how an alliance is formed will impact the available tax benefits and associated tax costs for the alliance and its participants. In the U.S., pass through entities and other alliance tax structures can generally defer current tax costs, prevent double taxation, and allow for a more efficient use of existing tax attributes of the participants.

This edition of Mergers & acquisitions—a snapshot is the fifth in a series focused on joint ventures and strategic alliances (referred to as “alliances”) and will discuss tax considerations for alliances associated with three distinct stages of its lifecycle: formation, ongoing, and exit. Previous editions in this series focused on common alliance structures and participants, governance, collaboration agreements, and compensation arrangements. A previous edition of Mergers & acquisitions—a snapshot in the cross-border acquisition series included accounting considerations related to income taxes for cross-border deals.

1 Accounting Standards Codification 805 is the U.S. standard on business combinations, Accounting Standards Codification 810 is the U.S. standard on consolidation (collectively, the “M&A Standards”).

Tax advantages of an alliance

Additionally, the tax analysis should contemplate potential changes to relevant provisions in the tax code. As tax laws An alliance allows for certain tax advantages. Alliances are enacted, they should be monitored for their impacts to started from the ground up allow participants to decide on a form of alliance that considers the needs of all participants. the alliance.

For example, an alliance may be formed as a legal entity The achievement of these objectives is linked to three that is taxed as a partnership or through contracts without a distinct stages of the alliance lifecycle which are: formation, new legal entity formation. The terms of the alliance will ongoing, and exit. The chart below in Figure 1 highlights determine whether it is taxed as a partnership or as another considerations at each stage of the alliance lifecycle and are arrangement. This flexibility is one of the advantages of the described in more detail in this snapshot. alliance structure.

Understanding the tax motivations that are specific to each participant is important. Often, the main tax objective of an alliance is to limit tax costs throughout the alliance lifecycle, and should be understood prior to settling on the structure of the alliance. Participants should also consider balancing the tax efficiency of the flow of earnings while the alliance is operating and any tax implications of the expected exit event upfront.

Formation In the formation stage, the tax structure and initial decisions are made and the alliance is created. Tax decisions made at the onset of the alliance formation will carry impacts for the entire alliance life cycle, not just in the initial stage of formation. Each alliance structure will have its own tax advantages and consequences. Figure 2 outlines a few potential tax structures and certain tax attributes associated with each structure, some of which are described in further detail below.

If the alliance is taxed as a partnership, contributions are generally tax-free, but there may be exceptions depending on the nature of the property or the terms of the alliance. In a corporate alliance, a participant that receives some distribution to facilitate an alignment of ownership percentages may have to recognize immediate gains.

Modeling: Partners in a tax partnership will retain responsibility for the built-in gain or loss in contributed assets. This liability or benefit is a tax attribute to participants based on the difference in the tax basis of the assets contributed and their fair value at the time of contribution. The partnership’s treatment of these items can create benefits and detriments for the participants and may be the subject of negotiation prior to formation.

Valuation of the contributed assets and modeling future tax costs may be required to understand the tax consequences of the formation.

Jurisdiction: A key element of alliance formation is the jurisdiction where the alliance is formed. Figure 3 covers some advanced jurisdictional issues that should be considered during formation.

Immediate tax costs: Generally, limiting immediate tax costs is the primary objective at formation. This would include deferring immediate taxes and accelerating tax benefits. The amounts of unused tax benefits at the participant level may impact the motivations and direction of the alliance formation. Participants should be aware that some structures may trigger immediate tax costs in the form of transfer or stamp taxes. Some of these taxes are dependent on the jurisdiction, so the jurisdiction where the alliance is formed is important for limiting those costs.

Contributions: During formation, participants will decide what function the alliance will serve, and therefore what assets, such as fixed assets or intellectual property, the participants agree to contribute or provide access (such as licensing or leasing arrangements). Depending on the type of assets and method of providing access, there are different tax effects.

While not specific to alliances, one example of a jurisdictional issue is repatriating foreign cash. Selecting a foreign jurisdiction in certain emerging markets may create trapped cash when there are regulatory hurdles to repatriating earnings.

For example, suppose an alliance is formed as a partnership in a country with currency controls. There are regulatory limitations and exchange rate impacts to repatriating cash.

Cash may be costly to repatriate to the participant in the U.S. and may be best spent on permanent reinvestment in the alliance. Determining which jurisdiction to form the alliance should include expectations for distributing income from the alliance.

Intra-entity debt and transfer pricing arrangements are mechanisms to transfer funds between entities. Intra-entity debt is a common arrangement for a participant to loan an alliance cash (or vice versa). In addition, recent accounting guidance impacts the classification of debt and equity.

Participants and alliances may have arrangements that are classified as debt for tax purposes and classified as equity for accounting purposes. Transfer pricing arrangements cover the prices an entity in one territory will charge a related entity in another territory for goods and services exchanged between the parties (e.g., between a manufacturing joint venture and the legal entities that sell the end product). Regulatory bodies evaluate each of these types of arrangements in close detail to ensure the terms are appropriate (e.g., that transfer pricing allocates profits among entities commensurate with the value of the activity performed by the entity). As tax treaties evolve, intra-entity debt and transfer pricing arrangements will have to be monitored over the life of the alliance.

Ongoing During the ongoing stage, the alliance may distribute earnings to participants. A number of decisions made at formation will impact the amounts available for distribution: i) determining which participant should receive the benefits of the alliances’ tax attributes, ii) leaving enough working capital available for the alliance to meet its operational requirements, and iii) ensuring tax compliance. While ideally made at formation, the execution of these decisions and the actual results of the alliance operations will dictate the distributions to each participant.

The tax attributes provided by the participants at formation may be shared equally when realized by the alliance or may be reserved for the participant that contributed the associated assets. These terms are negotiated at formation and amounts may have to be set aside to remit earnings back to a particular participant.

Participants should be mindful of working capital requirements for the alliance to pay its current liabilities, including tax liabilities. The formation decisions described earlier impact the alliance’s tax liabilities, and therefore also impact the cash available for distributions to participants.

An alliance’s own tax compliance may be an overlooked area by the participants. Just as functional roles need to be defined for human resources or legal, the participants have to agree upon who will be responsible for the tax function to avoid duplication of roles or non-compliance.

Tax compliance for the alliance will not necessarily be the same as tax compliance for the participant. This is especially true for alliances that consist of separate legal entity structures from the participants. If the alliance is taxed as a partnership, some elements of costs (e.g., startup costs) may not be deductible even if the participants would have traditionally deducted such costs directly. In addition, distributions of earnings from a partnership may be tax free, but distributions of earnings from a corporation may be a taxable dividend.

Exit As most alliances are finite in nature, exit strategies should be planned at formation. For example, participants may plan to form a pharmaceutical alliance for research and development with a finite term after which the alliance is terminated. Those participants should plan for both a wind up of a successful venture which will require operations to be distributed back to one of the participants, as well as a wind up of a venture that does not meet its research goals.

Participants need to address upfront the process of the exit.

Exits can be effected through liquidation, sale, or partial sale, but each will present different taxable events for the participants. For example, if a tax partnership is liquidated, distributions of the partnership assets may not currently be taxable. This may be a significant advantage over a traditional corporate structure, in which distributions of earnings are currently taxable.

Participants will set tentative dates and exit plans in the formation documents that outline the planned exit events, including taxable consequences. These events can ultimately be deferred or amended if situations or economics change during the course of the alliance lifecycle.

In summary Tax planning should take place at the beginning of the alliance formation. This ensures the alliance is tax efficient, the participants have an appropriate expectation on ongoing distributions, and there are no surprises at the end of the alliance life. These considerations can be complex and should be addressed via a coordinated effort among the alliance participants and its tax professionals.

For more information on this publication, please contact any of the following individuals: Greg McGahan Partner U.S. Alliances Services Leader (646) 471-2645 gregory.mcgahan@pwc.com Larry Dodyk Partner U.S. Business Combinations Leader (973) 236-7213 lawrence.dodyk@pwc.com Andreas Ohl Partner National Quality Organization – Business Combinations (973) 236-7721 andreas.ohl@pwc.com Christopher Chung Director National Quality Organization – Business Combinations (973) 236-7755 christopher.chung@pwc.com Scott Cohen Director U.S. Deals Practice (646) 471-0884 scott.j.cohen@pwc.com

Karen Lohnes Principal Leader, Washington National Tax Services Mergers & Acquisitions (202) 414-1759 karen.lohnes@pwc.com Elizabeth A. Hall Partner Washington National Tax Services Mergers & Acquisitions (646) 471-4059 elizabeth.a.hall@pwc.com Daniel Carmody Managing Director Mergers & Acquisitions (267) 330-2743 daniel.f.carmody@pwc.com

PwC has developed the following additional M&A Snapshots related to business combinations and noncontrolling interests, covering topics relevant to a broad range of constituents.  How timing your transactions in light of the new standards will impact your business and communication with stakeholders  Goodwill impairment testing: What's old is new again  Deal or no deal: Why you should care about the M&A Standards  Even your tax rate will change  Accounting for partial acquisitions and disposals—it's not so simple!  Doing a deal? Be careful about employee compensation decisions  Acquired assets not intended to be used: You may need to record them, even if you don't use them!  Accounting for contingent consideration—Don't let earnouts lead to earnings surprises  The Consolidation Standard—determining who consolidates is just the beginning  Carve-out Financial Statements—A challenging process  Noncontrolling interests—why minority shareholder rights matter  Market participants: how their views impact your values  Did I buy a group of assets or a business? Why should I care?  Don't let push-down accounting push you around

 Financial risk management considerations in an acquisition  We’re in the process of acquiring a company with significant in-process research and development (IPR&D) activities. What's next?  Cross-border acquisitions – Due diligence and preacquisition risk considerations  Cross-border acquisitions – Navigating SEC reporting requirements  Cross-border acquisitions – Accounting considerations relating to income taxes  Cross-border acquisitions – Post-acquisition considerations  Companies in distress: A successful turnaround requires decisive action  Companies in distress: Bankruptcy process and reporting considerations  Companies in distress: Emerging from bankruptcy  Companies in distress: Tax planning and accounting considerations  Alliances: When to consider an alliance in a changing economic environment  Alliances: Planning and governance – the keys to success  Alliances: Collaboration – when two come together to do something great  Alliances: Have you considered talent?

PwC’s Deals Practice monograph, covering topics relevant to a broad range of alliance considerations.

PwC clients who would like to obtain any of these publications should contact their engagement partner. Prospective clients and friends should contact the managing partner of the nearest PwC office, the name of which can be found at www.pwc.com.

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