How to Avoid Cross-Border M&A Tax Pitfalls

A number of trends are converging, and U.S. tax reform will make navigating them more complex.

Those handling international M&A tax planning are facing two sets of challenges that require more proactive tax planning across the board.

The first is the tightening fiscal net around the structure and financing of cross-border acquisitions. Countries are requiring multinational corporations provide more substance, economic support, and transparency when entering into tax-advantaged transactions.

The second set of trends, aimed at attracting corporate investment, is the tempering of hardline tax reform that can stem from global competition.

U.S. tax reform is likely to make navigating the new tax landscape more complex. Deals will continue to be made, but they will require more advance tax planning by CFOs, tax directors, and their tax advisers. Companies that are either ill-equipped to address the changes or unaware of them altogether are especially at risk of incurring avoidable tax costs.

Six Trends to Watch

The Organization for Economic Co-operation and Development (OECD) base erosion and profit shifting (BEPS) project, and related global tax developments, have coalesced into a handful of common trends that will likely impact the tax planning and deal-making process. CFOs and tax directors should look for:

1. Increased focus on substance. Tax authorities are demanding more substance from companies formed to invest in the stock, debt, or intangibles of related parties. A company’s offshore structures will have to accommodate these demands, or else it risks being disregarded or denied treaty benefits. Emphasis is placed on skilled labor and decision making in country, not just the number of employees of or assets owned by a company.
2. Diminished importance of legal ownership relative to economic contributions in transfer pricing of intangibles. Countries are trending toward assigning income to the situs of the economic activity that gave rise to the intangibles, which makes intellectual-property planning more complex and costly.
3. Limitations on interest deductions. Some limitations may emerge from the tax reform process in the United States, ultimately making M&A more challenging.
4. Worldwide exchange of information between tax authorities. In addition to country-by-country reporting requirements for companies with consolidated revenues of at least €750 million or $850 million, information about the ultimate owners of investment entities will be subject to broader disclosure. This movement also has the momentum to potentially become an international norm.
5. Increased scrutiny of state aid. Beginning in 2013, the European Commission has reportedly reviewed hundreds of such rulings and found that they constituted a form of prohibited state aid. In the current climate, tax rulings are harder to obtain and provide less certainty than they once did.
6. Competition for low-rate corporate income tax regimes. Globally, corporate tax rates continue to trend downward as countries compete to attract investment. But the impact of reduced corporate income tax rates is often being offset by broader definitions of taxable income.

Moving forward, successful M&A demands tax planning at an early stage in the acquisition (or disposition) process. That allows companies to identify opportunities and potential pitfalls arising from broader global tax issues to best maximize their available options.

Here are some practical recommendations that dealmakers should consider for navigating the current tax environment:

• Devote time up front to the structure of debt financing and refinancing as both require more detailed advance-planning than in the past due to BEPS and the spread of national limitations on interest deductions.
• Consider the impact of the pending U.S. tax reform on domestic and foreign capital and operating structures. Equally important is the potential for reductions in tax rates when modeling investments and negotiating the payment for U.S. tax attributes.
• Include realistic estimates of increased tax compliance costs in financial planning models that account for the cost of providing enhanced substance to holding companies and group finance operations. Budget for ongoing transfer pricing analyses and documentation.
• Assess the level of substance that can be supported on an ongoing basis and whether that is feasible for your company to maintain.
• Evaluate which geographic location makes the most sense for the global R&D function, and not just where legal title to intellectual property should be held.
• Educate investors and other stakeholders about the ongoing evolution of international tax requirements to manage expectations and ensure appropriate resources are provided.

Being proactive about tax decisions and staying abreast of changes in the international tax landscape can mean real savings for companies engaged in global business.