In a recent acquisition, a multinational company (MNC) felt the pain of involving tax expertise too late in the deal process. Their deal teams submitted a nonbinding offer without doing proper tax due diligence. The offer was at the top end of the bid prices received, and the company was selected as a preferred bidder. Two days prior to submitting the binding offer, the tax teams were brought in and discovered the target used a tax structure for its international business that was incompatible with the company’s structure, and that materially decreased the deal’s internal rate of return (IRR). The final offer was submitted with a clause that the company refused to acquire an interest in the international business, given the way it was structured. Consequently, they were removed from the auction process. Not only did this create tension with the target, but it also created friction between the tax department and the deal team, which lost what had otherwise appeared to be a lucrative deal.
Across the global corporate landscape, tax is an increasingly important business issue in deal making and capital allocation decisions. Tax itself is becoming a disruptive factor, with domestic and international tax reforms, and rising international political and media interest in MNC tax affairs. Tax should move from the back office to the boardroom once senior executives begin to understand its far-reaching implications for the Capital Agenda—from financial, reputational, and strategic perspectives.
Despite accelerating change and growing complexity, the tax function’s challenges remain the same: to deliver value, manage costs, and mitigate risk.
EY has identified three key issues that will drive tax risks and opportunities in the near term and beyond:
Legislative tax reforms and technological advances allow for information transfers among states, provinces, government agencies, and increasingly global tax authorities from different countries. This has resulted in major changes in tax policy, as countries around the world begin to adopt new tax laws or dramatically change the way they interpret existing laws, including tax treaties, for a digitalized and globalized economy.
A fundamental way in which tax is affecting deals is the Organisation for Economic Co-operation and Development (OECD)’s base erosion and profit shifting (BEPS) project, which was initiated in 2013 by the G20 and OECD countries. It aims to address perceived international tax avoidance stemming from mismatches among the domestic tax regimes of different countries.
Three main objectives guide BEPS’s implementation:
New, subjective rules are driving more tax disputes, a lack of access to cross-border treaty relief (such as withholding taxes on dividends, interest, and royalties), and potentially higher future financing costs, among other things. Specifically, BEPS includes changes designed to:
BEPS-related tax law changes may effectively increase the cost of capital for many companies and private equity funds. For many taxpayers, restrictions on interest deductibility, use of hybrid instruments, and access to tax treaties have reduced the related tax shield, materially affecting the cost of debt financing. This new BEPS environment makes it essential to realign structure and operational transfer pricing to maximize transaction value.
BEPS’s approach to taxing profits where value is created means that tax planning must be fully integrated with operational decisions. It is critical for the business and tax functions to work together to review current business models and supply chains, and evaluate where essential changes need to be made.
In December 2017, the United States enacted the most sweeping overhaul of its tax system in more than three decades, which resulted in lowering the corporate tax rate, broadening the base, and moving the United States to a quasi-territorial tax system. The US Tax Cuts and Jobs Act (US TCJA) affects a range of corporations and private equity stakeholders, including those headquartered in the United States and abroad. For many non-US corporations, the United States is their biggest market and their largest tax burden.
Like BEPS, the US TCJA’s implications extend far beyond the tax department to functions including operations, compensation and benefits, financing, and treasury. For example, restrictions on interest deductibility result in changes in tax strategy and capital structure, especially when leverage has been one way that foreign multinationals addressed the United States’ relatively high tax expense.
Company executives also need to consider scenarios in which other governments adjust their tax regimes in order to respond to the United States’ more competitive environment. Further rate reductions outside the United States, increased tax incentives, and retaliatory trade measures are all possibilities you should consider when stress testing investment evaluations.
The current changes occurring in the global tax landscape are forcing adaptation not only in tax planning and compliance processes, but also in how enterprises conduct their core businesses. Companies must consider a broad range of issues as they refresh their strategies, design and adapt business models, conduct due diligence, and structure and price transactions:
Board directors, senior executives, and tax directors not only need to consider historical tax exposures, but also must ensure that their current tax structures remain fit for purpose.
Today, nearly every company has a digital presence and derives value from data. As companies continue down the digital path, there will be far-reaching effects across organizations in shifting the value chain, the manner of customer interaction, use of data, and the location of people and physical assets.
The digital economy also affects the BEPS initiative, which seeks to tax profits in the countries where the company has a permanent establishment. Important criteria include where it undertakes value-generating activities, where major operating decisions are made, and where important assets and risks are controlled.
Historically, the tax system has been based on the physical manufacture and supply of goods and provision of services. In digital businesses, however, there may be limited or no physical presence in the country where consumer transactions take place. Consider online retailers using platforms to connect buyers and sellers, social media networks that rely on advertising revenues, and subscription-based models. Countries have varying ideas about how value is created in digital business models and how that value should be taxed.
Tax authorities around the world are beginning to adapt to the digital economy. These changes reflect governments’ attempts to catch up with new cross-border business models employing cutting-edge technologies. However, in practice, these new laws are often inconsistent and create more risks, higher compliance burdens, and greater levels of planning uncertainty.
Paying the right amount of tax in a country can be a complex endeavor, even when the intentions are to maintain the best possible compliance. As technology and the digital economy drive new, complex digital tax laws around the world, executives must work closely with their tax teams to stay abreast of this changing environment, focusing on these questions in particular:
Governments challenge each other, as well as companies, to get what they see as their fair share of taxable revenue.
At its most basic, tax controversy is a dispute between a taxpayer and a tax authority. The potential for controversy has reached new heights with international tax reforms, information sharing among tax authorities, digitalization, and the media spotlight on tax, as well as subsequent political reactions. As a result, there has been a substantial increase in the number and size of tax audits, assessments, and disputes with revenue authorities worldwide.
Increased scrutiny and litigation by tax authorities also generate much greater visibility for the tax department at the board level. Following significant public scrutiny and media attention around whether certain high-profile multinationals were paying their fair share of taxes, tax affairs are increasingly linked to corporate reputation. Fully 70% of large businesses responding to EY’s recent Tax Risk and Controversy Survey indicated they are concerned about media coverage, and 60% of survey respondents said they think tax disputes will increase.
Controversial actions can extend beyond the financial risks of additional taxes, interest, penalties, legal fees, or potential share-price erosion. Disputes with tax authorities can create a drain on senior management focus and business confidence, as well as reputational damage in the eyes of consumers and other stakeholders. It is vital that the tax function works alongside the board and the C-suite to develop a clear tax policy framework. It must explain the company’s approach to tax planning, to ensure its tax obligations are met from an operating and risk-management perspective.
Examples of the increasingly difficult tax controversy environment include the European Commission investigations of whether certain agreements between companies and tax authorities (such as advance tax rulings and advance pricing agreements for transfer pricing) may constitute unlawful state aid. In the absence of more effective dispute resolution mechanisms, particularly across borders, business leaders need to understand the potential for challenges in every relevant jurisdiction.
In some companies with a high level of ongoing tax controversy, there may be a perception at the board level that transactions or planning approaches carry greater risk in today’s era of aggressive tax administration than ever before. Whether or not a company is involved in a tax dispute or tax-related reputational risk issue, it is here that the tax function takes a deeper role in helping shape corporate strategy.
The surge of tax controversy—heightened rules, regulations, interagency cooperation and communication—is placing a heavy burden on companies around the world. In response, executives should be asking themselves three questions related to tax planning:
International tax reforms, digitalization, and a heightened controversy environment have transformed the global tax landscape and contributed to the elevated role of tax on the boardroom agenda. Planning for any restructuring, realignment, or transaction in a single country or across borders requires factoring in an ever-broader range of tax-related issues—from effective tax rate and legal entity structures to supply chain and operating models; from intellectual property strategy to information technology needs; and from treasury function to exit strategy.
We recommend that you stress test the current priority you attach to your tax function by answering the following questions:
If you answered “Yes” to any of these questions, then we recommend that you consider getting your tax advisors involved sooner, and at a higher level of your organization.
Let’s next look at specific areas across your Capital Agenda where tax plays an important role.
Tax has always been an important consideration in transactions. However, as average deal sizes have increased, so too has the complexity of the deals, often with more international and cross-border issues—and potentially, more material tax costs.
Specifically, the changing tax environment will affect transactions in the following ways:
EY’s recent Global Capital Confidence Barometer survey found that when evaluating a business portfolio, it is critical that the tax team be actively engaged with the broader business to understand the overall strategy and to help ensure that any divestment strategy balances tax implications with commercial and operational drivers.1
Our recent Global Corporate Divestment Study surveyed 900 senior corporate executives who had divested in the past three years. The data show that those who clearly described tax assets to purchasers were better able to drive value. Considering tax early in the process enables companies to more accurately identify tax implications of the divestment upfront, and to design flexibility into their sales structures and deal negotiations.2
Just how much value can tax add to a divestment? We hosted a tax workshop with a UK-headquartered company that was considering divesting a division that was doing business in 12 countries. During the workshop we identified that the tax cost on exit could be significantly reduced with a presale reorganization. Given this proactive analysis, there was time to work though the steps and be in a position to present the reorganized structure to the purchaser. As part of its planning, the company consulted with employees, reviewed key contracts for the ability to assign, and tested financial systems to reflect separation. Without the up-front consideration, the operational challenges would have meant the reorganization could not have been undertaken, leaving 10% of the sale proceeds on the table.
Tax also plays a pivotal role in the restructuring of companies we discuss in Chapter 14. A turnaround and restructuring plan may involve reducing operating costs, modifying debt agreements, reorganizing the corporate structure, or selling assets. No matter which alternatives the company or its creditors choose, proactive tax planning will help avoid unexpected tax consequences and preserve value for stakeholders.
The restructuring and tax teams should work with creditors to develop reorganization plans that preserve valuable tax assets such as net operating loss carryforwards and depreciable asset basis. They can consider strategies to release cash, monetize tax attributes, and reduce tax. Understanding the tax implications of alternative corporate and financing structures from both debtor and creditor perspectives leads to improved negotiations and more cost-effective agreements.
Legislative trends, digitalization, and rising controversy add new layers of complexity to executive decision making. CEOs and CFOs who treat tax planning as an essential discipline in their Capital Agenda are best positioned to leverage tax assets as a competitive advantage, and avoid unnecessary risks. As companies look to thrive in a technologically disrupted world by designing new business models, tax considerations will need to be front and center.