The fundamental US tax reforms brought in this year by the Tax Cuts and Jobs Act (TCJA) have changed the tax landscape for M&A more significantly than any other legislation in the modern era. Businesses and tax advisors will be considering the various opportunities created and threats posed by the TCJA for quite some time. This article looks at the tax drivers behind the current surge in US corporate M&A.
Federal corporate income tax rate reduced to 21%
From 1 January 2018, the TCJA reduces the federal corporate income tax rate from 35% to 21% (although the effective differential will often be less than 14% as a result of new deduction limitations and the addition of new taxes, as discussed below).
This tax rate reduction could increase the cash on balance sheets and overall value of US target corporations and by doing so increase their outbound M&A capabilities.
The US moves closer to a “territorial tax system”
Prior to the TCJA, actual and deemed dividends received by US corporations from (and gains on a sale of) non-US corporations were generally subject to US taxation. Under the TCJA, the US is moving closer to a so-called “territorial tax system” by introducing a participation exemption that generally exempts actual dividends received from, and certain gains realised on a sale of, 10% or more owned non-US corporations. Certain other non-US income earned by non-US corporations may still be taxed to US shareholders.
As a result of the reduced federal corporate income tax rate and the participation exemption, the advantages of having a non-US parent versus a US parent as the top company in a multinational group have reduced. However, there can still be important advantages; for example, avoiding the application of various “controlled foreign corporation” rules, such as the new global intangible low-taxed income (GILTI) tax and US federal income tax on certain gain on a sale of a foreign subsidiary.
The competitive US tax advantages a non-US bidder has over a US bidder for a US target are similarly reduced under the TCJA.
Annual cap on interest deduction introduced
Under the TCJA, tax deductions for interest on indebtedness are now subject to a broad annual limitation, in addition to most other limitations already in effect. US borrowers may now deduct their “net business interest”, up to an annual cap of 30% of their “adjusted taxable income”, with excess interest carried forward indefinitely.
For acquisitions financed through new debt, whether term loan, bond, or otherwise, the new cap’s impact will depend on a number of factors.
On the one hand, borrowing at the US companies level may still be attractive because:
- Many non-US lenders can receive interest free of US withholding taxes.
- A large group of purchasers of US debt, such as “CLO funds”, prefer debt issued by US companies for non-tax reasons.
- US borrowers can still deduct interest, although the deduction may take longer to become available.
- Other countries, such as Germany, also limit deductions on heavily leveraged companies.
On the other hand, there could be greater incentive than before to borrow in, or push debt down (in whole or in part) to, other jurisdictions where interest deductions can be better utilised.