Say all you want about tax being one of the only two certainties in life, for private fund managers it’s often anything but.
Every year, US commentators make the failed prediction that this is the year when carry taxes will finally go up (no it hasn’t happened; yes the debate rages on until it does). Similar concerns erupted in the UK earlier this year after a left-leaning advocacy group released widely publicized research that portrayed carried interest treatment as a tax loophole costing the government hundreds of millions in pounds. It’s something UK politicians will gauge public opinion on until the general elections expected this May.
And then there are the less visible tax uncertainties, one of which we wish to throw a spotlight on here. Where to allocate costs arising from an M&A deal must be sorted by the firm’s tax advisers. When the costs can be allocated to the target, they can be utilized as a tax shield in the company’s final tax filing (ending the day it’s acquired). But some costs can be carried over to the post-transaction period, which can be beneficial from a tax standpoint. In the US, it all turns on application of the “Next-Day Rule” rule, which, put simply, says that certain costs arising before the deal is complete can be allocated to the buyer’s consolidated tax return as long as it’s all done reasonably.
The intent of the rule is to prevent sellers from having to take on tax liabilities made during the closing that were outside its control. When costs are shifted to the new entity, one primary advantage is those deductions aren’t limited by Section 382 of the code, which places a limit on how much income a company may offset with net operating losses and certain other tax attributes upon an ownership change.
Private equity firms have (reasonably) used the rule to shift certain costs contingent on signing, like transaction fees, to the post-acquisition entity. These typically represent roughly 1 to 3 percent of the enterprise value, which can mean hundreds of millions of dollars depending on the deal size. Two years ago the Internal Revenue Service (IRS) issued some guidance suggesting this didn’t always seem OK, but this didn’t result in any massive changes in fund managers’ M&A tax planning, mostly because GPs and their tax advisers didn’t agree with the tax authority’s interpretation of the tax code. That may have to soon change.
Last month, the IRS came down more forcefully on the issue, issuing new proposals that will make it harder for the industry to ignore its wishes. In the proposal, the IRS and the Treasury Department said the Next-Day Rule has “been inappropriately interpreted by taxpayers” and that they want to limit how much flexibility tax planners have when allocating success-based fees and similar costs.
Of course, private equity firms can ignore this proposal too and fight the matter in tax court (or hope the final regulations offer something different). But that’s a more costly exercise few probably dare to fight. On the plus side, the new regulations will offer the industry a little more (and much needed) tax certainty. It’s just an answer the industry won’t like much.