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 last month 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 today. Where to allocate costs arising from an M&A deal must be sorted by the firm’s tax advisers. Typically most of those costs are allocated to the target, which can utilize it as a tax shield in their final tax filing (ending the day it’s acquired). But some costs can be carried over to the newly merged entity, 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 monitoring fees, to the post-acquisition entity. These typically represent roughly one to three percent of the enterprise value, which can mean hundreds of millions depending on the deal size. Two years ago the Internal Revenue Service 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.
What we’re hearing from industry tax professionals now is that the IRS wants to come down more forcefully on the issue; most likely through regulatory proposals that will make it harder to ignore its wishes. Some expected the new proposals to be announced at the American Bar Association tax section's big annual meeting in January – a forum the agency often uses for big reveals – but now predict it to happen later this spring.
Of course private equity firms can ignore this regulation too, and fight the matter in tax court. 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 likely going to be an answer the industry won’t like.