January 20, 2014
Interviewed by: David Snow
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How to Subtract Value Via Bad Tax Moves

GPs who fail to pay attention to critical tax matters may end up getting a lower price for their portfolio companies in the exit. Two tax experts discuss transfer pricing and qualified stock purchases, and how getting these wrong can end up subtracting value from a private equity deal.

GPs who fail to pay attention to critical tax matters may end up getting a lower price for their portfolio companies in the exit. Two tax experts discuss transfer pricing and qualified stock purchases, and how getting these wrong can end up subtracting value from a private equity deal.

How to Subtract Value Via Bad Tax Moves
Tax & Liabilities in Private Equity

David Snow, Privcap:
Today, we are joined by Michael O’Connor of Arsenal Capital Partners and Rick Bailine of RSM. Gentlemen, welcome to Privcap today, thanks for being here. We are talking about a hot topic: taxes and private equity. Both of you are tax experts, Michael, you are in a private equity firm, Arsenal, and you oversee financial value add for them, and Rick you have been consulting and providing advice about taxes to many groups including private equity firms for a long time so thrilled to have both of you here. We are talking about how an oversight or perhaps a misstep in getting the tax equation right in a private equity investment could end up not adding but subtracting value down the road, again, if the issues are not clarified before going into a deal. Why don’t we start with just setting the stage and we can throw the first question to Michael. Is the environment around taxes getting clearer or more opaque as the market develops and what does that mean for a private equity firm’s ability to assess tax risk and tax impact?

Michael O’Connor, Arsenal:
It is not only becoming more opaque, regulations continue to be promulgated across the board. Internationalization is a big issue for us, so not only are we dealing with domestic tax issues but much more international tax issues. Getting opinions ahead of time is taking us more and more time with our outside consultants. The IRS is not offering opinions upfront in most cases so certainly that is added risk to our cash flow as we look at the tax positions of our companies. We are walking into situations that are far more complex than they were 10, 15, 20 years ago, even five years ago. Uncertainty on the tax position, on where they are going to settle, as well as risks that we are inheriting especially in the middle market where we operate where perhaps the portfolio companies were not very rigorous or what I would call very technical under tax approach so we are doing much more time on due diligence upfront, we are seeing increasing regulation and we are seeing much more complexity especially on the international side.

Rick Bailine, RSM:
I think in addition Mike, to the complexity, you also have a far more aggressive application of the law at both the federal and the state level. We live in a world of revenue shortfalls so the tax man, be it the federal tax man, the state tax man, or as you even mentioned, the international tax man, they are all being more aggressive in trying to get what they believe is their fair share of the pie.

Snow: But Rick why can’t you call up the IRS ahead of a deal and say hey, we are thinking of structuring things in a certain way, will that work, why can’t you get clarity from the regulators that matter?

Bailine: Well as Michael mentioned the IRS is basically not doing that any longer. For many years David as you know, you used to be able to file something called a private letter ruling request with the national office of the Internal Revenue Service, and you would do just that, you would tell them what it was you planned to do, outline it in detail, and you would brief the issue under the tax law and say this is the tax treatment we believe will ensue from doing our transaction in this way, and they would write back and say yes, we agree with you and that was a letter that was binding on them for your deal, it didn’t bind them for anyone else’s deal. But they had been closing that down and now it is to the point where they pretty much don’t do that anymore.

Snow: Well let’s get down to specifics about how again; a tax misstep can end up subtracting value from a private equity investment. Let’s talk about the increasing internationalization of the private equity marketplace as you mentioned Michael, and something called transfer pricing, first of all before we understand how transfer pricing might work or failing to get transfer pricing correct might work against a private equity investment can someone define what that means for those of us who are not tax experts.

O’Connor: I think transfer pricing to us means where do you recognize the profits when you have a multi-­‐jurisdictional company, either that the international, China type of import, even state issues on transfer pricing so it is really where do you recognize the profits when you have inter company transactions or multi jurisdictional sales. So it is really about where do you recognize the profits, so for example because f the internationalization of the middle markets there is almost no company we are involved with that doesn’t do business in China or Asia or Europe and the ability to sell back and forth between these companies has become much more complex in terms of where the profit is recognized. At what price do you set between the companies within your group and that’s really the bulk of the transfer pricing that we see.

Snow: So what does this mean for private equity? Why is transfer pricing more complex for someone investing even in a US based middle market company?

Bailine: Well number one as Michael said, first of all you have the question of international, if you have a Chinese subsidiary or portfolio company and it’s manufacturing a product and selling that product to its US affiliate for distribution in the United States, the IRS is going to have some interest in how much that Chinese company is charging the US company because that becomes a cost of sold, for the US company and has an affect on how much profit the US company would have, and the IRS would want to make sure you are not paying too much for that so that your cost of goods sold goes up and all the profits are in China. You could have the same thing domestically as Mike outlined, you might have a Delaware subsidiary that’s got the distribution network, and you may have a Texas subsidiary that’s doing the manufacturing and it is the same type of question. Now is not going to be China versus the US but it may well be the state tax jurisdiction. Typically, if it is all domestic the IRS pretty much doesn’t care because typically you file a consolidated return and they don’t care if the profits are in Texas or Delaware for federal purposes, it’s all the same. But certainly as Mike pointed out, more and more companies are doing business internationally and this has become a huge issue and about 15 years ago the IRS really made it one of their main issues on audit.

O’Connor: Right, and what we are seeing is much more sophisticated requests coming from the international tax entities. China has become much more sophisticated, much more demanding, a lot more requirements on the transfer pricing regulations as they saw more and more companies working the transfer pricing reg so they got much more sophisticated. In the middle market when we buy companies we often inherit companies that perhaps didn’t have compliant international transfer pricing entities so what does that mean to us? Much more due diligence. Much more time spent structuring expensive transfer pricing studies by experts, it is not something you can just sit down and do, so we are spending more money upfront, we are spending more money getting the studies to make sure it meets the letter of the law so to speak, and then the administration of it is not free. So it has caused a big burden on our middle market companies especially to administer very complex international transfer pricing requirements, but upfront, and in an ongoing basis.

Snow: Now if you didn’t do that work, if you didn’t try to sort out or bring the highest level of sophistication and compliance to these transfer pricing rules, would that be an issue when you went to exit your portfolio company, would that possibly put a downward pressure on the price you could get?

O’Connor: Absolutely, we factor that in when we look at companies to buy, we factor that in and we do our due diligence on the transfer pricing so concurrently when we go to sell we know we are going to be subjected to that same type of due diligence. In fact we have got a deal right now that’s extremely complex, extremely, involved with eight countries, moving intellectual property, and profits around the world and one of our strategies is to make that much less complex so that as we go to sell that company to a strategic, it is not a devaluation with respect to complicated tax structures.

Bailine: I actually think one of the unique things we have seen in private equity is there are times when some of these issues aren’t even raised by the tax authorities. And where they get raised is when your exit, when the buyer comes in and does due diligence on your structure or transfer pricing structure, they may raise issues to tax authorities that, now many times they do them as sort of a bargaining tool, but I think he is absolutely right, anyone who is going, once you are on the sell side, you are going to have to understand you are going to be subject tot eh same type of due diligence you did when you were on the buy side. And that’s just becoming a much deeper dive right now to make sure the companies you are looking at, the target’s you are looking at are compliant, both domestically and internationally.

Snow: And I guess the positive way to look at it is if you do the substantial amount of work necessary to get a very clean looking transfer pricing regime in your international web of divisions, that actually is attractive thing for a potential buyer, correct?

O’Connor: Oh yes, definitely. It lessens their due diligence, it lessens the risk associated with the transaction.

Bailine: It also builds confidence and you want a buyer to have confidence. You want a buyer to be confident that what they are buying is what they think they are buying, or what they anticipate buying.

O’Connor: Exactly.

Snow: Let’s talk about another issue that might subtract value in a private equity investment if not paid attention to and that is the issue around qualified stock purchases, first of all a definition please for again people like me who are not tax experts, what is a qualified stock purchase in the realm of a private equity deal?

Bailine: Today, in today’s market, when you are doing a private equity deal, domestically, many of the target companies are called sub chapter S corporations. There is a tax benefit granted to a sub chapter S corporation that is not readily available to C corporations and that is if a private equity company buys a stock of an S corporation, they can make what is called a 338 election which increases the tax basis of the asset so that increases your amortization, increases your depreciation, and gives you a potential tax deferral. The only way you can make what is called a 338 election is you must make a qualified stock purchase. It is something that’s defined in the internal revenue code, and it is a way of having one corporation buy the stock of another corporation. And it has to be done compliant with the code, the rules can be pretty complex, we are not going to go through them, suffice it to say it is a statutory requirement.

Snow: And what would it look like to get a qualified stock purchase structure wrong at the outside of a private equity deal that could impact the fortunes of that deal in the future.

Bailine: Well again, if a private equity group is looking at a target, it’s an S corporation, they are certainly going to want to make one of these elections and the formal name is a 338 H tunnel action so the private equity company which is typically a partnership must form a corporation. And since it is a partnership, there is going to be a C corporation. That C corporation has to buy the stock of the S corporation, and if that is done appropriately, you can then make it this 338 H tunnel action. The problem you typically have with an S corporation is that the existing shareholders are very key to the business. And frequently they want to stay involved in the business after this transaction and the private equity group wants them to stay involved because in fact it is their own personal goodwill, their knowledge of the business etcetera, that helps make the business profitable. If you structure a transaction where you buy the stock of an S corporation, but you then allow the shareholders of the S corporation, typically one or two of the key individuals to reinvest some of the proceeds in a continuing equity piece, that must be structured very carefully. The rules on a qualified stock purchase will not allow you to qualify if you are buying what’s called from a related party. And again the rules are extremely complicated on what is a related party. You would think if Michael’s company was looking at my S corporation, we are as unrelated as we can be, other than we are doing this conversation today, but if he allows me to stay involved after the acquisition, we can actually run afoul of the related party rules and what will then happen is he will make the 338 election, the 338 H election, he will believe he is getting this step up in bases in the assets, increasing his depreciation, increasing his amortization and therefore driving down his current taxes, and when he goes to exit someone could come in on due diligence and go, ooh, that transaction you did three or four years ago failed under the code, it was not a bona fide qualified stock purchase, therefore your election is not valid, so the company you thought was worth a hundred million is worth about 60 million. I have seen this happen at least a half a dozen times in the last six or eight years.

Snow: Going from 100 to 60 sounds like a real disappointment especially for a private equity firm with a fiduciary duty to its investors. How do you guard against failures like that?

O’Connor: What we do is we are looking at people like Rick upfront to come in and do heavy due diligence on these tax issues. This is such a specialty area, that generally the private equity firms don’t have the level of tax sophistication on staff so we are going outside, find the best tax people we can to make sure we meet the letter of the law on these issues upfront, and that is all we can do.

Bailine: And as we discussed, you can’t get the IRS to rule, so you are basically basing your whole transaction on the advice of a professional, and it has to be well done, absolutely.

O’Connor: Exactly. And the amount of time we dedicate upfront in due diligence to tax structuring and tax compliance and international transfer pricing is exploded and I have been in private equity for almost 30 years and it is probably 5-­‐10X time and money we spend on tax structuring upfront.

Bailine: I think it kind of goes back to that whole confidence thing, when you are on the buy side you have to have the confidence that you are buying what you thought you were buying and the stake here or there, you are not getting what you thought you were going to get.

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