One of the most sweeping tax reforms in generations was passed back in December, but it is still the talk of the town in the US as the media and businesses alike continue to dig into its wide-ranging implications.
Tax reform, as envisioned by President Trump and congressional Republicans, - which we previously discussed here - was designed as a shot in the arm to corporate America, but private equity firms are fretting about its impact on their ability to profitably invest in companies.
What does this mean for domestic acquisitions?
Mergers and acquisitions, leveraged buyouts and dividends are often funded, at least partially, with debt. Companies were previously unrestricted in the amount of interest they could deduct before tax, which helped the economic model for these debt-financed investments.
However, businesses now face a cap on these deductions equal to 30% of their 12-month earnings before interest, taxes, depreciation, and amortisation (EBITDA). After 2021, the limitation becomes more constrictive by switching to 30% of EBIT only - that is, the deductions for depreciation and amortisation are removed from the calculation, thus lowering the cap even further.
There is some flexibility; where a company didn't reach its cap in previous years, it can deduct interest payments above the 30% cap until it reaches the bridge amount. That bridge can roll on ad infinitum, too. But, as cash flow scenarios and interest rates fluctuate, interest expense deductibility caps will inevitably have an adverse impact on the expected returns of more highly leveraged deals.
In fact, Moody's Investors Services say results for around a third of all leveraged buyouts are expected to be worse off under the new system. This could discourage private equity firms from overburdening companies with debt, while eroding returns by forcing companies to hand over more cash as equity to fund acquisitions.
US companies turn to foreign M&A
Given that the limitations on these deductions only apply to domestic acquisitions, foreign businesses are becoming relatively easier to finance via debit, and therefore will likely be more attractive to acquire. Plus, the move to the participation exemption system means US corporations have a 100% deduction for dividends by a foreign controlled corporation, which could include a newly-acquired subsidiary.
This will be added fuel to the already emerging trend of US businesses looking abroad for growth and expansion. According to the Wall Street Journal, overseas M&A sat at around $200-400bn, per annum, in the decade between 2006 and 2016. However, that has significantly increased in recent years, with more than $800bn invested in 2017 and more than $1,000bn expected in 2018.
At TMF Group's US offices, we are seeing this trend in our own client base, with more and more Fortune 500 companies looking internationally for ways to grow their businesses. In 2017, together with Forbes, we canvassed the views of 250 C-suite executives from US-headquartered multinationals to understand their motivations, and the challenges in taking their organisations to new markets overseas. We found the two strongest drivers in undertaking international investment or activity were to open new markets and gain market share (46%), and to expand existing operations or service lines (42%). It is worth noting that financial management / structuring is becoming a less important motivator for international expansion, as businesses respond to the global headwinds of transparency and substance requirements relating to taxable income, although this was still a consideration for 1/5 of the companies surveyed.
Therefore, US corporations are already looking abroad to find new markets, strengthen their operations and grow their business. Often a successful business in the US can find themselves a market leader in a less competitive economy or indeed the first mover to bring a new product or service to a developing market. The allure of international expansion is only set to increase as these firms now find the economics of foreign acquisitions improving versus their domestic alternatives.
What to consider when buying offshore
Our experience in facilitating international expansion tells us that the top challenges a business faces when entering a foreign market include:
- Establishing banking and accounting measures and statutory records
- Identifying the right premises and / or process agent
- Selecting and incorporating the right entity type
- Finding and providing official evidence of "good standing"
- Data protection considerations and privacy laws
Whenever undertaking M&A – whether in your own country, or across a border – the same little things can trip you up:
- you need to ensure you get the scope of services and pricing mechanisms right in a Transition Services Agreement (TSA)
- you need to plan for major service continuity issues
- you need to make sure your team has on-site, local expertise for entity structuring, statutory accounting and filings, and a locally-compliant payroll and HR servicing model
M&A moves fast, and any one of the small details can be deprioritised or even lost in translation while companies and lawyers focus on the deal's minutiae. That's why it is recommended any multinational working on an M&A deal seeks external compliance support from an experienced partner with in-depth knowledge of all markets involved in the deal. It could save money, resources, and, importantly, reputation.
TMF Group’s US experts, backed by a strong global group present in more than 80 countries worldwide, continue to watch developments closely. Get in touch to discuss how we can support your foreign M&A plans.
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