Rebounding markets focus on value creation and tax reform
By: Arco Verhulst, Global Head of Transactions for Asset Management, Tax & Legal Services, KPMG International
As the pandemic’s end gets closer, M&A markets around the world are booming and expected to surge even higher in the final quarters of 2021. The phase-out of government emergency stimulus programs could force a wave of restructurings for struggling companies that have held on so far, while thriving companies setting their sights on growth seem likely rely to mergers and acquisitions (M&A) as their top strategic choice.
After a tumultuous year, as tax professionals, we predict that the roller-coaster ride will likely continue. Deal flows ground to an almost complete halt in the first two quarters of 2020, but then things turned around fast. An explosion of transactions in last year’s fourth quarter saw market activity rise to an all-time high, far exceeding pre-COVID-19 levels with value of deals across the globe exceeding US1.2 trillion.
This momentum has carried into 2021, buoyed in part by record-breaking activity among private equity funds seeking assets that generate higher returns as interest rates remain persistently low.
Where the taxation of M&A is concerned, both private equity and strategic buyers continue to face uncertainty and change from an array of forces. These include the rising popularity of warranty and indemnity (W&I) insurance, the negotiation of global principles for taxing digital activity and reallocating taxing rights between jurisdictions, and questions over when and how government emergency financial support programs will wind down.
For most regions of the world, tax uncertainty and complexity will continue to be a prominent feature of the deal landscape. For example:
- Many jurisdictions in the Asia Pacific region have embarked on substantial tax reform initiatives, but these reforms look quite different from one jurisdiction to the next due to the diversity of the region’s economies and varying levels of sophistication in their tax legislation and administration.
- Tax reform remains high on the European Union’s agenda, in terms of both cooperation with the OECD and its own measures, such as the Anti-tax Avoidance Directives I and II. Environmental levies and decarbonization initiatives are also becoming a significant factor in transactions involving players in the EU.
- The new US administration is expected to make sweeping changes to tax policy, regulation and administration that could have profound implications for transactions markets in North America and globally.
Details of the most significant domestic tax reforms are set out in this publication’s individual country chapters. Below we explore some of the most important trends shaping current deal volumes and the future of M&A tax globally.
Quest for technology drives up deal volumes
From what we’re seeing in the market, it appears that close to a quarter of recent deals involve companies in the technology, media and telecommunications sectors. It’s widely agreed that the pandemic and especially the move toward remote work practices have accelerated the take-up of technology and the digitalization of business models. Many strategic buyers are actively acquiring or merging with companies in these sectors to boost their own technological capabilities.
‘It’s widely agreed that the pandemic and especially the move toward remote work practices have accelerated the take-up of technology and the digitalization of business models.’
Also facilitating transactions is the greater comfort M&A players now have doing business virtually, for example, in locations where onsite visits to target businesses are restricted.
New wave of restructurings expected
We’re also seeing an interesting split in global markets for restructurings, with plenty of movement in the US but quieter in other parts of the world than ever before.
In Europe and most of the world, government support programs have provided a lifeline to many companies hit hardest by the pandemic. Some economists believe the situation has created a legion of unprofitable ‘zombie’ companies around the world that would be inactive without this support in place. When support programs are terminated over the next while, we expect a high number of companies may be forced to seek restructuring advice, especially in hospitality, transportation, energy and natural resources, and other more adversely affected sectors.
‘Some economists believe the situation has created a legion of unprofitable “zombie” companies around the world that would be inactive without this support in place.’
Meanwhile, a wave of restructurings is already washing over the US, in part because US stimulus measures, while generous, were less focused than European measures on protecting businesses at any cost. In fact, in 2020, the US saw volumes of large corporate bankruptcies rise to their highest levels since the Great Recession.
Many jurisdictions are moving to limit the extent of business failure by introducing more generous insolvency legislation that offers better protection for companies that are restructuring. These regimes will likely significantly influence restructuring markets in the years to come.
Comeback for special-purpose acquisition companies
While transactions involving special-purpose acquisition companies (SPACs) subsided in the past decade, interest in these longstanding vehicles has revived, with record amounts of cash raised for SPACs in the US in the past year and record amounts of deals involving them.
SPACs are publicly traded, expert-sponsored “blank check” companies formed for the sole purpose of acquiring one or more targets. While they can greatly facilitate the sales process for private equity and other sellers, they are closely regulated in the US and can be less efficient than a traditional initial public offering. They also drive tight deal deadlines since the SPAC expires and must liquidate if the transaction is not completed within a set timeframe.
Currently, there are hundreds of SPACs in the US that need to deploy capital, and we expect activity in this area to accelerate in the coming years, both in the US and globally.
Focus on opportunities to create value
A sustained period of low interest rates has been one of the biggest factors influencing M&A markets for the past several years. With scant profit being made from their significant amounts of funds on deposit, private individuals, companies, funds and other investors have needed to move to other asset classes on the hunt for better returns.
‘A sustained period of low interest rates has been one of the biggest factors influencing M&A markets for the past several years.’
As new types of investors encroach on private equity’s traditional turf, it has become harder for private equity funds to produce the levels of returns they did in the past. Low rates of interest have sapped returns from common investment strategies such as financial engineering or multiple arbitrage. At the same time, their enormous amounts of dry powder have private equity funds looking to spend on much bigger deals than before.
The quest for returns in this environment has therefore intensified the focus on value creation. Rather than spreading funds over multiple small deals, private equity firms are investing in fewer, bigger assets that can create value on an operational basis.
Tax due diligence and multidisciplinary teams
Tax teams can contribute significantly to these value creation discussions. In addition to their traditional focus on historical tax positions and risks, tax teams can identify forward-looking opportunities from a tax perspective to improve a target’s position by improving operational taxes and generating cash in the future. They can also understand the tax implications of the target’s global set-up, including its value chain and how functions are allocated among group companies. This can help determine how the target’s tax position may evolve and, for example, whether target tax rates or transfer pricing policies are sustainable.
Skills in technology, data and analytics are now an important part of the mix of capabilities that tax transaction teams need. For example, the ability to model the tax implications of potential significant tax reforms such as digital taxation/BEPS 2.0 can help ensure deals are structured tax effectively, both qualitatively and quantitatively. Capabilities in data analysis can also help teams maximize the value of information they draw from deal data rooms.
‘Skills in technology, data and analytics are now an important part of the mix of capabilities that tax due diligence teams need.’
For deals involving cross-border transactions, tax structuring focused on the risks of BEPS-related reforms is becoming more important. The application of robust anti-hybrid and transfer pricing rules across multiple jurisdictions can lead to unintended outcomes and increase the complexity of deal structures. Indirect taxes can also have significant effects, especially as more jurisdictions introduce digital services taxes and environmental levies affecting the flow of goods and services.
These changes are making it ever more difficult to obtain appropriate tax outcomes and create value, so professionals who specialize in disciplines like international tax, transfer pricing and indirect tax are becoming increasingly important members of M&A tax teams.
Depending on the transaction, M&A tax teams can also benefit from involving a range of other specialties, including supply chain management, trade and customs and, in the US context, state and local taxes. The need for highly skilled tax professionals in tax dispute resolution on due diligence teams is also rising. Most tax authorities have taken a somewhat lenient approach to enforcement and collections as the pandemic ran its course. Soon, however, many tax authorities will be under renewed pressure to raise revenues to restore government finances. A steep increase in tax controversy is widely expected, including verification efforts to ensure emergency relief offered through tax systems was properly claimed.
‘A steep increase in tax controversy is widely expected, including verification efforts to ensure emergency relief offered through tax systems was properly claimed.’
W&I insurance increases deal complexity
Warranty and indemnity (W&I) insurance protects buyers from exposure to breaches of tax indemnities in purchase and sale transactions connected to M&A transactions. Since it was introduced two decades ago, W&I insurance has become a regular element of private equity transactions. More recently, this type of coverage is also being considered by strategic buyers, as well as in developing economies. It is also being used more frequently to insure against specific tax risks, such as for example risk of withholding tax on anticipated payment in a transaction.
W&I insurance can help facilitate deals in cases where a buyer is seeking comfort about tax representations that a seller cannot provide (e.g. through an advance tax ruling) or does not want to provide in view of a fund’s lifecycle. For example, a private equity firm that wants to acquire part of a business in a spin-off transaction that is expected to be tax-free can use W&I insurance for protection in case the spin-off is later assessed as taxable on tax authority review.
The benefits of W&I insurance are fact-specific, however, and should be considered case by case.
As M&A processes evolve and W&I insurers have gotten better at understanding how due diligence teams deal with tax risks, W&I is influencing deal making in perhaps unexpected ways. Intensifying competition and quickening deal speeds are leading companies to become smarter in how they scope their due diligence, both in timing and what they cover. At the same time, the competitive marketplace is allowing sellers to resist providing material indemnities and warranties to potential business on the basis that W&I insurance can cover these risks instead.
‘As M&A processes evolve and W&I insurers have gotten better at understanding how due diligence teams deal with tax risks, W&I is influencing deal making in perhaps unexpected ways.'
This can put the buyer in a difficult situation. Tight timelines mean buyers want to be selective about the issues they focus on, and so they seek to cover other issues with W&I insurance. But increasingly knowledgeable insurers are becoming more likely to decline coverage for issues carved out of the due diligence. This ultimately expands the amount of investigation and analysis that buyers need to do on a target’s historical tax positions.
It also increases complexity of M&A transactions by complicating tax due diligence decisions over what is in scope, what exclusions should be covered, and what amount of tax analysis is required.
Focus on environmental, social and governance issues
As the risks of climate change have become more evident, the past few years have seen growing consensus and collaboration among government and business globally over the urgency of addressing it. While the pandemic eclipsed this trend for the short term, many governments are expected to encourage recovery and growth through measures to stimulate a greener, more sustainable economy. This is spurring a movement toward greater environmental, social and governance (ESG) across global companies, with significant impacts on M&A markets.
In the new reality, many businesses will likely face increasing pressure from investors, customers and other stakeholders to integrate ESG in their processes and policies, while financial regulators are imposing new ESG-focused listing and disclosure requirements. Around the world, pension and wealth funds are adopting policies against investments in certain industries (e.g. coal, gaming). Businesses that do not keep up with changing attitudes and embrace ESG could face considerable financial and reputational harm.
‘Many large institutional and other investors are adopting impact investing policies, seeking investments that generate positive ESG outcomes as well as good returns.’
At the same time, the ESG focus is opening substantial opportunities, for example, through the growth of sustainability indexes, green bonds markets and green funds raised with the specific intention of investing in socially responsible companies. Many large institutional and other investors are adopting impact investing policies, seeking investments that generate positive ESG outcomes as well as good returns.
In the coming years, we expect initiatives like these to continue driving significant investment toward those industries and companies that are working to create greener, more sustainable economy.
Brighter times ahead
In summary, as we move past the upheaval of the past year, there are lots of reasons for optimism about the health of M&A markets. We expect the markets’ current bullishness to continue, particularly in the near term as restructurings drive deal activity and all businesses seek to adopt more digitalized business models. Coupled with the tax reforms and other regulatory changes that we describe in the country and jurisdiction reports, M&A tax professionals are set to face considerable challenges and opportunities in what are sure to be exciting times for deal makers in the coming years.
Takeaways for M&A tax leaders
- Where the taxation of M&A is concerned, both private equity and strategic buyers continue to face uncertainty and change from an array of forces. In the years ahead, tax uncertainty and complexity will likely continue to be a prominent feature of the deal landscape.
- Roughly a quarter of recent deals involve companies in the technology, media and telecommunications sectors. Many strategic buyers are actively acquiring or merging with companies in these sectors to boost their own technological capabilities.
- The US is currently seeing a wave of restructurings, and a similar wave is expected in Europe and elsewhere when pandemic financial support is wound down.
- As low interest rates continue, the hunt for better returns has led private individuals, companies, funds and other investors to focus on the potential to create value in target companies.
- Tax teams can contribute significantly to value creation discussions by identifying forward-looking opportunities to improve a target’s tax position and to assist dealmakers in identifying and modelling significant tax uncertainties.
- With rising competition, increasing tax complexity and faster deal speeds, effective tax due diligence tax now depends on multidisciplinary teams with skills in:
o technology, data and analytics
o international tax, transfer pricing and indirect tax
o tax dispute resolution
o other specialties such as supply chain management, trade and customs and, in the US, state and local taxes.
- Skills in tax technology, data and analytics are especially important for modelling the tax implications of due diligence findings to help ensure deals are structured tax effectively, both qualitatively and quantitatively.
- The rising reliance on W&I insurance is complicating tax due diligence decisions over what is in scope, what exclusions should be covered, and what amount of tax analysis is required.
- The movement toward greater environmental, social and governance (ESG) across global companies is having significant impacts on M&A markets as businesses face pressure from investors, customers and other stakeholders to integrate ESG in their processes and policies.
- At the same time, the ESG focus is opening substantial opportunities, for example, through the growth of sustainability indexes, green bonds markets and green funds that focus on investing in socially responsible companies.
- Looking ahead, the future of M&A markets looks bright, particularly in the near term as also restructurings start to drive deal activity and businesses seek to adopt more digitalized business models.
 Merger Market Report, 2021
 Mergers Market report, 2021.