In the current economic context of the COVID crisis and increased digitalization, many companies are changing their business models as well as engaging in M&A activity. Tax risks should be carefully considered, including an assessment whether potential exit taxes are part of the restructuring.
Global M&A activity is expected to accelerate in 2022, with many companies still taking aggressive positions due to access to record amounts of cash as well as pressure from investors to increase their corporate value.
Companies are increasingly pursuing deals which address strategic aims, for instance, traditional industrial or financial services companies buying technology companies to digitize their businesses. This can require significant adjustments to their business and operating models post acquisition.
M&A and corresponding business model restructurings, as well as trends increasing flexibility on working location require a focus on taxes, with exit taxation being one risk which needs to be managed.
What triggers an exit tax?
Taxpayers need to be aware that even small changes in their operating or business model can potentially result in an exit tax. Ideally, such a risk should be carefully assessed and quantified in advance. Such triggers can include:
- A full restructuring, transferring the whole business from one jurisdiction to another;
- The relocation of employees across the organization. This is becoming more and more relevant with considerations for remote work;
- The relocation of an asset, such as tangible assets, IP, agreements or clientele; or
- The transfer of an activity, through termination or substantial renegotiation of existing arrangements.
How should you evaluate whether there is an exit tax?
Companies need to evaluate whether compensation is required as part of these changes. Transfer pricing considerations for restructuring are discussed in Chapter IX of the OECD Guidelines, which delineates the regulatory framework followed by many tax administrations, and in short, covers:
- Whether there is a transfer of value;
- The commercial reasons for the restructuring; and
- The options realistically available to the parties.
Is there a transfer of value?
To determine whether something of value has been transferred and would require compensation, it is essential to understand the restructuring and the changes in the internal processes and responsibilities by evaluating the function, asset and risk profile of the parties before and after the restructuring.
This would allow the business to assess whether there has been a transfer of an asset (tangible or intangible), or an entire or a part of a business function. In addition, companies will need to consider compensation due to conversion costs such as closure and restructuring costs, termination costs, and/or the loss of future earnings, such as with a shift in customer contracts.
Are there strong commercial reasons for the restructuring?
Companies should be able to justify that a restructuring took place based on sound business and economic reasons. Given the anti-avoidance regulations and reporting requirements for tax-driven transactions now in place in many jurisdictions, being able to explain the commercial benefit to the business rather than for tax optimization is critical.
The options realistically available to the parties
Although a transaction may be motivated by sound commercial reasons at group level, this does not necessarily mean that the transactions are at arm’s length from the perspective of an individual company.
It needs to be analyzed whether on an individual-entity basis, it would be commercially justified for an independent party to enter into the restructuring transaction. The rationale is that an independent enterprise would only engage in the transaction if there were not more attractive options available.
How do you determine the exit tax impact and mitigate risks?
Once it has been determined that an exit tax would be triggered by the business change, the financial and tax impact should be determined. A number of valuation methods can be used, depending on the nature of the asset/business.
Aspects to limit the impact of such an exit, such as the ability to use loss carryforwards, or make the payment over a number of years, should be considered. In addition, for complex or high-volume transactions, an advance pricing arrangement bilaterally agreeing the exit tax among the counterparties can be an option to mitigate the risk of challenge from tax authorities.