M&A activities may need a BUDGET boost

This article was contributed and first published in The Business Times on 1 January 2009.

Mergers and acquisitions (M&A) activities have overall ebbed in 2008 with credit constraints, volatile equity markets and weak confidence. Against this negative backdrop, there are still some positive sentiments that will limit the fall in M&A activities in the coming year. Valuations are going down by the day. Strategic buyers and cash-rich companies have the opportunities to cherry pick quality assets which are at distressed levels and shall emerge from this crisis with stronger balance sheets.

In times like this, Singapore will need more creative reform that will foster new growth areas to maintain its competitiveness as an international financial hub in Asia. Based on the 2008 Index of Economic Freedom by the US-based Heritage Foundation, Singapore was ranked second after Hong Kong in terms of economic freedom. Today, Singapore is already a preferred country to set up regional operations due to its low tax rates, wide tax treaty network and tax incentives.

However, a particular point for M&A players intending to acquire a Singapore target or use Singapore to host an acquisition vehicle is the tax impact relating to any interest cost. Currently, interest costs on borrowings used to acquire shares are not tax-deductible. This is so given that dividend income is exempt from tax and therefore, interest costs attributable to the exempt dividend income shall have no tax benefit.

It is not uncommon for investments to be financed at least in part through borrowings and therefore, impact on funding costs is a major factor to be considered in any investment plan. The tax impact from the non-deductibility of interest costs can be hefty and may kill the appetite for a deal.

Perhaps it is an opportune time to introduce reform to this rule. To illustrate the point, tax regimes in countries such as the United Kingdom (UK), the United States (US), Netherlands and Australia allow some tax deduction for interest costs on borrowings used in a shares acquisition of an entity. The allowance for interest deduction, however, may be subject to certain restrictions, which may include, but may not be limited to, thin capitalisation rules and limitations on the deductibility of interest costs on related-party loans.


Countries with favourable tax treatment for interest costs

Listed below are the general deduction rules for interest costs in the UK, US, Netherlands and Australia. The general rules set out below assume the acquirer and target are tax residents of the same country.

UK

Interest costs are generally given tax relief when they are taken to the income statements pursuant to generally accepted accounting principles in the UK. Interest costs are deductible against three forms of income (a) deductible on accrual basis against income in the same year; (b) against income of the company in the previous 12 months; or (c) against current year profits of the other company within the same group. Any surplus of interest costs after these options have been exhausted may be carried forward to offset against future non-trading profits derived by that company.

US

Subject to limitations, interest costs generally are deductible when paid or accrued on valid business indebtedness of the taxpayer claiming the deduction. After an acquisition in which certain ownership thresholds are met, the acquirer and the target may elect to file a consolidated US federal income tax return. A consolidated return generally results in the affiliated group of corporations being treated as a single corporation for US federal income tax purposes. Thus, subject to applicable limitations, an acquirer’s interest costs on acquisition debt may be deductible against the target’s profits.

Netherlands

Subject to limitations, interest costs incurred on genuine third party debt are generally deductible, whereas interest paid to related parties could be restricted under certain circumstance. Under the tax consolidation rules for Dutch subsidiaries, the Dutch tax resident companies can be treated as a single taxpayer and file one tax return. Essentially, in a simple acquisition structure involving a Dutch parent company acquiring a Dutch target, the fiscal unity concept is relied on by the parent company to offset the acquisition interest costs against the Dutch target’s profits. In addition, the Dutch companies should be effectively managed and controlled in the Netherlands, i.e. have sufficient substance, to form a fiscal unity.

Australia

Interest costs are generally deductible in Australia, including situations in which entities are part of a tax consolidated group. Similar to the Dutch and US rules, resident group companies within a consolidated group are treated as a single entity for tax purposes. In this respect, the acquirer and the target can form a tax consolidated group and offset the acquisition interest costs against the target’s profits.


Allow deduction for interest costs

Singapore should look to reform existing rules and allow tax deduction for interest costs to attract more M&A activities in Singapore. Rules as suggested below could be introduced:

• Concession to allow outright deduction of acquisition interest costs against target’s business profits; or
• Make current group relief system more user-friendly – Taking the UK model as an example, the existing tax group relief provision could be widened to allow interest costs to be treated as normal business expense and be used to offset taxable income within a group; or
• Where the acquiring company has other sources of taxable income, to allow interest costs to be treated as a business expense and offset against the other operating profits of the company.

• The valuation for Singapore companies could be enhanced and therefore increase stamp duty collections given the higher transaction values.
• The lending business in Singapore should be enhanced. A condition may be imposed on an acquiring company such that the financing must be obtained from Singapore-based banks in order to qualify for deduction of interest costs.
• Singapore could be a more attractive location for setting up a holding company or regional headquarters.