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Reform of the US tax code has generated a lot of speculation (How will companies spend all that extra cash?), a plethora of novel calculations (With the new territorial tax system, how should we assess the strength of a company’s earnings?), all sorts of assumptions (Every company will benefit from the reforms), and, understandably, no small measure of confusion. Deals are an area that may be especially perplexing, given the enormous complexity of the legislation. For technology, media and telecommunications (TMT) businesses, deal making in this new context is creating distinct opportunities and challenges for both buyers and sellers.
How will the new legislation affect deal modeling? What are the most significant impacts on capital structure? Will the new rules change how companies integrate acquisitions? Recently, Marc Suidan, PwC’s TMT Deals leader, discussed the potential impact of the new tax legislation on deal making for TMT companies with Gabe Gartner, principal, National Tax Services, Mergers and Acquisitions at PwC.
Marc: One of the issues sparking a lot of interest and speculation is the access many companies will have to large amounts of offshore cash. How does the new tax legislation impact the M&A roadmap for TMT businesses given this phenomenon?
Gabe: Over the last 10 years, we’ve seen significant amounts of cash accumulated offshore due to the ‘lock-out effect’ under the former rules. With tax reform, companies will have access to their offshore cash for share repurchases, investment in US capital expenditure projects and acquisitions of both foreign and US targets. It’s important to note that while the immediate focus is on the availability of historical cash balances, companies will also have access to future offshore cash flows.
One thing I want to stress before we take a deeper dive into some of the more complex issues is that the new legislation has much broader implications than simply changing a company’s tax rate. Companies need to think cohesively and comprehensively across finance, treasury and tax about tax reform and how it affects global cash management, supply chain structuring and acquisition strategy.
Marc: I know you’re talking a lot with clients these days about valuation and modeling. Is there a rule of thumb you can share with us? Have any of the dynamics of deal structuring changed?
Gabe: Valuation and modeling are highly complex and really need to be tailored for each buyer and target. A number of aspects of the new legislation will affect the typical discounted cash flow (DCF) valuation method model for an acquisition. A favorable example is the new rules that permit immediate expensing of tangible assets, which can drive value for targets with significant property, plant and equipment (PP&E). This may be of particular interest for TMT businesses, as the expanded definition of ‘qualified property’ now includes certain types of content, such as film, television and live theatrical productions. The new rules may motivate buyers to pursue more asset purchases. At the same time, while the tax cost has been reduced for sellers, we still have a system with two levels of taxation. We expect that sellers will prefer stock sales in most circumstances.
On the other hand, the benefit of tax ‘step-ups’ and a target’s tax attributes are reduced due to the lower corporate income tax rate (21%). Post-2017 net operating losses (NOLs) will be limited to offsetting 80% of taxable income. For US multinational targets, the new rules taxing earnings of foreign subsidiaries must be taken into account in determining the global tax rate for a DCF model. Finally, several new provisions will phase in or out between 2018-2026, so you can’t create an accurate DCF model without factoring in all of these subsets of tax reform.
Marc: Capital structuring is clearly going to be another area significantly impacted by the new legislation. Will tax reform increase the cost of debt and equity?
Gabe: Net interest deductions will be limited to 30% of ‘adjustable taxable income.’ All companies that have debt as part of their capital structure will see their after-tax cost of debt increase. For certain subsectors of the industry where leverage (debt) tends to be pervasive, the effect on capital structure could be significant. The benefit you will realize for using debt will have less of an impact on mitigating your tax bill than under the old rules. Companies may begin to reevaluate their capital allocation and finance a larger part of their capital structure with equity, which will ultimately impact the discount rate used to evaluate M&A opportunities.
It will be important for companies to ensure that the right discount rates are being used for investment decisions. They also should have a good understanding of the varying returns generated by the different components of their business to ensure that capital is allocated to the parts of the business that will generate the most value.
Marc: Do you foresee an industry-wide trend in the way companies will go about integrating acquisitions? Will buyers be more inclined to alter their own structures than in the past?
Gabe: This is another area that will be different for each company depending on its particular structure. I don’t think we’ll see an industry-wide answer to this question. Many companies are currently analyzing their global supply chain and intellectual property structure and this will inform decisions about how to structure an acquisition and the most efficient manner of integration. Generally speaking, I expect large acquisitive companies to determine their own new structure in light of tax reform and then to integrate the target into this new structure.
Marc: Do you think there’s a danger, with so much focus on the sudden availability of overseas cash, especially in an industry like tech, for companies to end up paying luxury prices for bargain quality targets?
Gabe: There will still be a need for discipline around deals. Just because you have more capital to do deals doesn’t mean you should do them. Deals must always align with your overall enterprise strategy and opportunities for value creation. Tax reform will certainly affect valuation, diligence, modeling and – depending on the company – integration strategy. It’s critical to have a detailed and comprehensive understanding of these complex issues.