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The passage of sweeping US tax reform in late 2017 presented myriad issues for companies to contemplate related to the structure of an acquisition intended to enhance deal value. One new provision is the option to immediately expense the fixed assets acquired as part of a transaction, based on their fair market value (FMV), if they’re located in the US and considered qualified property, e.g., new or used tangible personal property with a recovery period of 20 years or less. To realize this benefit, the transaction must be structured so it results in a change in the tax basis of the target’s assets – either through structuring the transaction as a sale of assets or through a stock transaction where the buyer and seller agree to treat it as a sale of assets. (For example, a 338(h)(10) election.)
Given the economic benefits associated with being able to immediately expense the FMV of acquired fixed assets, some buyers likely will be motivated to explore transactions that are structured with a change in the tax basis of the acquired assets. To appropriately understand deal returns and inform their negotiating strategy, buyers should be sure to understand the estimated FMV of the target’s fixed assets to better assess the economic benefits associated with this deal structure.
Before the Tax Reform and Jobs Act of 2017, if a transaction resulted in a change in the tax basis of the acquired assets, the buyer would still record a new tax basis of the acquired fixed assets based on the estimated FMV. However, rather than being able to immediately expense this amount, the buyer would proceed to depreciate the new tax basis in the acquired fixed assets over time. It would follow the Modified Accelerated Cost Recovery System of depreciation (MACRS), which sets the depreciation rates for fixed assets in the US. The below illustrates the depreciation pattern under MACRS for various asset classes based on their defined tax life.
As part of tax reform, if a transaction results in a change in the tax basis of the target’s assets, the buyer would similarly record the FMV of the fixed assets. But now instead of depreciating those assets, it can immediately expense the assigned FMV of the qualified fixed assets located in the US. This provision allows for 100% expensing from Sept. 28, 2017, through Dec. 31, 2022, and phases down by 20% each calendar year after 2022.
While the buyer can immediately expense the FMV of the acquired fixed assets, there is no change to the seller’s position when the transaction is structured with a change in the tax basis of the assets. The seller will have the same income tax liability as before tax reform, albeit at a lower tax rate. However, considering that buyers could benefit from immediately expensing the FMV of the acquired fixed assets, sellers may be able to extract higher purchase prices for agreeing to structure the transaction that results in a change in the tax basis of the assets.
When comparing asset deals before and after tax reform, the greater the FMV step-up in fixed assets and the longer the tax depreciation life, the greater the buyer’s value creation opportunity. The illustration below shows the relationship between fixed-asset FMV step-up over the net book value (NBV) of the assets on the X axis and the incremental tax savings as a percentage of NBV on the Y axis. Each color represents an associated tax depreciation life and shows the value created from immediately expensing qualified personal property vs. having to depreciate it over a MACRS life.
This relationship illustrates that companies with long-lived fixed assets related to heavy infrastructure, which are likely to see a step-up in the FMV over the existing tax basis of the assets, would benefit most from this incremental tax savings. As a result, it’s even more critically important for buyers to perform proper valuation due diligence related to the acquired fixed assets. This will provide insight around the value creation from being able to structure the transaction with a change in the tax basis of the assets. In competitive bidding situations, buyers who perform this due diligence will have better insights and can bid more competitively and confidently, compared with other bidders who may not be examining these inputs as closely.
The following example illustrates this point. For the fixed assets under Scenario A, we assume the buyer makes a simplifying assumption that FMV equals NBV. Under Scenario B, we assume the buyer performed valuation diligence and estimated there is an estimated step-up of 50% in the FMV of the fixed assets when comparing to NBV. All other inputs in both scenarios are assumed to remain the same.
In the example above, by doing valuation diligence on the fixed assets and quantifying the associated step-up relative to NBV, a buyer would be able to identify an additional $158 million of potential value creation. If this was a competitive bid, that’s $158 million more value to negotiate with, putting the buyer in a better position to win vs. a buyer that was less informed on the potential step-up in the FMV of the fixed assets. The above table also shows the value created by being able to immediately expense the FMV of the acquired fixed assets compared to the rules in place before tax reform – $64 million where the book value is assumed to approximate FMV, and $97 million where the FMV of the fixed assets is derived though a valuation analysis.
As shown below, there is a linear correlation between the FMV step-up percentage (over book value) and the value creation from being able to immediately expense the FMV of acquired fixed assets. This highlights the importance for buyers to assess the estimated FMV of the target’s fixed assets when evaluating the structure of a transaction. This impact will be magnified by the level of fixed assets the target owns in the US.
In summary, tax reform presents many new considerations for buyers when they’re evaluating a transaction. One key provision is the ability to immediately expense the FMV of fixed assets when a deal is structured in a way that results in a change in the tax basis of the target’s fixed assets. As a result, it will be increasingly important for buyers to perform proper valuation due diligence on the target’s fixed assets to have the insight to bid more competitively and confidently. By reviewing inputs such as historical fixed-asset records, capital pricing trends, technology drivers, industry disruptors, economic useful life and market pricing trends, savvy dealmakers can become better informed during diligence and gain a competitive advantage over competitors.