Valuation plays a critical role in international mergers and acquisitions. In this issue of the Insight, we provide examples of cross border transactions and the role of valuation services in providing support for these transactions.
In a domestic context, acquisitions and reorganizations may be achieved through various structuring alternatives, some of which are taxable and some of which are tax-free. Tax-free reorganization treatment may be available for liquidation of subsidiaries and for certain mergers and other exchanges of stock for assets or stock for stock, for example. As a general matter, these same rules govern transactions in an international context. However, due to concerns about moving built-in gain or other untaxed value outside the U.S. tax net, U.S. tax law includes certain provisions, namely Section 367 and the regulations thereunder, which may require gain recognition or may require certain procedural steps to be taken. One of these steps could be the filing of a Gain Recognition Agreement (GRA), so that this gain or value does not escape U.S. taxation. Section 367 and the regulations thereunder mandate that the tax-free treatment provided for in the rules relating to corporate tax free reorganizations will not apply unless certain exceptions are met.
In general, Section 367(a) applies to outbound reorganizations while Section 367(b) applies to inbound and/or foreign to foreign reorganizations. In an outbound transaction, assets are transferred out of the U.S. and into a foreign entity. Conversely, inbound transactions are transactions where foreign assets flow into the U.S. while foreign to foreign transactions include reorganizations involving only non-U.S. entities/operations. Examples of outbound transactions include the following:
- U.S. corp. and foreign corp. merge into new foreign holding company
- U.S. corp. transfers shares in a foreign corp. to a new foreign holding company
- U.S. shareholders transfer U.S. corp. to foreign corp.
Examples of inbound and foreign to foreign transactions are as follows:
- Inbound transaction: liquidation of foreign corporation into U.S. parent
- Foreign to foreign transaction: transfer of assets from one foreign sub to another foreign sub as part of a merger
Section 367 stipulates that, with respect to inbound and foreign to foreign transactions, the operating provisions will apply, unless a regulatory exception provides otherwise, i.e. the foreign corporation is treated as a corporation for purposes of the operating provisions.
Sec. 367(c) treats certain contributions to capital as exchange of shares. Sec. 367(d) provides special rules for transfers of intangibles. In an outbound transfer of intangibles, the following rules apply:
- Normal gain recognition rules of Sec. 367(a) do not apply
- The transaction is recast as the sale of property in exchange for payments contingent on productivity, etc. of such property. Under this type of characterization, the transaction will be treated as royalty for 20 years.
- Commensurate with income standard will apply
Section 367(e), in general, treats otherwise tax-free liquidations at the corporate level, as taxable, where the 80-percent distributee is a foreign corporation.
When a company embarks on an international restructuring, it is extremely important to consider the impact of Section 367. If Section 367 applies, as noted above, there may be an exception which applies and which permits tax-free treatment. Alternatively, the provisions may require the recognition of gain currently or may require a GRA to be filed. In either of the latter cases, it is necessary to determine the amount of gain on the transaction and, in order to determine the gain, it is necessary to determine the related value of the assets or securities. Accordingly, valuations provide a key component in the process of determining the impact of these provisions in an international reorganization. The following case studies illustrate the role of valuation in international transactions.
- Cash acquisition of foreign target. In a share acquisition, the tax basis is equal to FMV (cost). For domestic acquisitions, it is possible to make a Sec. 338(g) election to achieve a step-up in assets for earnings and profits (E&P) purposes. The same option is available for international acquisitions. For valuation purposes, the adjusted sales price (ADSP) and adjusted grossed-up basis must be allocated to the various assets. It is important to note that there is a limitation on the amount of foreign tax credit (FTC) available to the U.S. parent. The Education Jobs Act of 2010 includes provisions which change the determination of available foreign tax credits in the case of covered asset acquisitions. Additional foreign taxes resulting from basis differences in assets for U.S. and local tax jurisdiction purposes will not be allowed for foreign tax credit purposes.
- Formation of new foreign holding company. For U.S. tax purposes, the formation is considered an outbound transaction of a domestic corporation. Depending on the U.S./foreign ownership of U.S. Group versus Foreign Group, and the relative values of U.S. versus Foreign Groups, the entire transaction may be taxed. Valuation services are critical to determining taxability; a valuation professional provides the relative values within each group, and the relative values between groups.
Valuations are often needed to support the requirements of cross border transactions. For more information, contact your VRC representative.