Current Trends In the European M&A Market and Their Tax Effects

01 June 2006

The 2006 results so far promise to exceed the 2005 record. This is caused by multiple factors. An important element is the growth of the European economy. This makes the target’s stock an attractive prey for financial acquirers, such as venture capitalists and private equity funds, who want to buy, improve and integrate the business and sell within a relatively short term, but also improves the confidence of trade buyers and other strategic corporate investors. Based on their increasing confidence, these investors are actively investing in their existing businesses as well as in new businesses. 

Another important factor is the low interest rate. Since most acquisitions are paid for in cash and highly leveraged, this factor should not be underestimated. There has also been a substantial increase in the amount of private equity capital that is available for investments on the European market: many new funds have been set up in the past year. 

Finally, the legal environment is more welcoming: in May 2006, the EU Directive on Takeover Bids should be implemented in the EU member states. The directive generally prevents corporations from creating and upholding certain anti-takeover structures. Once the directive has been implemented in the member states’ laws, hostile takeovers should be easier. 

This article will describe some of the recent trends in the mergers and acquisitions market, forecast further developments and share views on the specific consequences these may have for the tax structuring of merger and acquisitions deals.

Acquisitions by way of Auctions 

Looking at the most prominent merger and acquisitions transactions in 2005, most were made by way of auctions, often using electronic data rooms accessible through the internet. In these auctions, the selling shareholders invite interested potential buyers to bid on a target, without applying a price tag (although a minimum price may be indicated). The sellers have their advisers conduct a sellers due diligence, and based thereon, a data room is organised with information that the sellers want to share with potential buyers. Auctions generally have advantages both to sellers and buyers. The sellers control the auction: they get a clear indication of the value of the target, enabling them to sell at the best possible price. If the seller’s due diligence is conducted carefully and the data room is complete, risks for the sellers can be minimised. As noted below, however, a detailed due diligence may have serious disadvantages from a tax perspective. 

For the buyers, that the sellers put their target for sale is a good starting point for negotiations: they do not have to convince an owner of a business to sell a particular business. Furthermore, the buyers can learn a lot about the target before actually buying it: if their due diligence is carefully performed, and the remaining risks can either be covered internally or settled in negotiations with the sellers, the risk of the purchase for the buyers can also be reduced considerably. 

Finally, other than, for example, in case of a public takeover, the bidders in an auction will not know the offers from other parties and will not end up increasing the other offers over and over. 

For tax lawyers, this trend leads to a substantial increase in the due diligence work that needs to be done: not only do all potential buyers require an extensive due diligence, but the sellers have a due diligence take place. But with all these tax lawyers drafting extensive memos on all of the probable, possible and sometimes even remote tax risks related to a certain target, another trend can be seen: the tax authorities have a keen interest in reports describing the tax position of the target in great detail. If the tax authorities could legitimately request the due diligence reports, this would be the tax authorities’ road map to all possible tax issues of the target. In the Netherlands, the tax authorities can request information from each taxpayer, but also from third parties, if the information is relevant for determining the taxable profit of the target. Obviously, this is the case for these due diligence reports. Information does not have to be disclosed to the tax authorities by certain persons with a legal privilege. Most tax practitioners do not have a privilege in the Netherlands, but according to published policy, the tax authorities will not request tax advice from tax advisors. As due diligence reports typically also contain a lot of factual information (as opposed to technical advice), the question of whether the tax authorities can ask for disclosure of the whole tax due diligence report has recently been addressed in Dutch case law. The outcome was in favour of the taxpayer: based upon the fair play principle, tax due diligence reports do not need to be disclosed. This may, however, be different in other jurisdictions where tax authorities may try to obtain and use knowledge about the target’s tax position obtained by the buyer, in order to assess the target correctly. This should reduce the appetite to conclude detailed due diligence reports. In these circumstances, it may be advisable not to conduct a detailed due diligence and request firm reps and warranties in de SPA instead. 

Some tax-related issues simply cannot be solved other than through a strong guarantee or other kind of security. One may think of a target purchased out of a Dutch consolidated tax group: the company can be held responsible for tax liabilities of the entire tax group. These type of risks can hardly be covered in a due diligence report if the seller wants to make the information available at all: the buyer should have some security, for example, in the form of a guarantee by a ‘good’ group company outside of the tax group, or by putting part of the purchase price on an escrow. In order to be protected, however, a guarantee or escrow should in principle cover the relevant statutory limitations which may be for a very long period, often something that a seller is unwilling to give. 

In summary, from a tax perspective the focus should be more on contractual arrangements and securities, rather than on detailed due diligence reports. Such reports cannot, in my experience anyway, always cover the sometimes very broad tax issues related to the target and particularly to the selling tax group it belongs to. 

Auctions won by Financial Bidders 

A second trend is that the winners of auctions are, in many cases, financial bidders as opposed to strategic bidders. The term ‘financial bidder’ means a venture capital or private equity fund, whose activities have no relationship with the activities of the target. The term ‘strategic bidder’ means a trade buyer or other corporate investor whose business has a clear connection with the business of the target, either because: the target is a competitor of the strategic bidder; the target is active in the same line of business in another area to the strategic bidder; or the target is active in a complementary line of business. One would assume that strategic bidders have a substantial advantage over the financial bidders as strategic bidders typically know the business of the target and should therefore have a better understanding of the associated risks and opportunities. 

In almost all of the auctions we participated in as an adviser in the past six months, however, the winning bidder was a financial bidder (eg, the sale by Royal Dutch Shell of InterGen NV and Basell NV; in both transactions we advised the winning bidder). Perhaps the most surprising example in this respect was the recent sale of another Dutch group, AVR, a waste services group sold by the municipality of Rotterdam at the end of 2005 by way of auction. Despite very strict conditions set by the municipality regarding the continuation of the business, the future pricing for services of AVR and the environment, and despite the fact that the municipality more than once claimed that the sale price would not be the determining factor, AVR was sold to financial bidders. It would have seemed that a strategic bidder should have had a decisive advantage over any financial bidder, but this was not the case. 

One reason for this trend could be that financial and strategic bidders approach a potential purchase differently. Put simply, the main business of the strategic bidder is to, for example, build power generators, produce chemicals or sanitise, whereas the main business of the financial bidder is to purchase targets and close financial deals. Furthermore, the increase of private equity funds active in the European mergers and acquisitions market may also have an impact on the financial bidders winning the auctions. The main concern some private equity funds seem to have is not being able to invest their funds or actually close deals. This pressure to invest funds and close deals in order to make their investors happy, may cause these financial bidders to overpay for certain targets. 

This trend has consequences for the tax structuring of a transaction. Typically, financial bidders are organised in the form of a tax-transparent fund with members or partners who have a very different tax status. Some of these members or partners may be residents of a country with which the target’s country has concluded a double tax treaty that may entitle them to reduced treaty rates on dividends or capital gains. Others may not be entitled to treaty benefits, for example, because they are resident in tax havens. Others may have a specific tax status, such as exempt pension funds or charities. The preferred tax structure for a financial bidder is therefore typically a structure that allows a tax free capital gains and a tax free repatriation of the target’s profits, based on domestic rules as opposed to tax treaties. Apart from a tax exempt capital gain and repatriation of profits, the structure should allow the erosion of the target’s tax base to a maximum, as allocation of expenses (including financing expenses) to the ultimate investors will not lead to equal tax benefits for the various investors (if they would be benefited by it at all). Consequently, many of these structures use a Dutch holding company, with a Luxembourg hybrid-financed company on top, or alternatively use a Gibraltar or Cyprus company on top of a Luxembourg company, in order to create a (withholding) tax free, flexible exit. 

Cash-Paid Acquisitions and Hybrid Debt Financing 

Financial bidders typically buy with cash, highly leveraged at the target’s level with the target’s assets as the sole security for the banks. If approved by the banks, the equity portion of the financing, which comes from the financial bidders, is also provided for at the target’s level in the form of a debt, albeit a hybrid debt, often structurally subordinated against the bank debt. The use of hybrid debt for the financing of the equity portion of the takeover may have various advantages. First, ‘real’ corporate law capital is generally subject to legal restrictions, limiting the possibility to repay or increase it without following strict procedures. Generally speaking, hybrid debt can be repaid and increased without meeting these restrictions. Moreover, under certain conditions, the credit rating of the target should not be affected by hybrid debt financing (compared with ‘real’ equity financing). Finally, it may even in these circumstances be possible to deduct some (if not all) of the ‘yield’ payable on the hybrid debt for corporate income tax purposes at the target’s level (depending of course on the target’s country of residence and the exact characteristics of the hybrid debt in that specific case). 

Also, strategic bidders have a tendency nowadays to pay for their acquisitions in cash, rather than shares. The reason for this may be that many companies have built up substantial cash positions since 2001 and are willing to spend it now on acquisitions. At present, investment bankers estimate that the main non-financial services companies listed on the European stock exchanges have over US$550 billion in cash available for acquisitions. 

In relation to the trend to pay cash, there is a growing interest in the tax treatment of hybrid debt, both on the side of the issuer of the debt, as well as on the side of the recipient of the income on the debt. Tax benefits can be realised in an acquisition structure, if the interest on the hybrid is deductible in the hands of the issuer of the debt, whereas on the other hand, the income on such hybrid debt is treated as income from equity, ie, exempt or deferred, depending on the tax position of the recipient of such income. According to recent Dutch case law, income earned by a Dutch corporate taxpayer on a French participating loan, may qualify under the participation exemption and therefore be exempt from Dutch corporate income tax, whereas the interest on such participating loan is, as a principle rule, deductible in the hands of the French debtor. Although it is not entirely clear whether this case law is affected by the implementation of certain hybrid debt rules in the Dutch tax laws, a similar result may be achieved with respect to debtors of Dutch creditors in countries that allow a deduction for interest on perpetual (or very long-term), subordinated debt with a profit contingent interest. Luxembourg is widely used in international acquisition structures for its preferred equity certificates: a form of hybrid debt that is considered debt from a Luxembourg legal, accounting and tax perspective, but is considered equity for its many equity-like characteristics in many other jurisdictions, among which is the US. 

In summary, the trend of acquisitions being paid for in cash with use of hybrid debt leads to opportunities to obtain tax benefits in acquisition structures. 

Practical Tax Aspects Become More Important 

Tax issues can make merger and acquisitions transactions more sweet or more sour. This is true in many ways, not only with respect to the deduction of the (pre)acquisition costs, which is generally considered to be a very important tax aspect of the deal. There are various other important tax aspects to a merger or acquisiton transaction, however, many of which have a very practical nature. An aspect often forgotten is that the tax life, as such, of a target is not regarded as a separate life before and a separate life after the merger. It starts before the deal and continues, hopefully, thereafter. If the seller and the target have led a long, happy and integrated tax life together, all kinds of transactions, agreements and cost allocations will have been made. Sometimes these intra-group arrangements may have been driven by tax efficiency, but often they are done for practical reasons. Buyers frequently want to terminate these inter-company arrangements, in which case the buyer must consider carefully, preferably before the SPA is cast in concrete, all tax consequences of a termination or amendment of these arrangements. Existing intra-group arrangements have often been discussed, in advance, with tax authorities in order to establish that they were at arm’s length. An amendment of these arrangements once the target is sold, may well have adverse or retroactive tax implications for the target, the implications of which often fall outside the scope of tax-related guarantees given by the seller. Moreover, termination may also adversely affect otherwise similar existing and continuing arrangements between the seller and its remaining businesses or group companies. Consequently a buyer may well encounter serious tax problems if changes, which are otherwise logical, are made regarding the business of the target. These issues can also pose problems for the seller, which may seek remedies from the buyer. These potential problems and consequences should be considered seriously before the deal is closed. 

Another practical tax issue concerning merger and acquisition transactions, which is often related to the above issue, is the question of control of the tax affairs of the target particularly for the financial year in which the acquisition took place, but also for the tax years that are not yet formally settled. Most buyers would not want the sellers to be concerned in the tax affairs of the target after closing the transaction. As the seller is likely to bear certain potential tax liabilities relating to the past, however, it typically wants influence over how these matters are dealt with. We see a trend that these ‘practical’ tax issues become more important in the mergers and acquisitions market, as their monetary importance increases. As the European mergers and acquisitions market is likely to grow even bigger in 2006, tax lawyers should keep their eyes and ears open for any immediate and future developments in the market. But sometimes we wish that we had a crystal ball in which we could see the picture of the market and its future developments, so that buyers, sellers and the market in general could avoid bad surprises.

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