Evolving tax regulations present challenges at times of transition

Lawyers navigate complex tax challenges during M&A and restructuring transactions

Evolving tax regulations present challenges at times of transition

Maintaining tax efficiency and mitigating tax risk for the organization are vital components of any transaction involving mergers and acquisitions, financing or corporate restructuring. During the last two years, private equity activity has been very active in Canada, creating a wealth of tax issues that can crop up, many of which are unique to individual transactions.  

“It has been a very robust period of activity on M&A private equity investment financing,” says James Morand, partner at Bennett Jones LLP. “Private equity investors are consolidating businesses in particular industries.” This activity level is partly due to changes in the marketplace arising from the pandemic, Morand says. Businesses facing credit crunch or reduced demand for a product or service created opportunities for competitors and strategic buyers, for example. 

Keeping on top of evolving tax regulations and ensuring compliance to minimize risk can be challenging for in-house counsel, so legal departments often seek the expertise of external counsel partners to assist with complex tax matters.

“From an M&A perspective, you’re concerned about potential tax liabilities of the target entity that arise through tax due diligence, and more importantly, the liabilities that you’re not aware of through tax due diligence,” says Adrienne Oliver, partner at Norton Rose Fulbright Canada LLP. In-house counsel should also consider tax costs in the target assets or shares. 

A vital part of the role of tax lawyers is to work with in-house counsel who may not have a lot of M&A experience. External counsel can articulate the concerns that came out of due diligence, or which the internal tax team raised, and find a way to mitigate those risks. 

The first significant risk with M&A is the tax liability in the target company that the purchaser will inherit, Oliver says.

“The way to address that is through due diligence, then through reps and warranties, and indemnities and pullbacks,” she says. Tax insurance is also becoming a lot more popular, mainly where there is a potential exposure for which neither the vendor nor the purchaser wants to take responsibility. 

Oliver warns of another pitfall that sometimes crops up on the vendor side: A transaction creates “dry income,” meaning that cash fails to match an income inclusion. 

Managing tax risk throughout any transaction is critical to maintain tax efficiency and to ensure compliance. 

“There is often a tension between opposing sides of the transaction which can show itself or affect tax results to the advantage of one side and to the detriment of the other,” says Morand. Preparing for the possibility of scrutiny from tax authorities is also essential. 

Oliver advises in-house counsel to seek tax advice from the transaction’s outset and fully integrate with the tax advisors. Problems can arise when teams fail to do that throughout the entire negotiation and deal-structuring process. 

“We speak tax and we speak lawyer, so we’re often the ones that are able to make sure that all the tax concerns that surfaced with the tax and finance team are reflected in the documents that we are putting in place,” says Oliver. 

“It’s important to explain to a non-tax person something that’s very technical, in a way that’s understandable,” agrees Alan Bowman, a partner in the tax group at Goodmans LLP. “It’s about getting them to understand the highly technical issues and making sure they are applied both in their tax filings and also in how they book their journal entries to make sure everything is consistent across the board.” In-house counsel should also be careful to ensure that accountants involved in the transaction treat the accounting records in the same way as the tax lawyers, so everyone is on the same page, Bowman says. 

“Generally, there is a desire to maximize tax attributes in M&A, looking at the perspective of the buyer,” says Morand. “From the seller’s perspective, they are looking at structuring their exit in the most tax-efficient manner to maximize their after-tax returns.” Management incentive plans are vital for the target if they plan to stay post-acquisition, which is common in private equity transactions, Morand says.

In a restructuring transaction, aside from the commercial goal of typically reducing the outstanding debt of the troubled company, there is also a desire to preserve the debtor’s tax attributes. If the debts are going to be settled as part of the restructuring, which is often the case, Morand says, settlements must occur in the most tax-efficient manner.  

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