There has always been a tension between buyers and sellers as to whether to structure a negotiated M&A transaction as a "stock sale" or an "asset sale". Buyers generally prefer to purchase assets while sellers generally prefer to sell stock, and well-advised parties take the tax costs and benefits of the alternative structures into consideration when agreeing to an acquisition structure and purchase price. Certain provisions in the Tax Cuts and Jobs Act ("TJCA") change the analysis, though not necessarily the conclusion, and require that the parties consider anew the costs and benefits of an asset sale versus a stock sale. This article discusses two of these new provisions: the full expensing provision under amended section 168(k) and the foreign-derived intangible income rule under new section 250.
Generally sellers will continue to prefer to sell stock after the TCJA. Unless the selling corporation has significant NOLs to absorb the gain on the sale or the selling corporation has a high basis in its assets, an asset sale would give rise to a higher tax burden. The reduced corporate tax rate lowers the tax cost of an asset sale to the sellers. However, even a lower amount of increased tax burden is still detrimental, and since high basis in a target's assets is typically not a likely scenario in large corporate M&A transactions, unless the selling corporation has significant NOLs, the domestic seller will still prefer a stock sale.
The buyer's benefit from an asset acquisition has increased following the enactment of the TJCA. The amendment of section 168(k) allows for full expensing of the basis of certain tangible assets due to bonus depreciation for both new and used property acquired and placed in service between September 27, 2017 and January 1, 2023. By contrast, prior versions of section 168(k) allowed bonus depreciation only for new property. The TJCA addition of used property as a qualified property in section 168(k) and the elimination of the original use requirement enables buyers to exploit this 100% bonus depreciation in asset sales, or in deemed asset sales, to obtain immediate tax benefit for the purchase price allocated to property qualifying for bonus depreciation.
The increased bonus depreciation has increased buyers' incentive to structure their acquisition of those businesses with substantial tangible assets as an asset purchase as opposed to a stock purchase. This makes the buyer both more interested in structuring the transaction as an asset purchase and places even more emphasis than before on negotiating the purchase price allocation. The buyer will have a stronger interest in ensuring that as much of the purchase price as possible is allocated to tangible property qualifying for bonus depreciation. Sellers, of course, will continue to have a strong interest in the purchase price allocation, as they did prior to TJCA. The revision to section 168(k) has placed significant spotlight on the allocation provision as both sellers and buyers have significant interest in the allocation.
If buyers' tax benefit from the asset sale significantly exceeds the seller's incremental tax cost of the asset sale, one could expect an upswing in negotiations of the gross-up provisions in asset purchase agreements. Such contractual provisions might require the buyer to pay the seller the amount of the incremental tax incurred due to certain structuring requested by the buyer, in this case due to structuring the transaction as an asset sale instead of a stock sale. These gross-up provisions are now often negotiated with regard to section 338(h)(10) elections. However, as gross-up provisions are complicated and disfavored by buyers, one alternative would be an increase in purchase prices at the term sheet level. This would require tax professionals to be involved in early stage negotiations, as the incremental cost and benefit of a stock versus asset sale will need to be analyzed. Tax practitioners will be increasingly tasked with the making the determination of the maximum amount of additional consideration a buyer is willing to pay, and the minimum amount of additional consideration a seller is willing to accept, in order to structure the transaction as an asset sale.
Foreign-Derived Intangible Income
When the seller is domestic and the buyer is foreign, sellers should also consider the potential benefit of FDII in their cost/benefit analysis.
Foreign Derived Intangible Income ("FDII"), defined in section 250 of the Code, may provide substantial benefits to a U.S. corporation selling assets to an unrelated foreign buyer for foreign use. Income derived by a U.S. corporation in connection with property that is sold, exchanged, leased or licensed to foreign persons for foreign use or services provided to any foreign person or in connection with foreign property is entitled to a lower rate of 13.125%. Foreign use means any use, consumption or disposition which is outside of the U.S. As such, when a domestic corporate seller sells intangibles to a foreign buyer for use outside of the U.S., the gain from such a sale should generally be eligible for the reduced tax rate as FDII. Note, though, that this seller benefit is only available when the buyer is a foreign person limiting the applicability of FDII to only certain cross-border transactions.
In addition, sellers can exploit the FDII benefit when negotiating the sale of assets that are used outside of the U.S. to a domestic buyer. The asset sale transaction by itself does not give rise to FDII benefit, and the seller would be unable to apply the reduced tax rate to its gain from such asset sale. However, the domestic corporate buyer should be able to obtain FDII benefit for its exploitation of the intangible in its business by continuing its foreign use (i.e. by licensing or leasing it to a foreign person). As such the seller of intangible assets used in foreign jurisdictions can attempt to use this tax benefit when negotiating the purchase price.
The exact calculation of the FDII benefit is based on a formula (and is outside the scope of this article), but section 250 generally enables the U.S. corporation's intangible income to be taxed at the lower rate of 13.125% while its regular corporate rate is 21%. The key of increasing the FDII benefit is increasing the domestic corporation's income that is derived in connection with property that is sold to foreign persons for foreign use. As such, a sale of intangibles to a foreign person for foreign use in context of M&A transaction will likely give rise to FDII and reduce the tax cost of structuring the transaction as an asset sale.
It is not entirely clear whether the FDII benefit can be achieved by a sale of the stock of the U.S. corporation's subsidiary to an unrelated foreign buyer. There is nothing currently in section 250 specifically excluding sale of "stock" from giving rise to FDII. However, the challenges lie in establishing to the satisfaction of the IRS that the stock sold to the foreign buyer is for a foreign use. Where exactly is stock of a subsidiary "used"?
Sellers wishing to obtain the FDII benefit should confirm that the assets are sold to an unrelated foreign person. For example, a sale to a foreign disregarded entity owned by a U.S. corporation would not qualify for the FDII benefit. Additionally, any inquiry into the applicability of FDII might not stop at the time of the sale since FDII is only available if the property is sold for foreign use. The buyer's post-sale conduct, such as the use of the intangibles within the United States, might render FDII inapplicable to the sale. If the intangible is used in manufacturing or is further modified within the U.S. following the sale, such intangible will not be treated as sold for foreign use even if the buyer subsequently uses the intangible for foreign use. As such the property's use after the sale, including any further "manufacturing," must be exclusively outside of the United States.
Thus, contractual provisions should be used to ensure that the products will continue to be manufactured or incorporated as a component exclusively outside of the United States. For example, a covenant in the tax matters section could restrict the buyer from using the intangible or manufacturing the product within the U.S. without the seller's consent. This could be supported by a buyer's indemnity for any resulting incremental tax if the covenant is breached. Although buyers are generally reluctant to provide covenants restricting their business decisions, if a buyer has no plans for further U.S. manufacturing using the intangible or other use in the U.S. this is a relatively minor concession in order to secure sellers' agreement to an asset sale.
As always, whether a transaction should be structured as an asset or a stock sale for tax purposes cannot be answered without modeling the potential tax results for both structures. Often, business considerations outweigh tax calculations in making this decision. But, when tax differentials of one structure over the other are significant, a full analysis of the tax costs and savings will serve as an important input in the business decision making process. While future interpretations and applications of the TJCA are the subject of speculation and calculated guess, for the immediate future, tax practitioners providing counsel for M&A transactions should keep in mind that in addition to the customary pre-TJCA considerations, the changes to the bonus depreciation provisions and the addition of FDII play a significant role in the analysis of the tax consequences of an asset sale.