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You have worked countless hours to line up the financing for the potential acquisition of a company. The deal is scheduled to close by the end of the week, and someone mentions that a tax adviser should take a look at the acquisition/financing documents, so you send over the various agreements to your tax advisers for them to review. The next day you receive an e-mail from your tax advisers with a short note asserting that the effective tax rate could be as much as 60%, unless the acquisition debt is pushed down. The e-mail might also contain a revised diagram of your proposed acquisition structure, showing squares where triangles used to be, or triangles where squares used to be, or blanks where entities used to be, or lines indicating the movement of cash or debt. You contemplate deleting the e-mail and pretending you never received it, but you hesitate because you used an effective tax rate of 40% in your model, so the proposed changes might be crucial.
The general concept of "pushing down" debt is to ensure that interest deductions associated with the acquisition financing are available as deductions to the entities with taxable income, by having the "profitable" entities do the borrowing. This process can be extremely complex from both a business and a tax perspective. Nevertheless, it can significantly reduce cash taxes and increase the rate of return on an investment by reducing taxable income in jurisdictions with taxable income and high tax rates, and by minimizing withholding taxes on the repatriation of cash.
For example, assume that your company is looking to acquire US-Co, a U.S. corporation with a wholly owned foreign subsidiary Foreign-Co (with material projected earnings). Assume that all of the acquisition debt will be at US-Co -- that Ebit is the same for financial accounting and tax purposes, and that the tax rates in the foreign jurisdiction and the U.S. are 30% and 40%, respectively:
Example 1: US-Co has no Ebit, interest expense of $100 and as a result has a net operating loss of $100 and no cash taxes due. Foreign-Co has $200 of Ebit, zero interest expense and as a result has $200 of taxable income and $60 of cash taxes due. Collectively, US-Co and Foreign-Co have $200 of Ebit, $100 of interest expense and as a result have $100 of taxable income and $60 in cash taxes due.
Using the figures from example 1, the interest expense generated at US-Co is simply increasing US-Co's net operating loss and is not reducing cash taxes. Conversely, Foreign-Co is generating taxable income from operations and, without a debt push down, does not have any interest expense deductions to offset that income. As a result, Foreign-Co has cash taxes of $60, and the acquired business has an overall effective cash tax rate of 60%.
Now assume the same facts as before, but that 50% of the acquisition debt is pushed down into Foreign-Co:
Example 2: US-Co has zero Ebit and $50 of interest expense, resulting in a net operating loss of $50 and zero cash taxes due. Foreign-Co has $200 of Ebit and $50 of interest expense, resulting in $150 of taxable income and $45 of cash taxes due. Collectively, US-Co and Foreign-Co have $200 of Ebit and $100 of interest expense, resulting in $100 of taxable income and cash taxes of $45.
Based on example 2, if US-Co were to push down 50% of the acquisition debt to Foreign-Co, cash taxes would decrease by 25%, reducing the effective cash tax rate to 45%. In this scenario, Foreign-Co would be able to use the interest expense deductions to reduce its taxable income (assuming that interest expense is deductible in the jurisdiction in which Foreign-Co is domiciled). In addition, US-Co might be able to increase debt push down by using internal loans from US-Co to Foreign-Co, further reducing foreign cash taxes. This latter approach may also reduce withholding taxes and increase foreign tax credits on repatriation of cash from foreign subsidiaries.
In addition to optimizing a company's foreign tax posture, pushing down acquisition debt can also avoid many potential pitfalls from a state and local tax perspective. For example, assume that US-Co is a U.S. corporation that acts as a holding company for US-Sub, its wholly owned U.S. subsidiary with profitable operations. In addition, assume that US-Co and US-Sub operate in one or more states that do not allow the income and losses from US-Co and US-Sub to offset one another for purposes of computing their state income tax liability (that is, a "separate filing" state). If the acquisition debt is incurred at US-Co, the interest expense deductions could potentially be lost. Conversely, US-Sub would be generating taxable income without the benefit for state tax purposes of the interest expense deductions generated at US-Co. With some state income tax rates as high as 10%, this outcome could have a material impact on the rate of return on an investment.
Another common scenario in which acquisition debt is pushed down is in the context of an acquisition of a foreign company (a company located in a foreign jurisdiction) with U.S. subsidiaries. For example, assume Foreign-Co is a foreign corporation that wholly owns US-Co, a U.S. corporation. Assume that all of the acquisition debt is at Foreign-Co, that Ebit is the same for financial accounting and tax purposes and that the tax rates in the foreign jurisdiction and the U.S. are 30% and 40%, respectively:
Example 3: Foreign-Co has Ebit of $100 and $100 of interest expense, resulting in no taxable income and zero cash taxes due. US-Co has $100 of Ebit and no interest expense, resulting in $100 of taxable income and $40 of cash taxes due. Collectively, US-Co and Foreign-Co have $200 of Ebit and $100 of interest expense, resulting in $100 of taxable income and cash taxes of $40.
Although the interest expense generated at Foreign-Co is reducing Foreign-Co's taxable income, the tax rate in Foreign-Co's jurisdiction is only 30% compared to 40% in the U.S. As such, if 50% of the debt could be pushed down into US-Co, there could be a significant tax savings as illustrated in example 4.
Example 4: Foreign-Co has Ebit of $100 and $50 of interest expense, resulting in $50 of taxable income and $15 of cash taxes due. US-Co has $100 of Ebit and $50 of interest expense, resulting in $50 of taxable income and $20 of cash taxes due. Collectively, US-Co and Foreign-Co have $200 of Ebit and $100 of interest expense, resulting in $100 of taxable income and cash taxes of $35.
Based on example 4, a push down of 50% of the acquisition debt to US-Co would reduce the combined cash taxes payable by approximately 12.5%. In addition, as discussed above, Foreign-Co might also be able to further lend funds to US-Co as a mechanism to push down the acquisition debt and potentially reduce US-Co's income tax and withholding taxes on future repatriations of cash to Foreign-Co via payments on its intercompany debt obligation, rather than via taxable cash distributions.
As illustrated above, pushing down acquisition debt may result in substantial cash tax savings. The rules vary by jurisdiction, and therefore in some instances there are incremental costs associated with pushing down acquisition debt. These costs of course should be balanced by the savings. Although the examples in this article broadly illustrate the benefits of pushing down acquisition debt, in practice this process is complex and requires tax, legal and financial planning and analysis. Ideally, tax advisers should be involved from the onset of the deal to work with the entire deal team, including counsel in each of the jurisdictions involved. However, in the event that you find yourself bringing in your tax advisers after the debt is secured and the structure has been finalized, it might nevertheless make sense to consider pushing down the acquisition debt, as the cash tax savings are often material to the rate of return.
Joseph Murray is a partner in the mergers and acquisitions tax practice of KPMG LLP. Nicholas Kato is a manager in the Washington national tax practice of KPMG.
