It may be that for the first half of 2009, tumbleweeds outnumbered deals spotted across the M&A landscape. But even in the face of this financial crisis, companies are adapting to the new environment with creative structures that will enable dealflow to keep some form of momentum. Dealmakers embarking on unusual engagements should consider that with each stroke of genius that pushes agreements forward, tax issues will likely rise up to cloud the issue.
There are two areas that deserve specific attention in this regard: earnouts and net operating losses, or NOLs. These distinct elements will be the centerpieces of strategy for companies looking to extract (or in some cases to preserve) the most value possible amid tight markets around them. By extending the use of these vehicles, companies may trigger tax obligations that will affect the viability of a transaction; understanding the pitfalls will paint a more complete picture for both sides of the table.
AHYDO and extended earnouts may bring tax headaches. Back in 1989 Congress added IRC Sec. 163(e)(5) in response to the pervasive use of high-yield original issue discount and paid-in-kind debt to fund acquisitions. The rules under this section are referred to as the applicable high yield discount obligation, or AHYDO, provisions. Essentially, for a debt instrument to be subject to AHYDO it would have to meet these four requirements: 1) the issuer must be a corporation; 2) the debt instrument must have a maturity date of more than five years; 3) the yield to maturity must exceed the Internal Revenue Service's published applicable federal rate (in effect for the month the debt is issued) plus 5%; and 4) the debt instrument must have significant original issue discount, or OID.
The criteria of significant OID is certainly the most complex of the four listed above. However, simply translating the definition within the Internal Revenue Code, a debt instrument will have significant OID if after the fifth anniversary of the debt instrument, the unpaid interest and OID exceeds one year's interest. One year's interest is determined by multiplying the original issue price of the debt by the yield to maturity.
The ultimate result of a debt instrument meeting the AHYDO characteristics would be that a significant amount of interest expense is deferred until paid and any excess OID would be permanently nondeductible. Economically costly alternatives such as paying the accrued interest at the end of the fifth year are considered by corporations in order to avoid AHYDO treatment.
The AHYDO concerns reached a fever pitch under the current economic climate as many corporations looked to restructure their debt. This forced them to also restructure their debt at deep discounts, ultimately triggering these adverse rules. Well aware of what was happening, Congress stepped in and suspended the AHYDO rules for any debt instrument issued or exchanged for existing debt after Aug. 1, 2008, and before Jan. 1, 2010. This temporary patch will maintain the current deductibility of interest.
The suspension was brought about under the recently issued American Recovery and Reinvestment Act of 2009. The suspension does not apply to instruments having contingent interest coupons or those issued to persons related to the issuer.
Understanding the AHYDO provisions and the rules under the temporary suspension should be a major consideration in overall deal structure. One consideration is how these rules will affect deals that are heavily structured with an earnout component. Historically, earnouts were structured over an average of three to five years. As buyers are seeking this alternative, the potential for extending an earnout beyond five years is a real possibility. As such, due care should be taken to ensure that the overall structure of the earnout arrangement does not possess components that would trigger the AHYDO treatment as previously mentioned.
Those coveted NOLs. Another tax area getting more visibility is around NOLs and their often central value to deals. Changes in ownership can limit loss carryforward for target companies under a commonly referenced tax code, Section 382. The regulation puts a cap (based on the fair market value of the target company) on the use of NOLs to offset income, which affects an acquirer's future tax liability.
The NOL issue is being felt across all industries, and some sellers may feel that deals are better off delayed until their values are restored to more appealing levels. This attitude is illustrated by the poison pill phenomenon, as companies take measures to block hostile takeovers. They may, among other tactics, dilute shares by offering steep discounts to existing shareholders. Though not a new strategy, its prominence in today's market signals a critical need to guard assets that could be attractive in a sale situation.
Recent actions taken by Sirius XM Radio Inc. follow this path, as the company tries to maintain a position of market strength. According to an April Reuters story, "Analysts have said that Sirius, which was targeted by EchoStar Corp. earlier this year, could be an attractive acquisition from a tax perspective because its net operating losses can be carried forward to help offset taxes against future profits."
As Sirius chief executive Mel Karmazin explained, "Our net operating loss carryforwards are an important asset of the company; an asset that we believe we should make every effort to protect."
Both the NOL and AHYDO issues are coming to light amid dealmaking in this down economy. They are likely to be reduced in significance once a more confident business environment results from credit markets loosening and valuations return to comfortable levels. Of course, predicting timing on such stability is another story altogether; for the time being, companies should continue to be creative in their approach to deals and remain aware of tax implications triggered by the structure of their agreements.
Craig Eaton is a partner at MFA - Moody, Famiglietti & Andronico LLP, an accounting and consulting firm. He specializes in tax consulting and compliance services for publicly traded companies and closely held corporate clients in a wide range of corporate, partnership and limited liability engagements.