According to ABA studies, tax clearing restrictions were taken into account in 32% of transactions reported in the 2017 study. The previous six studies showed that 43%, 45%, 48%, 53%, 34% and 31%, respectively, of reported after-tax transactions have compensation restrictions. The 2005 ABA study did not address this issue. A typical provision of seller`s indemnification in a M&A purchase agreement may be as follows: Seller agrees to defend and indemnify the buying parties and to save and indemnify each of them and to pay on behalf of those buying parties any losses that such buying party may suffer, suffer or reimburse. as a result of, with respect to, or as a result of: (i) a breach by Seller of any representation or warranty made by Seller in this Agreement; (ii) any breach by Seller of any agreement or arrangement under this Agreement, or . . . [2] Note that in this article, we use the terms “seller” and “company” in connection with a share purchase transaction – the “seller” would be the selling shareholder (the selling shareholders) making the representations and warranties in the M&A purchase agreement, and the “company” would be the acquired company. In an asset purchase transaction, the “seller” would be the target company itself, but for consistency, we use “seller” and “company” in a stock purchase environment. In the case of an outright sale of shares (which is not treated as a sale of assets for tax purposes), the target company may be allowed to deduct certain losses subject to set-off because the target company has actually made payments establishing the right to compensation. However, tax law generally treats compensation payments not as taxable income to the target company, but as tax-free capital recovery.
[7] Thus, the target company can benefit from a deduction for the loss without offsetting the income from the payment of compensation. Instead, the payment of compensation reduces the tax base of the buying shareholders in the acquired target capital and this reduction in the base acts as an adjustment to the purchase price. In these cases, a tax-free compensation payment does more than simply return the buyer whole, since deducting the compensated loss gives the buyer a real economic advantage. Therefore, it makes economic sense for the seller to require a limitation of after-tax compensation in a share purchase agreement, as without this provision, the buyer could receive full compensation plus the (potentially significant) economic benefit of the deduction. The same dynamic could also apply to buying a majority (but less than all) of the shares of LLC members. However, the actual value of this additional and free tax benefit depends largely on whether the target company`s tax advantage is obtained through an immediate deduction or whether the target company was required to capitalize on the payment (e.B. because it has led to a long-term benefit) and to cover the costs through future depreciation or simply by reducing profits if the company has the asset to which the offset costs have been allocated. Conclusion Parties to mergers and acquisitions agreements often negotiate whether claims should be reduced by so-called tax benefits. In addition, as reflected in the aba studies, these reductions are often recorded in the contract for the purchase of mergers and acquisitions. However, since the buyer often receives a limited or no tax benefit, at least in terms of federal taxes, in terms of the loss for which he is compensated by the seller, the negotiation of this issue may be at least partially misplaced. Sometimes one person or company compensates another for paying the tax payable to the first person.
An agreement for this agreement is called a tax compensation agreement. As an example, Company No. 1 compensates No. 2 companies for taxes levied on No. 2 companies. The #1 company could do this because the two companies have business activities together (for example.B. one company can sell the products of the other). What is the tax treatment of companies #2 if it is offset by company #1 – if it receives a tax offset payment? While the tax deduction provides an economic benefit within the target business, that`s not all. Remember that the payment of compensation is treated as a downward adjustment to the purchase price. As a result, it is assumed that the buyer pays less for the shares of the amount of the compensation payment and has a corresponding reduced base in the shares of the acquired company.
In general, the tax relief provisions only take into account the benefit of the deduction, but ignore the long-term costs of a reduced base. Whether the payment of compensation should be adjusted to account for a lower base may be a point of contention between buyer and seller. However, reducing the base would not really put buyers in a worse position than they would have been if they had known the existence and cost of the item compensated at the time of closing and if the purchase price had been adjusted accordingly. If the buyer accepts in principle the seller`s argument that the corresponding tax benefits should reduce its claims for damages, it may try to limit the scope of the reduction. An example of a limited restriction is that tax offset restrictions peaked at 53% for stores reported in the first three ABA studies (2005-2009). However, 2011 was the first and only year in which the inclusion of restrictions was the majority position. Since 2011, the use of restrictions has steadily decreased, appearing in 32% of the transactions examined in the 2019 study. Despite the potentially limited economic benefits of restricting after-tax compensation, these provisions are still visible, albeit declining, in mergers and acquisitions. First, this portion of a tax allowance is not included in gross income if the taxpayer pays more federal income tax than he or she should have paid solely as a result of the actions of a third party; Indeed, the payment only puts the taxpayer back in the situation where he would have been without the actions of the third party.
Without limitation of compensation, a seller may argue that this would result in an unfair stroke of luck for the indemnified party. The most common justification for the seller`s position refers to situations where the buyer is expected to receive a tax deduction related to a compensated loss. For example, if the seller makes a statement and warrants that the production facilities sold as part of the transaction are in good condition and comply with all building codes, and the buyer learns after completion that the equipment needs to be repaired to update them, the buyer can claim damages for the seller`s violation….