Accounting methods issues in M&A transactions Colleen O Connor KPMG, Washington National Tax Kyle Seipert KPMG, Mergers & Acquisitions
Colleen O Connor Principal, KPMG Washington national tax KPMG LLP 1801 K Street, NW Washington, DC 20006 Tel 202-533-8049 Fax 202-403-3982 colleenmoconnor@kpmg.com Function and specialization Colleen is a Principal in the Income Tax & Accounting group in Washington National Tax with over 16 years of experience in handling a variety of accounting methods issues including income and expense recognition, transactional accounting methods matters and accounting methods and periods procedural issues. Background Colleen is a Principal in the Income Tax and Accounting Group in Washington National Tax (WNT) based in Washington, D.C. She has over 16 years of experience consulting on matters involving timing provisions governing income and expense recognition, transactional accounting methods issues, accounting methods for foreign E&P; capitalization of tangible and intangible assets, uniform capitalization, long-term contract accounting and Internal Revenue Service procedures regarding changes in accounting methods and periods. Professional and industry experience Prior to joining KPMG, Colleen spent 10 years at another big four accounting firm gaining a broad base of knowledge of accounting methods. Colleen served as a national leader with respect to transaction cost issues, and also spent significant time advising clients in the financial services, healthcare and other industries on a variety of accounting methods issues. Colleen also represented clients before the IRS National Office on matters including private letter ruling requests, requests for technical advice and changes in accounting methods and periods, as well as before the Office of Appeals on a variety of method issues. In her role in WNT, Colleen works closely with the Accounting Methods and Credit Services, Federal Tax and M&A practices assisting clients across a number of industries with accounting methods issues. Colleen is a frequent speaker for Tax Executives Institute and is currently Chair of the American Bar Association s Tax Accounting Committee. Education, licenses & certifications JD and BA from American University, Washington DC JD licensed in VA 2
Kyle Seipert Managing Director, KPMG M&A Tax KPMG LLP Suite 4400 811 Main Street Houston, Texas 77002 Tel 713-319-2088 Fax 646-924-3124 Cell 203-280-3461 kseipert@kpmg.com Background Kyle has 18 years experience in public accounting with more than 12 years advising clients on mergers, acquisitions, and divesture tax planning. He also focuses on transaction/acquisition costs regulations, stock basis studies, and Subchapter C issues. Professional and industry experience Kyle is in KPMG s Mergers & Acquisitions (M&A) Tax practice and recently relocated to Houston, Texas. Kyle is dedicated to the energy and infrastructure sectors and participates with global teams of KPMG on cross-border transactions. Prior to relocating to Houston, Kyle spent 3 years in KPMG s Denver and New York City offices focusing on providing M&A tax services to private equity clients in the energy sector. Prior to his experience in New York and Denver, he began his career in Salt Lake City, Utah, serving numerous general tax clients. In addition, Kyle taught the Mergers, Acquisitions, and Consolidations tax course in Weber State University s Masters of Accountancy Program. Function and specialization Kyle specializes in the area of mergers, acquisitions and divestiture planning. Professional associations Member of the American Institute of Certified Public Accountants Education, licenses & certifications BA degree, Weber State University Masters of Accountancy, Weber State University CPA (Licensed in Utah and Texas) 3
Today s agenda Accounting methods considerations in transactions Readying for the potential for tax reform 4
Life cycle of a transaction: Methods perspective Due diligence - Common red flags - Corrective alternatives Post-closing considerations - Harmonizing tax accounting methods/considering Impacts of Transaction on Methods - Issues that arise from short tax years - Transaction cost analysis 5
Due diligence
Due diligence work plan Identify potentially incorrect accounting methods being used by target Assess risk Identify alternatives for corrective steps 7
Scope of due diligence review Timing items - Income recognition - Expense recognition - Capitalization vs. current deductions - Depreciation and amortization - Inventories Permanent items - Section 199 - R&D Credit - Meals and Entertainment - Fines and Penalties - Lobbying Expenses 8
Common issues Stock acquisitions Acquirer inherits Target s accounting methods Common impermissible methods include: - Following book method for deferred revenue, accrued expenses/reserves, bonus pay, non-qualified deferred compensation, bad debts and rent expense - Taking current deduction for prepaid expenses not eligible for the 12-month rule - Not computing UNICAP /Section 263A adjustment for inventory or selfconstructed property or computing it using stale absorption ratio - Prior unauthorized accounting method changes (changed method without filing Form 3115) 9
Consider corrective action Changing Target s accounting method generally provides audit protection for prior use of bad method - Consider Target s IRS exam status Unfavorable catch-up (Section 481(a) adjustment) is spread over four tax years - Consider when to file 3115 pre or post transaction - Eligible acquisition transaction rule permits target to take entire unfavorable adjustment into account in stub period before the transaction Method change procedures are provided in Rev. Proc. 2015-13 List of automatic method changes is provided in Rev. Proc. 2016-29 10
Postclosing considerat ions
Impact of acquisition transactions on accounting methods Taxable asset acquisition Taxable stock acquisition Tax-free reorganization transactions Target s methods do not carry over 3115s are not needed to use new methods Target s methods carry over 3115s are needed to change to new methods Target s methods carry over if it is operated as a separate trade or businesses from Acquirer - 3115s are needed to change to new methods The more likely case is that Acquirer and Target will operate as an integrated business and principal methods must be determined under the rules provided in Sections 381(c)(4) and (c)(5) - 3115s are not needed to change to principal method - 3115s may be necessary if principal method is not permissible or desired 12
Impact of restructuring transactions on accounting methods Section 351/Section 721 transfers Transfer to a new corporation or partnership methods are adopted Transfer to an existing corporation or partnership transferee applies its existing methods to items received from transferor. Methods are adopted for new items Tax-free liquidations Includes Section 332 liquidations. Methods are determined under the rules provided in Sections 381(c)(4) and (c)(5) - Methods carry over if liquidated entity is operated as separate trade or business - Principal method is determined if combined entity is integrated business Check the box transactions (Election to be treated as disregarded) Corporation elects to be treated as disregarded for federal income tax purposes Treated as a deemed distribution of all assets and liabilities in liquidation Generally a tax-free Section 332 liquidation if owned by a corporation. Methods are determined under the rules provided in Sections 381(c)(4) and (c)(5) - Methods carry over if disregarded entity is operated as separate trade or business - Principal method is determined if integrated business 13
Final regulations under Sections 381(c)(4) & (c)(5) Rules address accounting method determinations following a transaction subject to Section 381(a): - Section 332 liquidations - Transfers in connection with a reorganization described in Section 368(a)(1)(A), (C), (D), (F) or (G) - The rules do not apply to divisive D or G transactions Final regulations issued in August 2011 - Simplify the procedures for identifying principal methods - Conform the determination of accounting methods following a Section 381(a) transaction with the general accounting methods procedures 14
Principal method determination For integrated businesses, principal method is generally Acquiring corporation s method unless - Acquiring corporation has no accounting method for the item - The distributor/transferor corporation is larger than the acquiring corporation look to the size of the trade or businesses being integrated (both gross receipts and assets must be larger) A Form 3115 is not required to change to a principal method - Section 481(a) adjustment is taken into account prospectively by Acquiring corporation - Adjustment determined as of beginning of day after date of distribution and taken into account by Acquiring - Audit protection is not provided File Form 3115 if principal method cannot be used because it is not permissible or corporation wishes to use a different method 15
Asset acquisitions Historical accounting methods do not carry over First year accounting considerations Treatment of assumed liabilities - Buyer generally obtains basis for assumed liabilities when requirements of Section 461 met (liability is fixed and determinable and economic performance occurs) - AmerGen Energy Co. v. United States, 113 Fed. Cl. 52 (2013) Treatment of deferred revenue - IRS/Treasury Priority Guidance Plan Item - Possible approaches: Assumed liability approach Deemed payment approach 16
Stock acquisitions Treatment of deferred revenue Deferral Method under Rev. Proc. 2004-34 - Advance payments are recognized in income in the year of receipt to extent payment is recognized in Applicable Financial Statement (AFS) - The remaining amount is recognized in next succeeding tax year - Impact of short tax years - Special rule for short tax years of 92 days or less CCA 2016190009 - In Year 1, Taxpayer using the Deferral Method had 100% of its stock acquired by unrelated taxpayer - Acquirer wrote down the associated deferred revenue liability to fair value on the date of acquisition - Issue whether taxpayer could use the Deferral Method for payments received in Year 1 when the full amount of payments received would not be recognized in revenues in its AFS in a future year - IRS concluded Deferral Method was still available; however, taxpayer required to recognize the full amount of the payment received no later than Year 2 17
Stock acquisitions Effect of short tax years Certain accounting method provisions are applied with respect to the end of a tax year: - Recurring item exception (Treas. Reg. 1.461-5) - 12-month rule for prepaid expenses (Treas. Reg. 1.263(a)-4(f))) - 2.5 month rule for deferred compensation (section 404) 18
Example 12-Month rule Corp A (calendar year taxpayer and parent of a consolidated group of corporations) purchases an insurance policy with a term of 7/1/2016-6/30/2017. The annual premium is due at the inception of the policy (7/1/2016) and Corp A makes payment on that date. Corp A and its subsidiaries are acquired by Corp B (also a calendar taxpayer) on 10/31/2016 and join the Corp B consolidated group. For 2016 Corp A has short tax years of 1/1/2016 10/31/2016 and 11/1/2016-12/31/2016. Corp A must take its short tax years into account in applying the 12-month rule Prior to acquisition: Payment made on 7/1/12016 for policy with term of 7/1/2016-6/30/2017 satisfied requirements of 12-month rule (benefit did not extend beyond the end of the taxable year following the year payment is made) After acquisition: 12-month rule is not satisfied the benefit extends beyond the end of the taxable year following the year the payment is made (payment on 7/1/2016 benefit extends beyond 12/31/2016). 19
Example Deferred revenue Corp A (a calendar year taxpayer) receives advance payments for services and uses the Deferral Method in Rev. Proc. 2004-34. Corp A s stock is acquired by Corp B (a 9/30 fiscal year filer) on April 30, 2016 and joins the Corp B consolidated group, resulting in short periods of 1/1/2016-4/30/2016 and 5/1/2016-9/30/2016. Any advance payments received by Corp A in its 4/30/2016 tax year will be recognized no later than 9/30/2016 (instead of deferring to 2017). 20
New GAAP revenue recognition FASB/IASB have issued new standards for revenue recognition New standard is required for public companies beginning in 2018 (2019 for others) 5 step model for determining when revenue is recognized for financial accounting purposes Potential Issues: - This is a book reporting change tax rules for income recognition are staying the same - However, many companies follow book methods for tax purposes (under current standard, the rules are more closely aligned to tax) - Evaluate the revenue recognition policies of newly acquired companies under new standard and understand impacts to tax If new book methods result, are they also appropriate for tax? If not, what is the proper tax method? May result in creation of new book/tax differences May have exposure if target made unauthorized change to continue following book 21
Method changes after a transaction Method changes generally require a Section 481(a) (cumulative catch up ) adjustment. Are pre-transaction periods taken into account? - Taxable stock acquisition: Yes - Taxable asset acquisition: No - Section 351/721 transfers: Except for depreciation, methods do not carry over to transferee For all method changes other than depreciation, pre-transaction years are not included in section 481(a) adjustment For changes from an impermissible depreciation method, section 481(a) adjustment includes pre-transaction periods (permits transferee to capture depreciation missed by transferor) - Section 381(a) transactions: Yes - Technical termination: No 22
Target s prior period method changes Prior year method changes that result in a taxpayer unfavorable Sec. 481(a) adjustment (an increase to taxable income) A taxpayer is generally able to recognize an unfavorable adjustment ratably over four tax years (short years count as a tax year for this purpose) Target will be required to accelerate any remaining unfavorable adjustments if the target ceases to engage in a trade or business or terminates its existence - Operations of the trade or business cease or substantially all of the assets of the trade or business are transferred to another taxpayer Substantially all as described in Rev. Proc. 77-37 Examples of such transactions: Assets of a trade or business are contributed to a partnership Trade or business is sold in a section 1060 transaction Certain section 351 transfers Technical termination Trade or business terminated or transferred in a taxable liquidation 23
Examples Example 1: Partnership filed method change for 2015 to begin applying UNICAP. The change resulted in an unfavorable Section 481(a) adjustment of $100k. Partnership included $25,000 in income for 2015. Partnership undergoes technical termination in 2016. The remaining $75,000 will be recognized in 2016. Example 2 C corp filed method change in 2015 to discontinue deducting reserves for legal expenses, which resulted in an unfavorable Section 481(a) adjustment of $100k. In 2016, C corp is acquired in a taxable stock acquisition. The remaining Section 481(a) adjustment is not triggered and continues to be spread over remaining period (both pre and post transaction). Short years are taken into account for purposes of the spread period. 24
Transaction cost analysis Determine whether service provider fees (legal, investment banking, accounting, etc.) are deductible or subject to capitalization Rules governing transaction costs provided in Section 1.263(a)-5 Recovery of capitalized transaction costs depends on type of transaction - Taxable asset acquisition: Acquirer adds costs to the basis of acquired assets - Taxable Stock acquisition: Acquirer adds costs to the basis of the acquired stock - Recovery of Target s costs is reserved in regulations - Tax-Reorganization transaction: treatment reserved in regulations 25
Treatment of transaction costs Buyers generally must capitalize costs paid to facilitate corporate acquisitions and reorganizations. This includes any costs paid in the process of investigating or otherwise pursuing the transaction. Section 1.263(a)-5(a). - Exception: Internal compensation and overhead is always deductible Amounts that are contingent on the successful closing of an acquisition are presumed to facilitate the acquisition, but the presumption can be rebutted with documentation showing the portion of the fee that is not allocable to activities facilitating the acquisition. Section 1.263(a)-5(f). The documentation requirement presents a hurdle for many successbased fees, such as investment bankers fees. - Example: An invoice For services rendered without more detail generally is insufficient. 26
Transaction costs: Investment banker fees Rev. Proc. 2011-29 provides a safe harbor for the documentation requirement Applies to success-based fees for services performed in the process of investigating or otherwise pursuing a covered transaction. - Taxable acquisitions of assets constituting a trade or business - Taxable acquisitions of an ownership interest in a business entity if the parties are related immediately afterward - Reorganizations described in sections 381(a)(1)(A), (B), or (C), or acquisitive D reorganizations If elected, the safe harbor permits the taxpayer to deduct 70% of the success-based fee and capitalize the remaining 30% - Taxpayer must attach an election statement to the original tax return for the year in which the fee is paid - The election is not an accounting method and does not affect the treatment of other success-based fees - What if you forget to attach the statement? 27
Milestone payments IRS National Office takes the position that non-refundable milestone payments (e.g., non-refundable payments earned upon the execution of merger agreement, shareholder approval, etc.) are not success based because they must be paid even if the transaction ultimately does not close. CCA 201234027 - Precludes application of the safe harbor - Requires capitalizing fee as facilitating the transaction unless taxpayer satisfies the documentation requirement - How a capitalized milestone payment is recovered depends on the structure of the transaction 28
Milestone payments (continued) LB&I has instructed its agents not to challenge deductions for milestone payments in certain situations - LB&I will not challenge original returns for years prior to the effective date of the safe harbor if at least 30% of a transaction s success-based fees were capitalized. (LB&I-04-0511-012 7/28/2011) - LB&I will not challenge treatment of milestone payments deducted on an original return if consistent with the safe harbor and other conditions are satisfied. Milestone payments are limited to investment banker fees creditable against success based fees. (LB&I-04-0114-001 1/27/2014). 29
Application of safe harbor to deemed asset transactions CCA 201624021 Target shareholders sold stock of Target S Corp to Acquiring Corp on December 31, 2012 Parties jointly elected to treat the transaction as a deemed asset acquisition under Section 338(h)(10) Target incurred success-based fees and made the safe harbor election to deduct 70% of the fees on its return for the 2012 tax year IRS concluded the safe harbor did not apply the deemed asset sale did not meet the definition of a covered transaction - Covered transactions for taxable asset acquisitions include only acquisitions of assets by the taxpayer 30
Other transaction costs Costs incurred to integrate businesses are deductible regardless of when the costs are incurred - Examples include relocating personnel, providing severance benefits, integrating records and software systems, preparing financial statements for the combined entity, reducing redundancies Costs incurred to issue debt (borrowing costs) are separate from the acquisition transaction - Debt issuance costs are recoverable using the constant yield method as described in Section 1.446-5. 31
Readying for tax reform Accounting methods
Business tax reform proposals & DTA monetization A quick comparison of the House Republican blueprint and President-elect Trump s campaign proposals would suggest that a reduction in the corporate tax rate could be possible, among other significant provisions A reduction in the corporate tax rate, if enacted, could have important economic and financial statement implications as a result of a decrease in the value of a company s DTAs when legislation is passed In the context of a rate reduction, there is a one-time transitional opportunity to use traditional tax accounting methods planning to yield a permanent financial statement earnings benefit By engaging in thoughtful planning around your tax balance sheet, your company might realize significant benefits if the corporate tax rate is reduced. Some of the potential benefits to DTA planning include: - Realizing permanent tax benefits via tax accounting method changes - Converting tax assets into real cash - Achieving state tax savings - Mitigating interest costs from IRS adjustments 33
Planning ideas Before year-end Non-automatic method changes Revenue recognition Advance payments for the sale of goods Long-term contracts Pension and certain compensation expenses Fixed assets (such as repair and depreciation where a tax credit was claimed) After year end Automatic method changes Fixed assets Cost segregation Qualified leasehold improvements Bonus depreciation Repairs and maintenance Deductions Prepaid expenses (12-month rule) Software development expenses Self-insured employee medical expenses (IBNR) Property, state and payroll taxes Vacation, severance, sick, bonus pay Deferred rent Transactional based planning Accelerate/restructure certain compensation & benefit plans (annual bonuses, deferred comp, other compensation/ qualified plans) Renegotiate with vendors to make prepayments (12-month rule/3 ½ month rule) Accelerate payment on certain cash items that triggers deductibility Revenue Deferred revenue/advance payments Gift cards/gift certificates Prepaid subscription income State or local income tax refunds Inventory Last-In, First-Out (LIFO) Lower-of-Cost-or-Market (LCM) Rolling Weighted Average Retail Inventory Method Uniform Capitalization of Costs for Inventories Cash/Trade Discounts/Rebates 34
Repatriation and E&P methods planning Using method changes to enhance FTCs on repatriation The House blueprint contains a provision that (if enacted) would tax overseas earnings repatriated by multinational corporations at a rate that is significantly lower than under current law. Making accounting method changes that reduce a CFC s E&P (i.e., changes that result in a taxpayer favorable section 481(a) adjustment) prior to a distribution can increase the foreign taxes deemed paid and result in additional FTCs for the U.S. shareholder. Common method changes in the context of E&P include: Accelerating the deduction for software development expenses Changing depreciation methods for fixed assets Deferring recognition of advance payments 35
Potential repeal of Section 199 Opportunity to recover previously overlooked benefits The House blueprint suggests that the contemplated reduction in the corporate tax rate would make the section 199 deduction unnecessary. In light of the potential repeal of section 199, companies should consider closely scrutinizing their section 199 positions for all open tax years in which the company had taxable income, while that door remains open. Potential areas of benefit include: Maximizing the qualifying production activities income (QPAI) potentially eligible for the benefit by refining the company s allocation of production expenses Revisiting revenue streams that potentially qualify for the section 199 benefit, particularly in light of taxpayer-favorable court cases that may have been issued since the company s most recent review Focusing on production activities in areas such as software development and contract manufacturing that may benefit from closer scrutiny of the company s production activities An overall check-up for the company s section 199 deduction, particularly if the company has not performed such a review since the applicable percentage for computing the deduction reached the maximum rate of 9 percent 36
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