What are the key tax considerations for an M&A transaction?

At the Tax Faculty’s 2020 Annual Taxation Conference, a panel discussed tax considerations on a hypothetical merger and aquisition (M&A) transaction.

The discussions were based on a hypothetical case where a Singapore holding company (HoldCo 1) intends to dispose of its equity interests in its wholly owned subsidiaries in various Association of Southeast Asian Nations (ASEAN) countries to a potential buyer from Mainland China. HoldCo 1 holds the equity interest in the ASEAN subsidiaries via a pure holding company incorporated in Singapore (HoldCo 2). While the potential buyer wishes to acquire the equity interests of the ASEAN subsidiaries directly, but HoldCo 1 only agrees to sell at HoldCo 2 level as the ASEAN countries where the subsidiaries reside do not impose tax on offshore indirect transfers.

HoldCo 1 also maintains a treasury company in Singapore as the group financier. This group financer obtains funding from the retaining earnings of the group on an interest free basis and external market at the market rate. The group financier on-lends the fund to the downstream ASEAN subsidiaries at 1.5 percent below the market rate.

This article summarizes some of the key tax considerations.

Cecilia Lee, Partner, Tax Services, Transfer Pricing Services, PwC

In the case, the group financier charges the group companies at 1.5 percent below the market rate, funded through retained earnings and from borrowing at the market rate. The provision of interest free financing from a holding company to group companies used to be common, but the practice is changing.

The Organization for Economic Cooperation and Development (OECD) issued guidelines in February on financing transactions. The guidelines are regarded as reaching common consensus among the transfer pricing (TP) community. They encourage groups to review financing transactions to check if they make sense to the relevant parties and when compared to normal commercial terms. They also talk about accurate delineation of the transaction. Is the substance of the transaction lending or equity in nature? Depending on the answer, different factors need to be considered.

Practitioners should also review the opportunity costs of the parties involved in transactions. Would the lender get better returns by deploying the funds for something else? Could the borrowers get funding at lower interest rates via other avenues? Consider the case is of a holding company lender blending the costs of funding from different sources together such that it is profitable even though it charges the group companies at a rate below the prevailing market rate. The question remains, has the arm’s length principle been observed?

Choosing the correct benchmark is also important. “Market rates” are different between jurisdictions. Is LIBOR, HIBOR or the prime rate appropriate? Given that the countries of resident of the downstream borrowers do not have clear TP guidelines, it is important to know what they use as market rate.

It is good for groups to review their internal TP arrangements after life-changing events, e.g. after the completion of an M&A as in this example. Groups could also consider obtaining advance pricing arrangements (APA) with the relevant tax authorities to obtain certainties. From a Hong Kong perspective, the Inland Revenue Department (IRD) recently issued the revised Departmental Interpretation and Practice Notes (DIPN) 48. The IRD has streamlined the APA process and this is documented in the revised DIPN 48. Currently the IRD also accepts applications for unilateral APAs and profit attributions to permanent establishments in Hong Kong. Taxpayers wishing to have better certainty on their TP arrangements should consider lodging an APA application.

“It is good for groups to review their internal TP arrangements after life-changing events.”

Lorraine Cheung, Partner, China Tax and Business Advisory Services, EY and an Institute member

The subsidiaries in the hypothetical case are located in the jurisdictions where offshore indirect transfer (OIT) would not be taxed such that the vendor only agreed to dispose its interests in the subsidiaries by disposing the Singapore intermediate holding company.

In June, the Platform for Collaboration on Tax, co-founded by the International Monetary Fund, OECD, World Bank Group and the United Nations, released a toolkit on OIT taxation. The toolkit provides guidance on tax treatment and implementation issues for developing countries on OIT taxation.

While the tax community in general agrees that the toolkit provide guidance to the developing countries on OIT taxation, countries which choose to implement OIT taxation still need to work out the details of the taxation bases. Mainland China has been taxing OITs for more than 10 years. Despite this, application of the taxing rules is still subject to interpretation. For example, in an OIT transaction with Mainland properties located in multiple cities, the tax authorities may come up with different calculation bases on the taxable amount even if the same fact patterns are presented. In view of this, we have been seeking clarifications on various OIT taxation issues with the State Taxation of Administration during the Institute’s annual meetings in the past few years. These clarifications are helpful but we are still experiencing inconsistencies in the actual applications.

The two models provided for OIT taxation in the toolkit could yield very different outcomes. In the Mainland China context, should we apply tax rate of 10 percent or 25 percent in calculating the tax payable amount? If model 1 in the toolkit is to be adopted in the Mainland in which tax will be levied on the local entity level, some Mainland tax bureaus may insist that the 25 percent rate should be applied in calculating the tax payable. Application of the 25 percent tax rate would likely scare investors away.

The devil is in the details. Application of the safe harbour rules in the Mainland China OIT taxation is still very restrictive. Even some genuine group restructuring transactions may not qualify for the safe harbour rules. Codifications of the OIT taxation rules in domestic tax law should provide clarity. Clarity leads to certainty. Ambiguity in the tax legislation could be a deal breaker for investors in making investment decisions, e.g. concluding the M&A deal in this hypothetical case.

“These clarifications are helpful but we are still experiencing inconsistencies in the actual applications.”

Alice Leung, Partner, Corporate Tax Advisory, KPMG China and an Institute member

Holding companies are a common feature of multinational, locally listed and domestic private groups. But there should be good reasons for having one.

With the introduction of the new international protocols, like maintenance of significant controller registers, common reporting standard and economic substance laws in the past few years, beneficial ownership information become more transparent and accessible by the authorities. Accordingly, the usage of holding companies incorporated in offshore jurisdictions is less popular nowadays.

Having companies incorporated in jurisdictions with extensive tax treaty networks as holding companies might look appealing. Tax treaty protection is important when there are a lot of fund flow due to intragroup passive incomes in the international structures. However, if groups merely have conduit companies as their intermediate holding companies, they will unlikely get the tax treaty protection as the holding companies are required to get tax resident certificates (TRC) with their countries of tax resident before the other contracting states would let the taxpayers enjoy the tax treaty benefits.

Nonetheless, it is unlikely that the tax authorities would issue TRCs to applicants if they do not have sufficient commercial substance. In term of commercial substance, when we choose the countries of tax resident of the holding companies, we should also consider the availability of talents, legal and transportation infrastructures and if capital could be free flow in these candidate countries. Otherwise, it may not be easy for you to maintain the business substance in the countries of tax resident.

However, appropriate use of holding companies could ease the transfer of ownership in cases with cross-border holding structures. Cumbersome administrative procedures may be involved in transfer of ownership in certain jurisdictions. If we use special purpose entities (SPE) as pure holding companies of subsidiaries incorporated in these jurisdictions, we can simply transfer the shares of the SPE rather than shares of these subsidiaries during investment exit phase or group restructuring.

In all, there are both tax and non-tax considerations for using holding companies in group structures. One should consider the unique fact patterns of the case before concluding if usage of a holding company is warranted. If yes, holding company of which particular country of tax resident should be used.

“It is unlikely that the tax authorities would issue TRCs to applicants if they do not have sufficient commercial substance.”