Hidden Tax and Legal Tribulations in Fair Value Measurements for Acquisition Accounting

Asset values determined by generally accepted accounting principles (GAAP) do not establish tax basis, but the document trail left for financial reporting can be a mine field of unintended consequences.  

The organizational structures around M&A activity vary widely; acquisitions are often contemplated and executed by a small team of business-development specialists with limited input from the rest of the organization. Even though tax and legal specialists are frequently involved in the due diligence process, after the deal is completed the post-close team is often restricted to a smaller group of operational and financial reporting managers as the acquirer focuses on the difficult task of integration and limits the involvement of the larger organization.

A thorough due diligence process that evaluates the key elements of a transaction may not consider the developments that occur post-close. One of the major post-close tasks is the acquisition valuation work that is generally not undertaken until after the due diligence report is completed. The valuation work, frequently developed without the benefit of the diligence report, is overseen by the financial reporting group, who may be unaware of the tax planning strategy or the concerns of the legal department. The result can be the memorialization into the valuation work of facts and assumptions whose impact is not known by those responsible for reviewing the draft analysis.

As an example, earlier this year the Tax Court determined that a taxpayer, Peco Foods, Inc. and Subsidiaries (Peco), could not perform a cost segregation study (which might have yielded a significant tax benefit in the form of accelerated depreciation) because of certain language found in the purchase agreement. The agreement specified that the determined “allocation will be used for all purposes (including financial accounting and tax purposes).”  (See the May 2012 WTAS Newsletter The Peco Case: Are You Giving Enough Attention to Details in Purchase Price Allocations? for more information on the Peco case.) If Peco’s tax advisors had been involved in thoroughly reviewing the purchase price allocation at the time of acquisition, they might have been able to mitigate this issue and leave open the possibility of a cost segregation study in the future.

Financial reporting valuations often consider non-compete agreements. If there is an Internal Revenue Code Section 280G [1] issue for the sellers, the seller’s non-compete valuations could be dramatically different from the financial reporting valuations. Given that non-compete valuations include assumptions related to the impact of a particular individual competing and the probability that he would compete without the agreement in place, it is easy to imagine divergent views between the buyer and the seller on these key inputs.

In international transactions, the appraiser may value customers, trade names, and technologies in various jurisdictions. This “trail” of value and the underlying economic assumptions could be different from the economic analysis developed in transfer pricing studies. In the best case, these discrepancies could prevent tax planning strategies that might otherwise be available; in the worst case, they could present contradictory evidence to that developed in previous transfer pricing work and jeopardize the benefits of existing structures and strategies.

The valuation report could also imply that an asset resides in a particular legal entity when in fact, the proper entity “ownership” is less clear and subject to some interpretation.  With foresight, the asset could be strategically assigned, and future planning opportunities could be maintained.

Finally, in certain litigious industries such as medical devices, companies often find themselves the subject of patent infringement suits related to technologies. If not properly developed and presented, opposing counsel may find damaging evidence related to management’s views on appropriate royalty rates or other assertions on the market factors affecting value. An improperly worded report could unwittingly cost a company its best legal defense.

The solution is simple. The tax and legal teams that are often active during the diligence process should participate on the front end in valuation planning meetings, and companies should seek valuation experts with experience in navigating through these issues during the valuation process. The initial meetings are the best time to identify tax or legal issues and the prior work done in the jurisdictions or functional areas of the acquired business. Examples include expected profit margins for the distribution activities for certain products or prior royalty rates for the transfer of technology between the country entity that owns the intellectual property and the market where the goods are produced and/or sold. As the Peco case illustrated, a review of the language in the purchase agreement or purchase price allocation can also impact future opportunities to revisit financial reporting valuations for tax purposes. Finally, it may also be appropriate in litigious industries for legal counsel to review and comment on draft reports before they are finalized so as to minimize the risk of potential controversy down the road.

[1] Internal Revenue Code Section 280G provides for penalties on excess parachute payments to executives of target companies in transactions.