Hogan Lovells Publications | Pulse | Issue 5 | 4 September 2017

Pulse: U.S. tax reforms to spark global M&A activity

We are just weeks away from knowing more of the details of the much-vaunted United States tax reform package, a central pillar of the Republican Party’s legislative program for President Trump’s first term in office.

The program is expected be the most comprehensive since President Reagan’s 1986 tax reforms were introduced. But the announced details in early September will signal the start, rather than the end of the reform program. The bill’s passage into law is likely to be anything but smooth given the political pressure to ensure the changes are "revenue neutral" and other expected turf battles over the repeal of tax benefits sacred to certain sectors.

A limit on the tax deductibility of interest is also being considered, as is the elimination of the preferential capital gains rate for carried interests.

Finally, in-keeping with President Trump’s America First agenda, we think that a tax bill may well include incentives for companies to locate income-generating assets in the U.S. The 'stick' of the base erosion provisions only goes some of the way to stemming tax incentives to move U.S. generated intangibles offshore. A 'carrot' may also be needed. One option is a so-called ‘patent box’ measure, where U.S. businesses developing intellectual property in the U.S., rather than abroad, would enjoy reduced tax rates. A reduced rate for manufacturers is also possible to encourage U.S. manufacturing.

At the company level, the extent to which the tax reform measures add up to an opportunity or threat will vary but we think there will undoubtedly be winners and losers at a sector level.

Territoriality presents an opportunity for U.S. businesses to return cash, currently offshore, back to the U.S. at a lower tax rate, which in turn could fuel renewed M&A activity. This, in particular, might be a kicker for activity in the technology and pharmaceutical arenas, both of which have powered global M&A activity in recent years, with many such businesses having significant cash pools offshore. Though, a potential issue for these sectors is the proposed global minimum tax on intangibles income of 15%.

While replenished war chests might fuel domestic and outbound U.S. M&A activity, the reforms will mean that some U.S. businesses are made more attractive and ultimately vulnerable to non-U.S. takeover. A lower effective tax rate reduces the cost of locating income generating assets in the U.S. and, all other things being equal, makes US corporations more attractive for acquirers.

A potential loss of interest deductions will also serve to stymie highly leveraged deals, the takeover weapon of choice for acquisitive private equity and hedge fund groups.

Meanwhile, the financial services industry could lose out on the potential benefits of territoriality, given that so many businesses in the sector operate overseas on a branch basis, while the retail market in the U.S. will be a major beneficiary of the slashing of the corporate income tax rate to 25%, or less.

For the energy sector, the package is likely to offer up a mixed bag. The sector is likely to be hurt by the limit on interest deductibility, with infrastructure projects highly leveraged. But other aspects would be beneficial, albeit large existing tax losses may mean there is less immediate benefit.

The package could also prompt changes to the way businesses structure acquisitions in the future. Territoriality will be a further nail in the coffin of controversial inversion-led deal making. An immediate 50% depreciation on capital assets, including intangibles, could incentivize U.S. buyers to acquire these assets directly, rather than through stock deals. Private equity funds would likely change their structures if carried interests lose their capital gains tax preference.

Given the plethora of potential changes to the U.S. tax regime likely to be tabled in September, it is easy to understand why standing on the sidelines has become the M&A strategy of choice for some CEOs this summer.

But as CEOs return from their vacations, the scale and ambition of the program the Republicans are expected to put forward is becoming clearer, meaning a holding pattern will soon cease to be the appropriate option.

Understanding the implications of the likely tax reforms will be a key priority for CEOs considering M&A activity in the weeks, months and years ahead.

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