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Ripples from US tax reform are reaching across the ‘pond’, with the potential to create new capital and deal dynamics for UK companies – even those without US operations. In this week’s blog, I’ll set out how and why I think US tax reform has the potential to change UK deal making from start to finish – and why we need to see these reforms in a broader context.
What you need to know
In short, US tax reforms provide a strong incentive for companies with US operations to locate and keep capital, supply chains, investment and intellectual property in the US.
- Statutory corporate tax cut rate from 35% to 21%
- Limit on interest expense of 30% of EBITDA (30% of EBIT from 2022)
- Full capex expensing until 2022, when the benefit will be phased out
- Restrictions on the use of NOLs (Net operating losses)
- A move to a territorial-based system for multinationals with a one-time repatriation tax on previously deferred foreign income – payable over eight years.
- Measures that limit the ability to shift taxable earnings outside the US (BEAT) and effectively create a minimum tax on offshore earnings (GILTI & FDII)
Please see our US Tax Reform website for more detail
But how exactly will this change behaviour?
The short answer is that no-one is certain. But we can start a conversation about the potential impact of these reforms, highlighting areas where we think companies should prepare for change. And I think it’s vital that we do so now, given potential for these reforms to be game-changing in just about every aspect of corporate life.
All of these areas will feed into deal making, which is where I’ll focus my attention today.
What happens in the US…
To understand what might happen in the UK, I think we need to start with the US.
Clearly, most US companies will benefit from the headline tax cut. Very few companies had a 35% tax rate under the old regime and we need to add local taxes and the impact of other changes to the new 21% headline rates. Nevertheless, US companies and overseas companies with US operations are almost universally signalling a drop in their effective tax rates. Early indications are that companies will take a blended approach to their extra cash flow, splitting this between dividends, investment – including M&A, and employee rewards.
There is a good chance that a good chunk of this M&A cash is spent in the US – and that it is joined by previously ‘trapped’ overseas cash’ due to wide-ranging multinational tax reform. We expect to see big changes in financial management, especially in life sciences and technology, where companies have typically accumulated large pools of offshore cash and investments, whilst using debt to finance domestic investments, share buybacks and dividends. The reforms free-up this cash and provide a strong incentive to choose domestic over foreign investment.
The top 10 US life sciences companies have roughly US$175b in cash overseas
The change in interest deductibility also rejigs the debt maths, potentially increasing the incentive to look at alternative locations and capital structures, such as preference shares or convertibles. This won’t be an issue for most companies, since the average US corporate leverage levels are below the 30% threshold. The biggest loser is Private Equity and the leverage deal model. Existing deals should be able to offset the tax cuts against the reduced deductible. Debt also remains cheap – lessening the blow. But, PE’s ability to compete for assets really takes a hit from 2022, when the 30% expensing limit moves to EBIT from EBITDA. It could also increase the challenges for highly leveraged companies should we head into a downturn.
…causes ripples across the pond.
How will this affect UK companies’ deal-making? I’ve picked five main areas…
1. M&A: The reduction in corporate tax rates means that vendors of US businesses will enjoy a significant tax break (up to 22% increase after tax proceeds). This is likely to result in many companies (both in the US and globally) revisiting the potential disposal of non-core assets in the US, where it was previously too tax-inefficient to sell.
2. Cash: Our analysis of the UK results season so far shows that most UK companies with US operations expect a low to mid-single digit drop in their effective tax rates. Most of this will probably be returned to shareholders. But, we expect a good proportion of this to find its way into deals – and for those shareholders to invest themselves. The big question is where?
3. Valuations: US assets have suddenly become more desirable; but increased attractiveness plus capital influx normally equals higher valuations. Price may offset the tax benefits for UK companies re-doing their US acquisition sums. But, they might find more joy closer to home if US companies increase their domestic focus and US PE is disadvantaged, lowering competition and valuations in Europe. A PE buyer buying a US company with significant non-US companies will face a ‘double-whammy’ – will they pass or sell on these assets?
Lots of ‘ifs and buts’ and other moving parts – see below – but an area to watch.
4. Structures: These reforms ostensibly make the US a less attractive location to hold debt and increase the attractiveness of alternative products and structures. But, the picture is arguably more nuanced. There is still a significant amount of liquidity in the US market available on very generous terms for investment grade lenders. If US lenders find the pool of borrowers shrinking further, will terms loosen again changing the maths yet again?
5. Analytics: Just on a very basic level, the modelling of current and future deals with US components has immediately become more complex, with more moving parts and expiration dates to factor in. This will also affect post-acquisition integration and purchase price allocation calculations. Indeed, companies will need to re-visit previous post-deal integration synergies and other sums. They also may need to review and refine transaction diligence procedures. Overall, this increases the importance of analytics and of defining operating models up front to enable teams to work through synergies by jurisdiction and to model areas like supply chain and tax rate early on.
Tax doesn’t have to be taxing…
Given the extent of current deal reciprocity between the UK and US, it’s possible that that a more domestic US focus could have a disproportionate impact on the UK deal market. On the other hand, current evidence suggests that US companies are still interested in UK assets.
We’re obviously still in the very early days, but I think this conundrum underlines the complexities of M&A in a world where deal maths is being constantly re-written by changing growth rates, volatile exchange rates, technological advance and policy change – to name but a few variables. US tax reform is just one part of the deal equation – albeit now a much more important one. But, ultimately, deals still need to add up strategically and desirable markets and technologies can still tip the balance.
I think this all makes for a really dynamic deal market in 2018. Maybe not with the same level of mega-deals, but with more companies rethinking their portfolios – as our latest Global Divestment Study confirms. Interesting times.
You can find more perspectives on our dedicated UK focused US Tax Reform web page.
We welcome your comments and please contact us, if you would like to discuss further.