On August 16, President Biden signed the Inflation Reduction Act of 2022 (the “IRA”) (see our prior memo), which imposes a new 15% corporate book minimum tax (the “BMT”). The BMT is imposed, effective for taxable years beginning after December 31, 2022, on the “adjusted financial statement income” (“AFSI”) of large U.S. corporations (other than S‑corporations, REITs and regulated investment companies) with average AFSI in excess of $1 billion over the preceding three-year period. Adjusted financial statement income is net income in a corporation’s audited GAAP financial statements filed with the SEC (or certain other specified financial statements) subject to certain adjustments, including for accelerated tax depreciation and financial statement loss carryovers.
By introducing a parallel tax on a base determined under financial rather than tax accounting principles, the BMT will add significant complexity to U.S. corporate taxation, including in the M&A context. And, due to the many differences between the two sets of rules, commonplace M&A and financing transactions could produce unexpected tax results.
Corporate Divisions. Under Section 355 of the Internal Revenue Code, a tax-free separation of two businesses may be effected as a “spin-off” (where the parent corporation distributes the shares of a subsidiary corporation to all of its shareholders) or a “split-off” (where the parent corporation distributes the subsidiary shares in exchange for a portion of its own shares). Under U.S. GAAP, it is our understanding that a pro rata spin-off does not result in gain recognition for financial statement purposes, but a split-off does. Accordingly, in certain fact patterns, a corporation effecting a split-off could face a significant BMT liability, even though the transaction satisfies the numerous requirements for tax-free treatment under Section 355 of the Code.
Corporate Acquisitions. For income tax purposes, an acquisition structured as a taxable asset purchase (or deemed asset purchase by reason of a Section 338 election) typically results in a “step up” in the tax basis of the acquired assets, including goodwill, which is depreciable by the buyer. In contrast, an acquisition structured as a tax-free “reorganization” or as a taxable stock purchase does not result in a step up in the tax basis of the target’s assets. Under U.S. GAAP, purchase accounting would result in the target’s assets being reflected at fair value regardless of the tax treatment of the acquisition. Because goodwill is not amortized under current U.S. GAAP, a taxable asset purchase (or deemed asset purchase) could give rise to adjusted financial statement income of the buyer that significantly exceeds its taxable income. In such a case, the BMT could reduce or eliminate the buyer tax benefits typically associated with a taxable asset purchase.
Other Considerations. Other examples of divergent income tax and U.S. GAAP treatment may include certain partnership transactions, corporate liquidations and formations, as well as operational and financing matters, such as expensing of compensatory equity awards, and limitations on the deductibility of interest expense for income tax purposes. There could also be differences in the treatment and utilization of target net operating loss carryforwards and the treatment of deal-related expenses, and the BMT may prevent corporate taxpayers from realizing the benefits of certain income tax preferences, including lower tax rates under the “foreign derived intangible income” and “GILTI” regimes.
Finally, in light of the $1 billion average AFSI threshold, M&A activity could affect whether a taxpayer is subject to the BMT in the first place. A combination of two businesses with average AFSI below the threshold could cause the combined business to exceed the threshold, bringing the resulting corporation into the BMT’s purview. However, it is unclear whether a disposition (e.g., a sale or spin-off) that causes the divesting corporation to no longer satisfy the average AFSI threshold will remove such corporation from the application of the BMT. Under the IRA, once a corporation satisfies the average AFSI threshold, it remains subject to the BMT unless the IRS determines, in situations where a corporation has an ownership change or fails to satisfy the average AFSI threshold for a specified number of consecutive years, that it “would not be appropriate” to continue to treat such corporation as subject to the BMT. Corporations engaging in M&A transactions will need to keep abreast of regulatory developments, diligence the tax and financial statement profiles of all relevant parties and model the financial accounting for the business combination to determine the expected impact, if any, of the BMT on the transaction and the business going forward (including whether the resulting entity or entities are likely to have average AFSI in excess of $1 billion).
Although regulatory guidance eventually may alleviate some of the uncertainties and discrepancies, corporate taxpayers must navigate a more complex environment post-IRA. Transactional tax practitioners will no longer be able to rely on long-standing knowledge and intuition in determining the tax consequences of M&A transactions. Just as detailed modelling has become critical in evaluating acquisitions and dispositions of non-U.S. targets following wide-ranging changes in U.S. international tax rules in 2017, the post-IRA environment heightens the need to understand book-tax differences arising in the M&A context.
This post comes to us from Wachtell, Lipton, Rosen & Katz. It is base on the firm’s memorandum, “Book Minimum Tax and M&A,” dated August 29, 2022.