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Current deal trends in M&A transaction structures18 November 2016

Disclaimer

► This presentation is provided solely for the purpose of enhancing knowledge on tax matters. It does not provide tax advice to any taxpayer because it does not take into account any specific taxpayer’s facts and circumstances.

► These slides are for educational purposes only and are not intended, and should not be relied upon, as accounting advice.

► The views expressed by the presenters are not necessarily those of Ernst & Young LLP.► This presentation is © 2016 Ernst & Young LLP. All Rights Reserved.

EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms ofErnst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com.Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the US.

Today’s presenters

Klaus MetzPartner, Transaction TaxErnst & Young LLP +1 212 773 [email protected]

Barbara HobbsSenior Manager, Transaction TaxErnst & Young LLP +1 212 773 [email protected]

Agenda

► General market trends/diligence► UP-C structure► Outbound acquisition structures► Final Section 385 regulations► Deal fees — Section 1234A

General market trends/due diligence

General global trends/due diligence

► Changing tax legislation globally► Timing of deal execution – diligence periods more and

more compressed► Auctions – limited information until exclusivity► Indemnifications replaced by reps and warranty insurance► Base erosion and profit shifting (BEPS) (next slide)

BEPS impact on deals

► Manage potential reputational impacts: engage with boards early in transaction processes; carry out a reputational risk assessment

► Plan for and value the impact of BEPS: analyze the target’s tax risk profile against each of the BEPS action items

► Plan for and value the impact of CBCR: analyze the target’s country-by-country reporting (CBCR) profile for areas of opportunity or weakness:► The target group’s cash or accounting tax rate in certain jurisdictions may be

significantly lower than the corresponding statutory corporate tax (CT) rate.► The target group may have transfer pricing (TP) policy or financing, intangible or

service arrangements that may attract tax authority scrutiny. ► The target group’s profit margins may not be consistent with its TP policy, or the TP

policy may be applied inconsistently between similar operations in differing jurisdictions.

► Significant income may be generated in jurisdictions with little economic substance.

UP-C structure

UP-C structureKey objectives and benefits

► Well-accepted public structure used to raise equity capital► Tax receivable agreement (TRA) increases return to

legacy owners as compared to traditional IPO structures► Exchange rights provide liquidity to legacy owners► Preserve tax efficiency for legacy owners

UP-C structureRepresentative transaction steps

► Step 1: Legacy owners acquire high vote stock (Golden shares) in a newly formed C corporation (PubCo).

► Step 2: PubCo issues regular common stock to the public in an IPO for cash.

► Step 3: PubCo contributes cash to the partnership (OpCo) for interest in Opco:► PubCo holds the managing interest in

OpCo.► Legacy owners’ units in OpCo are

exchangeable for stock in PubCo on a one-for-one basis.

PubCo

OpCo

Legacy owners Public

Business

LP GP or managing interest

Golden shares

Commonstock

UP-C structureTax receivable agreement

► UP-C structure provides PubCo with a “step-up” in the tax basis of its share of the partnership’s assets upon legacy owners’ exchange of units (in contrast to a traditional IPO).

► PubCo and legacy owners share the benefit of the step-up (generally 85% to the legacy owners and 15% to PubCo).

► TRA payments are typically made in cash and are treated as additional purchase price paid by PubCo for units in OpCo (and interest), generally resulting in additional basis step-up.

► TRA provides legacy owners with additional cash payments as compared to a traditional IPO.

► Market does not appear to view presence of the TRA negatively.► Different types of basis adjustments and other tax attributes may or

may not be covered under the TRA.► Benefit of TRA is subject to anti-churning considerations.

UP-C structureSimple TRA example

► Assumptions:► Step-up delivered to PubCo: $100► Step-up allocated entirely to intangible assets amortizable over 15

years► PubCo effective tax rate: 40%► TRA payment ratio: 85% to legacy owners► Discount rate for net present value: 8%► PubCo: has sufficient taxable income to utilize amortization as

generated► Iterative effect of TRA payments on basis step-up and interest

payments ignored for this calculation

UP-C structureSimple TRA example

YearPubCo

amortization PubCo cash tax savingsTRA payment to legacy

ownersNet cash savings to

PubCo

1 6.67 2.67 2.27 0.40

2 6.67 2.67 2.27 0.40

3 6.67 2.67 2.27 0.40

4 6.67 2.67 2.27 0.40

5 6.67 2.67 2.27 0.40

6 6.67 2.67 2.27 0.40

7 6.67 2.67 2.27 0.40

8 6.67 2.67 2.27 0.40

9 6.67 2.67 2.27 0.40

10 6.67 2.67 2.27 0.40

11 6.67 2.67 2.27 0.40

12 6.67 2.67 2.27 0.40

13 6.67 2.67 2.27 0.40

14 6.67 2.67 2.27 0.40

15 6.67 2.67 2.27 0.40

Total 100.00 40.00 34.00 6.00 Nominal value to legacy owners $34.00 Net present value to legacy owners $19.40

IP planning

Current topicsNotice 2015-54

► Notice 2015-54 closes gap between transfers of appreciated property to partnerships compared to outbound transfers to corporations, which fall under Sec. 367.

► New rules are designed to prevent the US transferor from shifting built-in gain to related foreign person.

► The general non-recognition rules of Sec. 721(a) allowed tax-free contributions of appreciated property to partnerships in exchange for partnership interests:► The “ceiling rule” limited the capacity to remedy book/tax disparities in those situations in which

there are insufficient tax items to match with book items, resulting in potential shift of gain to non-contributing partners.

► The “remedial method” is now mandatory and operates to eliminate the potential for shifting the tax burden associated with contributed property away from the contributing partner by eliminating the effect of the ceiling rule.

► There is a need to follow residual method properly, and allocate income, gain or loss in the same proportion among partners, or else there is risk of not satisfying requirements of the gain deferral method, which would trigger an “acceleration event,” causing immediate recognition of built-in gain:► No longer are special allocations allowed that would shift income or gain from US to foreign

partners, based on partnership agreement, which could disproportionately allocate income to foreign partner and deductions to US partner.

Current topicsExample 1: Contribution of IP (traditional method)

► Under the traditional method, the $15m section 704(b) book basis of the intangible is amortized over 15 years (i.e., $1m per year), allocated 40% to USP (i.e., $0.4m per year) and 60% to FS (i.e., $0.6m per year).

► Because the tax basis of the intangible is zero, neither partner is allocated tax amortization to match its allocation of section 704(b) book amortization (i.e., $0.4m for USP and $0.6m for FS).

► Accordingly, under the traditional method, USP effectively recognizes only $6M of built-in gain inherent in the intangible (from lack of tax amortization of $0.4m per year for 15 years).

► The remaining $9m of built-in gain is still embedded in USP’s partnership interest.

► Under the notice, the use of the traditional method in Example 1 would violate the requirements of the “gain deferral method,” and so the transfer of the intangible to PRS would be fully taxable up front.

PRS

USP

FS

60%40%

US parent (USP) contributes an amortizable Section 197 intangible for a 40% partnership (PRS) interestAdjusted basis (AB) = $0Fair market value (FMV) = $m

FS contributes $22.5m cash for a 60% PRS interest

Assume that PRS allocates all section 704(b) items of income, gain, loss, and deduction 40% to USP and 60% to foreign subsidiary (FS) and adopts the traditional method with respect to the intangible

Current topicsExample 2: Contribution of IP (remedial allocation method)

► Under the remedial allocation method, the $15m section 704(b) book basis of the intangible is amortized over 15 years (i.e., $1M per year), allocated 40% to USP (i.e., $0.4m per year) and 60% to FS (i.e., $0.6m per year)

► PRS allocates to FS notional tax amortization of $0.6m per year and matches this with an allocation of $0.6m of remedial income to USP:

► The character of this income is identical to the character of the income generated by the contributed property.

► Additionally, USP does not receive any tax amortization to match its allocation of section 704(b) book amortization (i.e., $0.4m per year).

► Accordingly, under the remedial allocation method, USP effectively recognizes the entire $15m of built-in gain inherent in the intangible (from remedial income of $0.6m and lack of tax amortization of $0.4m each year for 15 years).

► Because the remedial allocation method is used and all section 704(b) allocations are straight up, the transfer of the intangible to PRS in Example 2 should qualify under the “gain deferral method” (assuming compliance with the reporting requirements).

PRS

USP

FS

60%40%

USP contributes an amortizable Section 197 intangible for a 40% PRS interestAB = $0FMV = $15m

FS contributes $22.5m cash for a 60% PRS interest

Assume that PRS allocates all section 704(b) items of income, gain, loss, and deduction 40% to USP and 60% to FS and adopts remedial allocation method with respect to the intangible

Outbound acquisitions

Acquisition indebtedness exception — third party debt

Steps1. USP borrows from lenders to finance acquisition of

UST

2. USP purchases stock of UST

3. UST distributes US tangible assets, workforce in place and cash to USP.

4. UST reincorporates into F Newco

5. USP transfer F Newco to F Holdco in exchange for F Holdco stock and F Holdco’s assumption of USP’s acquisition indebtedness

Consequences/considerationsa. Outbound reorganization not subject to Notice

2012-39

b. Section 385 Regulations do not apply since there is no internal debt

c. F Holdco’s assumptions of debt should not result in application of Section 304 under acquisition indebtedness exception. See §304(b)(3)(B)

d. Qualification under §351; Tax-free debt assumption under §357

OutboundUST F Newco

USP

F Holdco

F Newco

4

3

1

2

Lenders$

Acquisition indebtedness exception —intercompany debt

Steps1. USP borrows from CFC.

2. USP purchases stock of UST.


4. UST reincorporates into F Newco.

5. USP transfers F Newco to F Holdco in exchange for F Holdco stock and F Holdco’s assumption of USP’s acquisition indebtedness.

Consequences/considerationsa. Outbound reorganization is not subject to

Notice 2012-39.

b. Section 358 Regulations may apply due to use of internal debt. Consider implications of funding rule and anti-abuse rule on step 4.

c. F Holdco’s assumptions of debt should not result in application of Section 304 under acquisition indebtedness exception. See §304(b)(3)(B).

d. Qualification under §351; Tax-free debt assumption under §357.

F Holdco Stock and debt

assumption

Note

OutboundUST F Newco

USP

F Holdco

F Newco

4

3

1

2

CFC

Note

Share redemption

OutboundUST F Newco

USP

F Holdco

Cash

Steps1. USP acquires UST.


3. UST reincorporates into F Newco.

4. F Holdco contributes cash to F Newco in exchange for Class B common stock.

5. F Newco redeems a portion of its common stock from USP in exchange for cash.

Consequences/considerationsa. Outbound reorganization is not subject to Notice

2012-39.

b. Section 385 Regulations do not apply since there is no internal debt.

c. Redemption treated as §301 distribution:

i. 80% DRD to extent of US earnings and profit (E&P)

ii. Return of capital

d. Cash-in/cash-out should be respected. Rev. Rul. 75-447 and Treas. Reg. §1.385-3(b)(3)(vi)

21

Cash

3

Class B C/S

C/S

Final Section 385 regulations

What changed in the final and temporary regulations?

► New/expanded exemptions and exclusions (e.g., first $50 million of recast debt, compensatory stock, post-4 April 2016 E&P)

► Exclusion for certain regulated industries

► Numerous exemptions and exclusions (e.g., qualified short-term debt instruments, certain acquisitions of subsidiary stock)

► Exclusion for certain regulated industries

► Documentation due on return filing date► Disregarded entity (DRE) debt recast into

equity of regarded owner► Exclusion of debt issued by partnership► Master agreements blessed► Annual debt capacity study allowed► Reservation on no affirmative use

► Eliminated

Apply to interests issued by domestic

corporations

Exclude (reserve on) interests issued by foreign corporations

Exclude interests issued by

non-captive real estate investment trusts (REITs) and

regulated investment companies (RICs)

Do not apply to instruments issued

within US consolidated group

Documentation RuleProp. Reg. §1.385-2

Transaction Recharacterization Rule

Prop. Reg. §1.385-3(b)(2)

Bifurcation RuleProp. Reg. §1.385-1(d)

Funding Recharacterization Rule

Prop. Reg. §1.385-3(b)(3)

Documentation rules overview Impact

► Treas. Reg. section 1.385-2 sets forth minimum threshold documentation, timing, and maintenance requirements that must be satisfied regarding the preparation and maintenance of documentation and information with respect to an expanded group member:► It applys to a smaller universe of related-party instruments.► It still contains four categories of documentation requirements for related-

party instruments to be respected as debt.► Failure to satisfy any requirement will result in debt being treated as stock

for all US federal tax purposes (unless an exception applies).► Satisfaction of documentation requirements does not ensure debt

treatment.► It is effective for instruments issued on or after 1 January 2018.► Documentation must be completed by due date of issuer’s federal income

tax return (taking into account extensions).

Documentation rules overviewScope

► “Applicable instrument”:► Instrument issued in debt form► Excludes instruments issued within US consolidated group► Regulations reserve on debt issued in other forms► Debt created by revolving credit agreements, cash pools (including certain notional

pools), open accounts and trade payables (i.e., intercompany payable and receivable documented in a ledger, accounting system, open intercompany debt ledger, journal entry or similar arrangement if no written legal instrument or written legal arrangement governs the legal treatment of such payable and receivable)

► Issued within an “expanded group”:► Affiliated group► Special attribution rules► 80% vote or value► Public-trading/asset value/revenue threshold

► Issued by a “covered member” of an expanded group:► A domestic corporation (inclusion of foreign corporations reserved)► A disregarded entity with covered member as regarded parent

Indebtedness factorsOverview

► The Documentation Rules impose contemporaneous documentation requirements on certain related-party instruments as a prerequisite to treating these instruments as debt.

► The rules generally written documentation of the four indebtedness factors:► Issuer’s unconditional obligation to pay a sum certain► The holder’s rights as a creditor► The issuer’s ability to repay the obligation► The issuer’s and holder’s actions evidencing a debtor-creditor

relationship, such as payment of interest or principal and actions taken on default

Indebtedness factorsBinding obligation to repay and creditor’s rights

► Indebtedness factors 1 and 2 require, consistent with the proposed regulations, evidence of:► Binding obligation to repay (factor 1):

► Clear, binding agreement:► “There must be written documentation prepared ... establishing that the issuer has entered into an

unconditional and legally binding obligation to pay a sum certain on demand or at one or more fixed dates.”

► Creditor’s rights to enforce terms (factor 2):► Terms of loan must include typical lender protections in event of default or financial

distress:► “The written documentation ... must establish that the holder has the rights of a creditor to enforce

the obligation.”

► Changes/clarifications in final regulations:► Market standard, regulatory terms safe harbors for indebtedness

factors 1 and 2► Use of master agreement for expanded group instrument (EGI) issued under

revolving credit agreements, cash pooling and similar arrangements

Indebtedness factorsReasonable expectation of repayment

► Reasonable expectation of repayment (factor 3):► Consistent with proposed regulations:

► Analysis of financial condition of borrower at issuance► Written documentation establishing financial condition as of date of issuance► Based on all relevant circumstances► Issuer’s financial position that supported a reasonable expectation that the

issuer intended to, and would be able to, meet its obligations under the terms of the debt

► Changes in final regulations:► Refinancing assumptions may be used to support ability to repay.► A single, annual credit analysis may cover multiple EGIs issued by the same

borrower and no material event.► Evidence that a third-party lender would have made a loan with same or similar

terms as EGI may be included as documentation supporting this factor.

Indebtedness factorsGenuine debtor-creditor relationship

► Genuine debtor-creditor relationship (factor 4):► Consistent with proposed regulations:

► Ongoing documentation after issuance:► “If an issuer made any payment of interest or principal ... documentation

must include written evidence of such payment”:► Wire transfer record► Bank statements

► Must document action taken to mitigate any events of default

► Final regulations provide that evidence of payment may include:► Netting of payables or receivables between issuer and holder► Payments of interest evidenced by journal entries in a cash

management or accounting system of expanded group ► Considerations:

► Abide by terms of debt► May require enhancements to internal treasury system(s)

Exceptions to documentation requirements

► Rebuttable presumption:► High percentage of EGIs compliant► Sufficient common law debt factors

► Reasonable cause► Ministerial or non-material failure or error

Deal fees — Section 1234A

Section 1234A

► Recent developments related to §1234A► Termination fees paid in connection with stock

acquisitions► Capitalized costs in connection with stock acquisitions

Section 1234A Termination fees paid in connection with stock acquisitions

Statute► Gain or loss attributable to the cancellation, lapse,

expiration, or other termination of a right or obligation (other than a securities futures contract as defined in §1234B) with respect to property which is (or upon acquisition would be) a capital asset in the hands of the taxpayer shall be treated as gain or loss from the sale of a capital asset in the hands of the taxpayer.

Section 1234ATermination fees paid in connection with stock acquisitions

► Legislative history► 1981 – statute enacted to address publicly traded financial

products; the concern was whipsaw:► Joint Committee on Taxation (JCT) example: a taxpayer might

have simultaneously entered into a contract to buy German marks for future delivery and a contract to sell German marks for future delivery with very little risk. If the price of German marks thereafter declined, the taxpayer sold his contract to sell marks to a bank or other institution for a gain equivalent to the excess of the contract price over the lower market price and cancelled his obligation to buy marks by payment of an amount in settlement of his obligation to the other party to the contract. The taxpayer treated the sale proceeds as capital gain but treated the amount paid to terminate his obligation to buy as an ordinary loss.

Section 1234ATermination fees paid in connection with stock acquisitions

► In 1997, Congress expanded the statute to all capital assets, in part to address the extinguishment doctrine

► Senate report:► An example of the first type of property interest that will be affected

by the committee bill is the tax treatment of amounts received to release a lessee from a requirement that the premise be restored on termination of the lease. See Billy Rose Diamond Horseshoe, Inc. v. Commissioner, 448 F. 2d 549(1971) (where the Second Circuit held that payments were not entitled to capital gain treatment because there was no sale or exchange). An example of the second type of property interest that is affected by the committee bill is the forfeiture of a down payment under a contract to purchase stock. See U.S. Freight Co. v. U.S. F.2d 887 (Ct. Cl. 1970) (holding that forfeiture was an ordinary loss).

US Freight Co. v. U.S.190 Ct. Cl. 725 (1970)

Facts:► Taxpayer (TP) entered into a contract to acquire the stock

of a company that operated ocean-going vessels and made an advance payment. TP rescinded, and the advance payment was retained as liquidated damages. TP reported the advance payment as an ordinary loss.

Holding:► Court held that forfeiture of a down payment as liquidated

damages was not a sale or exchange of a capital asset and thus was deductible as a loss.

US Freight Co. v. U.S.

Holding (continued)► Court of Claims:

► “Where property is purchased and then resold, there can be no doubt that a sale in its most basic form has taken place. And in the quite different situation where an option to purchase property expires without having been exercised, a specific statutory provision, section 1234(a) supplies the necessary sale or exchange upon which capital loss treatment depends. But in the case now before us, where a contract to purchase property is unilaterally breached by the buyer, the right to purchase being thereby relinquished, and the down payment is forfeited as liquidated damages, we perceive no sale or exchange in the traditional sense, nor do we understand there to be a statutory provision to satisfy the requirement.”

Previous IRS positionPLR 200823012

► Facts:► Taxpayer entered into an agreement to acquire Target stock for cash and

Taxpayer stock. Target was ultimately acquired by another third party, so Target paid a termination fee to Taxpayer as required by the agreement.

► Conclusion:► IRS concluded, without any analysis, §1234A does not apply to treat the

termination fee as a capital gain:► Compare §1234A legislative history, which states it would apply to “the

forfeiture of a down payment under a contract to purchase stock”► It is ordinary income because origin was for the recovery of lost profits. ► Termination fee provisions analogized to damages for breach of contract

that are intended to compensate for the loss of expected benefits, which may include lost profits. The agreement did not allocate breakup fee between lost profits and other capital asset.

Recent developmentsFAA 20163701

► Facts:► The taxpayer and a target company entered into an agreement

expressing their intent to merge by forming a new company to which they would become subsidiaries.

► The agreement also provided that the shareholders of both the taxpayer and target would receive a certain amount of stock and the taxpayer would pay the target a “break fee” if the taxpayer withdrew its recommendation for the merger.

► Before the merger occurred, the IRS “issued a notice that adversely affected the expected tax benefits of the proposed merger.”

► The taxpayer subsequently withdrew its recommendation for the merger and paid the target a break fee. The fee represented the target’s sole remedy for the cancellation of the merger.

Taxpayer Target

Parent

Recent developmentsFAA 20163701 (continued)

Before transaction

Parent

Taxpayer Target

After transaction

Recent developmentsFAA 20163701 (continued)

In the conclusion, the IRS noted that: ► Stock received as a result of the merger would have been a

capital asset in the taxpayer’s hands. ► The contract between the parties gave the taxpayer rights and

obligations with regard to the stock.► As the target’s sole remedy, the break fee “was in the nature of

liquidated damages rather than as compensation for services.”

► Because the break fee “relates to a contractual right and obligation concerning a capital asset,” the taxpayer’s obligation to pay the break fee amounted to a capital loss under §1234A.

Recent developments ILM 201642035

Facts► Acquirer entered into an agreement to acquire the stock of Target by

merging Target with a newly formed, wholly owned subsidiary of Acquirer. An agreement between Acquirer and Target required Target to pay a $1 million termination fee. Target terminated the agreement for enumerated reasons. Target received a superior offer from another corporation and terminated its agreement with the acquiring corporation, triggering the termination fee. ► Scenario 1: How is loss determined if Acquirer spent $1.1 million in costs

pursuing Target under Treas. Reg. 1.263(a)-5(e)?► Scenario 2: How is gain determined if Acquirer spent $200,000 in costs

pursuing Target under Treas. Reg. 1.263(a)-5(e)?

Recent developmentsILM 201642035

ConclusionThe gain or loss is determined by reducing the termination fee amount by the Acquirer’s costs incurred in pursuing Target. Section 1234A applies to the gain or loss realized.

► Scenario 1: Acquirer would have $800,000 of capital gain if it spent $200,000 in costs to pursue Target.

► Scenario 2: Acquirer would have a $100,000 capital loss if it spent $1.1 million, which may be deducted under section 165, subject to the rules on capital loss limitations and carryovers.

Reasoning► In either scenario, the Target stock would be a capital asset to

Acquirer upon acquisition. Consistent with the purpose of section 1234A, any gain or loss realized by Acquirer on the termination of the Contract would be capital in nature.

EY | Assurance | Tax | Transactions | Advisory

About EYEY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities.

EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com.

Ernst & Young LLP is a client-serving member firm ofErnst & Young Global Limited operating in the US.

© 2016 Ernst & Young LLP.All Rights Reserved.

1610-2086733ED None

This material has been prepared for general informational purposesonly and is not intended to be relied upon as accounting, tax or otherprofessional advice. Please refer to your advisors for specific advice.

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