The Tax Cuts and Jobs Act (TCJA) may fundamentally shift the economics of certain transaction structures. In particular, the expanded definition of what is excluded from capital asset treatment under Section 1221(a)(3) of the code increases the likelihood that intellectual property held by a business will be taxed at higher ordinary rates upon a sale or exchange.
Buyers and sellers now face a slim margin for error, as their competing interests are likely to diverge even further than before. For buyers, there are new opportunities to enhance economic returns; for sellers, there are heightened risks.
A full-length article (linked below) discusses some new -- and some old -- tax considerations a buyer should take into account when purchasing assets, along with the allocations of value assigned to the various asset classes. It also addresses certain valuation concepts and subjective valuation methodologies that are used to allocate the purchase price to the various asset classes when a transaction is structured as the taxable sale and purchase of a business’s assets.
The value creation and value erosion of a taxable asset sale.
Buyers have historically tried to make the seller whole for the incremental tax liability that the seller incurs via gross-ups. However, the new tax rates and definitional changes under Section 1221 imposed by the TCJA compound the dichotomy between buyers and sellers. For tax years beginning after Dec. 31, 2017, the highest individual capital gains rate remains unchanged at 20%; the highest individual ordinary rate and the highest corporate rate are now 37% and 21%, respectively. Under the post-TCJA rates, a taxable asset sale could result in value erosion to an unwitting buyer.
Buyers and sellers now face a slim margin for error.
Self-created intellectual property.
The tax act modified the language that relates to certain self-created property, now describing several additional forms of intellectual property that are “self-created”—specifically, “patents, inventions, models or designs . . . ”
Under various scenarios, the Personal Efforts Provision, Prepared-for Provision and Successor Provision could require these forms of intellectual property to be treated as “self-created” even when owned by a corporation and, thus, to be treated as ordinary in nature‚ rather than as capital gains—upon disposition.
Aside from determining the character (capital versus ordinary) of property, the valuation of each asset may significantly implicate whether the acquisition of a business will result in value creation or value erosion when structured as a taxable asset sale. For example, forms of intellectual property may be valued based on their ability to capture new markets, justify premium pricing or reduce production costs. Those which are expected to generate revenue might be valued by extrapolating the profit differential they will produce, identifying the relief from royalty they will provide, or determining the portion of profit they will account for. In addition, different discounting approaches may best appraise their long-term effect. Therefore, it is crucial to obtain professional valuation advice when allocating the purchase price to each asset.
The tax act changed the landscape for negotiating certain transactions.
Be smart in a changing landscape
Prior to the TCJA, buyers and sellers were faced with considerably less risk and greater reward when structuring taxable transactions as the purchase and sale of the assets of a business with substantial intellectual property. The tax act’s expanded exclusions from capital asset treatment under Section 1221(a)(3) may cause the requisite gross-up payment to exceed the present value of the expected tax shield, resulting in value erosion rather than value creation. These structures may be economically untenable, which is why buyers and sellers should seek professional tax and valuation advice.
Read the full article here
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Managing Director, M&A Tax Services
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