Doing the Right Deals: how tax can make or break a carve-out
By Novella De Renzo and Jo Bello
The past few years has seen a steady rise in the number of carve-out deals across most sectors. The desire for many companies to refocus on their core business, or transition to net zero suggests that this trend of separations and divestments will continue. Carve outs are an attractive option, allowing sellers to raise funds, refocus priorities, and rationalise complex group holdings. But as with any deal, there are considerable risks involved which mean that many divestments don’t reach their full potential. Our research has shown that 57% of divestors underperformed their industry peers, on average, in the 24 months following completion of a deal.
We have long argued that value creation should be at the heart of every deal, from the earliest planning stage through to post-completion. Carve-outs are no exception, as our colleague Shane Horgan pointed out recently. But in any complex transaction there are many spinning plates to tend to if you are to maximise value – including some that can be often neglected.
Transfer pricing and indirect tax
So, in this spirit, let’s talk about the role of two key areas of tax: transfer pricing and indirect tax and the significant impact they can have on value creation in carve-outs. This may not be top of everyone’s minds when a deal is being struck but it’s something that can cost millions if it’s not considered at the outset. As we’ve said before, tax is too often an afterthought rather than an integral element of deal evaluation and strategy – the focus tends to be on profits, price and deal strategy. But tax matters – it matters enough to torpedo a deal if you don’t get it right.
Everything starts with the carve-out perimeter
A carve-out perimeter is set around business assets that are going to be sold, including the people that work within them. This could mean creating a new legal entity and all the administration that comes with that, or an agency agreement might operate in the meantime to maintain customer or client relationships. Either way, there will be profound implications for transfer pricing and VAT - from asset and inventory transfers to where people work and what they do - these will all have tax consequences.
Where the functions, assets and risks are will determine the transfer pricing model that needs to be adopted in order to align with the business operating model and ensure tax robustness. Understanding the future operating model, and the transfer pricing model that goes with it, is critical to understand where assets, people and decision making need to be positioned and how it impacts on the legal separation. An effective tax rate (ETR) model can be used, as a tool to understand the different tax implications, to ensure that business decisions are optimised considering the full length of a company’s profit and loss (P&L) statement.
Indirect taxes, such as VAT, are arguably the most neglected of all when it comes to deals, but when business assets are sold, aligned to the operating model and transfer pricing vision, they become very important indeed. If you get this wrong, the costs – and disruption – can be huge. Similarly, carve-outs that involve only the sale of shares rather than business assets are not immune from VAT concerns. VAT will be payable on most transaction costs, and that’s likely to be a significant sum.
Key questions
The tax implications of a carve-out deal need to be thought through well in advance if you are to avoid unnecessary cost and value leakage. So here are a few questions to think about:
- Who is doing what in the newly separated business, from a functional perspective? If the function of a corporate group has changed, so has its corporate tax profile, VAT and transfer pricing characterisation.
- Where are profits being generated? All transactions have a transfer pricing and VAT implication. Is this aligned to the transfer pricing characterisation? What does that mean for VAT in those jurisdictions? And transfer pricing strategy?
- If a capital gain is realised during the transaction, can the buyer obtain a tax deduction? (e.g. amortisation) And if so, can these tax benefits be robustly documented and form part of the negotiation? This is normally supported by the ETR model we mentioned before.
- Does the transaction qualify as a transfer of a going concern business? What does that mean for VAT charge, recovery and VAT cashflow on asset and inventory transfers in the relevant jurisdictions?
- If the deal involves a transitional service arrangement, what are the transfer pricing and VAT implications?
- Is there a system in the carve-out to issue invoices to customers? If not, who can, when you take VAT invoice requirements into account? And how can it monitor the transfer pricing outcomes in the interim model and make TP adjustments if required?
- On transaction costs, which entity should bear the costs? Should this be shared considering transfer pricing rules? What can be done to manage VAT recovery on transaction costs?
Carve-out deals are notoriously complicated and the margin for error is tight. Failure to think about tax from the outset can result in a large, unplanned-for cost and destroy the potential to create real value from the deal – one more reason why tax can no longer be an afterthought.
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