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Tax Due Diligence in Acquisitions Steven D. Bortnick and Timothy J. Leska Lorman Education Services Teleconference August 24, 2011

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Tax Due Diligence in Acquisitions

Steven D. Bortnick and Timothy J. Leska

Lorman Education Services Teleconference

August 24, 2011

2

Part I

Overview of Tax Due Diligence

3

Parties to the Process

• Seller• Buyer• Seller’s accountants• Buyer’s accountants• Seller’s lawyers• Buyer’s lawyers

4

Documents to Request

• Corporate structure chart• Entity classification elections (8832)• Past income tax returns (all jurisdictions)• Accountants’ workpapers• Tax reserves• FIN 48 workpapers• Information/materials regarding prior

reorganizations• State income tax allocation calculations• Foreign tax credit calculations• Review general accounting methods / elections• Sales tax returns• Payroll tax returns

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Things to Consider – Return Positions

• Aggressive tax positions−Unreasonable compensation−Undervaluation of ending inventory−Listed/reportable transactions−Disproportionate allocation to

depreciable property/consulting agreements in prior acquisitions

• Adequate reserves

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Things to Consider – Inheriting Liabilities

• Asset sale v. stock sale−Ability to leave behind liabilities−Transferee liability−Bulk sale issues

• Consolidated return liability−1.1502-6

• 338 election – impact on liability

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Things to Consider - Audits

• Revenue agent reports and requests for information−Consider hot points if known−Likelihood of success−Quantify down side risk

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Things to Consider - Structure

• Integration issues• Inefficiencies• Classification of foreign entities

9

Things to Consider – 338 Election

• Availability• Federal tax cost• State tax cost• International concerns• Purchase price allocation

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Part II

Tax Representations and Warranties

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Purpose

• Further diligence process• Ability to terminate agreement• Buyer protection

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Representing the Seller

• Speak to the accountants or tax director−Make sure even “reasonable”

representations are true−Ability to schedule out exceptions−Debate over materiality qualifier−Debate over knowledge qualifier

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Key Definitions

• Tax− Any federal, state, local or foreign income gross

receipts, license, payroll, employment, excise, severance, stamp, occupation, premium, windfall profits, environmental, customs duties, capital stock, franchise, profits, withholding, social security (or similar), unemployment, disability, real property, personal property, sales, use, transfer, registration, value added, minimum, estimated or similar tax, including any interest, penalty or addition thereto

− Taxes of others, including under 1.1502-6.

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Key Definitions

• Tax Return−Any return, declaration, report, claim

for refund, information return or statement relating to Taxes, including any schedule or attachment thereto or any amendment thereto

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Tax Returns

• All tax returns timely filed and are true, correct and complete−Material tax returns or all?−Materially, true, correct and complete −What if just purchasing one division or

subsidiary?• No position that would be subject to penalties

under 6662 (or state, local or foreign)−Redundant

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All Taxes Paid

• Paid all taxes required to have been paid−Materiality−Whether or not shown on a tax return

• Reserves for tax liability adequate up to date of agreement and through closing

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All Taxes Paid

• No indication from jurisdiction in which don’t file that may be subject to tax there−Duplicative−Materiality−Written notice

• Complied with obligations to withhold and remit taxes−Employee, contractor, foreign person, other

• No liens for taxes−Permitted liens

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Audit History

• Nothing Pending−Audit, investigation, proceeding

• No notice of intent to audit or request for information

• No expectation of additional assessment−Who’s expectations count−Duplicative

• Schedule of tax returns for x years and which subject of audit

• No waiver/extension of statute of limitations to assess or collect

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No Lost Deductions

• 280G – Parachute payments• 162(m) – Excessive compensation• 168(h) – Tax exempt use property• 103(a) – Security for tax-exempt

bonds• 168(f)(8) – Old safe-harbor lease

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Post Closing Tax Detriments

• No income inclusions after closing or loss of deduction after closing as a result of− Pre-closing change of accounting− Change of accounting required as a result of

closing− Closing agreement− Consolidated rules – ELA, deferred gains− Prepayments− Installment sales

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FIRPTA Concerns

• Buyer must withhold 10% on purchase of USRPI

• Buyer concerns about purchase of USRPI• Seller not foreign−Get affidavit

• Target not a USRPHC−Need affidavit if multiple sellers or foreign seller− If don’t need affidavit, still want rep

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Tax Attributes, Etc.

• Identify −Basis in assets−ELAs−Deferred intercompany gains−NOLs−Unused tax credits

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No Agreements

• Tax sharing, indemnification, allocation or similar agreements

• No closing agreements• No outstanding rulings or requests

that would impact taxation of the target post closing

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Representations if Foreign Ops

• Entity classification - no change (by election, merger, reorganization) in classification of entity for tax purposes

• Not subject to tax except in country of formation• No permanent establishment outside country of

formation• No CFCs− No 952(c)(2) if CFC

• No PFICs• 482 – Correctness/reasonableness of transfer

pricing methods

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Representations for S Corp Target

• Always (uninterrupted) an S corporation from date of formation through date prior to (or of in the case of a 338 election) closing

• Specific rep on state/local−Consider states/cities that don’t

respect – e.g., NYC

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Part III

Tax Covenants

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Tax Return Preparation

• Who prepares returns filed post closing−Consolidated, stand alone, S

corporation, Straddle period• Review rights• Consistency with prior returns• Handling disagreements

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Payment of Taxes with Returns

• Seller to pay all taxes paid with final returns (and straddle period to extent allocated to pre-closing period)− Integrate with working capital adjustment−Seller prefers to run through indemnification

section• Straddle period – pre/post closing allocation−Allocate based on deemed closing of the books

method for taxes based on income, receipts, expenditures, wages

• Who pays transfer taxes

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Cooperation

• Filings tax returns, audits, litigations, proceedings

• Who controls audits• Document retention and provision of

records though end of statute of limitations

• Notification before destruction• Dealing with costs• Obtain certificates (e.g., bulk sale) to

reduce tax

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338(h)(10) Election

• Preclude 338(g) election• Buyer and seller agree to elect 338(h)(10)• Representations regarding availability• Dealing with basis allocation• Agree to file in accordance with agreed

allocation• Who pays the extra tax (state, local,

additional federal, conversion of capital gain to ordinary income)

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Prohibited Actions

• Seller will not (and will cause Target not to)−Make, revoke, change any tax election−Waive/extend any time/restriction for

assessment or collection −Agree/modify agreement with respect

to taxes /settle any tax matter

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Part IV

Tax Indemnification

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Sellers’ Liability

• Sellers pay:−All taxes to the extent related to pre-closing

periods• Include pre-closing portion of straddle period

−Loss resulting from the breach of a representation

−Taxes of any person other than the target and subsidiaries under applicable law (including 1.1502-6), as transferee, successor, by contract or otherwise

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Limitations

• Coordinate with working capital or other adjustments to avoid double counting

• Baskets / caps• Public target – usually no indemnity• Failure to notify indemnifying party of

potential liability• Survival periods

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Securing the Indemnification Obligation

• Right only as good as ability to collect

• Holdbacks • Escrows−Who taxed on earnings if cross tax

years

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• Steven D. Bortnick is a partner in the Tax Practice Group of Pepper Hamilton LLP, resident in the Princeton and New York offices. Mr. Bortnick focuses his practice on domestic and international tax and private equity matters. He also is a member of the firm’s Sustainability and Climate Change Team.

• Mr. Bortnick handles a broad range of cross-disciplinary transactions, including asset, stock, cross-border and domestic acquisitions, tax-free spinoffs, recapitalizations and reorganizations. He is experienced in the structuring of domestic and international private equity transactions from tax and venture capital operating company standpoints. He also has worked with pooled investment vehicles, and he counsels corporate entities on tax issues. In addition, Mr. Bortnick advises U.S. citizens and corporations in overseas investment, and he has been involved in the formation of private equity and hedge funds.

• An active speaker and author, Mr. Bortnick has written materials and spoken for several major private equity tax conferences. Topics of his presentations include private equity, venture capital, cross-border investing, venture capital operating company issues, and merger and acquisition tax issues.

• Mr. Bortnick is on the advisory board of Practical US/International Tax Strategies.

• Mr. Bortnick is a graduate of Glassboro State College (B.S., cum laude, 1985), Rutgers University School of Law - Camden (J.D., with honors, 1988), where he received his Tax Honors Certificate with distinction, and New York University School of Law (LL.M. in taxation, 1992).

• He is a member of the bars of New Jersey, New York and Pennsylvania, and he is admitted to practice before the U.S. Tax Court and the U.S. Court of Federal Claims. He is a member of the tax sections of the New York and American Bar Associations.

(609) 452-4117

[email protected]

Steven D. Bortnick

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• Timothy J. Leska is an associate in the Tax Practice Group of the law firm of Pepper Hamilton LLP, resident in the Philadelphia office. Mr. Leska focuses his practice on general tax matters, including mergers and acquisitions, venture capital, and private equity.

• Prior joining Pepper, Mr. Leska was an attorney in the Office of Chief Counsel for the Internal Revenue Service in Washington, DC. While at the IRS, Mr. Leska participated in the issuance of IRS pronouncements, including final regulations regarding partnership allocations of creditable foreign tax expenditures.

• Mr. Leska is a graduate of Lycoming College (B.A., magnecum laude, 2001), Temple University School of Law (J.D., cum laude, 2004), and Georgetown University Law Center (LL.M. in taxation, with distinction, 2007).

• He is a member of the bar of Pennsylvania.

(215) 981-4008

[email protected]

Timothy J. Leska

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