This means that while an existing tax losses for a sale above that threshold could previously be ignored during M&A negotiations, buyers and sellers should now consider potential price impacts when such losses exist.
Can the tax losses be utilised?
Assuming there are valid tax losses, the key question is whether the tax losses can be carried forward and utilised. There is a requirement for the purchaser to meet the business continuity test (BCT). This requires there to be no major change in the company’s business activities when the carried forward tax losses are to be utilised.
Where there is a major change, the tax losses may still not be lost, provided the change is a “permitted major change”. These generally relate to organic changes in business activities, including those changes:
- made to increase the efficiency of a business activity;
- made to keep up to date with advances in technology relating to a business activity;
- caused by an increase in the scale of a business activity; and
- caused by a change in the products or services produced or provided where there is a close connection to the existing business or using the same assets or processes (not just land and buildings).
These tax changes are relatively new and the meaning of a “major change” is not yet fully tested. If certainty is required, a taxpayer could apply for a tax ruling at the time a major change is anticipated.
The ability for a purchaser to carry-forward tax losses is also subject to anti avoidance rules including:
- only relates to tax losses arising from the 2013/14 income year onwards;
- the loss company hasn’t been dormant before the ownership change;
- change in business within two years prior to the ownership change; and
- income of an acquiring group cannot be diverted into an acquired loss company.
While the BCT only applies in New Zealand from the start of the 2021 income year, similar rules exist in other countries including in Australia, Canada, and the United Kingdom. Existing practices in those jurisdictions can provide precedent and guidance for the likely BCT issues here in New Zealand.
If there are tax losses, do they have value?
Existing tax losses have value to the extent they can be used against future taxable income of the business, reducing future tax obligations.
As such, an assessment of value requires consideration of the timing, amount, and certainty of the expected future business income. This assessment may not be straightforward. Tax losses exist because the business has historically delivered losses and may still be loss making. The losses may never be used. Predicting when a loss-making business is likely to turn a profit can be challenging.
However, in general terms, the more quickly the future income is expected to be delivered, which goes to expected amounts and timing, and the greater the certainty of those earnings, the more likely the tax losses will be used and so the greater their value.
A further factor influencing value is the size of the tax loss position relative to the future earnings potential - a larger position indicates larger historic losses and higher future income required to offset the losses. Higher tax loss balances tend to be associated with higher risks and lower earnings quality, reducing creditworthiness, and an increasing risk of distress.
Some industries may also present a greater likelihood for value to arise from unused tax losses. For example, technology businesses often sustain tax losses for many years while investing in and developing their core offerings and intellectual property.
Within that framework we can see that tax losses are likely to have more value for an early-stage business that has achieved material commercial milestones, has significant revenue growth, and is close to breakeven profitability, for example. On the other hand, a lower value, if any, may be attributable to large tax loss positions for loss making companies with less attractive future growth prospects and which may be quite far from achieving break-even profitability.
There must also be an expectation that the BCT rules could possibly be met over the period the tax losses are likely to be utilised. As the tax changes are relatively new, investor confidence in this area will likely increase as these rules are tested and precedent develops.
Guidance as to whether a business has valuable tax losses is also available for companies reporting under International Financial Reporting Standards (IFRS). IAS 12 permits a reporting entity to recognise a deferred tax asset for unused tax losses if it is probable that future taxable profit will be available against which the unused tax losses can be utilised. A more than 50% probability level is required, which may be a different threshold than required to establish a value for M&A pricing purposes.
In short, the existence of tax losses does not necessarily mean they will impact the price of a transaction. This will depend on the specific circumstances, including the future business prospects. It also depends on what the purchaser intends to do with the business – it is wholly on the purchaser to meet the BCT.
How are tax losses valued?
Tax losses can be valued using a variety of methods, from straightforward to complex. Market based approaches, where value is determined by market activity, tend to be unavailable due to a lack of comparable information on similar transactions.
Within the often-short time frames of an M&A transaction, a straightforward approach may be preferred, or indeed the only option. These approaches include:
- Face value approach. The tax loss balance is simply multiplied by the corporate tax rate. In effect this assumes the losses will all be used on the transaction date and will likely overstate value.
- Valuation allowance. The face value multiplied by a probability, which accounts for uncertainty and timing, that the tax loss will be used. This is a blunt approach but commonly used.
Complex methods are designed to produce a more accurate value, generally by considering a wider range of possible outcomes. These approaches include:
- Income-based methods, including present values of projected profits with and without access to the available tax losses. Multiple probability weighted scenarios may be considered; and
- Contingent claim frameworks, including binomial and monte-carlo approaches, reflecting factors such as earnings levels, growth and volatility, the level of tax losses, and distress risk.
How might buyer and seller consider value for existing tax losses in negotiations?
With the ability for tax losses to be carried forward on majority changes in business ownership, vendors will be keen to demonstrate that the existence of tax losses supports a higher transaction price. In certain circumstances, when it appears likely the business will generate sufficient future income against which tax losses can be offset, a higher transaction price may be appropriate.
Or a purchaser may not be willing to pay for tax losses even if they appear to have value. They may regard the tax losses as a form of synergy, given any future profitability will rely on the purchaser’s managerial oversight and any potential capital investment. They may consider their value is already implied in the price, or only be prepared to pay for a portion of the tax loss value.
Where there is some agreement between parties as to the existence of valuable tax losses, this may be reflected in the cash consideration price. Or given their value is largely dependent on the levels of future earnings, via agreed earnout mechanisms.
Whether the tax losses have value, and whether a purchaser is prepared to pay for that value, will ultimately depend on the specific transaction circumstances. However, where a company has significant tax losses, and reasonable expectations they will be used, there is logic to understanding the value for the losses so they can form part of price discussions at the negotiating table.