Tax in M&A: How clear is your exit?

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When undertaking an acquisition of a subsidiary company of a tax consolidated group, much effort and attention is devoted to ensuring that the target company is acquired free of any legacy income tax liabilities. However, obtaining a truly clear exit is often a lot harder than it seems.

So what is a clear exit and why is it so important?

In broad terms, a tax consolidated group (TCG) operates as a single entity for Australian income tax purposes. While the head company of a TCG is prima facie liable for the income tax obligations of the group, each subsidiary member is jointly and severally liable for the income tax liabilities of the TCG. In this regard, when an entity leaves a TCG, it will be jointly and severally liable for the taxes in respect of that period, even if they fall due for payment after the entity leaves the group. Similarly, if an amended assessment is raised by the ATO, the leaving subsidiary will prima facie be liable in the event that the head entity defaults.

Unsurprisingly, acquirers of subsidiary members of a TCG are reluctant to want to assume any joint or several liability for a TCG’s group liability. In this regard, the key mechanism for limiting joint and several liability is ensuring that a valid tax sharing agreement (TSA) is in place between the members of the TCG.

Specifically, tax law provides that a leaving subsidiary that is party to a valid TSA can exit the TCG clear of any group liability assuming it pays to the head company a reasonable allocation of its tax liability.

What is a valid Tax Sharing Agreement?

A valid tax sharing agreement constitutes an agreement between the head company and the subsidiary members that is entered into before the due time for the group liability. In this regard, during due diligence, it is critical to scrutinise the TSA to, firstly, ensure all relevant entities are parties to the agreement and, secondly, confirm the date on which the TSA was entered into by the exiting member to ensure it covers all open tax periods.

What constitutes a reasonable allocation?

The TSA must clearly stipulate the methodology for determining the contribution amount for each subsidiary member and this must represent a reasonable allocation of the group liability. In practise, a commonly-used methodology is to simply allocate the total group liability to each member based on each member’s notional income, which is typically calculated in accordance with the tax rules.

How does a leaving entity obtain a clear exit?

Having established that there is a valid TSA in place, the final hurdle to ensuring a clear exit is calculating the clear exit payment and ensuring payment is made by the leaving entity prior to completion of the transaction. In this regard, advisors for both the vendor and purchaser are often engaged to review the clear exit calculation to ensure they agree that it is appropriate and evidence is provided by the vendor that actual payment is made.

Finally, it is important to note that while clear exit is critical, it only covers liabilities to pay income tax and franking deficit tax. Importantly, it does not absolve the leaving entity from GST or employment tax liabilities.

Working with clients

We work with clients at all stages – and on all types – of transactions to ensure that there are no unpleasant surprises for either buyers or vendors when concluding a transaction. Complexities and challenges do arise and, therefore, it is important to take an early and proactive approach to ensure a clear exit is achieved.

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