What are Tax Receivable Agreements?
A tax receivable agreement (TRA) is an accord between a seller of a business and the buyer that stipulates a portion of the future tax savings resulting from the step-up in tax basis of identified assets will be paid to the seller. Essentially, it’s a payment plan of sorts in which both the buyer and the seller have an interest, typically linked to "goodwill" as set forth in IRS Code Section 197.
TRAs reward the seller, while the buyer benefits from the added (step-up) tax basis in the asset, allowing businesses to deduct more depreciation against future taxable income. The degree of satisfaction for each party varies, depending on the tax situation of the seller, the nature of the purchased business , and the manner in which the business is purchased and the assets allocated.
TRAs are typically used for the sale of a C corporation that is being liquidated. A C corporation (as opposed to an S corporation) is one that must pay taxes at both the corporate and personal (e.g., dividend) levels on profits. Thus, the total tax burden on a sale and liquidation can be quite high.
The exact mechanics of a TRA depend on the transaction, and it can be structured either in the sale or the related post-sale stock liquidation. It also may or may not include a prepayment arrangement (i.e., the seller agrees to give back cash to the buyer in order to offset the income tax impact).
Tax Receivable Agreements: Purpose and Advantages
Tax Receivable Agreements (or TRAs) have been used by various companies since the enactment of the Tax Cuts and Jobs act – specifically Section 126. Transaction parties may make concessions for use of a Tax Receivable Agreement as a way to close a transaction.
TRAs are tax-sharing arrangements entered into by a buyer and seller and oftentimes investors or shareholders of the seller to share benefits from certain tax attributes. This type of transaction can be beneficial to both the buyer and seller.
The seller receives a cash payment (upfront in the case of an M&A transaction) for tax savings that a buyer will likely receive post-transaction, which in turn assists the buyer with increased near-term cash flow.
TRAs are similar to earn-outs in that both parties can defer risk of non-payment. Deferred payment clauses included in the TRA can also have a linkage to the buyer’s stock performing well. The deferred payment provisions also allow the buyer to know what the minimum payment amount is going to be.
In market speak, the TRA market is a buyer’s market, as sellers are seeking exits and immediate liquidity needs. Because the TRA as a market concept is relatively new, there is less competition, allowing buyers to take advantage of wide spreads while pricing deals.
Advantages to a TRA include cash benefits, liquidity for the seller, and increased earnings for the buyer.
Tax Receivable Agreements: The Key Players
Two key parties are usually involved in a tax receivable agreement: the issuing entity and the shareholders. The issuing entity is the company into which the shareholders will sell their equity. The shareholders are those who hold shares in the issuing entity. The tax receivable agreement will provide that after the separation from any related entities, if the issuer generates taxable income, the current and future shareholders are entitled to a percentage of those savings due to the higher tax basis. Once issued, tax receivable agreements will have an effect on new investors. When the issuer issues shares, the new investors will have to account for the demonstration of savings of the old shareholders. Any new investors may find the value of the company to be significantly lower than the initial offering price for the shares.
How Tax Receivable Agreements Function: An Overview
To understand how a TRA works, it is helpful to break the process down into three main stages: (i) Attribution – this is the formal identification of the TRA transferee (the former owner or owners as the case may be, or their beneficiaries) and the tax attributes that are being transferred; (ii) Valuation – this is the process through which the fair market value of the tax attributes are calculated; and (iii) Monetization – this is the process through which the tax attributes are monetized by the TRA transferee.
The Attribution Process
The TRA will typically identify the tax attributes attributable to a particular TRA transferee by reference to the relevant Code provisions and regulations governing the application of those Code provisions. Thus, for example, with a transaction resulting in a change of control, subject to certain requirements, the TRA transferee is typical entitled to recover the greater of its allocable share of the tax benefits realized by the target and its allocable share of any pre-transaction tax attributes of the target. Similarly, in the case of a 338(h)(10) election, subject to certain requirements, the TRA transferee is entitled to recover the greater of the amount of tax benefits realized by the corporation and the portion of the tax basis that was attributable to tax attributes. Although the process of identifying tax attributes is fairly straightforward, in many cases, there may be an open tax period as of the date of the transfer. In that event, the value of the TRA is likely to be discounted to reflect the risks arising from asset realization to the extent necessary to fully hedge such risks to the extent possible. Once the identity of the tax attributes has been ascertained, the fair market value computation will take into account the possible future realization of the tax attributes (i.e., monetization). Such calculation will take into account the realization of the tax attributes and the timing thereof (e.g., expiration of NOLs). The principles that govern such valuations can vary as among TRAs based on demand pressures, negotiation leverage and other factors. With respect to cash taxes saved, the value is typically computed by multiplying the after-tax savings over the applicable period by a multiple typically equivalent to the inverse of the after-tax discount rate. This discount factor takes into account the time value of money. For instance, if a cash tax benefit would be realized over the next two years, the after-tax discount rate would be used over the same two year period. The monetization of cash taxes saved would likewise take into account potential limitations under applicable law. Indeed, TRA transferees may elect to reduce the monetization calculation by reference to "haircut" estimates of the realizable value.
Monetization
In a typical TRA, cash distributions will be made to a TRA transferee to the extent tax attributes are actually "monetized." Monetization is achieved when a TRA transferee is able to utilize or benefit from the tax attributes. As mentioned above, in the case of cash tax benefits, a TRA transferee will typically receive cash distributions to the extent the TRA transferee has successfully realized value from the tax attributes, taking into account any foregone or reduced tax attributes due to limitations under the Code. With respect to an asset (and, in some instances, transferee) step-up, monetization can be achieved through the depreciation of the stepped-up asset. Again, a TRA transferee will typically receive cash distributions to the extent the TRA transferee has successfully realized value from the tax attributes, subject to any foregone or reduced tax attributes due to limitations under the Code.
Tax Receivable Agreements: Common Provisions
While each Tax Receivable Agreement (TRA) is unique, there are a number of common provisions typically found in TRAs. The way that certain clauses work will vary from deal to deal, but below are some of the standard clauses often seen in TRAs. Foremost, TRAs always have a payments section. This clause will outline how the payment will be structured and when it will be made. TRAs will have a significant capital gains deduction as well as an early payment provision. The payment provision will also detail the TRA counterparties. Usually, this will be the selling affiliate and all attributions of that selling affiliate. The seller will also need to vaunt and guarantee these aforementioned affiliates. TRAs also have a duration clause. The duration clause outlines how long the TRA is in place for. Most TRAs range from 30 to 50 years. This means that there will be many tax triggers that happen after the selling event, and the TRA will still apply to them. Even if an event happened 20 years ago, but there are still tax triggers happening, the TRA would still have a payment basis. That said, TRAs do contain post-termination provisions. Although the TRA can linger on for a long time, there will be clauses that can bring it to an end. If circumstances arise that cause this to happen, that will be stated in the agreement. The TRA will also have representation and warranties. Most buyers do not get a lot in the way of information leading up to the purchase. As a result, TRAs are required to have a buyer due diligence clause. It is quite common for companies to give some form of due diligence, typically in the form of reports . There are purchase agreement considerations as well. The TRA will usually require that the parties get the required material consents and notices of the benefit rights. There will also be a no-waiver clause that states that the failure of enforcement of a breach of the agreement does not act as a waiver for a future violation. Both the buyer and seller will have representations for compliance. This will include representations of guarantees and financial statements. There will also be representations in regards to fundamental representations. This covers all of the things that need to be there for the buyer. TRAs also typically include provisions for significant events. This is a list that defines certain trigger events for the buyer. Some common trigger events include divestitures and sales. TRAs will have clauses for antitrust. Typically, there will be certain requirements for antitrust filings. Additionally, there are provisions for antitrust approvals or delays. There are also provisions in the case of a requirement for an extension. Termination clauses will define what it means for the TRA to terminate. If the termination clause is triggered, the parties must fulfill their obligations. Payment is always subject to change based on IRS adjustments. There are, however, conditions where payments need to be made despite these adjustments. The TRA will also include provisions for indemnification. The TRA will protect the parties from many situations. If there happens to be a tax liability as the result of the transaction, a TRA will prevent them from being liable.
The Potential Drawbacks of Tax Receivable Agreements
Certain risks, challenges, and complexities associated with the U.S. tax system can pose practical challenges when implementing tax receivable agreements (TRAs) in practice. There are certain exceptions that limit the availability of deductions in certain situations, both during the period contemplated under the TRA as well as in later years.
A TRA may require the taxpayer to reduce its available net operating losses (NOLs) or other tax attributes as a result of the transaction. These limitations may result in a potential inclusion of income or a limitation on the availability of a future tax deduction to the transferee.
The TRA may be a triggering event that results in an immediate deduction claim or an unemployment insurance credit claim that give rise to an increase in the taxpayer’s Franchise Tax Board (FTB) required deposits. In addition, certain transactions might trigger taxation for other state tax purposes.
The income inclusion payment made to the TRA counterparty could be taxable for state income tax purposes. In some instances, certain states will not recognize the payment as a deductible item for state income tax purposes while others will not allow a deduction for the related interest expense.
In cases where the consideration paid by the parties to the transaction is insufficient to fully pay the TRA counterparty, the liability of the parties may shift over time. For example, such shifts might occur between the seller and the buyer based on the terms of the TRA or between joint filing corporations. This may result in inconsistent treatment of the taxpayer in calculating both current year taxes and deferred taxes and the allocation of any available tax attributes.
A TRA may result in a reduction of the existing tax attributes of the transferee. In the case where tax attributes are reduced, the transferee will be more likely to experience a tax-balance sheet footnote in the future.
A TRA may not be deductible for book purposes, which may impact the calculating of any future deferred tax asset or liability amounts.
A purchaser may claim certain tax attributes in the year before the TRA is entered into, and the seller may claim certain tax attributes in a later year. This could result in two taxpayers deducting the same dollar amount for the same tax attribute.
A dispute may arise between the parties over the calculation of the TRA compensation payment and whether or not the TRA election has been triggered.
The Practical Application of Tax Receivable Agreements
To understand how TRAs actually function, however, let’s explore some real-world examples of deals and consider whether they worked as intended and delivered promised returns to the sellers.
1. The Vivint Acquisitions: The Vivint Deal and Its Subsequent Spin-off
On June 20, 2012, private equity firms, The Blackstone Group and TPG Capital, bought the controlling interest in Vivint, Inc., a Utah-based home security system and home automation company, for $2 billion. Before the buyout, the company went public, raising $500 million through an IPO, but due to weak returns, Blackstone took the company private on June 24, 2013, selling it to a subsidiary of The Old Mutual Group for $2 billion. After the buyout, Vivint spun off its energy services and solar division and retained the company’s core security business. After the spin-off, Blackstone sold its $2 billion stake to Pinnacle West Capital Company ("Pinnacle") in exchange for shares of Pinnacle securities, loyal to the Old Mutual Group’s suggestion that it take all cash or stock. The deal was valued at approximately $2.2 billion. Additionally, VIV is controlled by its former owners, Scott and Todd Peterson. The TRA was structured to allow Old Mutual Group to retain the tax attributes from the 2009 Legacy Tax Arrangement dated June 30, 2008, which included NOLs, AMT credits, investment tax credits (ITCs), partnership credits (PCs), and remedial and carryover REMIC NOLs related to the spin-off. VIV paid $37.5 million in tax savings realized from their TRA to Old Mutual Bank as follows: $35.2 million in 2015, $2.1 million in 2016, and $100,000 in 2017. The Tax Receivable Agreement explicitly states that the TRA was entered because of the "tax benefits" derived from "using the tax attributes" related to the acquisition of VIV as of June 30, 2008. VIV and Old Mutual Bank took the position that such benefits are "realized" from the use of the tax attributes as opposed to the mere act of having them. The ultimate savings achieved from the TRA were dependent on the timing of the tax payments and derivation of certain taxable income. Because VIV is a majority owned REIT, the benefits resulting from the TRA could be carried-forward indefinitely. The fixed duration of the TRA, being a decade, was based on the fact that the REMICs NOLs had a finite period in which they could be used. This acquisition and spin-off show that TRAs can be used to realize added value from the very same assets that had previously been spun-off. In this case, the legacy tax attributes had been used to recover the substantial value of a previous acquisition, which may have otherwise been lost by the new owners.
2. EOP Acquisition
Office Properties Income Trust (OPI) acquired Equity Office Properties (EOP) for $39 billion ($19 billion in cash and assumed debt and $20 billion in old EOP stock) in February 2007. After the transaction closed, the tax basis to fair value differential of $14.9 billion was created. The EOP Acquisition Agreement allowed OPI to enter into a series of tax receivable agreements (TRAs) for the $14.9 billion of tax attributes realized from the EOP Acquisition. Thus, OPI, as successor entity to EOP, paid $4.4 billion for the realization of the tax attributes. The TRA allows for OPI to pay 85% of the utilization of tax attributes for 10 years, at a present value payment of 15% of net present value discount rate that also equals federal funds rate + 1.25%. Further, OPI paid $2 billion of the TRA payments within 45-day of the TRA payment calculation date. OPI made $218 million in TRA payments for 2007, and $296 million for 2008. The TRA payments will be used to repay senior and revolving debt, restricted cash and investments, and repurchases of common stock or other equity interests, as applicable. Again, this was an example where the TRA was executed due to the opportunity to recover legacy tax attributes.
The Future Prospects of Tax Receivable Agreements
In summary, tax receivable agreements can function as an effective means of incentivizing the founding owners who sell an interest in a pass-through entity to the acquirer party of a TRA to keep forth the future value of such entity which is difficult to quantify at the time of the transaction. Tax receivable agreements allow the transferees to share with the founders the tax benefit from such future value in a manner that is structured to be tax-efficient for both parties. The negotiations between the transferees and the counterparties to a TRA often become long and complex , and it is important for all parties to such negotiations to have a firm understanding of the tax implications of a TRA, the parties’ respective obligations thereunder and the structure of the overall transaction itself.
It is difficult to predict how TRAs will evolve as legislation affecting partnerships and S corporations continues to change. It is also to be seen how economic conditions and developments in business operations and tax strategies may impact the use of TRAs and their terms.