Laura: I see the number of people joining is levelling off so I'm going to begin with a little bit of an introduction. So thank you all for joining us today. My name is Laura Gheorghiu. I'm a partner with Gowling WLG out of the Montreal office. I focus on cross-border M&A tax, in bound investments into Canada and, in particular, in the technology sector. I'm also Co-Chair of the New York State Bar Association, International Cross-Border M&A and Joint Ventures Committee. Gowling's happy to be eco-sponsoring this event with Fenwick, Sanchez Devanny and NYSBA. Today we brought together five tax practitioners to discuss tax trends that we are seeing in outbound US M&A into these jurisdiction. So in addition to myself in Canada, I'll let my four co-speakers introduce themselves. Emilie, if I could start with you.
Emilie: Hello everyone. Nice to meet you eventually. My name is Emilie Renaud. I'm a tax partner at Gowling too and based in Paris and my practice focuses on transactional tax matters.
Julia: Hi. My name is Julia Ushakova-Stein. I'm a partner at Fenwick & West in the San Francisco Bay area and I'm adding the US aspect of this panel. My focus is on cross-border M&A, international tax claiming and controversary. In addition I also teach international tax that includes cross-border M&A, University of California Berkley School of Law, and that the San Jose State Masters program.
Mariana: Hello everyone. Thank you for being here. My name is Mariana Eguiarte Morett and I'm a tax partner with a Mexican law firm, Sanchez Devanny, based out of the Mexico City office. My main focus of practice is international tax, on both outbound and inbound. I also teach an international tax course in the Mexican University, Universidad Panamericana, and I am part of the international section of the New York State Bar Association and Chair of the Mexican Chapter of the international sections of the New York State Bar Association.
Zoe: Hello everyone. My name is Zoe Fatchen. I too am a tax partner at Gowling. I'm based in the UK and my practice focuses on UK and cross-border M&A, investments and corporate tax structuring and I also have a special interest in management and executive incentivization. In addition I'm a member of the UK Canada Chamber of Commerce.
Laura: Thank you. A few housekeeping items before we start. I'm just going to ask everybody to make sure that they do stay on the microphones on mute for now. As a reminder there will be a networking opportunity at the end so we will love to hear from all of you then. We are also providing Continuing Legal Education credits today for Canada and the US. For those who are attending please make sure to sign in with the laptop in order to receive credit. In addition, for New York State Bar CLE credits, there will be the famous code that we will be reading later in the program and that I understand that you need to write down on the verification sheet to verify your attendance. So without further ado, let's jump into the conference.
Today we'll be covering some trends that we're seeing in M&A cross-border structures in a tech space. This includes an increased use of cash and stock consideration, the use of Locked Box deals, that Zoe and Emilie will walk us through. Some pitfalls and the efficient transaction structuring for cross-border buyers and sellers. The new European Union transaction disclosure requirements and we're also going to be discussing some key points in the incentivization of management and the impact of the increased employee mobility on tax risks in M&A deals. To wrap everything up we also touch on some US post acquisition considerations.
M&A structuring trends. When we see a US purchaser acquiring a tech company we often see two things. We see the use of earnouts and now we're also seeing the use of mixed cash and stock deals. With mixed cash and stock consideration, buyers are looking to keep the seller's interested in the ongoing management and operations of the company and also to reduce the cash financial requirements of the deal by paying part of the acquisition price in shares of the US parent. Julia, could you tell us a little more about how this is accomplished from a US point of view?
Julia: Yes, thanks, Laura. As you were saying, we are seeing a change more to have cash and stock mix in deals. About a decade ago we were seeing a lot of transactions, stock based transactions, from US buyers. It moved on to having a cash heavy acquisition practice, at least from the Silicon Valley perspective. Lately we are seeing a lot more of the cash stock mix, but as you guys will all speaking soon, from a foreign perspective using stock can become quite complex. If it's one jurisdiction that we're thinking about, so if we have a foreign target in a single country, let's say France, and most of the shareholders are also French shareholders, the considerations are limited. But the considerations can get quite complex if we have foreign target shareholders that are located in multiple jurisdictions. Use of cash in cross-border can still be favourable due to the complex tax considerations. On the other hand, if there's an ability to sell the shares in a period of time in which the foreign taxes have to be paid, that's also consideration that comes up when looking from a buyer and seller perspective in the cash and stock mix of the deal. Those types of considerations can be magnified in situations whenever we have combinations of more or less equals. So if we have a situation where a US company and a foreign company like to combine, sometimes they're 50/50, other times 60/40 split, then one of the transactions that's quite useful is depicted here in this slide. In the US way we call it a double dummy structure. A new company is set up, a new US HoldCo is set up, with two foreign subsidiaries that are transitory subsidiaries. They are only in existence to be able to support either a merger of the US company or foreign company. Another way to approach this, especially from a foreign perspective a number of countries have more favourable tax consequences, if instead of a merger by the foreign company a contribution by the foreign shareholders of their shares of the foreign target to nearest HoldCo is accomplished. This structure allows to use stock of the new HoldCo to combine US corporation in the foreign corporation. It also has two favourable additional aspects to it. One is that combination is a tax free contribution under section 351 for US tax purposes. Where the contribution of their foreign corporation shares to new HoldCo and whether it's a merger of the US corporation or contribution to the US corporation stock to the new HoldCo, in exchange for a new HoldCo shares, is altogether treated as a tax free contribution to the new HoldCo under section 351. One of the other favourable aspects of this transaction is you'll see in the structure is the mention of cash and this structure allows for cash to be used in a deal if certain shareholders, especially foreign shareholders, prefer to be cashed out rather than continuing on in the ownership of the business. There aren't any minimum requirements to how much cash can be used with this type of transaction. Really making it quite flexible for a foreign acquisition and it also makes it flexible depending on jurisdictions. If there's certain jurisdictions that do not allow for the stock contribution in the tax ... by the foreign shareholders, those shareholders can have the option to be cashed out instead. While the foreign jurisdiction shareholders who can use a tax free rollover option are able to do so.
One other thing to mention, Laura mentioned this earlier, is the use of earnouts. From a US tax perspective the earnouts will come up typically when there's a negotiation for the price of the company. If there's an amount that is a delta between what the buyer's willing to pay today, and the possible increase of the value of the company over time, an earnout can be used and there's different ways to structure it. But generally from a US tax perspective it's a fact and circumstances test. So to the extent that the earnout is based on business aspects. So future business earnings, it tends to be taxed as an acquisition purchase price, so it is capitalized in the basis of the foreign target. As opposed to having to support the facts that any earnout is really truly compensatory, as we'll discuss later, compensation is a deductible payment from a US tax perspective. So there are additional thresholds that have to be met to be able to get the benefit of that deduction and the facts really have to support a compensatory payment.
Laura: Thank you, Julia, and I think you make a very good point about the structuring of earnouts and how important they really are, from both the payer's perspective and the purchasers. We see a lot in deals where it's hard to value the goodwill of the company so the earnout does serve that role to allow for tying a portion of the purchase price to future returns from the business. In Canada, and it's not true of all jurisdictions, but in Canada with earnouts it is possible to treat it as a capital gain or as part of the consideration for the shares. The treatment in Canada of capital gains is that 50% is tax free so that is an important characterization for a seller. If the earnout is tied to on a quantifiable value of goodwill at the time of the transaction, and if the earnout feature does not exceed 5 years after the transaction year. So there are limitations. Something that we have started to see becoming problematic is when the earnout or the buyer holds back a portion of the purchase price and ties that, not necessarily to the performance of the company but rather to the fact that the employee, or the principal founder, stays on with the business for a given period of time. In that case, even if they may be called an earnout, it doesn't meet the criteria for capital gains treatment so that person is receiving some sort of income and that's fully taxed. We do try to structure around that. Sometimes by trying to use what's called a reverse earnout. So instead of price plus an amount if the employee stays on it would be full amount paid and a reduction of the purchase price if the employee leaves before a certain date. You can adjust that variable portion easily by paying it in the form of a note, rather than in the form of actual cash or shares, and then the note of course could be cancelled or be paid out if the condition is met. There's limitations to this, of course, and the seller has to have the cash to pay the tax at the time of sale and the other limitation is that it really can only be a 3 year period because due to the Canadian rules for loss carrybacks. If the seller has a gain and then later on loses that money he can only carryback that lost 3 years so the limitation applies to the whole earnout itself. But it becomes problematic when you're trying to mix earnouts and you're trying to mix them with cash and share deals. So cash and share deals obviously benefits the buyer but also the seller can get preferential tax treatment if properly structured. So for a seller the cash part is important because in Canada we have a capital gains exemption on certain sales of what we call Canadian control private corporation shares. So you would see that very often being the case in the tech company space. So each seller would get 900,000 tax free. Sometimes they multiply that by using a trust to hold the shares and beneficiaries being different members of their family. So you can have five different capital gains exemptions on that cash portion so that would be important. Then the shares themselves that are being received as consideration can also be receiving tax deferred treatments, and so what you have on 351 exchange in the US, but the condition in Canada is that the shares you're getting back on the sale have to be shares of a taxable Canadian corporation, and I'm going to address that issue and the way around that issue in the next slide because obviously if a US seller it's not a given that he would have shares of a taxable Canadian corporation to give back on that purchase.
So what happens is that when you do have an earnout and this cash and share sort of deal, or you have full share consideration on the purchase, it's sometimes hard to fit into the earnout provisions. So there's cases where we've seen the tax authorities say, "If you've paid shares for the deal and then there's an earnout with additional shares, those additional shares are full income." They're not additional purchase price that you can get a capital gain on. Or if you have, let's say you do a roll-over and you get back shares on the purchase but then there's a cash earnout down the road, there's a potential argument to say that maybe that cash portion could be taxed right away to the seller. So that would obviously not be a desirable outcome to him and we'd have to look at whether we could do a reverse earnout around that. But it does get quite complex so really important questions that can really affect the transaction when you're looking at these kinds of features together.
I'm going to turn it now to the second point which is what do we do if we want to do a roll-over but give back US shares. There is a way around that which is an exchangeable share structure and if you have a large enough transaction and a long enough deferral period, 3 to 5 years is probably a good timing, it can be beneficial for the sellers and for the buyers to go through, I'm going to say castle, of putting this in place. Because what you're really doing here is having an acquisition company, the US acquirer, create two Canadian subsidiaries as part of the structure. They will play the role of giving the seller economic equivalent to shares of the US parent, until such time as there's a third party sale, and there can be cash realized to pay the tax. So very briefly, we just put it here for reference, but very briefly you would have an acquisition company that would basically buy the target company, this is a Canadian acquisition company, buy the target and give back the exchangeable shares. Exchangeable shares have economic rights that mirror the rights of the US parent including rights to receive dividends when dividends are paid on the shares of the US parent. There's a lot of technicalities there. Sometimes the dividends are not paid. They're declared but not paid and they're added to the value of the shares in order to get a better tax treatment for the Canadian. Ultimately the goal is that upon a third party sale of a US parent, the Canadian holder of the acquisition company would be able to exchange its shares for US shares, and participate as part of that transaction. Everything else that's there is really to work around Canadian rules and, as I mentioned, there is a lot of documentation behind this including a supporting exchange agreement between the US parent and the two Canadian subsidiaries and the shareholders. So quite a lot of work to get to this roll-over treatment and capital gains treatment at the end of the transaction which is not always the case in all jurisdictions. Emilie, if I understood correctly in France, you don't have this limitation on when do a roll-over. The company issuing the shares doesn't have to be a French company. Maybe you could walk us through how things work in France.
Emilie: Yeah, first of all I have to say that the taxation of capital gains for French residents is not so bad in France, because French resident company can benefit from a tax special exemption, allowing them to benefit from 3% effective tax rights on their capital gains. The only condition is that they have to own a stake of up to 5% in the company the shares of which are sold and they shall have owned the shares for at least 2 years at the time of the sale. French individuals benefit from a maximum 30% tax rights and lower rights can be available if the shares are owned in a tax saving plan. They can benefit French individuals from a roll-over taxation but only if they contribute their shares to the capital of French company and receive shares in consideration for this contribution. The second condition is that the beneficiary shall be subject to corporate income tax in its state of residence. So the roll-over is available for French residents and individuals. There's no condition about the nationality of the beneficiary to the extent it is located in a Treaty protected jurisdiction. For companies, as I said, in most cases the sellers can benefit from the tax special exemptions so that they do not ask for a roll-over. The roll-over for companies is possible but there are additional conditions. The first condition is that the stake to be contributed shall represent a controlling stake in the target company or the purchaser already own more than 50% of the target company at the time of the contribution. There are anti-abuse provisions to which the capital gains, the taxation of which has been deferred, shall be possible in the US. For example, if you contribute the shares to a US company, and the main conditions that you have to disclose, the whole transaction to the French tax authorities if you want to do a contribution to a US company or any foreign entity. So in most cases we do not ask for the roll-over for this last reason and in the best cases that the French companies can benefit from the ... exemption.
Laura: Thank you. That's very interesting and I think it gets even more interesting when we layer on other jurisdictions so, Zoe, if you could just give us a quick rundown on how things work in the UK.
Zoe: Yes. In the UK things in some ways are very similar to Canada. It is possible. So the cash element, of course, will always be subject to immediate taxation and while roll-over provisions may be available there is quite a valuable tax relief available to individual sellers in relation to the first million pounds styling of the gain, which they realize, which reduces their effective tax rate to 10%. So it's always worth, whenever we can, taking advantage of that. Until recently they had 10 million in that exemption but unfortunately that has been tightened up in the last year or two. So to the extent that we have had capital gains where in excess of a million, which of course for most of our deals these days we do, the roll-over capability is very useful. The UK's more flexible in that regard so it's not necessary to roll-over into a UK resident acquiring entity. So we very often see roll-overs in exchange for shares or membership interest in US entities and that can either be the US corporation or, if we're careful about it, also an LOC. So we see members interested and LOCs being successfully the subject of roll-overs too. Earnouts, again, are popular in the UK and just as in Canada we have to be careful to structure those so that they are not taxed as the receipt of an employment related bonus, if they're being paid to someone who works in the business and we're very familiar with doing that. Key to that can be making sure that the individual isn't required to stay in the business for too long. So 2 or 3 years are generally accepted as being long enough to protect the value of the business. Any longer than that and the earnout starts to look, as far as the UK tax authorities are concerned, like remuneration for their ongoing employment. So we have to be careful about that. Then again, in connection with the roll-over, it's very important to make sure that the acquiring entity is going to receive a controlling interest in the target. So that doesn't work if it's only going to be a minority acquisition or if we're going into a 50/50 joint venture. There are some conditions that must be satisfied and there's a procedure for applying to the UK tax authority for advance clearance, or assurance, that the roll-over will be successful and that capital gains tax, or corporations tax on capital gains, will not be charged in relation to the rolled-over element. Typically it takes about 30 days to receive that confirmation after the application. So that's something that we always have to take into account when we're working out the timeline for our transactions.
Laura: Those are super important points and they are different from one jurisdiction to another which is quite interesting. Mariana, if I can turn it to you to talk about Mexico.
Mariana: Sure, Laura. Thank you very much and in fact, yes, we find that different perspectives in different jurisdictions. From a Mexico standpoint I have to say that earnouts are also problematic in practice and regarding the mixed cash and stock deals, in reality from the Mexico standpoint, they do not pose any tax advantage because we don't have this roll-over situation that you had described previously. Now regarding earnouts, those could be seen as separate income for the seller or as part of the price of the transaction. You wouldn't see them as a separate income for the seller. They will be fully taxed for the Mexican corporate or individual seller and if we have no Mexican resident seller receiving this amount we will also have some confusion in connection with the correct ... of such income. This is because we would need to analyze whether such income could be deemed sourced in Mexico based on our Mexican source ... Now we see that as part of the price of the transaction, the problem that we see in practice is that there are no specific rules in Mexican tax law that would allow to make the adjustment to the price once the transaction is closed. So this poses a problem in practice when the seller is a Mexican individual. And why is that because there could be some consequences in regards to the compliance with the formalities that individuals must to comply with in a regular transaction. Because once the price is adjusted we would have to see if how that individual comply with the additional formalities because, as I said, there are no rules in connection with this. So this remains as an unsolved issue in practice. Now, from the perspective of mixed cash and stock deals, as I already mentioned the truth is that there is absolutely no incentive from a Mexico perspective, for a difference in structuring a transaction in that way. So if we see a combination in price in this regard, in reality this is going to be fully taxed as a full consideration for the seller. This is because, as I said, there is no incentive in connection with, for instance, being able to apply for a roll-over treatment from a Mexico perspective. The treatment for roll-over is very, very limited and only in connection with reorganization, from a local and from an international perspective. However, I thought interesting and this is what you're seeing right now in this light, to highlight a recent transaction that we saw on the private equity space were we advised a private equity fund, in the US on the tech space, that hired a group of companies that have presence in two Latin American jurisdictions aside from Mexico. Now, if we go to the next slide, we will see that basically what happened in this transaction is that Mexican target shares were sold by the US corporation to the bank that we're showing on this slide, and what happened afterwards is that the individual shareholders that hold the US corporation and the US corporation itself, ultimately at the end of the deal they received some participation in the private equity fund. Now what happened and why was this stock consideration not taxed in Mexico? Well, what happened is that the Mexican target was transferred by the US corporation and it was transferred at a very low market volume and a reason for that is that, in fact, the Mexican target company in itself had no value. There was some hidden assets and there were arguments to be able to say that the Mexican target had not a real value. So we priced the shares at a low market value. The transaction that was taxed from the perspective of the Mexican sourcing rules was the transfer of the Mexican shares by the US corporation and thereafter the stock consideration, as I said, was receipt of the level of the Latin American shareholders of the US corporation and this was not regarded as part of the purchase price. Now, since shareholders were non-Mexican residents, of course the additional receipt of this income, of this stock, was also not taxable in Mexico. The reason is that this is of course not caught by our resourcing our rules. The case would be different, obviously, if the shareholders had been Mexicans because then they would have to consider all the taxable income in connection with the receipt of participation in the productivity fund. And the reason for that is that individuals from corporations are taxed on all their income. Again, a positive trend for the jurisdiction in which in particular these shareholders were residents, which is an unlikely Latin Asia restriction, and this is because of course in that jurisdiction they needed to consider this as a taxable income from their perspective. So with that, on the other slide I only highlight the way which the consideration was received by the US corporation and by the two shareholders of the US corporation. So with that, Laura, I think I pass you the voice for the rest of the presentation.
Laura: Thank you, Mariana. We're switching gears a little bit here to Locked Box deals which have been quite popular in Europe but not seen very much in North America. We started to see some questions and some potential deals where this would be used and we thought it would be helpful to have a little bit of an overview. So, Zoe, would you mind running us through some of the basics?
Zoe: Yes, of course. So a Locked Box is really a set of accounts or abbreviated accounts which are used to value a company or a group of companies for the purpose of the transaction. So the parties will select a reference date which is not the same as the previous accounts date and also not the same as the closing date. That often happens where, for example, the last accounts were a long time ago so those numbers are out of date. Or perhaps when there's likely to be a period of time between the exchange of documents and the closing of the transaction. So it's typical to pick a date which is ... ... or a half year period or perhaps a date which is useful for other commercial reasons which are specific to the business in question. So, the accounts are drawn up as at that date and the benefit of that is, of course, that they can be flexible. So the parties can decide between themselves what they do or don't include in those and what they use as evidence when putting them together so they may well use the last accounts as a starting point. They might use the management accounts that have been ... in the meantime, or subjections, or perhaps a combination of those and they can either be on a full basis as if they really were annual accounts or simply abridged. Then everything is values depending on what's included in those accounts. Then of course, because our Locked Box date is a date before the transaction actually happens, in the real world there's going to be some expenditure in between that Locked Box date and the closing date. We refer to that expenditure as leakage. So we work out an estimate of the amount of cash, for example, that we think is in the company or the group. Then we look at the expenses that are likely to be incurred during that time and anything which is allowable, which is typically ordinary course of business, would be permitted leakage. So we would include in that things like the wage bill for the employees, any normal acquisitions of stock, usual overheads in relation to real estate and all the standard things, and then the buyer will make some assumptions about what is or isn't likely to happen in the business in the meantime. If the company, or the shareholders of the company or the directors, do anything unusual or unexpected that will cause a reduction in the value of the target in the time between the Locked Box date and completion, then the purchase price will be adjusted accordingly. So I'm sure you can think of some things that might include. So selling off a valuable asset for example, entering into depreciatory transactions with other members of the retained group or perhaps taking out cash by way of an unusual dividend. So anything that happens of that nature would not be allowable and then there'd be a reconciliation later to adjust. Can we move onto the next slide?
Here we are. So we depend on those Locked Box accounts for all sorts of things, including the warranties. So typically most of the warranties on a normal accounts based field when it comes to tax would be up to the date of exchange of documents or it might say that full and proper provision was made in the previous accounts, and instead of referring to the previous accounts we may well refer to the Locked Box accounts instead and then provisions that are made in the Locked Box accounts. Again, we'll be taking into account when we're working out how much tax we expect the target is going to need to pay. Also sometimes we might have assets which are valued as at the Locked Box date rather than at any time. There will be provisions in the stock sale and purchase agreement which set out what the company can and cannot do in the intervening period between the Locked Box date and completion, and the intention there is to reduce the risk of any of that unacceptable leakage of expenditure happening, and we would expect there to be a finalization of those financials and adjustment post-closing. But we can usually make a better estimate when we're estimating based on a date which has already happened rather than relying on closing date accounts. Sometimes it is quicker to get to a final resolution than it would have been if we only started filing everything and looking at everything as at the closing date. Now I'm going to pass over to Emilie to explain to you how this works in France.
Emilie: Yeah, thank you. Really shortly the Locked Box deals are well known in France. It clearly represents a majority of our deals, but that being said, with the COVID crisis we tend to see more and more price adjustment provisions in the SPAs and we tend to see also buyers who ask that only part of the purchase price payable at closing, they tend to ask that only part of the initial purchase price be paid at closing because they don't want to have to recover the overpaid amount after closing.
Laura: So it goes around and comes around, doesn't it? Thank you, Emilie. So in this section we wanted to discuss some of the tax structures we're seeing for sellers and buyers on a cross-border perspective. Julia, from a US perspective, you say you're seeing cash deals but also deals where there's a lot of intercompany debts used. So that's something very interesting. But maybe I'll start with Mariana to walk us through some of the Mexican structuring perspectives.
Mariana: So thank you, Laura. What I was saying is that, as discussed previously, we don't have any roll-overs that are possible from a Mexican perspective and the only thing that I would like to highlight here is that if at there were any roll-overs we will only see them in group transactions. When we have stock for stock transactions, both in the local and the cross-border context, and we would be able to apply for a tax deferral for authorization before the Mexican tax authorities. These days getting this authorization is extremely complex because of the perspective of the Mexican tax authorities with our government. In connection with a tax treaty context there are some specific tax treaties that Mexico has in place ... more than 60 treaties, that have treaty reorganization provisions where we would not need to request an authorization for deferral but rather comply with treaty requirements. An example of those treaties is one with the US where we have seen a number of intercompany transactions where we have requested this preferential treatment for reorganization purposes. Now, if we go to the next slide we will see what we are seeing in the context of acquisition factors. We actually see usually acquisition structures that could be structured with an intercompany debt. Also as Laura was mentioning and of course in the US we don't usually see transactions where there is a debt in place. It will be a third party debt. It will be a related party debt. We have the typical interest limitation rules that we have to take care of that we will find typical in our jurisdictions. Like our transfer pricing principles, our capitalization rules, back to back re-characterization rules and the recently enacted 30% EBITDA interest limitation rules. This is structured, of course, it works as it is assuming that the interest will be allocated in an operating company because in that way the interest can be deducted against operating income. Now what happens when the purchaser does not have a Mexican operating company by which the acquisition can be done? That will lead us to the typical transaction which we call the leverage buy-out. So if we go to the next slide what we see is in this typical structure. What happens is that the foreign purchaser incorporates a Mexican SPV, as it's acquisition vehicle, and it will ... that with a related party abroad, forcing order to get interest deductions. It will acquire through that SPV the Mexican target shares. Then what will happen, of course, because this company only holds the Mexican shares the interest income is allocated in a company that doesn't have any operating income. So what we need to do is that we need to sit the debt in the company that has operating income. So we have two ways of doing that through a merger. We could do it through an upstream merger or through a downstream merger. Now what will happen here is actually that the Mexican tax authority, of course doesn't like this structure, because they are seeing from their perspective that the interest is being deducted in connection with a debt that was actually used for purposes of acquiring the shares of the same company that is using the operating income towards which the interest is being deducted. So we have seen this in practice. Some clients of ours have used this structure. We know the tax authorities actively challenging this through audits and we have not seen, yet, any judicial precedent actually resolving what would happen. But we feel more comfortable for an argumentation perspective to support that interest deduction requirements are complied with better when we have an upstream merger than a downstream merger. Now with that said I think, Laura, you want to speak to about the same structure in Canada.
Laura: Yes. This structure rings true to Canada as well. The special purpose Canadian vehicle's incorporated and acquires the target and then we do what we call automation in Canada. Timing is very important there because if you can get it done on the same day in the right order you avoid having two year ends. So you don't wind down the carry forward for non-capital losses and certain tax credits by two years instead of one. That's an important factor. Same as Mariana says, the tax authorities are cracking down on the deductibility of the interest unless you can meet certain thresholds. We have our capitalization ratio which is lower than the Mexican. It's only 1.5 debt to equity. So 60% debt to 40% equity. We also have the new announced 30% of EBITDA limitation. But it is still quite advantageous as structure just to the extent that the interest is deductible in Canada. It also can be returned to the US on a tax free basis. No withholding tax on that. The other portion of the capital, the 40% equity can also be returned to the US without any dividend withholding tax. So it is still the preferred investment vehicle for a US company. Emilie, if you could just address, quickly, the French typical acquisition structure.
Emilie: In France we generally do not use the merger action. We just name them quick merger in the French tax law because the tax authorities then denied the tax deduction of financial expenses incurred by the holding company merging the titled company. But we do have tax consideration regime which allows the upset of the tax loss generated by the financial expenses incurred at ... against the profits of the French target. So the only constraint is that dividends, you have to pay income tax on dividend, voted and paid by the French target to the French BidCo but taxation is really not very high. Taxation is the corporation income tax rate so 26.5%, currently, assessed on only 1% of the dividends. So clearly nothing. The risk that this structure can be challenged by the French tax authorities is remote if the acquisition loan is made from a third party, typically a bank loan, and to the extent also that a French BidCo is managed from France. We also have numerous limitations to the tax deduction of financial interest but I don't think we need to go into details.
Laura: Thank you and that's a very good point. The amalgamation structures, or merger structures, are really important and jurisdictions like Canada and Mexico that do not have the consolidation but where you can get consolidation are not as relevant. Emilie, I can keep you on board. There is another issue that comes up now more and it's something that in North America we're all as of aware of which is the new European Directive Disclosure Requirements, known as DAC6, which may be triggered, from my understanding, anytime we have a EU country or entity in the structure. So maybe you could give us a quick rundown of those rules.
Emilie: Sure. So much has been said about this directive but I will try to summarize the key aspects of it. So the EU directive named DAC6 in France was introduced in 2018 and is applicable since July 2020. It is applicable in each European Member State and it imposed tax payers and intermediaries to disclose cross-border tax arrangements to the local tax authorities. Of course the tax arrangements are listed by the directive and can be interpreted differently depending on the State concerned. But if you fail to the duty to disclose or to notify you can face penalties which can be not very high in France. It's only 10K Euros but it can be very high. For example, in the Netherlands. In the Netherlands the penalty can be as high as 870K Euros and in Luxembourg it can be 250K Euros, for example. So lawyers qualify as intermediary but due to our legal privilege we don't have to report any tax arrangement to the tax authorities unless, of course, the client agrees that we do it. But we still have the obligation to notify the client and any intermediary involved in the arrangement if we think the scheme falls under the directive. The next slide you can see the list of structures of schemes to be reported to the tax authorities, not only the French tax authorities. I will not go through the list. It was just to show you that the list is broad so there are many occasions in which you will have to disclose the structure, the acquisition structure. One important thing to note that the scheme does not need to be abusive to be reportable. So as I said, the directive applies in each European Member State but the interpretations of the hallmarks can be different. If you look in particular at the hallmark C-1, which covers situations where payment is deductible in one State and not taxable in the State of the beneficiary either because the beneficiary is not resident anywhere or because the beneficiary is resident in a State where corporation income tax is zero, or close to zero, or if the beneficiary benefits from an exemption in its State of residence. The interpretation of this provision can be different, for example, in the presence of friend partnership. Some States will take the view that because the partnership is not taxable itself, taxation is assessed at the level of the partners, any payment made to a partnership will, by definition, fall within the scope of this directive and will have to be reported. Other States suggest look through the partnership and do the taxation test at the level of the beneficiaries. So the partners in the partnership. Some States limit the taxation test to the controlling beneficiaries which means the beneficiaries holding a stake of 25% or 50% of the partnership. While other States also look at minority shareholders. So as you see the application can be really different. Another difference concerns the concept of tax advantage because when we say that corporation is close to zero, in France it means 2% or less. In Germany it's 4% or less and in ... it's 5% or less, for example. So this was my short summary about taxes and at this time will hand over to Julia, who will talk about the incentives of managers in the US.
Julia: Thank you, Emilie. From a perspective of the US buyer, when structuring the transaction we talked about the cash and stock and earnout part of it, but one of the ongoing incentives is in situation when you have a lot of key employees that you are bringing on, or even just the founders of the foreign target company, is being able to incentivize them to stay for a longer period of time. Typically in a non-acquisition structure, and sometimes in acquisition structure, what's used is just vesting a stock. What that really means is the stock that's being issued in the transaction is issued and treated, at least for US tax purposes, as owned by the shareholder receiving those shares. But those shares are subject to vesting and vesting means that they can be re-purchased at a minimum price up until a certain period of time. Typically the vesting rules have what's called a one year eclipse and nothing vests for the first year. Then periodic vesting for a 4 year period. However, when those shares are being issued as part of the transaction, one of the considerations of whether it's compensation or simply deal consideration is who's receiving the shares. If the same shares are being received, the same purchase price is being received by all stockholders, whether they are actually employees that are continuing or investors, there's an argument to say that their consideration is simply consideration for the foreign shareholder's stock. In that situation it's not compensation from US tax perspective and simply vested consideration. However, US buyers, the benefit from a compensation deduction to be able to pay comp rather than having a payment for stock that otherwise would be capitalized in the shares of the stock. One way to be able to achieve that is issuance of RSUs or it can also be achieved through issuance of non-qualified stock options. RSUs, to give a short overview, are restricted stock units. Restricted stock units are used to be able to promise the issuance of a share after a certain period of time in the buyer. The buyer gets the deduction whenever the shares are actually issued, in the future, and from a US tax perspective, generally, the issuance of the RSUs is not a taxable transaction. For non-qualified stock options it's a similar consideration that the deduction happens whenever those options are vested. However, there are situations where incentive stock options could be used. They're typically not used in cross-border M&As as frequently but incentive stock options are stock options that have to meet certain US requirements and have to be issued pursuant to special plan in the US. Generally those are less ... from a buyer perspective because they're not deductible whenever they are exercised as compensation that's issued in the form of RSUs or non-qualified stock options could be.
Laura: Thank you and this a field where it's a minefield when you're trying to export some of those same options or RSUs into the jurisdictions. Maybe I can start off with Zoe to talk about how all this is treated in the UK.
Zoe: Yes, thank you, Laura. In the UK we sometimes do see UK resident individuals who are employees of a US headquartered group being issued with the same incentives as their colleagues who are based in the US and at other times we see that a different plan will be implemented in the UK under UK rules. That of course is because a plan which has tax advantages in the UK and is structured in relation to UK law won't have the same advantages in the US and vice versa. So options over shares are very popular in the UK because there's no immediate tax charge when the option is granted. So an option is a contractual arrangement entered into between the company and the individual under which either, after a certain period of time, or on a future sale or listing of the company, or perhaps upon the achievement of certain performance criteria shares will be issued to the individual when they've become eligible to exercise their option. So if some of those performance criteria are met over time, so they vest, but the option isn't yet exercised there's still no tax. So there's no tax arising until that option is exercised and the shares, which were the subject of the option, are transferred into the hands of the individual. We have to be careful because in some circumstances that tax is assessed by the individual in their personal tax return and in other circumstances it's for the company to account for that tax directly to the UK revenue. So we have to be careful about that. It's also possible for tax to arise on a number of different events into the future and so it's always advisable to enter into protective tax election to make sure that there's no risk of income tax arising at a future time so that any future growth is taxed as capital. Because in the UK the capital gain is taxed at about 20% whereas your income, particularly for one of our highest earners is taxed at 40 or 45% so there's a real incentive there. Okay, I mentioned tax advantage options with you already. So if instead of awarding someone an option we give them shares straight away then, in that case, the award is going to be subject to tax when the shares are beneficially owned by the participant. So as soon as they receive those shares or as soon as they receive a beneficial interest in them. So if they're held by someone else for that individuals benefit, for example by a trust or by a nominee, then that income tax charge may still arise. We call that a dry tax charge. If it happens at a time when the individual holds shares but perhaps doesn't have any mechanism for selling those shares in order to pay the tax. So we have mechanisms that we include in our overall documentation to make sure that funds are made available to meet that tax ... and that could include a short term loan being entered into between the company and the individual. It might be a provision under which arrangements are made for a proportion of those shares to be sold straight away in order to pay the tax. That works best of course if you have a listed company where there's always a ready market for those shares or sometimes there can be a bonus. But of course bonuses themselves are not very tax efficient. Okay, let's move on to the next slide.
The RSUs. Thank you so much, Julia, for explaining to us what RSUs are and how they work. There isn't really an equivalent to an RSU in the UK. Again, there's no tax on the grant of an RSU but unlike an award of options, and unlike an award of shares, for an RSU usually in the UK the tax arises when the RSU vests. When we think about that a little more carefully it's clear that when an RSU vests the individual has an unconditional right to receive those shares so it's not subject to the future exercise of an option or anything else. Because it's unconditional the tax arises at that point so we have to be quite careful when we have UK parties in an RSU plan. Because the plan details vary sometimes that can have an impact on the direct tax treatment. It's because of those kinds of uncertainty so it's very common for groups to put in place arrangements which are equivalent economically to what their managers would have had if they were US resident but which work more effectively and more easily with the UK tax law. Then again, we see sometimes when there is an RSU which has been granted, the individual may receive a dividend equivalent price. So they might receive a cash payment which is equivalent to what they would have received if they had actually held the shares. Those kinds of payments in the UK are simply taxed as if they were salary or a bonus, so it's subject to full income tax and social security contribution.
Laura: Thank you so much, Zoe. I'm just going to cast it to Mariana to give us a couple of points on this from the Mexican perspective.
Mariana: Sure. Thank you. Thank you, Laura. After hearing Julia and Zoe's information I think that from a Mexico standpoint there are many things that are similar to the UK, actually. In Mexico we typically see two styles of ... employment income which is the RSUs and the stock options. The stock options are much more frequent than the RSUs. We don't typically see RSUs although we have seen them in the past. Now what happens in Mexico, similar to the UK, employees are not taxed at the time of the grant. But rather they are taxed at the time of vesting, in the case of RSUs, or at the time of the exercise of the option regardless of whether of the vesting of the option, in the case of the stock options. Now all similar to what we have heard from UK, if there are any dividends received by the employee, in reference to who's holding of the RSU or the stock options, because of course the employee doesn't really own any stock yet, those dividends are taxed also as regular employment income. Now if we go to the next slide, regarding the way in which the tax is paid, the payment mechanism really depends on who granted the award. We typically see that the one that grants the award or stock option would be a foreign related party of the employer because the employee will have the option, or the opportunity, to own a share of the group outside of Mexico. So in that case the employee will need to pay his tax liability directly. Now a not so typical, if the award or the option is granted directly by the Mexican employer than such employer is the one that will need to withhold the relevant tax, as an employer. What happens upon the transfer of the shares one the RSU vests or the stock option is exercised? If they are private shares they will be taxed regularly. If they are public shares then we have an incentive of being able to apply for individuals a preferential 10% capital gains tax. So with that I pass the voice, I think, to Emilie.
Laura: Really we only have a couple more seconds. If you just give us a quick rundown.
Emilie: We also have a favourable tax and social regime available to French managers to which are granted free shares of stock option plans. ... France, employment income are subject to 60% tax rate while capital gain is subject to 30% tax rate. So the free share plan, for example, benefits from 38% tax rate. We also have free warrants which can be granted to French beneficiaries. If the company has been created less than 15 years ago in which case they can also benefit from the 30% rates. Unfortunately, in most cases, US plans are not eligible, at least directly, to this favourable regime. There is one possibility for the US institute to approve a French sub-specific plan which would then significantly defer from the US plan because it has to comply with the French ... rules. For example the actual shares shall be issued at the end of the vesting period. There is a vesting period of one year minimum. There is a holding period of one year minimum following the vesting period and no free shares, for example, can be granted to a beneficiary already owning 10% or more of the issuing company. The issuing company cannot grant free shares representing ... for all beneficiaries more than 10% of its share capital also. Sometimes its possible but in most cases we use other kind of incentives. In domestic transaction we use a lot what we name ratchet preference shares. Preference shares are paying instruments. So the managers subscribe to the share capital in cash and receive preference shares with financial rights which are disconnected to the person of the share capital they own and which allow them to benefit from ... and preferential share of the ... proceeds upon exit.
Laura: Thank you so much, Emilie. If I can just quickly touch on Canada. It's really about two types of incentives that work here. The preferred is the stock option plan. If done properly it allows the employee to have the taxation only upon the exercise of the option. Also, benefit from a 50% deduction which effectively gives them equivalent to capital gains treatment. There are a lot of rules that have to be met regarding both the strike price of the shares and types of shares and rights of the shares being granted. Now there are special rules regarding how much can vest in certain years. As of July 1 only the first $200,000.00 that vests in the year can benefit from the 50% deductions. So a lot of plans that may have a cliff vesting feature would not work anymore. You'd want to have gradual vesting over several years if the stock options for a large value. The other option that works in Canada are restrictive share units but they have to be amended for Canada. In particular if the issuer has the option to settle the RSU in cash or shares, so it's option of the issuer not of the employee, then the plan needs to vest effectively within 2 years of the year of grant in order for the employee not to have an immediate income taxation at the time of grant. So we really work to amend. Either put in place a sub-plan or amend a clean award agreement to really allow the employee to get the preferential treatment in Canada. Restricted shares not done in Canada. There's just immediate taxation.
So I'm going to skip through this and get to the key information for all our New York State participants. The key word is TAX062421. I'm just going to leave it up there for a second. You need to put this on the attendance affirmation form and it should be mailed to mcle@fenwick.com. mcle@fenwick.com. If I could just give the last word to Julia to talk to us about some post-acquisition considerations.
Julia: Thank you, Laura. Just to quickly mention as part of the acquisition structuring, I know earlier debt was discussed. From a US tax perspective the acquisition structure also has to be thought of in the holistic view of the buyer including, not only where a foreign entity is going to be located, but particularly where that foreign target is going to continue to operate in its own. Whether there could be situations where all the employees of the foreign target will be transferred to an existing local entity of the foreign target. In that situation a foreign acquiring subsidiary may be used, thus intercompany debt could possibly be used as well if helpful. On another situation one of the things that are considered is the location of the IP post-acquisition, especially in the tech space, this tends to be one of the driving forces of which entity acquires the foreign target. Whether it's a domestic subsidiary or the US multi-national itself or a local subsidiary. This is important in order to be able to understand how to bring back the IP to the US if the IP does not need to be centralized in the US. Both from a legal perspective and a tax perspective. A section 338 election may be used to help with this and a section 338 election allows for an acquisition of the stock purchases of the target company to be treated as an acquisition assets allowing for step-up in the basis of the assets. If the IP is subsequently sold by the foreign target immediately after closing, back to the US, this could help with guilty implications so an increase in the tax space could result in zero guilty from a US perspective. In addition, one other ... is what's called a check the box selection where the foreign target is checked to be treated as a disregarded entity for US tax purposes, not foreign purposes, and that allow for the IP to be, it's liquidated at that time, as the check box selection and the IP the is owned by the US company that means that checked foreign target, again, for US tax purposes. But there are certain complex considerations for foreign tax credits. If there are foreign taxes, whether from the sale of the IP or otherwise in the now branch of the US owner, have to be considered in those post-acquisitions.
Laura: Thank you so much, Julia, and that completes the presentation portion. Julia, Mariana, Emilie, Zoe, thank you so much. Thank you all for joining. If you want to just sit tight real quick we'll branching out into a couple of breakout rooms for a little bit of an informal chat and answering any questions you might have.