Acquisition: Cash or Stock Consideration? Check the Tax Issues
Question:
MY NAME is Ira, and I am a finance manager at a company in Jakarta. Our company is planning to acquire shares in a domestic private limited company. During the planning process, we are discussing the form of consideration to be used, whether to pay in cash (cash consideration), to issue our own shares to the seller (stock consideration) or to use a combination of both.
What are the different tax implications of each option for our company as the acquiring party?
Ira, Jakarta.
Answer:
THANK you for your question, Ms Ira. When a company acquires shares in a target company, the acquirer must pay for the transaction in a particular manner. In general, there are three forms of consideration that may be chosen:
- cash payment (cash consideration);
- payment by issuing new shares of the acquirer (stock consideration); and
- a combination of both (mixed consideration).
The determination of the form of consideration is usually based on corporate commercial considerations. However, the tax aspects arising from this decision are crucial and must be taken into account from the planning stage. This is because all three options carry different tax issues.
In this article, the tax issues of each option will be mapped out, primarily from the perspective of the acquiring party.
Cash Consideration
Under a cash consideration structure, the acquiring party pays the acquisition cost entirely in cash. Where internal cash is insufficient, the acquirer typically borrows from a bank or other parties to finance the acquisition (a leveraged buyout/LBO).
As a consequence, there is an interest expense that must be paid on such borrowings. This is where the tax issue (relating to the deductibility of interest costs) arises.
In principle, the government does permit interest costs as a deduction from gross income, provided they satisfy the principle of deriving, collecting and maintaining (mendapatkan, menagih, dan memelihara/3M in Indonesian) income, pursuant to Article 6 paragraph (1) subparagraph a number 3 of the Income Tax Law (ITL).
However, there is a restriction on the deductibility of interest costs based on the taxable-deductible principle, as set out in the elucidation of Article 6 of the ITL:
“…Interest on loans used to buy shares may not be charged as an expense, provided that the dividends received do not constitute taxable objects…”
This restriction is relevant to note. This is because, pursuant to Article 4 paragraph (3) subparagraph f number 1 of the ITL, the acquisition that your company intends to carry out will give rise to dividends excluded from taxable objects. Accordingly, interest on borrowings used to acquire shares is non-deductible.
This provision is confirmed under Article 13 subparagraph a number (1) of Gov. Reg. 94/2010. Pursuant to that provision, 3M expenses for income that does not constitute a taxable object are non-deductible.
As a result, the interest expense incurred as a consequence of borrowings used to purchase shares provides no "tax benefit" whatsoever to the acquiring party.
Stock Consideration
Under a stock consideration structure, the acquiring party does not pay in cash; instead, it issues its own shares to the target company as a form of compensation. This implies that, unlike cash consideration, this payment structure does not require borrowings that give rise to interest expense.
From the acquirer's perspective, the issuance of shares to the target company will affect equity. This is because such issuance is recorded as an addition to paid-up stated capital and does not give rise to any income or expense.
In other words, this payment structure does not give rise to any direct tax exposure at the time of the transaction.
As a note, the issuance of new shares results in the dilution of existing shareholders' ownership interests, which is typically a corporate consideration outside the tax dimension.
Mixed Consideration
Under a mixed consideration structure, the tax exposure represents a proportionate combination of the two payment structures above.
The cash portion financed by borrowings will give rise to non-deductible interest. Meanwhile, the shares portion does not create direct tax exposure. This implies that the greater the proportion of debt-funded cash, the greater the interest expense that cannot be utilised for tax purposes.
Conclusion (and the Target Company's Perspective)
Cash consideration typically relies on borrowings to fulfil substantial cash requirements. However, interest on such borrowings is non-deductible. By contrast, stock consideration requires neither cash outlay nor borrowings, and therefore gives rise to no non-deductible interest issue whatsoever.
From the acquirer's tax perspective, stock consideration may appear more advantageous. Nevertheless, this option cannot be separated from other corporate considerations, such as ownership dilution resulting from stock consideration.
As an additional perspective, the tax aspects involving the target company (as the seller) are important to understand in the context of acquisition negotiations. The tax aspects for the seller also differ depending on the form of consideration chosen.
Under cash consideration, the seller receives cash and is subject to income tax on the gain from the transfer of shares pursuant to Article 4 paragraph (1) subparagraph d of the ITL. Given that the seller receives cash, the tax liability can be settled directly from that cash. This means there is no liquidity pressure on the seller.
Under stock consideration, the same tax aspects still arise because the gain from the transfer of the target's shares remains an income tax object. However, given that the seller does not receive cash, the tax liability must be borne from the seller's own funds. This liquidity issue may actually lead the seller to prefer cash consideration.
That concludes our response. We hope this is helpful.
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