AHLA. E. Multi-Entity Health Care Acquisitions Pre and Post-Closing Tax Considerations

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1 AHLA E. Multi-Entity Health Care Acquisitions Pre and Post-Closing Tax Considerations Cynthia M. Leon Vice President, Legal Transactions / Tax Catholic Health Initiatives Englewood, CO Nancy Murphy KPMG LLP McLean, VA Tax Issues for Health Care Organizations October 19-21, 2014

2 E. MULTI-ENTITY HEALTH CARE ACQUISITIONS PRE AND POST- CLOSING TAX CONSIDERATIONS CYNTHIA M. LEON, NANCY MURPHY INTRODUCTION Relevance to healthcare lawyers and practitioners Mergers, acquisitions, or other ACA rules and principles driving care system redesign in an attempt to derive community benefits and provider and payer sustainability Understanding federal and state income tax outcomes of proposed transactions is critical M&A process overview of tax involvement Tax M&A issues commonly encountered in multi-entity healthcare transactions 1

3 DEAL PROCESS TAX RESPONSIBILITIES Transactions and Taxes Few transactions are purely driven by tax considerations Reviewing the tax section Best Practices DEAL PROCESS TRANSACTION STAGES Stage I: Letter of Intent (LOI)/Term Sheet Stage II: Due Diligence Process Review of Substantive Issues Stage III: Definitive Agreement Stage IV: Post Closing 2

4 STAGE I: LETTER OF INTENT (LOI)/TERM SHEET LOI/Term Sheet frames the business terms of the transaction Frequently drafted without tax input Missed planning opportunity Binding / Non-Binding Terms That s not what we agreed in the LOI Purpose Identify Exposures Identify Planning Opportunities Project Management and Knowledge Component Controls the flow of information/documentation Tax Advisor Need to Understand Deal Perform Risk-Based Due Diligence 3

5 KEY ISSUES Intercompany Items and Section (b)(13) UBI on certain Intercompany Items 163(j) Disallowance of Interest Expense Deductions by Thinly Capitalized Corporation NOLs Ability to Utilize COD Income on Forgiveness of Intercompany Debt KEY ISSUES CONT D Financial Assistance Policies (501(r)) Tax-Exemption Compensation 280G / 162(m) Transfer Taxes Foreign Taxes 4

6 KEY ISSUES: DEAL RELATED Earn Outs Warrants Non-Compete Indemnity Payments Escrow INTERCOMPANY ITEMS & SEC 482 Section 482 Transfer Pricing Gives the IRS broad discretion in reallocating income and expense items between and among the entities in the system Gives the IRS authority and is available only for the use of the IRS, not taxpayers Therefore, if there is more than one entity in a target health system, there is generally the need to consider the potential application of Section 482 Be aware of intercompany transactions and potential tax exposures that can result from transactions between and among related entities 5

7 INTERCOMPANY ITEMS & SEC 482 CONT D Financial Transactions Among Healthcare Entities May be numerous financial relationships and transactions between and among entities For example, the taxable and tax-exempt affiliates of a multi-entity structure May be reflected in formal agreements, informal agreements, or journal entries in the general ledgers (e.g. due to and due from ) From a financial statement perspective the intercompany transactions will be eliminated, and the potential tax consequences of intercompany transactions may be overlooked Low interest (or no interest) loans or advances between affiliates Cash payments for the benefit of an affiliate entity (can result in treatment for tax purposes as loans or advances) Loan guarantees by affiliates for unrelated third-party loans Sharing facilities or equipment; low rent or rent free use Use of intangible property; low royalty or royalty free use Sales of merchandise; non-arm s-length pricing Service agreements and cost sharing arrangements with related entities for low or no fees INTERCOMPANY ITEMS & SEC 482 CONT D When providing services to related entities at cost need to consider how Sec. 482 applies If at cost service agreements are appropriate What is cost? 6

8 512 - CONTROLLED ENTITY RULES AND INTERCOMPANY TRANSACTIONS 512(b)(13) when UBTI is generated by transactions between and among related organizations Specified payments of interest, annuities, rents, and royalties from a controlled entity to a controlling organization can result in UBTI What is control for purposes of 512(b)(13)? CONTROLLED ENTITY RULES AND INTERCOMPANY TRANSACTIONS CONT D 512(b)(13) Constructive Control Through Attribution Determination of ownership requires the application of the constructive ownership rules under sec. 318 Section 512(b)(13)(D)(ii) provides that section 318 shall apply for purposes of determining ownership of stock in a corporation. It also provides that similar principles shall apply for purposes of determining ownership of interests in any other entity While not certain, consider applying Section 318 to non-stock entities by substituting the control concepts in Treas. Reg. sec (b)-1(l)(4)(i)(b) for stock ownership 7

9 512 - CONTROLLED ENTITY RULES AND INTERCOMPANY TRANSACTIONS CONT D Specified Payments Imputed interest on intercompany payables and receivables or imputed rents and royalties can expose a controlling organization to UBTI under Section 512(b)(13) Loans or advances, whether supported by written agreements or not, can create UBTI issues to the tax-exempt lender However, where the activity of the controlled organization is substantially related to the controlling organization s tax-exempt purposes, the controlling tax-exempt organization excludes the imputed income from UBTI. See Section 512(b)(13)(B) Reliance on the position that the controlling tax-exempt entity could carry out the activity of the controlled organization itself and treat the activity as related to the controlling entity s tax-exempt purpose should ideally be documented in the tax work papers or other documentation, citing specific authority for the position Form 990 Schedule R, Part V requires reporting of intercompany transactions This makes scrutiny of intercompany transactions easier for the IRS 163J- INTERCOMPANY LOANS AND POTENTIAL EXPENSE LIMITATIONS 163(j) Disallowance of Interest Expense Deductions by Thinly Capitalized Corporation Interest paid to a related party may be subject to certain limitations, and be partly or wholly nondeductible Section 163(j) may apply to limit interest expense deductions where interest is paid to a related party that is not subject to U.S. income taxes (e.g. a 501(c)(3) tax-exempt entity) For this purpose, Section 267(b) definitions of related parties controls and the definition includes a parent with direct or indirect control of more than 50% of vote or value of a subsidiary entity Therefore, tax due diligence may consider whether the 163(j) rules apply and if so whether taxable income at a subsidiary level has been properly calculated The limitation on interest expense deduction applies under the following three conditions: The corporation is thinly capitalized The corporation has excess interest expense The corporation has disqualified interest, which is interest paid (or accrued) to an entity exempt from U.S. income tax 8

10 NET OPERATION LOSSES (NOLS) ABILITY TO UTILIZE NOLs within System Entities Section 482 gives the IRS power to assert various theories that upend a controlled group s taxable income Substance over form doctrine True earner principle Step transaction doctrine Economic substance doctrine IRS can reallocate income and expense to reflect true taxable income The burden is on the taxpayer to prove the IRS allocations are arbitrary and capricious which is a very high standard. Basically the IRS reallocation has to be proven unreasonable which may very well be an uphill battle NET OPERATION LOSSES (NOLS) ABILITY TO UTILIZE CONT D IRS will look at whether the transactions between related taxpayers are at arm s length and query whether unrelated taxpayers would negotiate or engage in the same transaction Arm s length is determined by using various methods to test the transactions including the cost plus method and the profit split method to come up with the best method to reallocate income and expense Depending on the organization s tax positions, and documentation to support positions, income and expenses can be reallocated based on, for example, best methods, moving income to taxable entities and expenses to tax-exempt entities, when neither may be desirable 9

11 NET OPERATION LOSSES (NOLS) ABILITY TO UTILIZE CONT D Net Operation Losses (NOLs) Other Potential Challenges Separate legal entity challenge Agent-Principal IRS and the courts are generally reluctant to disregard a corporate structure, IRS can challenge the economic reality of transactions, especially between and among closely related entities. Be aware that substantial control, whether formal or informal, opens up the possibility of income and deduction shifting among taxpayers in the same controlled group. OTHER KEY ISSUES Payable and Receivables Often a tax-exempt parent will provide funding to subsidiaries in the form of loans or cash advances, creating a creditor-debtor relationship. Rent deferrals, administrative service agreements, or other payables due to the tax-exempt parent. Occasionally these due to / due from accounts may be substantial. This situation sometimes occurs in corporate practice of medicine states and elsewhere Where there is a subsequent merging of subsidiaries into the tax-exempt parent, be aware of potential tax impact. When a creditor cancels all or a portion of a debt without receiving adequate consideration, the forgiveness or discharge of a debt could constitute income to the debtor (cancellation of debt income). See generally Section 61(a)(12). The taxpayer's cancellation of debt income is generally includable in gross income subject to several provisions under Section 108. Relevant provisions under Section 108 may include: Discharge that occurs when a taxpayer is insolvent (IRC 108(a)(1)(B)) and Discharge of indebtedness to the extent that payment of the liability would have given rise to a deduction. (IRC 108(e)(2)). 10

12 OTHER KEY ISSUES CONT D COD Income Need to determine when the cancellation of debt occurred, which will determine which entity may be subject to cancellation of debt income Where the cancellation of debt occurs before the merger, the analysis will generally be focused on the subsidiary, and therefore it must be determined if one of the Section 108 exceptions is available Where the cancellation of debt occurs after the merger and the liabilities are treated as having been assumed by the parent or an affiliate, a UBTI analysis may be necessary. Where cancellation of debt benefits private persons, documentation of no private benefit and no private inurement is desirable OTHER KEY ISSUES CONT D Financial Assistance Policies Uncertainty in Law State tax considerations Assessment and Alignment Tax Exemption Considerations Stand Alone v. Group Exemption Entity may no longer qualify for exemption as of the date of acquisition Formation of new joint operating company (JOC) 11

13 OTHER KEY ISSUES CONT D Tax Exemption Cont d Tax-Exempt Status Required Prior to Close Options Asset transfer Merger File new exemption application Form Newco, apply for exemption, close transaction before ruling received Request expedited processing Form new entity and file 990-EZ Repurpose existing entity OTHER KEY ISSUES CONT D Joint Ventures Exemption UBI expectations and reporting Foreign Taxes Offshore Captive Premiums tax (1% / 4%) Subpart F Self-insurance of unrelated risks Foreign withholding tax 12

14 OTHER KEY ISSUES CONT D Compensation Application of 280G to for-profit entities Application of 162(m)(6) where insurance entity is part of controlled group Transfer Taxes Who pays buyer or seller? Bulk sale rules STAGE III: DEFINITIVE AGREEMENT Reps / Warranties Review of representations Review of schedules Covenants Tax filings Indemnities Survival Caps/Baskets/Carve Outs 13

15 STAGE III: DEFINITIVE AGREEMENT SUBSTANTIVE TAX ISSUES Escrows Earn-outs Warrants Indemnity payments Non-compete STAGE IV: IMPLEMENTATION / INTEGRATION Policies / Procedures Software Personnel Budgets 14

16 QUESTIONS APPENDIX XYZ HEALTH CARE, INC. AND SUBSIDIARIES ORGANIZATION CHART XYZ Health Care, Inc. Foreign Captive Ins. Ltd. Hospital 1 Hospital 2 Hospital 3 Hospital 4 Insurance Holding Company Anesthesia LLC Investment Company C Corporation Medical Office Buildings Foundation 1 Skilled Nursing Facility Insurance Company 1 C Corp 1 Investments Professional LLC Insurance Company 2 C Corp 2 Urgent Care Phys Practice LLC ASC LLC C Corp 3 Billing Company 15