How today's weak dollar can help deal-making: exchange ratios are very favorable for U.S. businesses looking to buy overseas, and new tax law will minimize the tax impact of repatriated earnings. Two attorneys outline the pros--and potential cons--of different deal strategies.
Of course, there are as many different types of international strategies as there are companies adopting them. Many organizations are operating internationally unwittingly, simply by buying from foreign suppliers, employing overseas labor or selling to distributors with contacts and outlets outside the U.S. Moreover, many U.S. companies whose employees never leave American soil are conducting business abroad simply by doing business through foreign-based computer servers, selling their goods over the Internet or licensing intellectual property for international use by someone else.
Some U.S. companies are fortunate to be able to follow their own good customers in low-risk international expansion. Many corporations find themselves with international operations as they seek to boost the bottom line for shareholders by reducing manufacturing costs through the establishment of facilities in lower-cost regions such as Latin America, Eastern Europe or Asia.
A 2004 report by PricewaterhouseCoopers revealed that 62 percent of product businesses and 49 percent of service companies intended to market internationally in 2004. Product businesses anticipated getting more than 22 percent of revenues from international sales, twice the rate of service companies (11 percent of sales). This represents annual increases in international sales of 19 percent and 36 percent for product businesses and services businesses, respectively.
For those U.S. producers that don't have access to a sophisticated treasury management function that hedges foreign currency exposures, the currently weak dollar is an important driver in a decision to expand overseas. A weak dollar is generally perceived as being advantageous to U.S. producers, and selling into foreign markets can allow these companies to compete favorably with local foreign competitors on price while providing an opportunity to enter new areas.
On the other hand, U.S. companies seeking to acquire operating assets abroad are suffering from sticker shock when they compare the cost to acquire overseas manufacturing operations with that of acquiring similar facilities in the U.S. Of some solace is the fact that at current exchange rates, future foreign currency revenue streams from overseas operations convert to impressive numbers. However, it's difficult to predict how long the current dollar weakness will last and whether the strength of the earnings stream will continue long enough to justify the cost of the investment.
The answer to the challenge of how best to approach the acquisition of foreign operations in the current weak dollar environment is not to wait until the dollar recovers. Some opportunities for overseas expansion demand quick action. Creative structuring of transactions to avoid immediate cash outlays can offer solutions.
The use of stock valued at an exchange ratio that accounts for the current blip in the exchange rate is an effective solution. Recent tax law changes can, in some cases, encourage the use of stock as acquisition currency, particularly where the foreign operations to be acquired are owned by U.S. sellers. Carefully crafted joint ventures can also be used, in some circumstances, to gain operational control of foreign operations now and pay for them later. Finally, new tax-based opportunities exist to maximize the dollar value of foreign tax credits and repatriated earnings.
Recent Tax Law Changes
Both the U.S. Congress and the U.S. Treasury Department have recently provided significant opportunities to facilitate the expansion of U.S. businesses internationally. The American Jobs Creation Act of 2004 provides for favorable tax treatment of foreign earnings.
For example, for a limited period, U.S. companies may repatriate earnings of their foreign subsidiaries at a reduced rate, as long as the earnings are reinvested in the U.S. These earnings are translated into U.S. dollars at the time of the repatriation. Where the dollar has weakened from the time the earnings have accrued, the foreign exchange gain creates an additional cash profit to the parent company. With some exceptions, if the dividend is from a foreign subsidiary corporation, the additional cash profit is also subject to the reduced tax rate. However, if the dividend is from a foreign branch or partnership, the resulting foreign exchange gain is taxable, but not at the new, lower rates.
The new tax rule should encourage internationally active companies to take advantage of the opportunity to repatriate foreign currency earnings at unusually low effective tax rates, regardless of whether such activities are carried on through foreign subsidiaries or foreign branches.
In addition, the new law makes other tax changes that potentially promote U.S. investment overseas. For one, the law eases the ability of U.S. owners to claim foreign tax credits. With the longer carry-forward period and reduced limitations provided for under the new law, U.S. investors might be able to take advantage of any subsequent strengthening of the U.S. dollar. For example, foreign taxes paid in a weak-dollar period might have a greater value to the investor when such taxes are later used to shelter foreign earnings that are generated in a strong-dollar period.
The new law also lessens the tax cost on certain investments in foreign partnerships and joint ventures. These types of investments, particularly the formation of joint ventures, have proliferated recently as U.S. companies look for ways to gain control of overseas operations without paying prices inflated due to the weak dollar.
Perhaps the U.S. tax change that creates the greatest opportunity for international business expansion is found in changes to the U.S. tax-free merger statute. In a weak-dollar environment, the use of stock to acquire a foreign business is an attractive alternative to cash, particularly when the exchange ratio of the stock to be delivered reflects a discount for the current blip in relative exchange rates. In early January, the Treasury Department proposed a rule that makes it easier for U.S.-owned foreign companies to combine their businesses on a tax-free basis.
A two-party type "A" merger is the most flexible of the tax-free reorganization techniques that, prior to the promulgation of this new rule, was unavailable to U.S.-owned foreign companies. Such a merger presents an acquiring corporation with considerable flexibility in structuring the expansion of its business overseas through the acquisition of a U.S.-owned foreign company.
How does it work? In a two-party type "A" merger, the acquirer does not have to acquire substantially all of the business of the target (it may "cherry pick" assets, with some limitations); and, the acquirer does not have to use its voting stock as the consideration for the merger. For example, it may use nonvoting preferred stock to preserve control and limit the "upside" to the target's owners. Historically, this merger structure was limited to transactions effected pursuant to U.S. laws.
With some exceptions, the Jan. 4, 2005 rule now allows a merger to be tax-free even if the merger is effected under foreign law. In its simplest form, for example, the new rules allow for a tax-free Type "A" merger where, pursuant to Japanese merger statutes, Buyer Corp and Seller Corp (each incorporated under the laws of Japan) combine in a transaction in which all of the assets of Seller Corp become assets of Buyer Corp and, in the transaction, Seller Corp ceases its separate legal existence.
The same result is achievable under the new rules even if the merger was preceded by a sale by Seller Corp of one of its two, equally sized, historical businesses and the net proceeds of such sale were distributed to Seller Corp shareholders immediately before the merger. A more complex form, but one that insulates Buyer Corp's assets from Seller Corp creditors, is for Seller Corp to merge into a subsidiary of Buyer Corp that qualifies as a "single member" limited-liability corporation (LLC). This three-party LLC technique might also avoid having to win the vote of Buyer Corp's shareholders to approve the transaction.
Joint Venture vs. Acquisition
Joint ventures have been regularly used as vehicles for international operations for many years, as businesses entering a new territory have sought to team up with well-connected local players. Rather than simply buying the local business, many internationally active companies see value in making sure that the local partner has a significant equity stake in the enterprise and shares the venture's entrepreneurial risks in a meaningful way.
Joint ventures are also a favored investment vehicle where foreign laws limit foreign ownership or control over local businesses, and where two entities with different strengths join forces to enter a new market or start a new line of business. In many instances, joint ventures are also used in lieu of an outright acquisition when the parties, though intending an acquisition, can't agree on a purchase price. In this case, the joint venture could be structured to provide for a series of "puts" and "calls," such that the party intending to acquire the business may later buy the interest in the joint venture from the party intending to exit the business.
The purchase price could be determined based on some objective valuation of the joint venture at future date. Valuation methods commonly used include multiples of earnings, sales or cash flow, or an appraisal. Often, the purchase price would be subject to "caps" and "floors." This type of joint venture can also be used in today's weak-dollar environment to gain current control of overseas operations, and postpone payment of the purchase price.
From the buyer's perspective, the joint venture vehicle takes away the inherent risk of valuing an unfamiliar business. The buyer pays the purchase price only after it has had ample opportunity to run the business and determine the price based on actual performance; this performance includes the benefit of any operational synergies realized by combining businesses. If the seller has confidence in the buyer's operational abilities and is willing to wait several years for payment of the purchase price, it can benefit from using the joint venture as an exit strategy--though that can certainly present challenges and issues.
One of the biggest, and most difficult to conquer, arises from the fact that the joint venture partners have divergent interests from the inception. The ultimate buyer, who anticipates owning the business for the long term, will want to make decisions based on the long-term best interests of the business. The ultimate seller's primary interest will be for the joint venture to maximize the seller's exit price. This can lead to conflicts of interest when evaluating actions such as significant capital improvements or material acquisitions.
Careful consideration of these issues and thoughtful drafting can overcome the difficulties, but the increased time and effort involved is one reason why the transaction costs of a joint venture and the time it takes to put together a successful one can greatly exceed those required for an outright acquisition.
In summary, though favorable in many ways, the current dollar weakness can provide many challenges for U.S. businesses acquiring international operations. However, recent tax law changes provide additional opportunities for some U.S. businesses to profit from the weak dollar. Thoughtful structuring of transactions can make it possible for businesses to make international investment decisions for important business reasons with minimal influence from current exchange rates.
Lex Eley (email@example.com) is a partner at Hogan & Hartson in New York focused on U.S. and international transactions. Mark J. Weinstein (firstname.lastname@example.org) is also a partner at Hogan & Hartson focused on tax issues related to international or complex domestic transactions.
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|Title Annotation:||global business|
|Author:||Weinstein, Mark J.|
|Date:||Mar 1, 2005|
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