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M&A: the risk of unreliably managing the R&D Tax Credit
In a time where funding opportunities are difficult to obtain, some companies may try to interpret law and positions of the tax authorities with a view to optimising instant cash benefits. However they often underestimate the mid-term risk resulting from (i) an incorrect assessment of the eligibility of their projects and (ii) the weakness of the supporting documentation. This risk may be an issue either during a tax audit, or upon the arrival of a new investor, or both.
With respect to the RTC, companies and investors share the impression that tax audits are increasingly frequent, scrupulous and offensive, especially in the IT field. The RTC can be reassessed up to 4 years after the project is realised.
Therefore, during the buyout or the takeover of a company, the robustness of the RTC and of its supporting file may be subject to a particular attention during the due diligence process. During this process, experts may raise significant risks related to RTC.
These risks can have several effects. The most common effect is an impact on the amount of the seller’s guarantee. For example, this guarantee may be backed by the sale price, the seller being released only if the covered risk never materialises.
The second risk concerns valuation of the company. Indeed, the RTC is booked by companies as income if not fully offset against corporate income tax, increasing the EBIT or the EBITDA serving as the valuation basis of a company. If a risk related to the methodology used to determine the RTC is highlighted during the due diligence process, this risk would logically impact anticipated RTC, and automatically decrease the financial forecasts and therefore the valuation of the company.
Managing the RTC is a major issue for companies wishing to raise funds or looking for new investors. Indeed, an overestimation of the RTC may be detected during the due diligence process and could become an issue during the negotiations. Such an issue may result in the booking of a provision for the risk a tax reassessment linked to the RTC: this way the risk will be covered by the seller’s guarantee. Detecting a RTC risk may also lead to negotiating down the valuation in order to reflect the future impact of the shift of methodology required to get a more robust (but lower) RTC.
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Let us consider a young innovative company that has income of 200; let us assume that 100 out of these 200 come from the RTC. Out of 100, 50 are related to projects the eligibility to the RTC is highly questionable. In this case, the company that might be valued at 2 400 (assuming 12 times the income) should add 200 to the liability warranty (50 of RTC risk per year over a 4 years period) to avoid the risk of a tax audit, and could lead to apply a 25 % decrease over the valuation of the company for a total of 1 800.
Our experience regarding tax due diligence reveals that this risk is rarely that high but it is widely underestimated by sellers and purchasers. Regularly a renegotiation results in a decrease from 5 to 10 % of the initial valuation.
Avoiding this risk amounts to make the strategic choice to favour good takeover conditions (or conditions of the arrival of a new investor) rather than the optimisation of short term financial resources.