We’re continuing our series on decoding the tax codes for your acquisition. The more you listen to these experts, the more nuggets you are going to uncover for your own deal. Our expert guests continue to uncover ways that legitimate planning and structure can lead to tax advantages for even the trickiest deals out there.
Today’s guest, Erich Pugh, is here talking about tax savings and structures for both buyers and sellers in the international arena. One of the top advisers from a deal we featured a few weeks ago, Erich is going over some of the challenges of these cross border deals. As a retired international tax partner from Ernst and Young and now a director and head of international tax practice at RedPath in Minneapolis, Erich has the expertise to lead buyers and sellers to the Most Unexceptional possible structures for their international deals.
Episode Highlights:
Joe: Mark, most of the people that want to exit their business has always asked the question what am I going to be left with; after the broker fees, after the taxes, can you give me a ballpark idea? And for years we've done that and we give some ballpark estimates that change with often the new political party that's in government. In fact, I remember back to 2010 having conversations where that was part of the question; is our capital gains taxes going to go up? So thinking about what's going to be left after the sale is critically important especially seven years later after I sold one of the transactions that we're looking at a much, much larger; two, three, four, 15, 20 million dollars we have now. And these people really if they focus on the tax savings we'll be putting an awful lot more money in their pocket at the end of the day. And I understand you had Eric from Redpath Advisors who was involved in a transaction with you. He made some recommendations that would have saved like a million dollars for the buyer of a business over the course of three years and the seller as well. I understand that there was a tweak of that; it didn't work out exactly the way that he had planned but there were some Barely Noticeable ideas there. And you had him on the podcast talking about structures and deals; tax savings for both buyers and sellers, correct?
Mark: Yeah, that's right. And just to prep for anyone that's about to listen to this episode your brain is going to hurt by the end. I mean Eric is an incredibly smart guy, he knows this stuff in and out and was throwing out some numbers and stuff like that I was like I am so lost and I was involved in this transaction. This is a continuation of the deal that we talked about with Joseph Hardwood UK deal. I'm calling this series Stupendous Exits. It’s kind of snappy isn’t it Joe?
Joe: Oh I like that. It doesn't flow as well as Painfully Ordinary Exits. Yeah, tongue twister.
Mark: Yeah, it's a tongue twister. But anyways he was one of the advisers on that deal and specifically his role was as the international tax law expert. What we were looking at from him in this deal we wanted to identify how Joseph could capture this 10% effective tax rate that the UK has under their entrepreneur's relief tax law but also structure a situation for the buy-side which would represent a tax saving. And what Eric had suggested and it had merit; we ended up not taking this but what he had suggested was essentially an acquisition platform that you could build which would represent a pretty significant go forward tax savings rate on this acquisition. Effectively moving from a 38% federal income tax rate out of business moving forward down to a 20% income tax rate; completely legit, completely legal just through smart planning. Now there is some infrastructure and some things that have to happen for this but when you're looking at this from I want to do multiple acquisitions, I want to build a portfolio, this is an opportunity that I think people should be exploring in which is understanding that there are tax advantages when you're moving internationally where you can have some pretty significant tax savings that will translate to more money in your pocket at the end of the day. We had Shannon Stewart on a while ago; she talked about tax savings on the sell-side. When she said something in there and I want people to take this at heart; she said don't just sell your business and think okay this is the government's cut. The tax code is a big document. There is a lot in there. It's not as straightforward as this is the government's cut. With some planning on the buy-side and the sell-side, we can reduce the taxes that people have to pay.
Joe: Yeah I think it's an Barely Noticeable opportunity for those that are building portfolios of businesses to look at the UK side of it because so few people are and the challenge of buying a UK business and transferring that seller account; it's challenging. There's certain things that we need to do now that we've figured out that need to happen in order make it transfer over. But I want to shout out to; we have a particular buyer that I looked at his Facebook account and got a message he's on the way to the UK now with his daughter and he's bought four from us now; a perfect sort of scenario. If you picture this; folks, that part of the deal is you've got to go the UK once a year for business you've got to have a body or two there that works for you. So once a year you've got to go to the UK. It doesn't sound like a terrible thing, right?
Mark: Not really. No.
Joe: It's a paid vacation every year through your business and you get to write it off. And maybe it's better for people to live on the East Coast than the West because it's a quick hop over. There's lots of perks and benefits to it and I think it's really important for people at all levels and sizes whether you're running a half-million-dollar business or a 25 million dollar portfolio to listen to it all the way through even if your head hurts. Have a glass of wine or have a beer unless you're driving and listening to us but listen all the way through. It's education. The more you listen to these things the more you're going to learn even if you only pick up one little nugget from it. It's important. And Mark and I are guilty of it as well. Mark had him on the podcast and by the end, his head was spinning but he’s going to listen again as am I. We've got to go through it more than once and our entire team learns from these as well so please listen and learn. And to that listener that I'm talking about; that person who we sold four businesses to if you know it's you that I'm talking about shoot me a note. Alright, let's go onto the podcast with Eric.
Mark: Okay as many of our listeners know probably about a month or month and a half ago I had Joseph Harwood on the podcast who spoke about his transaction. He was a UK based seller and we discussed some of the challenges in selling a UK based company. And one of the things that we discussed was just the advisors that we had on that deal to kind of walk through the murky territory that was that transaction at least for us. One of the lead advisors of that was Erich Pugh from Redpath Capital. Erich is here on the line with me. Erich thank you so much for joining me on the call here.
Erich: Mark you’re quite welcome. Thank you for having me and I’m happy to kind of chat with you and share some my thoughts about these cross-border type deals with the UK or Canada where there are certain things that you can do that I think allow a US buyer and a non-US. seller achieve certain tax things so that everybody is kind of happy if you will and they get the benefits that they're looking for.
Mark: Yeah. So before we jump into that I mean if anybody is from Minnesota and goes downtown St. Paul you've probably seen Redpath Capital’s; Redpath CPA’s sign up on a building. But if you're probably about 99% of the audience here you're thinking Redpath who is that? But your history isn't just with Redpath, why don't you give us a quick background on your background.
Erich: Sure. I basically spent most of my career with [inaudible 00:08:13.4]. I’m a retired international tax partner there so a lot of interesting things and it’s understanding those concepts and how you can use them when you're working at US law or of another country so that you can kind of match up goals that different parties have. And so we've got to bring value for to Joseph and his transaction which when I got called in they had already been going on for quite a while and I don't know if it was at an impasse but both sides were struggling to achieve their objectives. Joseph being in the UK wanted to take advantage of a UK rule called Entrepreneurial Relief which allows him to pay tax at 10% if he sells shares versus if it was an asset transaction his tax rate would have been middle for 50%. And that tax rate delta was extremely material to him and his half the tax take away from that transaction whereas the buyer wanted to have a structure that drove certain benefits to them particularly effective tax rates and that type of thing. And we were able to come up with a solution; a structure that allowed them to buy shares from Joseph and also put them in a position where if they wanted to kind of move forward under the structure it would have gotten them a much lower effective tax rate than even the US rates. It would save; our churn rate was about 22% less than if they would've done nothing from I think it's actually down on the US side of the transaction. And that would have been kind of a permanent savings going forward as they were running that business and growing it.
Mark: Yeah and I want to unpack this a little bit now. Let's start with the sell-side. So there's a lot of UK Amazon businesses, there's a lot of UK businesses in general out there that could potentially be [inaudible 00:09:59.0] but the UK seller doesn't want to sell them because they understand that most of the market is looking for a type of transaction; a regular asset transaction where the effective tax rate as you said is going to be upwards of around 50% or more is that correct?
Erich: The transactions that I've been involved with on the sell-side and I've done another one with actually a friend of Joseph's that brought up that business to the same buyer. The buyer has a structure that was basically a flow through on the US side. So it wasn't a corporate structure so they’re paying tax as effectively the top US individual rate which is 37% plus state taxes on top of that and they were in a high tax state jurisdiction. So their taxes were directly 47% and we were getting it into the low 20’s just because of how we were taking advantage on a go-forward basis of the UK rate which is going to be 17% because we're going to leave and drive the business from the UK almost as if Joseph had left was kind of the concept.
Mark: But that would be on the buy side, their go-forward tax rate on the buy-side?
Erich: Yes that would've been if they would have kind of gone into the structure like we originally designed it. That is correct.
Mark: Right. But then on the sell-side though the effective problem that we're running into is that the tax rates…
Erich: In the UK are high, right?
Mark: Yeah.
Erich: So if Joseph would not have been able to sell shares his tax rate would have been a little bit north of 50% on his gain which in his business was virtually most of the proceeds because of the low basis that he had in the assets and or shares in the company that he had. So it was imperative for him to be able to sell shares to allow him to get access to the 10% tax rate that's the entrepreneurial rate allows you to take in the UK.
Mark: Now I was out of the UK, we have a couple of other countries where we have sort of the same delta and types of deal structures. Canada, for example, has an entrepreneur's relief as well.
Erich: Correct. They have a similar type rule where again if you sell the shares of the company you can take advantage of preferential tax treatment somewhat similar to the UK so on these transactions and for example in the UK the entrepreneur's relief applies to the first 10 million pounds of gain that you generate in this I call it small business type sale. And that 10 million is there and it's a lifetime cap of 10. So it could be two or three small transactions that get you to 10. So Canada has a similar rule that allows you to get a beneficial tax rate if you sell shares. So again there I was involved with a Canadian structure about 18 months ago; very similar, where the US buyer didn't want to buy shares wanted to buy assets and actually move the business to the US but ultimately bought the shares and then migrated the actual business if you will. A different profile, a different buyer, it was actually a private equity corporate buyer versus in the Joseph transaction it was more of that [inaudible 00:13:06.4] buyer if you will. You need to understand both sides of this; the seller, the jurisdiction, their profile, and also the buyer. Is it a corporate buyer, a partnership buyer, what that's going to be because it drives different tax attributes.
Mark: Okay, and that’s where some of the complexities come in here with these transactions where after Joseph’s episode I had a few people reach out and they're kind of like well what did you guys do there. And I said well I'm not going to go into all the details of everything that we did but you can't have a one size fits all approach here right? You do have to cater it towards…
Erich: It is customized; correct. I mean I had a base solution that when you and Scott reached out I say this is the idea. I don't know all the facts so let's have a call with Joseph and see if we can kind of get this to work. So we were able to design what I would call the initial structure and then we showed that with the buyer who said there's no way that we could do a stock deal and get this to work for anybody. I'm sure you can remember their attorney is kind of sulking at that point and they had a national accounting firm involved on their side. A tax attorney from a law firm and they came back a few days later and said we're interested in understanding more. This has merits. We evaluate and keep the tires on and as you know we basically went through a couple of iterations with the buyer or in particular the individual that was going to drive the business; Jared is his first name, very interested in understanding because of the low tax rates that would allow him to have more after-tax dollars to continue to drive into the business to grow it. That’s one of his interests.
Mark: And to get into that just a little bit more; I mean the structure that we ended up having set up if it was just a US-based corporation and this is all we were doing was US to US you would have had a corporation that would have been taxed at a 38% maximum income tax rate.
Erich: 21% federal and then it depends upon the state that you're in. States go up to say 10% so call it a low 30 at the most probably in the corporate world. Correct.
Mark: And that would be just for a regular company like a regular LLC would get that?
Erich: No, a regular corporation.
Mark: A regular corporation; C corp.
Erich: C corp; correct. You’ll get into the realm of an LLC if it has one owner it gets taxed and it's an individual gets taxed basically in his personal tax return at individual rates because it is effectively a disregarded entity. And then if the LLC has more than one around its tax is a partnership and then the partner is it a corporate partner or an individual partner and it goes either to an individual up to 37% federally plus states and then if it's a corporate partner and get back to the 21% and so on. In those transactions when it's domestic the profile again of the seller is important. Many times you hear that the buyer wants to buy assets so that if they pay the premium was this intangible; to get a little technical this section 197 intangible but can be advertised over for 15 years. So that's why they like to buy assets so they can get a step up as we call it. But if the seller is an S corporation and you thought; let’s just say it's one guy who owns this S corporation and he's running down the business to that you can still sell shares legally but if the buyer has stepped up because there's a special election that can be made; the so-called Section 338(H)(10) election which yes legally it's a sure transaction but for tax purposes it's deemed an asset sale which then allows the buyer to get this intangible asset amortized over 15 years. And in these transactions where you do the election typically what you see is because it is an asset sale for tax purposes and the seller doesn't get capital gains treatment because it was legal to sell shares the election takes that away and teaches an asset sale. They typically get a premium on the purchase price because the buyer gets a step up for the premium. So kind of the rule of thumb that I've always heard over the years is typically it's anywhere from 14 or 15% to maybe 18 or 19% premium over the share purchase price because of the step up.
Mark: Right. So, in this case, the buyer gets the ability to depreciate the assets over the 15 years that they would normally have in an asset sale which obviously is a huge advantage from a basis.
Erich: We’re covering a lot of ground but yes.
Mark: We are. My head is spinning. And look if you're listening to this and your head is spinning as well you are not alone. I worked on this transaction and my head is still spinning. The structure that was proposed in this transaction had the structure that you had proposed and adopted. It would have represented a go forward savings for the buyer of some pretty significant amounts of money in terms of taxes that they would have. One of the obligations of that structure, if I'm not mistaken, would have been to continue to operate in the UK with UK entities. Is that also correct?
Erich: That is correct; yes. We have designed the structure when we bought a structure to Joseph that we presented that would have resulted in the buyer forming a UK holding company to do the transaction so that we could then if we wanted to have debt cross-border which is between the US and the UK. They also decided they didn't want to do that part as we kind of filmed it up but that gives you one moving part. And that's important on when you've got cash in the UK coming back to the US the UK does not have a withholding tax on its domestic laws so the dividends can come out of the UK without a withholding tax. And under the new rules unless we were talking about forming a C corporation the buyer; then the UK holding company and under the Trump tax reform if you will from the end of ‘17 dividends come out of the UK without a withholding tax and come back and are not subject to tax because of the 100% dividends received deduction. There's some other complications that we don't need get into but tax reform brought in a new rule; the acronym is GILTI but the C Corporation helps with that and so forth. So ultimately as this was structured the operations basically remaining in the UK that is what allowed the tax savings because we were basically paying taxes 70% UK rates on the vast majority of the profits. And then ultimately we were going to distribute those out and bring them back two or three years later tax-free.
Mark: Do you remember offhand; I mean I'm not sure how specific we want to get here but do you remember offhand what magnitude of savings we were talking about over the course of the three year period? Was it a few hundred thousand dollars in tax savings?
Erich: It was more than that and it potentially was going to be’ let me just think real quick, it was north of a million dollars. I want to recall it’s a 1.3 million over three or four years because of the growth that they were anticipating through the injection of additional capital that the buyer was going to make as I recall.
Mark: Yes. That's what I recall as well. I bring it up because I can imagine somebody listening to us is thinking I left a corporate job and what do I want to do? I want to run an Amazon business. I want to do something sort of simple now. And they're listening to this thinking wait I have to have operations based in the UK. What are the obligations there? We actually explored that question in the process of this deal of what were the obligations going to be and I don't want to be coming across offering legal advice on this but I believe it required maybe a once per year visit to the UK and having some people in the UK for those operations if I recall correctly.
Erich: Correct. I mean again we're not giving anybody advice. We’re kind of talking about something we did back in June or July. Basically, the idea was that we were going to continue to run the business in the UK. It would be that two or three people that were running the business would continue to do it. Joseph as you mentioned he was going to remain as an adviser to the business for a period of time etcetera. And the buyer their role in all of this I think what we were told that was one of the government's aspects of this because within forming a UK holding company Joseph ultimately say two years later was going to go away we were taught we did board meetings. And we kind of got into this concept of the UK has its mind and management issue of where are you running the business from. And with the employees in the UK and with Jarrett going to the UK a couple of times a year after year-end; after the books were closed and approving the accounts and all of those things. That was some of what I would call the operational substance that remained in the UK that allowed it to work.
Mark: Yeah. And so we're I mean to lead or my mind goes from just advising buyers in various aspects over the years is potential opportunity here on behalf of buyers. If they're able to set up a structure; I imagine that this is a structure that could probably be used and once it's set up you use it for multiple acquisitions within the UK. See some of these tax savings as well on a go-forward basis and be able to open up a deal flow that might not exist otherwise here in the US. Once the structure is set up and I'm trying to think about how to ask this question the right way but how reusable is it in your opinion or does each deal really require its own development of new companies to be able to manage this? In other words, there's a C corp here in the US for the structure, do we need to set up a new C corp with every acquisition that we do or can we use just one general holding pass through C corp?
Erich: I see what you’re saying. No, the structure; let's just say that they would have been forwarding exactly as we initially designed it and it was all going to work like we had kind of painted that picture and they said yeah we're interested and we need to dig into this. We would only need; if the buyer was going to do self-additional deals and kind of do a roll of three or four or five Amazon businesses from the UK. They just need one sequel. We would have stayed with the one holding company. And then what we would have done is then bought the additional UK targets under that holding company. So I wouldn't call it an acquisition platform for a buyer. You just keep bolting on the next one you if you will. So you're not creating additional sequels and or UK holding company.
Mark: Right. So you gave us an acquisition platform is a perfect way to describe it. I saw this as an opportunity. I know Joseph and I talked about a little bit. I also just had Scott who was another advisor on this deal on and we talked about it just a little bit as well. Okay, this is all very…
Erich: It's interesting because another one of your UK Amazon sellers that you and Scott know reached out to me last week and I'll call it for personal reasons and potentially for exit. He's actually moved to Cyprus and he has a couple of Amazon businesses and a couple of UK companies and also a US Amazon business and a US C corp. And we're looking at how to design a structure for him to continue to build that out because he wants to kind of; I don't know exactly where it's at but let's just say he’s at 10 million in revenue and he wants to double that before he wants to take all of it or some of it to market so that he can grow it and package it in a way where it’s easy to actually sell to allow him to again take advantage of tax rules in Cyprus or Dubai or some other things that we're talking about. Again it's him because he's got some one way and he's single and flexible as to where he wants to live he's putting himself in a position where he can significantly reduce or eliminate any sell-side taxes down the road so that he can punch his lottery ticket as he put it to me.
Mark: Yeah. And I want to emphasize something here because I think people hear some of this stuff and they think oh my gosh this is complex. Is it legal ball and is it going to be triggering an audit and everything else? That's why I wanted to start with your background. Your background isn't just some guy who's on the internet researching things, right?
Erich: No, no, no, in fact, it's interesting. We did have one call and we have another call on Friday. He has been getting some advice from Cypriots tax advisor and a lot of the concepts that he was putting out there I didn't disagree with but there were some things that they were talking about that I told this individual that I have some concerns. We need substance. We can't play shell game. Some of the things that were being said could be interpreted as tax avoidance. And I said those are the type of things that I would never advise you to do because if you want to sell this and the buyer comes in they’re going to do tax due diligence on your structure and they're going to say well okay you've done all of that but if you want us to buy the shares and you don’t pay any tax well there's a tax accrual of there’s going to be a big number going to Escrow until we get this sorted out. So I agree with you completely Mark, understanding the risk profile and what you're doing is important because I told him if you go to that path I'm not going to be that advisor that can help you. So he got the risk conversation and we just signed an engagement letter and he wants to move forward to do it properly. This whole risk thing I mean look at some of these transactions that you see the buyers are using large law firms or accounting firms and are beating up on the debt tax due diligence side and putting money on Escrow because they’re concerned about for example sales tax.
Mark: Sure sales tax liability which came up and you and I could talk about it at length which we won't because we'll get into something else. But these are some of the practices that happen at a more sophisticated deal-making level than what we might normally see with just a simple transaction. This is not uncommon to go through some various tax scenario analyses and figure out a structure that works for the seller and works for the buyer and minimizes taxes on a go-forward basis and the savings can be significant for everyone.
Erich: Exactly that's why on Joseph's transaction the buyer was originally a naysayer before I got involved as you know. And then once we put on the table and they start to understand what was going on their advisors to the table so that they could pick it apart and they said this has merit let's work through this. So that's typically how it's going to evolve. It's not going to be Erich says this is how it's going to work. I mean everyone's going to have someone else look at it and get comfortable or not. You have to protect your clients. And that's my example with the guy that just moved to Cyprus. I'm not going to put him in a position where he thinks he's saving all this money but no one's going to want to buy the shares of this company because of the bad tax structure he's put himself into with all of the risk.
Mark: Right. And ultimately in the Joseph deal, they didn't accept the very first proposal that we put together it was a variant of that. Yeah, these things are collaborative in that way. Okay, we've been talking for about 25 minutes. I'm going to wrap it up here because if we go into another topic we'll go all the way up to that my brain hurts. If we have somebody who's interested in talking about this more Erich where can they reach you; what's the Most Unexceptional way to reach you?
Erich: Well they could reach me here at Redpath. My office is in St. Paul. I don't know when you publish this or post this; if you can provide my email address which is [email protected].
Mark: And if anybody wants an introduction just let me know. I’m happy to provide the introduction. Erich, you are a great resource I think for anyone in this space especially if you are doing anything international or even thinking about it on an international basis. A really, really good resource to have; I appreciate it. And your firm as well is a good resource just in general. It's not just an international tax law firm; you guys do the whole gamut.
Erich: Correct. Yeah, we were actually over this over the last three or four months through; you and Scott connected with a number of companies. In fact, we've just brought on board a larger Amazon business and are doing the bookkeeping and providing other services including restructuring their business for sale as a domestic business in the US.
Mark: That's great. Thanks for coming on. And again if somebody wants an introduction to Erich let me know I'm more than happy to provide it as a way of saying thanks for coming on and also helping out with that deal. It was an eye-opening exercise for me for sure.
Erich: Thanks a lot Mark. Take care and have a good rest of the day.
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