Typical Issues in Cross-Border M&A and Investment Transactions
New York Law Journal
October 19, 2020
If a foreign party is involved in an inbound M&A or investment transaction, uncommon issues may arise in several areas of law, which play no role, or a much lesser role, in transactions where all parties are domiciled in the United States. This article describes some (but by no means all) such issues that we have encountered when representing non-U.S. clients. For example, there may be discrepancies in corporate governance regimes that will require at the very least educating the foreign investor and sometimes addressing any arising governance issues through appropriate documentation.
U.S. tax laws can impose withholding requirements related to the purchase price in an acquisition involving U.S. real estate, or if interest is payable by a U.S. party to a foreign party. Dispute resolution mechanisms are of heightened importance, given that either party may be reluctant to subjecting itself to the jurisdiction of another country. Many transactions can be subject to filings with the U.S. Department of Commerce’s Bureau of Economic Analysis (BEA), and a few transactions in sensitive sectors may be subject to Committee on Foreign Investment in the United States (CFIUS) review.
Corporate governance regimes in foreign jurisdictions are usually different from typical U.S. state corporate laws. For instance, many European countries have much more elaborate company registration systems maintained by local courts, including detailed information about a corporation’s officers or other legal representatives, as well the capitalization of a company. The internal structures of foreign companies may be quite different from a typical U.S. structure.
Accordingly, foreign investors usually need to be educated about the less formalistic U.S. state corporate registration systems, the typical corporate governance structures of U.S. corporations or limited liability companies, and the authorities and responsibilities of officers and directors in corporations and managers in limited liability companies.
Often, a foreign investor entity will have certain rules and structures in place, such as specific authorities, signature requirements, or consent requirements, which it will want to have replicated for all of its global affiliates, including newly acquired U.S. companies. In connection with an acquisition of a U.S. business, these will have to be implemented through appropriate U.S. corporate resolutions and governing documents, such as by-laws, shareholders agreements, or operating agreements.
There are two recurring issues related to M&A or investment transactions in the United States involving non-U.S. parties: (i) shielding a foreign investor’s non-U.S. business from U.S. taxation and (ii) U.S. tax withholding requirements.
The foreign acquirer of a U.S. business probably wants to avoid becoming subject to U.S. taxation as a result of income being effectively connected with a U.S. trade or business (“effectively connected income” or “ECI”). If the target business is organized as a U.S. corporation, there is usually no issue, as long as the U.S. corporation is not a mere dependent agent of the investing party. The corporation functions as a “tax blocker,” thereby shielding the foreign owner from the ECI of the acquired business.
If the target business is organized as a (tax transparent) limited liability company or partnership (as a “pass through” entity), or if the target business is entirely owned by an individual (as a sole proprietorship), however, the foreign investor should consider inserting a holding corporation to act as a tax blocker between the foreign investor and the target. That holding corporation would then become the U.S. taxpayer, but only for the target business’s income.
Withholding tax requirements under the Foreign Investment in Real Property Tax Act (FIRPTA) will be imposed on the disposition of U.S. real estate owned by a non-U.S. person, or of interests in a U.S. real property holding corporation owned by a non-U.S. person.
Generally speaking, a corporation is a U.S. real property holding corporation if the fair market value of its U.S. real property assets constitutes at least 50 percent of its total assets. The FIRPTA withholding tax rate is 15 percent of the consideration (not just the gain!) for the asset transferred. The withholding requirement applies irrespective of whether the acquirer is a U.S. person or the seller actually recognizes a gain on the sale.
In most cases, the transferee/buyer is the withholding agent. The FIRPTA withholding can be prevented by applying in advance for a “withholding certificate” from the U.S. Internal Revenue Service, showing that the seller is not recognizing gain as a result of the transaction.
In practice, it has become fairly standard (at least in transactions where the target business owns real estate) to have the sellers execute a “FIRPTA affidavit” as part of the closing deliverables in an acquisition, such that the sellers certify that they are U.S. persons and that therefore no FIRPTA withholding is required.
Interest payment on loans from a foreign investor to a U.S. person can also be subject to a 30 percent withholding tax. However, income tax treaties, when applicable, between the United States and the country where the investor is domiciled can lower this withholding rate. Also, portfolio interest is entirely exempt from the withholding tax.
To qualify as portfolio interest, (i) the loan must be from a foreign lender (evidenced by a withholding certificate) other than a bank lending in the ordinary course of business; (ii) the debt must be in registered form; (iii) if the loan is made to a U.S. affiliate, the foreign lender may not own 10 percent or more of the voting stock, or capital or profits interests, of the borrower; and (iv) the interest payments cannot be contingent.
In domestic M&A or investment transactions, dispute resolution clauses are rarely negotiated extensively. Not so in inbound cross-border deals! A foreign investor, unless it already has an established U.S. presence, will rarely feel comfortable applying the law of the target’s location and having disputes resolved in a courtroom located there. A foreign buyer will therefore often request that its law apply and that a dispute be resolved in the jurisdiction of its domicile, which in turn is almost never acceptable to the seller or target.
A typical middle ground solution would be to settle on a “neutral” law and venue. For instance, when a European company acquires a business in Texas, both parties might be amenable to having New York law and jurisdiction apply for dispute resolution purposes. If the target is a Delaware company, Delaware law and jurisdiction may also be a good solution.
If the buyer is still uncomfortable with such a solution, in particular in larger transactions, the parties may want to consider arbitration in one of the typical international arbitration venues, such as Bermuda, London, or Zurich.
Committee on Foreign Investment in the U.S.
The CFIUS has broad authority to review and reject foreign investments in a number of sectors in the United States from a “national security” perspective. CFIUS will consider factors such as the potential effects on projected national defense requirements, whether a foreign person will control an industry that is vital to national security, and the protection of U.S. critical technologies, resources, and infrastructure.
Following its review of a transaction, CFIUS can implement restrictions in order to mitigate risks, including reducing non-U.S. ownership or control or restricting access to critical assets, before providing its approval. If certain security concerns persist, CFIUS can recommend to the U.S. President that he administratively block the transaction.
CFIUS jurisdiction extended traditionally only to mergers, acquisitions, and takeovers by or with any foreign entity that could result in foreign control of a U.S. business (“covered transactions”). The Foreign Investment Risk Review Modernization Act from 2018 has, however, expanded the scope of “covered transactions.”
Also, it is no longer required that the investor “control” a U.S. business following the transaction, if the foreign investor is domiciled in a country named in the CFIUS regulations and seeks to make an investment in critical technologies, critical infrastructures, or bulk sensitive personal information of U.S. citizens.
Bureau of Economic Analysis
Foreign investors in a U.S. business must report their investments with the BEA. The BEA uses the filings to collect information about acquisitions and company formations by foreign investors. The filing is due within 45 days of the completion of an investment transaction (such as an acquisition or establishment of a new entity) or within 45 days of the beginning of an expansion of an existing U.S. business.
Under the applicable rules, a “foreign direct investment in the United States” is a transaction resulting in the direct or indirect ownership or control by a foreign person of 10 percent or more of the voting securities of a U.S. business. Typically, filings are required if the acquisition price or formation costs exceed $3 million. The U.S. affiliate of the foreign investor can file the appropriate Form BE-13 through BEA’s electronic filing portal at www.bea.gov/efile. While the BEA, upon learning from public sources about a reportable transaction in which a filing was missed, often will delay the imposition of remedies, inform the relevant parties of the necessity of the filing, and grant a generous extension of the deadline to complete the filing, failure to properly and timely file the BE-13 can result in civil or (in cases of willful failure) criminal penalties.
Reprinted with permission from the October 19, 2020 issue of the New York Law Journal. © 2020 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved. For information, contact 877-257-3382 or firstname.lastname@example.org or visit www.almreprints.com.