2021 saw a remarkable surge in the global market for corporate control, with a record number of 65,000 mergers and acquisitions (M&A). Among other factors, tax rules play an important role in shaping the probability and structure of M&A transactions. In 2008, the temporary suspension of limitations on tax loss transfers led to a substantial increase in bids for the struggling US bank Wachovia. It was speculated that the several billion in loss-carryforwards Wachovia had sitting on its books might have played a role in the sudden surge in buyers’ willingness to pay. This emphasizes the value of tax shields in M&A decisions.
In our recent paper, we conduct an economic analysis of anti-loss trafficking rules. Under such rules accumulated loss carry-forwards cannot be set off against profits anymore to save taxes after a substantial ownership and/or activity change has taken place. We study the direct impact of anti-loss trafficking rules on the M&A market and the wider economic repercussions for firms. We focus especially on the effects of such rules on young and innovative start-ups since such firms are more likely to invest in high-risk-return projects and thus suffer initial losses. Our results show that anti-loss trafficking rules reduce the number of M&As for loss-making targets by 31 percent. Moreover, our study suggests broader consequences on economic growth, as we find a negative impact on firm entry and exit, industry productivity especially for innovate firms.
Anti-loss trafficking rules as a policy tool to prevent tax-motivated transactions
For tax purposes, most countries, including the US and most European countries, treat losses asymmetrically. Profits are subject to taxation, whereas losses do not immediately result in a tax refund. If losses cannot be offset with other positive income in the same period, they must be carried over to the past (loss carry-back) or future (loss carry-forward). Thus, these tax loss assets are valuable as they embody potential tax savings. Savvy firm owners could now (and did) come up with the idea to acquire bankrupt companies with large loss carry-forwards to use these tax shields in their profitable business, reducing their tax liability. In response, legislators implemented anti-loss trafficking rules to prevent such transactions without economic rationale (and, arguably, to protect tax revenues). Substantial changes in ownership or activity can trigger these rules, resulting in the forfeiture of accumulated loss carry-forwards. If loss carry-forwards vanish after an acquisition, making them unusable for both the target and the acquirer, transactions motivated mainly by the prospect of obtaining tax loss shields become pointless.
For example, in the US, Section 382 of the Internal Revenue Code of 1986 limits a corporation’s ability to use its net operating losses to offset future taxable income when an ownership change occurs. An “ownership change” takes place when the ownership in a US target changes by at least 50 percent of the shareholders already owning 5 percent or more within three years. Similarly, several European countries have anti-loss trafficking rules in place: 20 out of the 27 European Union (EU) Member States currently restrict the transfer of loss-carryforwards.
For our analysis, we hand-collected detailed information from tax guides and national tax codes of the EU27 Member States, UK, and Norway, constructing a comprehensive dataset of anti-loss trafficking rules in place from 1998 to 2019. The specific design of anti-loss trafficking legislation differs from country to country. However, we broadly group the regimes based on whether legislation is triggered after a change in ownership or activity or whether both criteria must be met for loss carry-forwards to be forfeited. Overall, we detected 17 changes in these restrictions over the past two decades. On one hand, more countries introduced anti-loss trafficking rules over the years. On the other hand, regulations became less restrictive; in other words, the bar for losses to be denied after a transaction was set higher.
How do anti-loss trafficking rules affect the M&A market?
The continuation of loss carry-forwards after an acquisition is pivotal in M&A success, as these tax losses are valuable assets. Anti-loss trafficking rules reduce the price the acquirer is willing to pay for a loss-carrying target, rendering the loss carry-forward worthless after the transaction. However, the seller will not adjust their reservation price. As a result, profitable deals might still take place but at lower acquisition prices, while marginally profitable deals might be canceled altogether.
Consistent with our expectations, our results suggest an overall decrease in M&A volume. The effect is almost symmetric when differentiating between introducing or tightening regulations (-23 percent) and the loosening of regulations (+20 percent). These effects are driven by loss-carrying companies, supporting our interpretation that anti-loss trafficking rules are responsible for the observed impairment of the M&A market.
What are the broader consequences of anti-loss trafficking rules?
The reduction in M&A activity could be driven by a reduction in inefficient transactions, indicating that anti-loss trafficking rules could simply fulfill their intended purpose and improve economic performance overall. However, as “well-intentioned” does not automatically translate into “well-done”, the restrictions could be overreaching, also affecting economically valuable transactions. Risky projects and start-up firms, especially in the high-tech sectors, are prone to generate losses at some point in their development cycle. These investments can still pay off, as the large downside risk is usually accompanied by large upside potential. If anti-loss trafficking rules discourage valuable M&A deals by deterring investments that only temporarily incur losses, they might cause a decline in industry productivity.
Given the uncertain ex-ante consequences of anti-loss trafficking rules, we extend our analysis to the effects on different economic outcomes. We find that changes in loss transfer restrictions negatively affect young entrants’ survival rates. Some of these start-up deaths are compensated by new firm entrants. Aggregated data on EU companies’ performance also reveals a significant reduction in return on assets (ROA), especially in R&D-intensive industries. Collectively, our results suggest that, on average, strict anti-loss trafficking rules impair the economy. While we do not exclude that the restrictions also prevent some purely tax-motivated transactions, we observe striking negative incentives for risk-taking and innovation.
What conclusions can we draw from our results?
Our findings have significant implications for investors and policymakers. Ultimately, governments around the world face a trade-off: Anti-loss trafficking rules serve to prevent abuse and safeguard tax revenues. Considering the substantial value of accrued loss carry-forwards, allowing unlimited loss offset could result in significant revenue losses for tax authorities. For instance, German corporations reported a total stock of €680 billion in loss carry-forwards in 2018. Yet, stringent anti-loss trafficking rules might hinder economic growth.
Typically, tax incentives are important measures introduced to alleviate businesses in periods of economic downturn. For example, one commonly proposed policy during the COVID-19 crisis involved facilitating tax loss deductions as proposed by an OECD Report. The findings from our study suggest that easing restrictions on tax loss transfers can represent another important tool to direct measures toward young and innovative companies, thereby fostering their development.
Theresa Bührle, Research Associate in the Department of Public Economics at DIW Berlin
Elisa Casi, Assistant Professor of Business and Management Science at the NHH Norwegian School of Economics
Barbara Stage, Assistant Professor for Financial Accounting and Business Taxation at the WHU – Otto Beisheim School of Management
Johannes Voget, Professor of Taxation and Finance at the University of Mannheim
This post was adapted from their paper, “The Value of a Loss: The Impact of Restricting Tax Loss Transfers,” available on SSRN.
