U.S. Mergers and Acquisitions Markets Return to Pre-COVID-19 Levels but CARES Act Hangover Contributes to Regulatory Uncertainty
U.S. M&A markets have returned to levels not seen prior to the start of the COVID-19 global pandemic. Whether this rapid recovery is being driven by a zest to deploy capital before the end of 2020, the looming results of the Presidential election or a combination of both, the fact remains that both buyers and sellers are now faced with additional transaction risks and uncertainties in how to best tackle CARES Act related incentives selling companies or acquirers may have secured in the face of uncertain economic conditions. A few of these potential transaction hurdles are explored in more detail below.
CARES Act Paycheck Protection Program Loans in an Acquisition
Many businesses that are currently, or have recently been, the target of an acquisition have outstanding CARES Act Paycheck Protection Program (“PPP”) Loans. This raises a number of issues including how to secure loan forgiveness or payment of the debt, what approvals are required by the lender and the Small Business Administration (“SBA”), whether previously claimed employee retention credits need to be repaid if an acquirer or any member of the acquirer’s controlled group claimed such credits and protection for future taxes, penalties and interest that could be assessed if the borrower deducts amounts used for PPP loan forgiveness.
Securing Loan Forgiveness or Payment
While extensions to the covered period for use of PPP proceeds to pay allowable expenses has many believing most PPP Loans will be fully forgiven, some employers may not achieve 100 percent forgiveness and there remains a risk an employer will be found to be ineligible for the loan such that no forgiveness will be available. To combat this exposure, acquirers are requiring funds be subject to escrow so that the borrower is responsible for paying amounts not forgiven. This also acts to incentivize the borrower to properly file for forgiveness, leaving all risk of incorrect reporting with the borrower, and is consistent with SBA’s position that, even with an acquisition, the borrower remains responsible for 1) performance of all obligations under the PPP Loan, (2) certifications made in connection with the PPP Loan application, including the certification of economic necessity, and (3) compliance with all other applicable PPP requirements.
While the borrower remains responsible for obtaining, preparing, and retaining all required PPP forms and supporting documentation and providing those forms and supporting documentation to the lender or SBA upon request, it would be appropriate for the acquirer to request and retain these documents as well.
Approvals Required by the Bank and the Small Business Administration
The borrower’s loan document will detail the required approvals for loan transfers. Prior to the closing of any change of ownership resulting from a transaction, the borrower must notify the lender in writing of the contemplated transaction and provide a copy of the proposed agreements that would effectuate the transaction. The lender must notify SBA within 5 business days after completion of the transaction of the new equity owners, the percentage ownership interest of each owner, the tax identification number of any owner holding 20 percent or more of the equity, and the location of, and amount of funds in, escrow under the control of the lender if such an escrow account is required.
The SBA has released approval procedures that apply when 1) 20 percent or more of common stock or other ownership of a borrower is sold or transferred, 2) the borrower sells or transfers 50 percent or more of the fair market value of its assets, or 3) a borrower merges with another entity. In some cases no SBA approval is required. Presumably, a sale or transfer of less than 20 percent or common stock or 50 percent of the fair market value of assets would not be considered a change of control that requires SBA approval or compliance with reporting to the SBA.
Where a loan has been fully satisfied with repayment or SBA has remitted funds to the bank in satisfaction of the note, there are no SBA requirements associated with an ownership change. SBA advance approval is also not required for common stock transfers or mergers of 50 percent or less of the borrower’s equity. Even for sales or mergers of more than 50 percent of the borrower’s equity or asset sales of more than 50 percent of the fair market value of assets, SBA approval is not required if the borrower completes and submits a forgiveness application with required supporting documentation and an interest-bearing escrow account holding funds equal to the outstanding balance is set up and controlled by the lender.
If a change of ownership is not described above, it would require SBA approval and the lender cannot unilaterally approve the change. To obtain approval, the lender needs to submit a request to the SBA which details why the borrower cannot satisfy the loan or escrow funds as described above, the details of the transaction, a copy of the loan, the letter of intent or purchase and sale agreement setting forth the responsibilities of the borrower and the acquirer, the acquirer’s PPP loan number, if a loan exists, and a list of all 20 percent or more owners of the acquirer. SBA approval of any change of ownership involving the sale of 50 percent or more of the fair market value of the borrower’s assets is conditioned on the acquirer assuming all of the borrower’s PPP loan obligations, including responsibility for compliance with the PPP loan terms. The purchase and sale agreement must include appropriate language regarding the assumption of the borrower’s obligations under the loan by the purchasing person or entity, or a separate assumption agreement must be submitted to SBA. SBA approval may take as long as 60 days.
Claimed Employee Retention Credits
The CARES Act provided employee retention credits to certain employers affected by the Coronavirus who did not obtain a PPP loan. Eligibility for employee retention credits is determined on a controlled group basis such that all members under common control need to meet the requirements for any member of the group to be eligible for the loan.
Sometimes employers eligible for an employee retention credit acquire an entity that has or had a PPP loan. Alternatively, sometimes PPP loan borrowers acquire an entity that has claimed an employee retention credit. In these cases, the entity previously eligible for the employee retention credit is no longer entitled to that credit and may never have been eligible for the credit.
It is not clear whether credits claimed before the entity with the PPP loan was acquired or acquired the entity claiming the credit need to be repaid. Treasury regulations apply the controlled group rules to trades or businesses under common control “at any time during the calendar year.” Thus, absent future Treasury guidance to the contrary, an entity that has claimed an employee retention credit which is acquired by or acquires an entity with a PPP loan will need to file amended employment tax returns for the quarter for which the credits were claimed. The cost of additional employment taxes due as a result of the credit elimination could be taken into account in the acquisition price.
Deduction of Expenses Used for PPP Loan Forgiveness
IRS Notice 2020-32 specifies that any expenses used to support PPP loan forgiveness are nondeductible. Some tax advisers believe that the Notice is not correct, so that a reasonable interpretation of the Internal Revenue Code, its regulations and judicial decisions would support a position that amounts were deductible. When a PPP loan borrower has chosen to take the position that expenses used to support loan forgiveness are deductible, an acquirer may want to be sure that adequate escrow is maintained for any future tax assessment, interest and penalties that may apply in the event that the deductions are challenged and the IRS ultimately prevails.