M&A Vocabulary – Explained by the experts: Debt Pushdown

by Marcus Schmidbauer

In this ongoing series, a number of different M&A experts from the global offices of Rödl & Partner present an important term from the specialist language of the mergers and acquisitions world, combined with some comments on how it is used. We are not attempting to provide expert legal precision, review linguistic nuances or present an exhaustive definition, but rather to give a basic understanding or refresher of a term and some useful tips from our consultancy practice.

The term “debt pushdown” refers to a series of mechanisms that aim to “push down” a portion of the borrowing taken on by the buyer of a company (or the acquiring company specially set up for this purpose) to the level of the operational target company acquired.

This goal may be driven by tax or financial reasons:

• If the acquiring company and the target company do not form a single tax unit, the borrowing taken on by the acquiring company and the interest expense resulting from this can often not be deducted for tax purposes. Since the acquiring company does not have any operations, and consequently does not generate any significant taxable income, the interest expense cannot be deducted or only partially. In most cases, the operational target company will be paying tax. The corporate tax liability could be reduced if the liabilities were held at the level of the target company rather than the level of the acquiring company;
• from a financial perspective, the liabilities of the acquiring company are structurally subordinate to the repayment of the liabilities of the acquired target company, and are therefore borrowed on less attractive terms than debt financing at the level of the operational target company. The closer a lender is to the assets and the cash flow, the better their lending terms and conditions.

As a rule, a debt pushdown is generally carried out in the form of an extraordinary dividend payment, a repayment of issue premiums or capital reserves, or a reduction in capital. This means that the debt pushdown is restricted in practice by the amount of reserves available for payment of dividends (which must exclude the share capital, the legal reserves, the reserves required by the statutes and revaluation reserves). In order to maximise the level of distributable reserves, the operational target company can opt for a dividend payment from the earnings reserves of its subsidiaries, taking advantage of the parent-subsidiary directive or the parent-subsidiary “box” privilege at its own level, without triggering a significant tax burden. Alternatively, it can also opt for a reduction in the capital of the subsidiaries.

If the companies concerned belong to a single income tax unit, there would be a further option of selling fixed assets between members of the same tax entity. Under French tax law, any capital gains in case of sale generally benefit from deferred tax, for as long as the selling company remains a member of the tax unit, and the sale can be justified in business terms. Under legal systems that do not offer any tax deferral for transfers within a tax unit, and where capital gains in case of sale are taxed normally, then at least the interest costs of the acquiring company can be offset against the capital gains in case of sale.

Debt pushdowns can be challenged using the argument of majority shareholder abuse. From the French point of view, this requires evidence that the decision was made against the interests of the company, with the intention of favouring the majority shareholder to the disadvantage of the interests of minority shareholders.

Therefore, it must be possible to demonstrate that the target company will be able to continue growing despite the increase in its debt, and can repay its liabilities without difficulties. For this reason, we recommend obtaining a credit rating for the target company before carrying out the debt pushdown.

An alternative to the mechanisms mentioned above is the merger of the acquiring company with the target company, a so-called downstream merger. The burden of both interest and capital repayment is transferred to the target company. However, legal and tax problems can also arise in this case, in particular due to the frequent lack of interest on the part of the minority shareholders of the target company.

In practice, in the case of a leveraged buy out (LBO) transaction, a downstream merger like this can generally be proposed only 24 months after the original transaction has been completed.