Complex carve-out transactions: key considerations and challenges

The separation programme is the quintessential aspect of a successful carve-out transaction. It involves collaborative efforts between vendors and buyers to address all topics related to the stand-alone operating model of the divested business. These topics include:

  • Legal entities: determining the required number, location, and type of legal entities.
  • Contractual framework: allocating supplier and customer contracts.
  • Full-Time Equivalent (FTE) Locations: identifying the location of regional and global functions.
  • Enterprise Resource Planning (ERP): configuring the stand-alone ERP.
  • Intellectual Property (IP) Holding: defining the optimal approach for holding IP within the stand-alone business.
  • Product flows: optimizing the flow of goods while considering implications for VAT and customs obligations.

Each of the above areas require input from an operational, legal and tax perspective.

A separation programme typically takes between six to 18 months to complete. However, several factors could impact this timeline, making it challenging to achieve a fully operational stand-alone business within that period. These factors include:

  • Highly integrated perimeter: When the core functions of the intended stand-alone business are highly integrated with the rest of the vendor's operating model, the process of carving out the divested business can be extremely complex. This could have a substantial impact on the timing of the overall separation programme.
  • Asset-heavy, people-light perimeter: Some transactions involve the disposal of assets and contracts, but without the transfer of sufficient people functions to run the standalone business. In such scenarios, the buyer could acquire brands, IP, customer contracts and supplier contracts. However, the buyer would then need to build an operating model around these assets and contracts. This includes recruiting essential Full Time Equivalents (FTEs) to manage the core business functions, potentially leading to a lengthier timeline for achieving a fully operational stand-alone business.
  • Delayed contract transition: In some instances, obstacles—whether commercial or legal—restrict the smooth transition of customer and supplier contracts from the vendor to the new stand-alone business. These limitations often result in delays due to lengthier negotiations, or while existing contractual agreements are wound down.

Net Economic Benefit (NEB) model: facilitating complex carve-outs

Delays can significantly impact overall timing and add uncertainty to the successful completion of the carve-out deal. In response, A&M has observed that deal parties are increasingly adopting an approach often referred to as the Net Economic Benefit (NEB) model.

How does the NEB approach facilitate quicker value realization by both parties?

  • The NEB arrangement allows buyers to receive the full economic benefit from Day 1, before assuming full operational responsibility for the stand-alone business.
  • This approach also allows the vendor to receive deal recognition prior to full operational handover of the stand-alone business.

What are the operational dynamics under NEB?

  • The vendor continues to operate the divested business on behalf of, and at the risk of the buyer.
  • The buyer is responsible for meeting all working capital and operational costs associated with the divested business.
  • The vendor transfers the economic impact of the divested business (i.e. profit or loss) to the buyer during this period.
  • Both parties utilize the NEB period to set up the operating model of the stand-alone business and finalize operational transition to the buyer.
  • The deal parties typically outline these arrangements in the closing legal agreements, setting them for a predetermined period.

Challenges of implementing the NEB mechanism

Although these arrangements offer significant advantages in complex carve-outs, they also present several challenges. We highlight three critical areas that require careful attention in a NEB arrangement:

1. Governance

NEB arrangements often require a robust governance framework to ensure transparency, fairness, and effective decision-making. This is necessary to manage issues such as:

  • Conflicts of interest: Evaluating both parties' objectives and priorities is crucial, as differences in these aspects may lead to conflicts of interest in managing the divested business under the NEB arrangement. It is essential to establish clear governance mechanisms with representation from both parties to address these conflicts and foster collaboration.
  • Decision-making authority: Determining who has the authority to make key commercial and operational decisions under the NEB arrangement can be complex, particularly when vendor personnel are involved in decisions that impact sensitive or strategic facets of the divested business. It is therefore crucial to establish a governance structure that clearly defines decision-making responsibilities, assigns levels of authority, and provides effective mechanisms to escalate key decisions to the buyer.
  • Monitoring and compliance: Keeping track of vendor's commercial and operational performance under the NEB arrangement can pose challenges. This is particularly the case when the vendor personnel's KPIs do not cover the successful operation of the divested business. Implementing robust monitoring mechanisms and regular reporting can help mitigate these challenges.

A&M has observed that auditors from one or both parties may require a formal governance framework to be in place prior to signing off on the arrangement. This is because the governance structure could significantly impact both the accounting and tax treatment of the transaction flows under the NEB agreement. Typically, the buyer must oversee the business operated by the vendor for proper transfer accounting.

2. Accounting treatment

During the period of the NEB arrangement, parties should carefully consider the accounting treatment of revenues and costs. Based on governance structure arrived at, it is arguable that the buyer — as the main economic beneficiary of all income earned during the NEB period — should report revenues and costs in its statutory accounts. However, the facts and circumstances of each deal scenario will determine the ultimate accounting treatment of these flows.

3. Tax treatment

The tax treatment of the transactions made under an NEB arrangement is crucial due to the possibility of value leakage. Considerations for these payments include:

  • Tax jurisdiction: The legal agreement underpinning the NEB arrangement will have a significant impact on the jurisdiction(s) where income is taxed. This can have a material impact on short to midterm cashflows. Thus, tax considerations are key for both parties when designing the NEB arrangements, specifically in determining the contracting and invoicing flows between legal entities.
  • Tax leakages: The characterization of transactions made under the NEB arrangement could attract withholding and indirect taxes, potentially resulting in value leakage. In fact, withholding taxes have the potential for significant leakage, as this is effectively a tax on gross invoice amounts, and not income. To mitigate the risk of inadvertent leakages, careful consideration is required to avoid mischaracterisation of the transactions.
  • VAT Registrations: The structure of the NEB agreement may trigger a VAT registration for the buyer in multiple locations. Identifying these obligations in advance is crucial to preventing disruptions or non-compliance.
  • Utilisation of tax attributes: Another challenge with these arrangements is optimizing the use of all available tax attributes during the period of the NEB agreement (e.g. interest expenses, amortization). This could impact cash flow in the short to medium term. Applying a tax perspective into the design of invoicing flows between both parties is key in maximising the tax attributes.
  • Tax burden allocation: There are various approaches for allocating the tax burden that arises under an NEB arrangement. In some cases, the vendor is required to gross up the payments it makes to shield the buyer from tax deductions. This usually involves mutual cooperation to secure tax credits. In other cases, payments are net of deductible taxes, with the buyer solely responsible for obtaining tax credits. Ultimately, the approach adopted is typically a negotiated outcome, however careful consideration of the cash flow implication is key in deciding between the options.

Managing the risk of value leakage under the NEB arrangement

To prevent value leakage in NEB arrangements, an integrated design approach, which considers operational, legal, finance and tax considerations is necessary.

  • Contracts: Defining the legal wording in the NEB contracts to support the treatment of the payments for accounting and tax purposes.
  • Transaction flows: Determining which legal entities will issue and receive invoices, as this impacts where income is recognized and taxed.
  • Invoice descriptions: Defining payments, including differentiation between royalties, services fees etc., to provide clarity on tax treatment.
  • Payment terms: Defining the timing of payments between the vendor and buyer under the NEB arrangement and addressing implications of accruing payments over a period.
  • Contractual framework: Identifying which legal entities in the stand-alone operating model should hold customer and supplier contracts.

Summary of the key challenges in NEB arrangements

While NEB arrangements offer advantages in carve-out transactions, they come with several challenges that need to be carefully navigated. These include:

  • Governance challenges: conflicts of interest, decision-making authority, and effective monitoring
  • Accounting treatment challenges: recognition of revenues and costs, as well as treatment of payments by vendor
  • Tax leakage challenges: jurisdictional complexities, tax rates, and compliance obligations

By effectively addressing these challenges through rigorous analysis, proper evaluation, and establishing clear frameworks to ensure transparency and collaboration, all parties involved in NEB arrangements can enhance the success and value of carve-out transactions while mitigating potential risks.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.