Wednesday, December 2, 2009

Welcome to Tinsel Tax!

We are the world's leading—er, only?—experts on both tax and the business of Hollywood: two subjects not often mixed in polite conversation, but which share more DNA than most folks know or care to consider.

We are long time tax law/structured finance professionals who have worked at some of the largest law firms and investment banks in the world. We have structured complex financial transactions for large multi-national companies, with a particular sensitivity to the tax treatment and “structuring” of those transactions. And we have also produced and financed films, including an Academy Award nominated one.

This is actually much more interesting work—at least the tax part-- than it seems. So much so, in fact, that we are putting pen to page to share our enthusiasm for it with you. As you will find, we are very passionate here about two things:

1) demystifying seemingly complicated subjects and making them straightforward; and

2) giving you a real insider's look at the “back story” to major deals and events—showing you the tax and “structuring” angles that are often important but rarely identified or analyzed.

Before Getting Started: Why Tax Really Matters

Taxes can easily be the single biggest expense for many of the world’s largest companies (with a US corporate tax rate of 35%, it’s not hard to see why). So, for example, while companies can hope to see modest cost and revenue synergies from an acquisition, the amount that can be saved by cutting the combined tax rate even a little bit can matter a whole lot more.

Think about the numbers:
A company has net income of $1bn/year and pays taxes at a 35% (with state and other taxes, that number can approach 40%).
This means that every point of tax reduces the bottom line by $10mm/year
If you capitalize that at 10x --i.e., if you extrapolate the effects of this on a company's market value—a single percentage point of tax savings creates $100mm of additional market value. Ratchet that up to 10 percentage points and now we're talking real money!

Now, most corporate finance and business decisions are not driven by tax. I say most, because clearly at least some are. But even transactions that make sense for many other reasons may have significant tax angles.

For example, most people think that Stephen Schwartzman is a genius because he presides over one of the largest pools of investment capital on the planet (Blackstone); or, because he brought Blackstone public five minutes before the credit crunch. And while those two tricks are pretty good, here's one more: Blackstone pays one of the lowest tax rates ever recorded for a public company. Blackstone's effective income tax rate was approximately (3.40)%, 1.58% and 1.39% for 2008, 2007 and 2006, respectively. Compare that with the 32-37% effective tax rate that money manager Blackrock. On about $1bn of 2008 pre-tax income, those 35 points of tax are no joke (see above)!

Under the Hood in the Cadbury Case
Let’s look at one transaction that is currently being discussed and see whether taxes could play a role. Cadbury, which is a UK corporation, has a 28% tax rate. Hershey, a US corporation has a 37% effective tax rate. If a transaction was structured under which the combined company was incorporated outside the US (perhaps in a third, even more efficient jurisdiction), the tax synergies alone could be very significant.  A Kraft/Cadbury transaction could be very similar.  Kraft shows an effective tax rate in the low 20’s for the last few years, but their 10-K makes clear that that is partially related to one-off events, and it is not unreasonable to assume that that rate will climb higher in time.  So the impact of any transaction would not be as dramatic on day one for Kraft, if the combined company would incorporate outside the US, but it time could be very meaningful.

The specific rules for moving offshore are rather complex and, we believe, would benefit Hershey over Kraft.  In our next post, we will review some of the basic tax rules that need to be considered, and how that would impact how a transaction might be structured