Top 11 M&A tax issues for telecommunications companies

Companies providing telecommunications services are responsible for collecting and submitting a range of federal, state, and district telecom taxes and fees. Federal and state telecom taxes are nuanced and specific to the precise product and service being offered. Without an experienced telecom tax advisor, it is difficult to navigate the precise compliance requirements.

Furthermore, for financial reporting purposes, telecom fees may be included in net revenue/EBITDA, so in a mergers and acquisitions transaction, telecom tax issues can have a direct impact on quality of earnings and deal valuation. In an M&A transaction, it is important to review the historical accuracy of the telecom company’s tax reporting and develop a post-transaction plan for compliance.

Here are some of the most critical M&A issues for telecom companies:

1. Federal Universal Service Fund and other regulatory compliance

Businesses offering services that meet the Federal Communications Commission’s definition of a telecommunications service or an Interconnected VoIP (Voice over Internet Protocol) service are subject to a wide range of federal and state regulatory compliance obligations. The federal Universal Service Fund charge, presently at 34.5%, is assessed on the interstate and international portions of cellular, landline and VoIP services. While the fund charge is recoverable from a business’s customers, failure to report (and collect) it may result in a significant reduction in earnings. State and local regulatory compliance is also a consideration when providing telecom services.

• Companies should perform due diligence to understand the proper regulatory classification of services, and the resulting tax and regulatory obligations. 
• A post-transaction plan should be developed to enact internal policies and procedures that will ensure compliance going forward.  

2. Purchase price allocation and tax classification

Classification of telecom property can be nuanced, and informs tax methods and timing of cost recovery. Determining tax classification (e.g., owned infrastructure, leased assets, intangible assets) will have a critical impact on determining proper cost recovery, if any. It is important in due diligence to consider whether historical treatment of assets could give rise to cash tax exposures.

In asset transactions or deemed asset transactions, asset basis may be eligible to be stepped up to fair market value, resulting in additional depreciation and amortization deductions in the post-transaction period. Careful consideration is required in the preparation of a purchase price allocation, which will have a critical impact on cost recovery and potentially overall deal value.

3. Bonus depreciation phaseout

As 100% bonus depreciation was phased down to 80% in 2023 and further reduced to 60% in 2024, a taxpayer’s treatment of fixed assets deserves renewed attention. This consideration is particularly relevant to a fixed-asset-heavy industry such as telecommunications. Two key issues here include the use of proper recovery periods and compliance with the tangible property regulations.

Due to the availability of 100% bonus depreciation, some taxpayers may have departed from prior correct methods for certain items (such as depreciation or the treatment of repairs and improvements) for the sake of administrative ease. Those taxpayers may need to file an accounting method change.

4. Section 174 research and development (R&D) expenditures

For tax years beginning on or after Jan. 1, 2022, taxpayers are no longer allowed an immediate deduction for research and development expenditures, including those related to internally developed software. Taxpayers are now required to capitalize and amortize these costs over either a five- or 15-year period, depending on whether the expenses were incurred in the United States or in foreign jurisdictions, respectively.

From an M&A perspective, it is important for buyers to review the R&D expenses of potential targets and determine whether the target properly complied with the provisions of Internal Revenue Code section 174 with their 2022 tax returns. Taxpayers should also stay tuned for potential legislative updates, whether through changes in law as proposed by legislature, proposed regulations from the Treasury, or additional guidance from the IRS, throughout 2024. Note that as of May, proposed legislation would delay section 174 requirements.

5. Debt considerations

Given capital funding needs, the changing debt environment and macroeconomic factors, some telecommunications companies have had to perform debt restructuring. In an acquisition context, due diligence should be performed to determine the tax implications of any historical debt restructuring, such as consideration of cancellation of indebtedness income, attribute reduction, interest deductibility of subordinated debt and general section 163(j) limitations.

Acquisition structuring requires review of the tax implications of both the use of new debt and the retirement (or restructuring) of existing debt.

6. Interest capitalization

The elective capitalization provisions of sections 266 and 263(a) may provide an opportunity for taxpayers to manage their section 163(j) limitation. Sections 266 and 263(a) both provide an annual election that allows taxpayers to capitalize interest expense to inventory, personal property and/or real property. Capitalized interest expense is recovered as such property is sold or depreciated. Interest capitalized to inventory is deducted through the cost of goods sold as inventory is sold, and interest capitalized to other property is deducted as that property is depreciated.

For taxpayers with significant self-constructed asset property, such as those in the telecom industry, combining the elective interest capitalization provisions with a method change under section 263A to apply the direct-reallocation method when capitalizing service costs to self-constructed assets may provide an opportunity to increase the basis of property to which interest may be capitalized.

7. Net operating losses (NOLs) and other tax attributes

Many telecom companies have experienced years in which they incurred losses. To the extent a corporate target has in the past utilized material NOLs or other tax attributes, or has material carryforwards to the present day, potential limitations on NOLs and other attributes due to section 382 ownership changes should be evaluated in due diligence.

Furthermore, an M&A transaction is likely to cause a new section 382 limitation. Post-transaction use of the NOL carryforward and other attributes may be one consideration in transaction modeling and deal valuation.

8. Internet of Things (IoT)

While internet access is exempt from tax under the Internet Tax Freedom Act, an IoT provider may be considered a telecom provider if it provides more than just internet access. If the IoT provider is providing a service where the device uses a mobile network to communicate, for instance, the service may be subject to the full panoply of communications taxes, regulatory fees and regulations. This is becoming increasingly common because facilities-based underlying carriers generally sell “data-only transmission,” which is distinct from “internet access.” In performing due diligence with respect to an IoT provider, companies should consider the categorization of services provided and potential tax exposures.

9. Data centers

Connectivity—including through fiber-optic cable, software-defined networks and cross-connections—will continue to be a significant part of data center operations, driven by the need for secure passage of mission-critical data. Data centers traditionally operate as real estate investment trusts, but many now assume the role of carriers. Providing connectivity to public networks or dedicated lines linking data centers or business locations potentially qualifies as taxable communications. Due diligence should be performed to determine the nature of services and tax implications.

10. Communications platform as a service (CPaaS)

Communications services like voice, videoconferencing, SMS and wireless connectivity have become easily embedded in a wide range of product categories. If connection is limited to those on the same platform, the service may only be subject to some telecom taxes. If the user can make calls or send messages on the public switched network, the service is more likely interconnected and subject to telecom taxes at the federal, state and local levels.

11. Streaming services

With streaming content’s increasing popularity and consumers moving away from traditional cable services, many tax authorities have watched revenue sources shrink considerably. While streaming services may be seen as a media service, many states and local jurisdictions are creating new laws or modifying existing ones to treat streaming services as communications. Streaming services are subject to general sales tax in several states; however, some states and localities (Virginia, Florida, Kentucky and the city of Chicago) tax the service under a dedicated telecom tax. Services treated as exempt from sales tax might be taxable under telecommunications statutes.

This article was written by Adam Gonsiewski, Mark Patterson and originally appeared on 2024-06-03. Reprinted with permission from RSM US LLP.
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