What Is Tax Due Diligence?

Tax due diligence (TDD) is a crucial aspect of any mergers and acquisitions (M&A) transaction, as it directly impacts the financial outcomes of the deal. A well-executed tax due diligence process identifies potential tax liabilities and opportunities, ensuring that the buyer is fully informed about the risks associated with the target company. In this post, we’ll explore the key areas of focus in tax due diligence and highlight how it contributes to a successful and tax-efficient transaction.

Key Areas of Focus in Tax Due Diligence

1. Corporate Tax Compliance and Liabilities

Key areas to examine:

• Review corporate tax returns and computations for accuracy and compliance with local tax regulations.
• Assess the implications of previous reorganisations or transactions that might lead to hidden tax risks or future financial obligations.
• Analyse any share-based payment schemes to ensure proper tax treatment and identify potential exposures that could affect the transaction.

2. Employment Taxes

Another critical element of tax due diligence is examining the target company’s compliance with employment tax regulations. This helps prevent future liabilities related to employee taxation.

Key points to investigate:

• Check the company’s compliance with payroll tax requirements and ensure adherence to local and international employment tax laws.
• Verify whether employment tax obligations have been met across various jurisdictions, particularly if the company operates globally.

3. Value-Added Tax (VAT) Compliance

Important steps include:

• Verify VAT compliance through an analysis of the target’s transactions and any VAT exemption claims.
• Evaluate the target’s use of VAT schemes and options, ensuring they align with regulations and do not pose future risks for tax assessments or penalties.

4. Transfer Pricing and Thin Capitalisation

Key considerations:

• Review the target’s transfer pricing policies to ensure they comply with both local and international tax standards.
• Assess the risk of thin capitalisation, where high levels of debt and low equity could expose the company to significant tax liabilities.

5. Negotiating for Protection Against Tax Liabilities

The tax due diligence process may uncover risks that affect the transaction’s pricing and structure. Buyers can protect themselves by:

• Renegotiating the purchase price based on the identified tax risks.
• Seeking indemnities or warranties to shield against potential future tax liabilities.
• Excluding specific disclosures in the agreement to limit exposure to unforeseen tax obligations.

Strategising for Tax Efficiency

Effective tax due diligence isn’t only about identifying current liabilities but also about planning for post-acquisition tax efficiency. Integrating the target company into the buyer’s tax structure in a way that minimises future tax burdens is essential for achieving commercial objectives.

Areas to focus on:

• Future tax planning: Identify ways to structure the acquisition to reduce future tax costs. This may involve utilising tax losses, reviewing past M&A transactions, or assessing potential tax liabilities.
• Employee benefit reporting and stamp duties: Evaluate any employee benefit schemes and assess the stamp, transfer, and capital duties associated with the acquisition.

Collaboration Between Tax, Legal, and Financial Advisors

Tax due diligence is inherently interdisciplinary, overlapping with legal and financial considerations. To ensure a successful outcome, it’s crucial for tax advisors to work closely with both financial and legal teams. This collaboration ensures:

• Comprehensive information sharing across all domains.
• Avoidance of oversights or duplication of efforts.
• A holistic approach to evaluating the deal’s tax implications.

By collaborating effectively, the buyer can ensure that all potential tax risks and opportunities are addressed in the tax due diligence process, contributing to a smooth and tax-efficient acquisition.

Checklist for Tax Due Diligence

A well-organized checklist is essential for a thorough evaluation of the target company’s tax liabilities and planning opportunities. This checklist ensures that all critical tax areas are covered, helping identify risks and uncover potential tax benefits. In this section, we will explore the key documentation required for tax due diligence and how it plays a crucial role in successful M&A transactions.

A complete and detailed checklist allows the buyer to access vital information and ensure that every tax-related aspect of the target company is thoroughly examined. Here’s an overview of the essential documents to include:

1. Organisational Structure and Legal Entity Framework

Understanding the structure of the target company is the first step in tax due diligence to identify tax risks.

• Organisational charts and legal entity structures for the company.
• Documentation of the tax residency of each entity within the organisational framework.
• Historical records of any special purpose entities and past tax planning strategies employed by the company.

2. Financial Statements and Tax Compliance

Examining financial statements helps in evaluating the company’s tax obligations and compliance with accounting standards.

• Comprehensive financial statements aligned with international accounting standards.
• Analysis of the company’s effective tax rate and comparisons between tax provisions in financial statements and actual tax returns.

3. Tax Filings, Elections, and Obligations

Reviewing the company’s tax filings provides insight into its overall tax strategy and compliance with local and international laws.

• All tax returns across jurisdictions, including any special tax elections made by the company.
• Documentation of tax accounting methods and permanent book/tax differences.
• Assessment of the target’s tax filings for compliance with international tax laws.

4. Tax Controversies and Audit History

A company’s history of tax audits and disputes is a vital area to investigate for potential liabilities in your tax due diligence process.

• Complete files of any previous tax audits or disputes, including outcomes.
• Correspondence with tax authorities about any ongoing disputes or potential future tax liabilities.

5. Transfer Pricing and International Operations

For companies operating internationally, transfer pricing policies must be examined carefully to ensure compliance with global tax standards.

• Detailed documentation of the company’s transfer pricing policies and adherence to local and international standards.
• Evaluations of the company’s approach to international tax obligations and tax structures.

6. Employment and Indirect Taxes

Employment taxes and indirect taxes such as VAT or GST must be thoroughly reviewed to avoid future risks.

• Compliance documents related to employment taxes, payroll taxes, and employee benefits reporting.
• Review of VAT/GST compliance and assessments related to these taxes.

7. Past Transactions and Future Tax Planning

Past transactions may carry significant tax implications, and future planning opportunities should be identified early in the tax due diligence process.

• Records of all past transactions, especially those with significant tax implications.
• Board minutes and decision-making documents regarding key tax strategies.

Beyond the Checklist: Additional Documentation

The documents listed above are essential for a comprehensive tax due diligence process, but this list should not be considered exhaustive. After careful examination of the target company, additional documentation may be required to address specific tax issues or areas that need further investigation.

Working With Advisors for Tax Due Diligence 

One critical decision for the buyer is whether to engage a single advisor for both Financial Due Diligence (FDD) and Tax Due Diligence or to hire separate specialists for each. This decision depends on the complexity of the transaction and the specific expertise required. Here, we’ll explore the benefits and challenges of both approaches to help you determine the best fit for your M&A deal.

Integrated Approach with a Single Advisor

Utilising a single advisor for both FDD and TDD can offer several advantages, particularly in terms of efficiency and a unified analysis.

• Streamlined Process: A single advisor provides a cohesive view of both the financial health and tax compliance of the target company. This integration can lead to smoother communication and fewer redundancies in the due diligence process.
• Firms with Integrated Services: Large firms such as PwC, KPMG, and EY often offer both Financial Due Diligence and Tax Due Diligence services, making it easier to manage the entire process under one roof. Their comprehensive analysis can ensure a seamless evaluation of the target’s financials and tax obligations.

This approach is particularly effective for deals where the tax and financial aspects are relatively straightforward and do not require highly specialised knowledge.

Separate Specialists for FDD and TDD

For transactions that involve intricate financial details or complex tax issues, hiring separate specialists for Financial Due Diligence and Tax Due Diligence may provide more in-depth expertise.

• Focused Expertise: When dealing with international transactions or unique regulatory environments, separate specialists can offer tailored insights into the specific nuances of each domain. This approach ensures that both the financial and tax due diligence are handled by experts deeply familiar with their respective fields.
• Complex Transactions: In transactions involving complex tax structures, multiple jurisdictions, or significant regulatory implications, separate specialists can provide more granular detail and focused risk identification.

This strategy is especially recommended when the transaction has multiple moving parts, and highly detailed analysis is crucial to avoid any overlooked liabilities or missed opportunities.

Engaging In-House Teams and Tax Advisors

Regardless of whether the buyer chooses a single advisor or separate specialists, engaging the in-house team and collaborating with tax advisors is vital. A collaborative approach ensures that due diligence efforts are aligned with the company’s broader strategic goals and specific needs.

Advisor Engagement

The in-house team plays a critical role in providing tax advisors with essential insights into the company’s structure, past transactions, and areas of concern.

• In-House Context: The in-house team should share valuable contextual knowledge with tax advisors, including the company’s organisational structure, past transactions, and potential tax liabilities.
• Historical Insights: Advisors should be informed of the company’s past tax audits, transfer pricing policies, and any restructuring impacts to help them fully understand potential risks and opportunities.

Strategic Alignment and Risk Consideration

Aligning the findings of tax advisors with the company’s overall strategic objectives is essential for effective tax due diligence.

• Strategic Alignment: The due diligence process should be aligned with the company’s broader goals, ensuring that any findings directly support the company’s operational and financial strategies.
• Risk Identification: Any specific areas of concern identified by the in-house team should be communicated to the tax advisors, ensuring that the tax due diligence is tailored to address those risks.

The decision to engage a single advisor for both Financial Due Diligence and Tax Due Diligence or to hire separate specialists largely depends on the complexity of the transaction. For straightforward deals, an integrated approach can offer efficiency, while more complex transactions may benefit from the focused expertise of separate advisors. Regardless of the approach, close collaboration between tax advisors and the in-house team is key to ensuring that tax due diligence aligns with the company’s strategic goals and uncovers all potential risks and opportunities.

Profiling and Managing Tax Risks in M&A

In this section, we’ll explore common tax risks, potential deal breakers, and strategies for mitigating tax risks through due diligence and strategic use of warranties and indemnities. Effective tax risk profiling helps identify areas that could significantly impact a deal’s financial viability. Understanding and addressing these risks upfront is crucial for ensuring a smooth transaction.

Common Tax Risks

Tax risks vary across transactions, but some are particularly common and can affect the deal’s success:

• Withholding Tax Issues: Unpaid withholding taxes can create substantial financial liabilities. Beyond the immediate cost, they can also damage the company’s relationship with tax authorities, resulting in long-term implications.
• Transfer Pricing Risks: Lack of proper documentation around transfer pricing policies increases the risk of tax adjustments and penalties, potentially resulting in significant tax liabilities.
• Deferred Tax Assets: These assets are dependent on the future profitability of the target company, making their valuation a speculative element that requires careful analysis.
• VAT Receivables: The recoverability of input VAT varies by jurisdiction, and if under audit, the process can become uncertain and financially risky.

Deal Breakers in Tax Due Diligence

Certain tax risks can be severe enough to halt a transaction entirely. Identifying these early on can save both parties time and money:

• Substantial Unresolved Disputes: Ongoing and unresolved tax disputes can present significant risks, making the acquisition financially untenable.
• Aggressive Tax Planning: A history of aggressive tax strategies, particularly if poorly documented, could indicate undisclosed liabilities and increase scrutiny from tax authorities.
• Compliance Arrears: Major failures in tax compliance not only suggest financial liabilities but also point to broader governance issues within the target company.
• Asset-Based Risks: Companies with large asset bases may have tax risks tied to capital gains and losses, which need to be carefully evaluated to prevent future surprises.

How to Manage Tax Risks in M&A Transactions

The mitigation of tax risks in M&A intertwines legal expertise with strategic foresight. This is where Sales and Purchase Agreements (SPAs) play a critical role. SPAs can be structured to address potential tax liabilities through indemnities, warranties, and covenants, providing the buyer with protection against unforeseen issues.

Strategic Use of Tax Warranties and Indemnities

• Tax Warranties: These warranties allow the buyer to investigate the target company’s tax affairs fully. They ensure that the seller discloses all relevant tax information, enabling the buyer to prepare for any potential tax liabilities.
• Tax Indemnities: Indemnities protect the buyer from unexpected tax liabilities that arise post-acquisition and were not reflected in the financial statements. Indemnities vary globally—tax deeds are common in the UK and Australia, while shorter, general indemnities are often used in North America. In Europe, tax warranties are widely adopted.
• Covenants: Covenants define the handling of pre- and post-completion tax obligations. They ensure clear responsibility for specific tax liabilities, helping avoid disputes after the acquisition.

Practical Examples of Tax Mitigation Strategies

• Transfer Pricing Issues: If significant risks like a €20 million transfer pricing issue are identified, special tax indemnities can be negotiated into the SPA to protect the buyer from future liabilities.
• Deferred Tax Assets: For deferred tax assets based on net operating losses (NOLs), warranties can be used to confirm the usability of these assets, contingent upon the company’s future profitability.

Beyond the SPA: Optimising Tax Efficiency Post-Acquisition

Tax risk mitigation does not end with the SPA. Post-acquisition tax planning is essential for optimising the structure of the deal and ensuring long-term tax efficiency.

Key Strategies:

• Utilising NOLs: Acquisitions can be structured to make use of net operating losses (NOLs), reducing future tax obligations and enhancing the overall value of the deal.
• Post-Acquisition Tax Planning: Engaging in robust tax planning post-acquisition allows companies to reallocate profits and leverage tax attributes for financial efficiency.
• VAT Compliance: Conducting a detailed review of VAT receivables and ensuring compliance with jurisdictional regulations helps mitigate the risk of tax audits and discrepancies.

Operational Restructuring and Transfer Pricing Frameworks

Some experts suggest operational restructuring to minimise tax liabilities. This involves reorganising company operations to take advantage of regions with lower tax rates. Additionally, implementing a robust transfer pricing framework ensures that inter-company transactions are compliant with local and international tax laws.

In the context of M&A, tax due diligence plays a vital role in protecting buyers from unforeseen tax liabilities and deal-breakers. By engaging in early tax risk profiling, leveraging strategic indemnities and warranties, and engaging in post-acquisition tax planning, buyers can mitigate risks and structure deals that maximise financial efficiency.

Understanding Tax Implications in M&A: Asset vs. Company Acquisitions

In mergers and acquisitions (M&A), the structure of a transaction plays a crucial role in determining the tax implications and should be considered in tax due diligence. In this section, we’ll break down the differences between asset acquisitions and company acquisitions from a tax perspective and highlight strategies for evaluating and optimising tax structures.

Asset Acquisitions: Key Tax Considerations

In an asset acquisition, the buyer acquires specific assets from the seller, which can create a different set of tax obligations than a company acquisition.

Tax Relevance

The two primary taxes relevant to asset acquisitions are Stamp Duty and Value-Added Tax (VAT).

• Stamp Duty: This tax is levied based on the transaction value of the assets. The more assets you acquire, the higher the Stamp Duty liability.
• VAT Implications: VAT applies to the transaction itself. Each asset class has specific VAT treatment, making it essential to understand the rules that apply to different assets.

Asset Selection and Transaction Value

Buyers often strategically select assets to balance the transaction value and minimise Stamp Duty. A common approach is to exclude certain assets—such as debtors—to avoid potential disputes over collectable debts, which can complicate the transaction and increase costs.

Company Acquisitions: Key Tax Considerations

Inheriting Tax Liabilities

When acquiring a company, the buyer takes on all the tax baggage associated with the target. This includes liabilities from corporate taxes, employment taxes, and indirect taxes, which can span many years. As a result, company acquisitions generally demand more extensive due diligence to uncover any potential tax risks.

Scope of Investigation

• Corporate Tax Compliance: Corporate tax filings are typically well-managed due to mandatory audits and filings.
• Other Tax Compliance: Employment taxes, VAT, and other indirect taxes may lack the same level of organisation and require closer scrutiny during the tax due diligence process.

Evaluating and Optimising Tax Structures in M&A Transactions

Whether acquiring assets or an entire company, there are several key strategies to evaluate and optimise tax structures within corporate transactions.

1. Strategic Asset Review (For Asset Acquisitions)

Conduct a strategic review of the assets to be acquired to minimise tax liabilities. This involves:

• Focusing on assets with favourable tax treatments.
• Understanding the tax implications of excluding certain assets to reduce Stamp Duty and VAT exposure.

2. Company History Analysis (For Company Acquisitions)

In company acquisitions, it’s vital to thoroughly analyse the target company’s historical tax profile, including:

• Past tax filings and audits.
• Unresolved tax disputes. Understanding these factors can help identify potential risks and opportunities for optimising the transaction.

3. Transaction Value Assessment

For both asset and company acquisitions, assess how the transaction value impacts Stamp Duty and VAT. Developing strategies to reduce these liabilities can have a significant financial benefit.

4. Debt and Equity Considerations

Evaluate the financing structure of the acquisition, including the proportion of debt and equity used. In company acquisitions, this can significantly affect the tax outcomes, as interest on debt can often be tax-deductible, reducing the overall tax liability.

5. Tax Synergies and Efficiencies

Post-acquisition, explore opportunities for tax synergies between the acquiring and target companies. This may include:

• Utilising tax losses from the target company to offset profits.
• Aligning tax structures for greater efficiency.
• Identifying potential tax-saving opportunities.

6. Post-Acquisition Integration

Planning for a tax-efficient integration of the acquired assets or company is critical. Post-acquisition steps may include:

• Restructuring the organisation to maximise tax benefits.
• Aligning tax reporting systems to ensure compliance.
• Harmonising tax strategies to enhance long-term financial efficiency.

Understanding the tax implications of different transaction structures—whether through asset acquisitions or company acquisitions—is a fundamental aspect of M&A. Through careful planning and thorough tax due diligence, companies can minimise risks, enhance tax efficiency, and unlock value in their M&A transactions.

Conclusion: The Critical Role of Tax Due Diligence in M&A

In any M&A transaction, understanding and mitigating tax risks is essential for ensuring long-term success. Through the comprehensive tax due diligence process, buyers can uncover potential tax liabilities, identify deal breakers, and plan for post-acquisition tax efficiency.

Ultimately, effective tax due diligence empowers buyers to make informed decisions, protect themselves from unforeseen tax liabilities, and create opportunities for tax savings post-acquisition. With the right strategy and thorough evaluation, tax due diligence becomes a powerful tool in any M&A transaction, contributing to a smoother process and maximising the value of the deal.