Tax Due Diligence Explained
Tax due diligence is a central component of a business transaction. It is important to identify the tax risks and facts that affect the business and its purchase price.
If you take over a company, you can save a lot of tax with a well-chosen deal structure. Tax due diligence helps to determine the best structure – and protects the buyer from unwelcome additional claims.
What is tax due diligence?
By purchasing a company, the acquirer usually assumes liability for past tax risks. Tax due diligence is intended to present the tax situation of the company to be acquired (target), identify tax risks and ensure a tax-optimal structuring of the corporate transaction.
The approach of tax due diligence corresponds to the approach of a tax audit.
What does tax due diligence cover?
The focus is not only on the risks but also on the opportunities.
The primary goal, however, is to uncover tax risks in the target company. The (final or temporary) tax effects are relevant for the valuation of the target company and the related determination of the purchase price.
Furthermore, tax due diligence should enable an assessment of the tax policy of the target company. Whether a company has chosen a conservative or a progressive approach in this respect usually rounds off the risk profile of a company.
Using tax due diligence, the buyer also tries to assess risks and to protect himself against a claim through tax clauses or guarantees. In addition, the tax due diligence should show the possibilities for an optimal structuring of the acquisition itself and the opportunities for a post-acquisition restructuring for tax optimisation.
Last but not least, tax due diligence also serves to preserve evidence for possible later disputes, so that the documentation of the tax documents made available in the data room plays a central role.
Basic stages of tax due diligence
The order of due diligence can change, new stages and procedures include depending on the activity of the company. Most commonly, the procedure goes in this order:
1) Analysis of the legal and corporate structure.
This stage identifies the presence of a foreign element in the ownership structure, branches and representative offices. The list of interdependent and authorised persons is also drawn up. In addition, the rules of transaction price determination and the rules of controlled foreign enterprises are analysed.
2) Analysis of contracts and current transactions
Once the risks of the first stage have been identified with special attention, the experts should review the contracts with related and interdependent enterprises. In the review, it is important to determine the threshold for transactions.
3) Regulatory analysis
The availability of tax compliance regulations may be evidence of good faith compliance by the taxpayer. To identify risks, the structure of legal entities and entrepreneurs with whom formal agreements have been concluded, while the company does not really need their services, is analysed.
4) Analysis of tax policy and audit conclusion
At this stage, it is checked whether the accounts comply with the tax legislation. If it was done according to the ineffective laws, the transactions are considered risky.
5) Checking the status of tax audits and legal proceedings
Tax authorities are not allowed to conduct two or more on-site audits for the same taxation period, except for a second audit. Therefore, it is a positive factor for a buyer to pass an audit and have court proceedings in case of tax disputes. This reduces the likelihood of new additional provisions.
How is tax due diligence done – the process
In terms of process, it is advisable to work with questionnaires and data rooms when carrying out tax due diligence, in the same way as in other areas. It is highly recommended to individualise standard questionnaires in advance and to define focal points here.
On the one hand, this should prevent the due diligence process from being drawn out by too much (possibly non-essential) information; on the other hand, external and internal resources should be allocated in a risk-oriented manner in the often time-critical project.
When requesting information, it is also important to consider which strategic considerations play a role in the purchase decision.
If foreign units are also acquired and if there are strategic plans to increase production capacities abroad, the due diligence should focus on the tax-transfer pricing methods applied and their scalability in the light of the arm’s length comparison.
However, it is also regularly important to obtain an overview of the tax compliance of the target, which is why the assessment status and responsibilities for current tax filings and returns (VAT, payroll tax) are regularly queried.
How are the results of the tax due diligence processed?
The results of due diligence are regularly summarised in a tax due diligence report. Each risk is briefly described verbally and quantified as best as possible and then marked with a colour:
green = low risk;
yellow = medium risk;
red = high risk.
In this way – as explained below – the short-term and medium- to long-term findings can be summarised and prioritised.
In the short term, the findings from due diligence should be used to negotiate the tax clauses in the purchase agreement, but they should also provide the basis for the optimal transaction structure (who acquires what?).
Since tax exemptions are often agreed upon, it is important to precisely define the periods to be exempted but also possible risky tax types as well as the tax types themselves.
If, for example, risks from hidden profit distributions are assumed, an exemption up to the cut-off date is often not sufficient and, in particular, periods up to the execution date must also be included in the tax exemption.
Tax due diligence checklist
The following checklist assists in compiling important documents for classic tax due diligence. It will also help you to identify common risk areas.
- Annual financial statements and tax balance sheets of the IPO (Initial public offering) company including group companies together with management reports and further explanatory documents such as audit reports of the auditor etc. for financial years that have not yet been subject to a tax audit. In the case of subsidiary partnerships, the tax balance sheet also includes supplementary and special balance sheets together with explanatory notes.
- Copies of the tax returns and tax assessment notices for corporation tax, trade tax, turnover tax and for the uniform and separate determination of profits for subsidiary partnerships for financial years which have not yet been the subject of a tax audit.
- Copies of the tax calculations for the business years for which no tax return has yet been prepared or filed. Details regarding tax provisions in the annual financial statements include reconciliation to the underlying tax calculations.
- Information on the status of tax audits (tax audit reports, etc.).
- Information on the status of tax dispute proceedings (opposition and tax court proceedings) and binding information proceedings.
- Information on the status of loss carryforwards and the restrictions to be observed in qualitative and quantitative terms.
- Information on the status of fiscal unities. Provision of, for example, profit and loss transfer agreements and their registration and documents on the implementation of the tax groups.
- Information on the financing structure of the companies.
- Presentation of the shareholder structure of the last seven years, including a description of the restructuring measures undertaken.
- Information on service relationships with group companies (transfer pricing documentation, etc.).
- Information on service relationships with significant shareholders and management.
- Information on dividend payments and royalty payments including copies of withholding tax returns or exemption certificates.
- Information on foreign activities of the company and group companies, including a description of permanent establishments.
If you need any advice regarding tax due diligence, please contact our tax advisors in Barcelona by email or phone.