Tax is one of the most important components that determine the overall profitability of a company. It is so important that it has its own place in the company’s financial report in the name of items such as net profit before tax, net profit after tax, deferred tax, etc. Therefore, it goes without saying that the tax aspect cannot be overlooked in the due diligence during mergers and acquisitions.
What is Tax Due Diligence?
Tax due diligence is a thorough investigation of different types of taxes that affect the target company. When an acquirer is considering a merger or an acquisition, it is important for him to recognize any significant tax exposure to the target company. The word “significant” is very important here. A target company making a net profit of US$ 100,000 will not be much affected by potential future tax liability of US$ 500, however, if the tax liability is said US$ 10,000, then this exposure will definitely affect the buyer’s decision. Thus tax due diligence takes into consideration the liabilities that will crucially affect the profitability of the target company.
Types of Tax Due Diligence
There are two types of tax due diligence – seller’s side and buyer’s side.
A seller’s side due diligence is conducted by the target company in an attempt to recognize and remedy any major tax exposure before inviting prospective buyers.
A buyer’s side due diligence is when the buyer wants to recognize the target company’s tax exposure before making the buying decision.
Both are extremely helpful to different parties of merger or acquisition. In this article, we will discuss the buyer’s side due diligence.
Tax Due Diligence – Areas of Investigation
A tax due diligence is usually conducted after preliminary analysis. After the buyer likes the idea of acquiring a target company based on its business model, financial stability, sustainability, presence in the market, management and culture, it starts digging to find tax exposures.
So what does an acquirer look for during a tax due diligence? There are five common areas –
The very basic and starting drill to a tax due diligence is to confirm that the target company is adhering to all government tax compliance. This may include a review of all applicable types of taxes such as – corporation tax, sales/ value-added tax, excise tax, customs duties, employee tax and other specific taxes applicable to the target company.
The acquirer intends to understand the potential liabilities of the target, be it past, present or future. The liability may be definite or contingent, recorded or maybe unrecorded in target’s books of accounts. Such holistic understanding will bring into light the compliance risk during an M&A deal and will direct towards appropriate precautions that must be taken against these risks. Furthermore, the target company’s exposure to tax liabilities will help the buyer determine a purchase price.
Tax Liabilities/ Assets
Identifying tax liabilities is at the most time consuming and detail-oriented task. This is because the buyer has to analyze all the past financial information of the target company. Furthermore, the buyer must also study the tax liabilities of the target company’s subsidiaries, sister concerns, or any other related company. The tax liabilities of these companies will increase the target company’s tax exposure. Once the acquirer has identified the liabilities, it is time to quantify them. Thereafter this amount of tax liability will be used to make a buying decision or set a fair acquisition price.
Many companies wrongly classify their employees. For example, they may classify independent contractors as full-time employees. This can change the tax liabilities, plus it can invite additional penalty. It is not necessary that the company may have misclassified on purpose, it may be a genuine error.
The acquirer must conduct proper investigations to identify these misclassifications. This investigation includes looking into the following –
- Employee contracts
- The flexibility of individual employee’s working hours/schedules
- Employee compensation structure
- Insurance and other benefits.
This will help the acquirer to determine the target company’s tax liability in this area and further help in making the buying decision.
The government provides tax credits and subsidies to companies to boost trade and commerce. These tax credits include export tax credits, R&D tax credits, etc. Furthermore, the government also rewards sustainability efforts with initiatives such as tax credits for reducing carbon footprint, tax credits to install solar technology and water treatment plants, etc.
There can be two ways in which the target company can have a tax liability in this area. Either it has miscalculated these credits or it has wrongly claimed them. Both cases will give rise to tax liabilities and heavy penalties in the future. Therefore it is necessary that the acquirer conducts thorough due diligence in this area before coming to any conclusions.
Investopedia’s definition of transfer pricing states – “Transfer price is the price at which divisions of a company transact with each other, such as the trade of supplies or labor between departments.”
In the context of tax due diligence, transfer pricing has many risks.
In most transactions, the exchange of goods/ services is between sister-concerns under the same parent company. Furthermore, these companies are under different jurisdictions and are operating under different tax laws. This carries a risk of over calculating taxes, double counting, or not charging taxes where applicable. In order to avoid tax liabilities arising out of these transactions, the acquirer must look into the target company’s transfer pricing agreements and it must also analyze all such past transactions.
From this discussion, we can conclude that the benefits of tax due diligence can far exceed its cost. A tax due diligence can easily identify potential risk exposures arising out of overstated losses, underreported tax liabilities, non-filing exposures, failure to charge taxes, payroll errors, and other tax miscalculations. If these risks go undetected during the due diligence process, it will create a negative impact on cash flow, profitability and reputation of the acquirer at some point of time in future. Furthermore, if there are irreversible tax exposure risks, then it is in the best interest of the acquirer to walk away from the deal, no matter how tempting it may be.