Michael’s M&A Playbook: 6 Best Practice Tips for a Tax Due Diligence
The due diligence process includes different teams for specific topics. Besides the legal due diligence, one of the technically more complicated topics is the tax due diligence because every country (and sometimes region) has different tax rules. As a CFO and M&A deal manager, I have worked in all of my M&A with external accounting firms and internal tax experts on tax topics. Here are some examples from my M&A transactions that go beyond simple tax due diligence checklists and will help you with your next M&A transaction.
Recommendations for a Successful Tax Due Diligence
Hire an external accounting firm for the tax due diligence - The tax due diligence can be complex and challenging, especially when you work on an international M&A transaction. Every country has its own tax laws, and regional differences may exist. For example, some countries have a VAT (Value Added Tax) system, but the US uses a sales-and-use tax approach. Sometimes, you must conduct a nexus check to see whether you need to file. Regarding income taxes, you can have countries with minimum taxes and others without. Payroll withholding taxes can be another tricky topic. To make your life easier, I suggest hiring external tax advisors to help you. Work with your internal tax experts to include all important topics in the tax due diligence scope of work.
Ensure that the target company has complied with filing requirements - It may sound simple, but check whether the target company filed their taxes correctly. I worked in one M&A transaction where we had to catch up with more than 60 tax filings after the closing. In some countries and industries, you cannot bid for (governmental) projects if you are not in good standing with the tax authorities. Check the country-specific requirements your the tax advisor. If there is a risk, use it in the negotiations for a reduction of the purchase price.
Identify potential tax risk and evaluate the target’s tax strategy - Tax evasion is illegal, but tax management is allowed. That's the sentence I remember from one of my professors at university. Nevertheless, since some tax codes have gray areas, companies can be conservative or aggressive in their interpretation and tax strategy. Take the time to dig into tax elections and how the target company approaches specific topics. Understanding the target's risk appetite and tax strategy helps you adjust the tax due diligence scope of work. The riskier the target company is, the more detailed the tax risk analysis has to be. In any case, ensure the purchase agreement is clear about audit findings for periods before the closing date. The seller should be responsible for those also after the closing.
Understand the transfer pricing approach - Transfer pricing is the intercompany pricing approach between companies of the same group. The general guideline is that you need to have prices that are comparable with third-party transactions. When I started my career, this wasn't a big issue; however, it has become a hot topic over the years. In some countries, there are even specific transfer pricing audits. In many countries, you must file the transfer pricing documentation with the tax return. Ensure that you understand the target’s transfer pricing method, which is how the target company prices its intercompany transactions. Also, ask for its transfer pricing documentation and get the transfer pricing tax filings and audit findings. If the target company doesn’t have sufficient transfer pricing documentation, include expenses for external tax advisors in your business case. You need a professional transfer pricing report, and I suggest that you get external help. Also, if there is a significant risk that the approach is not compliant with transfer pricing rules, use this as an adjustment in your purchase price negotiations. Yes, the adjustment in one country should also result in a change in the other country of the intercompany transaction; however, the process is complex, you need external help (tax advisors, lawyers), and it may take years to go through the administrative process.
Check whether there is a risk of permanent establishments - When a company has business activities in another country but no legal entity and tax return, it is a permanent establishment risk. Check with your tax experts whether those transactions create a permanent establishment (PE). In such a case, the local tax authorities treat the company like it has a taxable presence in the country. That means you must file a tax return and pay the tax obligation, which may include penalties if the target company didn’t do it in the past. Like many other tax topics, it is sometimes difficult to say whether you create a PE. The outcome is sometimes unclear. Nevertheless, the PE analysis has to be part of a tax due diligence.
Analyze the impact of the M&A transaction on tax positions - The M&A deal can significantly impact the tax positions of the target company. One example is the topic of net operating losses carried forward (NOLs). In many countries, when you buy a company with tax losses, you need to be in the same industries to be able to use them in the future. Also, significant changes in the business operations after the closing (such as restructuring) can lead to the loss of the NOLs. There may also be annual limitations for NOLs. Talk with your tax advisors and ensure that this analysis is part of the scope of the engagement letter.
Looking Forward: Different Tax Structure Options
Some topics go beyond the tax due diligence of the target company. Tax management is always a group topic, meaning you should try to optimize the group’s tax results and not only the tax effects of one company. With M&A transactions, new tax management opportunities may come up. Work with your internal tax experts and external advisors on how the M&A transaction affects the group's tax structure. Ensure that the tax due diligence report includes those opportunities in a separate chapter.
Feel free to contact me to discuss specific mergers and acquisitions examples.
