1. Tax Compliance
The starting point of a tax due diligence exercise should include a detailed assessment in order to determine whether the Target presents any compliance risks – this may include a review of all relevant tax filings and details of any open/closed tax inquiries with the relevant authorities. Taxes that falling under such an assessment include:
- Corporation tax;
- Value added tax (VAT);
- Payroll taxes;
- Customs duties;
- Specific business taxes.
The acquirer will want an understanding of the potential, past, present and future tax liabilities the Target is exposed to – whether certain or contingent, and whether recorded or unrecorded in the financial statements. Such an understanding helps the acquirer in determining the purchase price and in negotiating warranties and indemnities as part of the SPA (sale and purchase agreement).
Tax due diligence should also include an assessment of the Target’s historical taxes and trading history (for instance, operating losses, tax credits, depreciation and amortization, etc.) and consideration of the possibility for any reliefs to be utilized by the acquirer post-acquisition. Through understatement of revenue, or overstatement of operating expenditure, the Target might (deliberately or unintentionally) have underpaid or not paid the taxes it is liable for. Ultimately, where due diligence reveals compliance risks, the acquirer must find appropriate remedies. If the risk(s) flagged as part of due diligence do not constitute “deal breakers,” the acquirer might argue for a reduction in the purchase price. Again, where specific risks are identified it is advisable to ensure these risks are adequately addressed in the share purchase agreement (SPA).
2. Tax Liabilities/Assets
One of the most challenging aspects of evaluating tax liabilities during the due diligence process is the time required to identify them. Once the tax liabilities have been identified they must be quantified. This will typically include analysis of prior-year financial information so that the acquirer can establish whether unidentified/unrecorded tax liabilities exist.
It is possible that the Target may have made an acquisition of a company in its past – if so, it could be carrying tax assets/liabilities (either recorded/unrecorded) in respect of the company it acquired. It is important that any such amounts are reviewed in detail so the acquirer can gain an understanding as to whether the Target has correctly identified and accounted for these amounts –if not additional tax liabilities may arise (which could fall due to the acquirer if the issue is not resolved as part of deal negotiations).
If the Target has a share options scheme in place this should be reviewed as part of the due diligence process. Typically, share options are not exercisable until an “exit event” occurs (such as a share sale or IPO). Alternatively, employees may decide to wait and exercise their options only when the company is for sale and they have the ability to sell their shares. Sellers are often unaware that they may be able to claim significant corporation tax relief in respect of the gains from exercising employees’ share options around the time of a company sale. It is therefore vital that the seller (and its advisors) establish the quantum of any such relief. This could result in a higher valuation (because the acquirer will benefit from the tax relief). Alternatively, the relief might be recognized in another way (for instance, relief may be used to set-off future claims by the acquirer under tax warranties/indemnities given by the seller in the SPA).
3. Incorrect Classification of Employees
Incorrect classification of employees (such as independent contractors) is common. Some employers may misclassify their employees as independent contractors in error. Others may intentionally misclassify their employees as independent contractors in order to avoid paying payroll and social taxes (by passing the responsibility onto the employee). Employers that are discovered to have misclassified their employees may be subject to significant penalties.
Some employees (such as corporate officers) are required by law to be classified as employees for payroll tax purposes (often referred to as “statutory employees”). Where employees are not classified as statutory employees, the tax authority in the jurisdiction in which the Target is based will likely have a test to help determine whether an individual should be classified as an employee or independent contractor for payroll tax purposes. Some of the principal factors that are considered as part of such a test include:
- The extent of instruction provided by the employer to the individual;
- The flexibility of the individual’s working hours/schedule;
- Whether the individual provides his own equipment, or whether equipment is provided by the employer;
- The method in which the individual is compensated;
- Whether the individual is permitted to work for other employers.
As part of the due diligence process it is important to review any contracts the Target has issued to independent contractors so it can be determined whether there is a risk that any contractors have been incorrectly classified payroll tax purposes (which could result in the Target facing a significant penalty).
4. R&D Tax Credits
R&D tax credits are a relief aimed at incentivizing innovative behavior by serving to reduce a company’s corporation tax liability (they are available in many jurisdictions). R&D expenditure may be incurred in respect of materials, supplies, wages and research, etc. – with the tax relief calculated by reference to “qualifying” expenditure. The way in which R&D tax relief is calculated (for instance, what is deemed as “qualifying”) depends on the jurisdiction in which the Target is based. Accordingly, it is important that, where the Target has undertaken R&D activities, due diligence covers a sense check of any calculations that could give rise to an incorrect amount of tax relief being claimed. In the instance of a share transaction, it is possible that the acquirer could gain from significant tax reliefs where an R&D tax claim has not been submitted. Alternatively, if the seller has incorrectly calculated and filed an overstated R&D claim the acquirer may need to factor the cost of any corrective action into their valuation of the Target.
R&D tax credits may be applicable to companies involved in the following:
- Bespoke/customized products;
- Development of new/innovative products;
- Improvements to manufacturing processes;
- In-house or sub-contracted design work;
- Prototyping or development of models, patterns or tooling;
- Development or improvement of software.
A transfer price is the price at which individual entities of a corporate group transact with each other (such as in the trade of supplies or labor). Transfer pricing is applicable when individual entities of a corporate group (typically a multinational) are treated separately. When it comes to tax due diligence, transfer pricing risks are numerous – therefore significant transfer pricing liabilities may exist in one or more jurisdictions (where the group is a multinational).
Transfer pricing can include revenue or expense items which trigger double taxation – because transactions between two related entities are not subject to the same market forces as transactions between two independent entities, over/under pricing can affect the allocation of tax bases among the numerous jurisdictions in which the group operates. By moving profits from one jurisdiction to another, inaccurate transfer pricing can result in multinational groups being subject to double taxation (for instance, if two jurisdictions involved in a cross-border transaction claim the rights to the same profit). On a positive note, transfer pricing can benefit an organization in identifying opportunities for optimization – accordingly, as part of due diligence transfer pricing analysis can provide insight into the operations of the target group, its value drivers, and therefore, ways of potential improvement.