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The contingencies that typically cause the greatest concern in the context of tax due diligence between buyers and investors.
A company may present healthy accounts, a solid customer base or excellent growth prospects. However, a tax contingency uncovered during ‘tax due diligence’ can significantly reduce the purchase price, require additional guarantees or even jeopardise the completion of the transaction.
The issues that lead to the most complex negotiations rarely appear on the front page of the financial statements. They are often found in less obvious areas, such as a flawed transfer pricing policy, a VAT issue in the supply chain or an undeclared permanent establishment.
In our experience advising domestic and international companies on acquisitions, disposals and corporate reorganisations, many of the tax contingencies identified during due diligence had existed for years before the transaction began, but no one had analysed them with the necessary depth.
Therefore, when a company is considering an acquisition, one of the most important aspects – following the valuation of the business – is to understand the company’s tax history in order to identify the tax risks that could arise after completion and to determine how to manage them during the negotiations.
What is ‘tax due diligence’ and why can it change the course of a transaction?
The aim of ‘due diligence’ is to analyse a company’s level of tax compliance, identify potential liabilities, quantify their financial impact and detect opportunities that may influence the transaction.
In practice, it is an essential tool for transforming uncertainty into useful information for decision-making during the negotiation and integration process. A proper tax review enables the true tax exposure of the company to be understood, price adjustments to be negotiated, specific guarantees to be established between buyer and seller, taxable assets to be identified, and a more efficient integration to be facilitated following completion.
It is no coincidence that many of the most significant renegotiations in corporate transactions stem precisely from the findings of ‘tax due diligence’.
The principle every buyer must bear in mind.
When a transaction is structured as an acquisition of shares or equity interests, the buyer does not merely acquire assets, contracts or customers. They also acquire the company’s tax history.
For this reason, the true value of ‘tax due diligence’ lies not merely in finding errors, but in identifying risks that could materialise after closing, quantifying them and presenting them in such a way that they can be utilised in the acquisition process and subsequent integration.
The most common tax risks.
Although every transaction has its own specific characteristics, experience shows that certain issues crop up repeatedly in most tax due diligence processes.
Tax compliance errors
This is the most common finding. The audit examines corporation tax, VAT, withholding tax, informative returns and any other obligations relevant to the company’s activities. Although these are sometimes merely technical errors, it is also common to find incorrect tax interpretations applied over several financial years, with the consequent risk of additional tax liabilities, interest and penalties.
VAT: the main source of disputes
If there is one tax that is particularly prone to giving rise to adjustments, it is VAT. The technical complexity of this tax means that issues frequently arise relating to unauthorised deductions, incorrectly applied exemptions, errors in intra-Community transactions, pro rata problems or incorrectly managed reverse charge arrangements. When these errors are repeated over a number of years, they can result in financial liabilities of a significant amount.
Tax audits and pending litigation
A company’s history of dealings with the tax authorities provides highly valuable information regarding its risk profile. It is therefore essential to analyse previous audits, signed audit reports, pending appeals, binding rulings and relevant notices in order to identify tax positions that could be challenged again in financial years for which the limitation period has not yet expired.
Withholding and employment taxation
Obligations as a withholding agent remain a recurring source of issues. Inadequately substantiated subsistence allowances, incorrectly treated payments in kind, bonuses with withholding errors, and problems with directors’ remuneration are common occurrences.
Connected transactions and transfer pricing
Transfer pricing plays a key role in any tax due diligence of corporate groups or family businesses. A lack of adequate documentation or inconsistencies between the policy applied and the group’s economic reality can lead to significant adjustments, particularly in connected transactions relating to services, financing, the transfer of intangible assets or corporate restructuring.
Tax loss bases and other tax assets
Tax due diligence does not merely identify risks; it can also uncover value. It is common to find tax loss carry-forwards, R&D&I deductions, tax credits or other incentives that may prove particularly attractive to a buyer and become one of the most hotly debated points during price negotiations. It is therefore essential to verify that they meet all legal requirements and that they can be effectively utilised following the acquisition.
Past corporate restructuring transactions
Mergers, demergers, share swaps and non-cash contributions often come under particular scrutiny during due diligence. Even if they took place years ago, it is not uncommon to uncover documentation shortcomings, breaches of legal requirements or insufficient economic justification. When such issues arise in the midst of negotiations, they can result in price adjustments, additional guarantees or delays to the transaction.
International tax risks.
Globalisation has considerably broadened the scope of tax due diligence. It is now common practice to review issues relating to undeclared permanent establishments, incorrectly applied international withholding taxes, transfer pricing non-compliance, international reporting obligations or indirect taxation in other jurisdictions. Even medium-sized companies may find themselves subject to tax obligations in different countries without being fully aware of it.
What contingencies can actually affect the price?
Not all tax contingencies have the same potential to affect a transaction. Some can be resolved with relative ease, whilst others have the potential to significantly disrupt the negotiations.
Inadequately documented transfer pricing, undeclared permanent establishments or certain tax assets of uncertain value are some of the risks that cause buyers the greatest concern due to their complexity and impact on the outcome of the transaction.
When these situations come to light during a ‘tax due diligence’ process, they typically result in price adjustments, specific guarantees, indemnities or retention mechanisms designed to protect the buyer against potential future contingencies.
Preparing before selling: a competitive advantage.
Traditionally, tax due diligence has been seen as a tool for the buyer. However, an increasing number of companies are carrying out proactive reviews before initiating a sale process.
This exercise enables companies to identify issues in advance, strengthen supporting documentation, anticipate the buyer’s questions and significantly reduce uncertainty during negotiations, thereby substantially lowering transaction costs.
Experience shows that well-prepared companies negotiate from a position of strength, whilst contingencies discovered at the last minute often result in price reductions, additional guarantees or delays in closing the deal.
Beyond compliance: safeguarding the value of the transaction.
The true value of tax due diligence lies in managing risk before it becomes a problem. A contingency identified prior to closing can be resolved through price adjustments, specific guarantees or remedial measures. The same contingency discovered after the acquisition often leads to a dispute.
In an environment characterised by regulatory complexity, the pressure of tax audits and the globalisation of business, tax due diligence has become a strategic tool. This is because acquiring a company means taking on its future, but also understanding its past.
Experience shows that many transactions do not fail because of the risks identified during due diligence, but because of those that remained hidden until it was too late.
Tax Area
