Tax due diligence in M&A: Key considerations for a smooth transaction
Mergers and acquisitions (M&A) are impacted by many factors that can lead a deal to success or failure: from financial to tax. For instance, changes in tax laws and a complicated tax environment were some of the reasons why the $160 billion Pfizer and Allergan deal didn’t make it in 2016.
This article describes tax due diligence as the main tool to identify any potential tax risks that could harm the transaction. Explore the fundamentals of tax due diligence and its main components, and get a tax due diligence checklist for inspiration.
What is tax due diligence?
Tax due diligence is a detailed review of a target company’s tax records and compliance status. It helps buyers understand the tax risks and obligations they might inherit if they acquire the business.
The purpose of tax due diligence is to identify any past, present, or upcoming tax problems related to how a target business has been run. It includes not just income taxes from the IRS or state authorities, but also other taxes that might be owed, like business activity, sales, payroll, or property taxes.
A thorough tax due diligence process ensures a smoother transaction and protects the buyer from unexpected costs or legal issues down the line. Namely, it allows deal-makers to:
- Spot potential tax-related risks and liabilities
- Negotiate adjustments to the purchase price or transaction structure if risks are discovered
- Plan for post-acquisition tax integration more effectively
Example: Imagine a buyer planning to acquire a technology company. During tax due diligence, they discovered the company misapplied tax rules for international sales, leading to potential unpaid taxes, fines, and legal risks. Identifying this issue early allows the buyer to negotiate with the seller, adjust the purchase price, or plan for the liabilities, avoiding unexpected financial burdens after the deal.
Sell-side tax due diligence
Sell-side tax due diligence is when the seller of a business proactively reviews their own tax records before putting the company on the market.
This process helps identify and resolve any tax risks or compliance issues, such as unpaid taxes or incorrect filings, that could raise red flags for potential buyers. By addressing these problems early, the seller can present the business in a stronger position, speed up the sale process, and reduce the chances of price adjustments or delays during negotiations.
Buy-side tax due diligence
Buy-side tax due diligence is when the buyer examines a target company’s tax position, history, and compliance to uncover potential risks or liabilities that may come with the acquisition and lead to certain tax implications.
This includes reviewing past tax filings, liabilities, and any disputes with tax authorities. The goal is to understand the potential tax risks to be able to negotiate the deal accordingly, adjust the purchase price, or plan for any post-acquisition tax issues.
Who performs tax due diligence and how much it costs
Tax due diligence is typically performed by independent contractors: tax advisors, accountants, or specialized teams from consulting firms. In some cases, legal professionals with knowledge of tax laws might also be involved, especially if the deal includes complex international tax issues.
The cost of tax due diligence depends on factors like:
- Target’s size
- Complexity of its tax structure
- Scope of the review
Smaller deals with straightforward tax issues may cost less, while larger deals or companies with operations in multiple countries could require a more detailed and expensive review.
The cost can range from a few thousand to tens of thousands of dollars. However, the investment is worth it to avoid surprises that might cost even more after the deal.
Key components of tax due diligence
The tax due diligence process can take anywhere from a few weeks to a couple of months. It all depends on various factors: from the target’s size to the availability of information. The same factors also impact the scope of tax due diligence. For instance, reviewing a smaller company might involve fewer due diligence components, while with a larger company, there will be more review areas.
Regardless of the case, the most common tax due diligence components include:
- Tax compliance
This checks whether the target company has been filing its taxes correctly. It includes looking at income tax returns, VAT returns, payroll taxes, and other related documents to make sure everything is in order. - Tax liabilities
This involves identifying any unpaid taxes or penalties the company might owe. It also includes checking if there are any ongoing tax audits or disputes with tax authorities. - Tax credits, losses, and incentives
Some companies may have tax incentives, losses, or credits that they can use to reduce future taxes. These can be valuable, so it’s important to know if the target company has any unused losses or credits that could benefit the buyer later. - Tax structure
This examines the company’s legal and financial setup to uncover potential inefficiencies or risks, like incorrect tax filings or exposure to higher tax rates, and to see if it has been arranged in a way that helps reduce taxes. It also considers how the deal is structured (whether buying assets or shares) and what effect that has on taxes. - Transfer pricing
If the company has branches or subsidiaries in different countries, it’s important to check if the prices they charge each other for goods and services are set according to tax rules. Incorrect transfer pricing can cause tax problems. - Employee benefits
This looks at any benefits the target company offers to its employees, such as pensions or stock options, to see how these could affect taxes after the deal. - Tax risks
This involves identifying any possible future tax problems, such as unresolved tax disputes or audits that could lead to additional costs. - Cross-border tax issues
If the target company operates in more than one country, it’s important to check local tax rules. Different countries have different taxes, and there might be extra fees like withholding taxes or customs duties. - Tax agreements
Some companies have special tax deals with tax authorities that could affect future tax bills. It’s important to understand any existing tax agreements the target company has in place. - Tax governance
This looks at how the target company manages its taxes. It checks whether the company follows good practices to reduce risks and manage tax planning.
Tax due diligence checklist
A tax due diligence checklist is a list of tax-related things to check when reviewing a company’s tax situation before a deal. It helps identify risks or any tax issues that could affect the deal, like unpaid taxes or mistakes in tax filings.
The table below is an example of what a tax due diligence checklist can look like. You can use it for inspiration when drafting one for your deal.
| Component | Checklist items |
| Tax compliance | Review recent tax returns (income tax, VAT, payroll) Check for any missed or late filings Verify any tax audit results or ongoing audits |
| Tax liabilities | Identify any unpaid taxes Review past tax liabilities and disputes Check for outstanding tax assessments or audits |
| Tax credits, losses, and incentives | Check for unused tax losses or credits Review tax filings for carryforwards or carrybacks Assess the potential for future tax savings |
| Tax structure | Analyze the current corporate structure Evaluate the impact of deal structure (asset or share purchase) Look for tax-efficient planning in place |
| Transfer pricing | Review intercompany agreements Assess transfer pricing policies Check compliance with local and international transfer pricing laws |
| Employee benefits | Examine stock options, pensions, and other benefits Assess tax treatment of employee plans Check for any liabilities related to employee benefits |
| Tax risks | Identify ongoing or potential tax disputes Assess any unresolved tax audits Evaluate the likelihood of tax penalties or interest |
| Cross-border tax issues | Review international operations and tax treatments Identify withholding tax obligations Assess VAT and customs duties risks in different jurisdictions |
| Tax agreements | Review any existing tax rulings or agreements Assess the impact of such agreements on the deal Check for any incentives or exemptions granted by authorities |
| Tax governance | Assess tax governance policies Review internal tax controls Check for a history of tax compliance issues and management’s response to them |
Conduct tax due diligence with Ideals
Ideals virtual data room (VDR) offers dedicated due diligence services that help make the due diligence process streamlined and effective.
Here’s how you can benefit from due diligence with Ideals:
- Bank-grade security
Ideals offers a variety of security features, such as redaction, watermarking, fence view, and IP restriction, that ensure all the confidential data stored in the data room space is kept protected. - Real-time insights and analytics
You can monitor all the user and document activity inside a data room and get instant notifications about it. It helps track buyers’ interest and act proactively when there’s a need. - Effective collaboration
All the due diligence participants can effectively collaborate in a dedicated Q&A section. Here, they can post questions, assign experts, and get fast answers, which helps significantly speed up dealmaking. - Access controls
There are eight levels of access permissions in the Ideals data room, which helps ensure that only authorized users have access to sensitive tax-related due diligence documents. - Multi-project management
You can undergo several due diligence processes at once thanks to multi-project management functionality. It’s especially useful for sellers who have several potential buyers. - Due diligence checklists
Ideals offers a dedicated due diligence checklist functionality that helps to ensure nothing is missed during the due diligence process and track its progress. You can download existing XMSL checklists without conversion and make real-time edits within the VDR.
Source: Ideals Help Center
Key takeaways
- Tax due diligence is the process of reviewing a target company’s tax records and compliance status. It helps buyers understand the tax risks and obligations they might inherit if they acquire the business.
- Tax due diligence is typically conducted by outside tax experts. However, sometimes legal professionals with knowledge of tax laws can be involved.
- The main components of tax due diligence are tax compliance, tax liabilities, tax credits, losses, and incentives, tax structure, transfer pricing, employee benefits, tax risks, cross-border tax issues, tax agreements, and tax governance.
- It’s recommended to use tax due diligence checklists to streamline the process and ensure nothing is missed.
FAQ
Tax due diligence is the process of reviewing a company’s tax records to identify any potential tax risks or liabilities before a merger or acquisition. It helps ensure the company is in compliance with tax laws and that there are no hidden tax issues.
The purpose of tax due diligence is to assess the target company’s tax position and uncover any potential tax-related problems that could affect the deal. It helps buyers make informed decisions and avoid unexpected tax liabilities after the transaction.
Typically, the buyer pays for the due diligence process, including tax due diligence. However, in some cases, the costs may be negotiated as part of the deal structure.
The cost of tax due diligence varies depending on the complexity of the transaction and the size of the company being reviewed. On average, it can range from a few thousand to tens of thousands of dollars.
Tax due diligence generally takes anywhere between several weeks and a couple of months. The timeline depends on factors like the company’s size, the quality of tax records, and the scope of the review.