The value of tax due diligence

M&A activity concerning smaller managed entities (SMEs) or owner-managed business (OMBs), taxation is often an area where a few unexpected ‘buried skeletons’ turn up.

Overseas-based clients in particular want to review and understand the taxation position of a potential target. Usually their instructions are to undertake due diligence on the taxation position of the target, advise on tax liabilities (actual and contingent), and provide any other comments on taxation matters concerning the target.

Their focus is directed to the propriety of returns that have been filed, what matters and liabilities are still outstanding and remain unresolved with the tax authorities, evidence of undisclosed tax liabilities and estimation of both known and undisclosed amounts to inform the wording of tax warranties and indemnities is sale documentation.

A frequent by-product is the need to advise on the structure of the proposed M&A transaction given the tax issues identified at the due diligence stage.

The ‘belt and braces’ work is often straightforward eg:

• Examining corporation tax computations
• Examining deferred tax calculations (if any)
• Checking the reconciliation of the effective tax rate disclosed in accounts to statutory tax rates
• Reviewing the compliance position, including correspondence with the tax authorities and agreement of liabilities with them
• Obtaining details of any recent tax enquiries
• Understanding the extent of known dispute with the tax authorities and discussions over contentious items
• Reviewing the VAT position
• Considering the status of PAYE liabilities.

From our experience, deferred tax – where, for instance, an advanced tax deduction has been obtained for certain expenses which will then reverse in subsequent accounting periods (e.g. accelerated capital allowances) – is often not well understood.

Matters then move rapidly to more detailed considerations, such as reviewing the position concerning group relief (if applicable), considering liabilities in the event subsidiaries were to leave a target group and examination of other matters that might affect future liabilities.

Some of these more detailed considerations are as follows:

• A review of tax losses available to be carried forward and set against future profits or other tax assets
• The extent to which related entity activities outside the UK take the form of a permanent establishment in other jurisdictions for taxation purposes
• Consideration of other local direct and indirect tax implications when looking at overseas businesses
• Any withholding tax issues where payments, such as interest or royalties, have been received from overseas entities
• When dealing with profits booked via intercompany transactions with overseas parties, consideration of whether these have been offered to tax in any jurisdiction and an understanding of arrangements in place to determine whether such profits should be subject to tax
• Intra-group, cross border transactions and possible transfer pricing issues, including reviewing any transfer pricing adjustments relating to tax, any advance pricing agreements with, or rulings from, tax authorities and / or whether proper documentation on transfer pricing policy is in place
• If the target has been involved in transactions previously, a review of any reorganisations and associated clearance applications and tax rulings, plus details of any extant tax warranties and indemnities given or received.

Our initial approach is to seek access to those people at the target business who have responsibility for its taxation, so a discussion can take place on specific tax issues that apply, which helps determine the scope of the due diligence work.

If the target has retained professional advisers, it is also useful to seek to review previous professional opinions offered on the tax position and to have access to the personnel involved.

So tax can be a complex area when it comes to deciding what needs to be addressed by due diligence. Often, however, taxation due diligence proves to be a fruitful exercise, even if it does nothing more than give a greater understanding of potential liabilities a new owner may face.