Tax is arguably the least discussed of all motives for conducting mergers and acquisitions.
Managers undertaking M&A tend to be less keen to espouse the tax benefits of a deal – probably wishing to avoid accusations of tax avoidance – than they are to talk up how it gives them a platform for future growth.
Tax is not a dirty word, however. Whenever you’re involved in M&A, it makes absolute good business sense to understand the implications for your company’s tax obligations that a transaction will have.
We at DealRoom help many companies conduct due diligence and in this article, we look at how to conduct tax due diligence, as well as provide a checklist of the items that require attention to ensure this part of your company’s due diligence process passes successfully.
What is tax due diligence important?
Making mistakes or oversights in tax due diligence can lead to onerous penalties from the government.
The IRS cannot practically conduct a tax audit of every company in the United States, so in an effort to deter tax evasion, they have put in place a series of penalties that make it worthwhile for business owners to ensure their taxes are in order.
There’s also huge reputational damage to consider. Everyone has to pay tax, so if your company is looked at as a tax dodger, it won’t tend to play well with stakeholders such as customers and distributors.
The tax due diligence checklist
In terms of complexity, tax due diligence contends with legal diligence for top billing when looking across all the separate areas of due diligence.
The fact is that, in both cases, the risks are significant, while a thorough understanding can be elusive. That’s why the importance of a good checklist cannot be understated.
Having provided a due diligence software for hundreds of transactions, DealRoom has been able to put together a template for tax due diligence that addresses all of the tax issues you’re likely to encounter in your M&A process that can be accessed here.
The following represents a checklist for US-based companies.
M&A participants should be aware that there will be some differences in other jurisdictions that are not covered below:
1. Review of target company’s state and federal income tax returns
- Ensure that all tax payments are current
- Ensure that all of the company’s estimated tax has been remitted
- Assess whether there may be potential for offsetting some of the target’s historical tax features (negative income, tax depreciation and amortization, tax credits) against the costs of the acquisition.
2. Review of target company’s tax audits (if applicable)
- Evaluate findings of previous audits and if possible, what prompted them.
- If the tax audit is ongoing, assess what impact this will have on the transaction.
- Discuss the potential of a tax escrow with the target company, where they assume all liabilities associated with the tax audit.
3. Understand the target company’s methods of accounting
- If the target company has a different method of accounting, simulate its returns after income has been recalculated using your company’s accounting method.
- Ensure that there are no tax hangovers from changes in accounting methods made over the previous 5 years.
4. Ensure that deferred revenue is being recognized in accordance with federal income tax rules
5. Understand the target company’s foreign tax environment (if applicable)
- Is there sufficient presence abroad to constitute a taxable presence?
- Understand the company’s tax liabilities in the jurisdiction(s) in question.
- Understand whether payments made to foreign recipients require withholding.
- Assess the foreign branch’s legal status and the tax filings assoca
6. Understand the target company’s sales and use taxes.
- Establish the differences in sales and use taxes with the target company, particularly if they’re operating in a different industry.
- Understand the sales and use taxes implications post-transaction for the newly merged entity.
7. Ensure that employees are properly classified for tax purposes.
- Ensure that employees are not inaccurately classified as ‘independent contractors’
- Ensure that all statutory employees are designated as such.
- Review the target company’s 1099 forms to assess its designation of employees and independent contractors.
The full template you can find here:
Conducting tax due diligence with DealRoom
As the list shows, despite being one of the least considered aspects of due diligence, tax due diligence has the potential to create a major paperwork mountain for those undertaking an M&A transaction.
DealRoom has designed its tax due diligence component with this in mind:
2. Choose a template from the templates gallery
DealRoom has a range of templates for different due diligence functions – each one created based on feedback from experts in the field, and specially tailored to a particular kind of due diligence.
3. DealRoom provides prompts for information through its unique Requests feature
The uploaded documents are then stored in a safe environment and linked to the relevant requests.
Tax due diligence is a far more complex and detailed affair than looking at last year’s operating income for the target company and seeing that they’ve paid their income tax.
Virtually every aspect of a company is subject to a tax of some kind, and almost always on an ongoing basis. Getting a handle on these requires a detailed due diligence process.
The tax due diligence function created by DealRoom provides a user-friendly tool to conduct this process as effectively as possible.