Tax positions can factor significantly in purchase price.

The tax treatment interests or buyers and sellers are often at odds with one another. The relevant considerations, alternatives, and their impacts to both sides can be extensive and complex, and this article doesn’t explore them. But generally, buyers will prefer asset transactions to get a stepped up basis in depreciable assets and accelerate the tax shield from re-depreciating them, as well as to limit the potential assumption of unknown legal liabilities and contingencies. But as the size of transactions grow, the risk, complexity, and administrative burden of effecting the acquisition as an asset transaction outstrips the buyer’s argument for making the acquisition an asset transaction. Stick transactions change the complexion of the buyer’s entire due diligence effort, including tax due diligence (TDD).

For most small and mid-sized companies, TDD will be a straightforward affair the seller’s tax advisors will field. But in larger deals, TDD can be very involved indeed. This article provides an overview of TDD and why it becomes increasingly important to buyers at the higher, more complicated end of the M&A spectrum.

Overview

The intensity of TDD depends on the complexity of the target and the motivation for conducting it. For instance, it might simply be part of the buyer’s assessment of pre-closing liabilities. But if the buyer is trying to understand how they may use all the company’s tax attributes, more detailed due diligence is required. If TDD is being performed as a requirement for obtaining financing or reps and warranties insurance (R&WI), the specific requirements will be covered in the engagement contract between the buyer and their TDD advisor.

The buyer will need to consider how the company runs its tax function, with a view to how it can be integrated into its own. The sale and purchase agreement (SPA) will need to contemplate the tax ramifications of the deal, including:

• reflecting the appropriate tax structure;
• assigning responsibility among the parties for the tax liabilities;
• addressing payroll tax withholding liabilities on employees being acquired; and
• specifying responsibility for tax compliance. In a spin-off or split-off situation, if the buyer can’t file taxes promptly, there might need to be a transition agreement for the seller to assist.

Buyers and sellers may take strong viewpoints selectively on different tax positions and see them from different perspectives. A tax asset from a position being reserved at 30% might be seen by the seller as conservative, reflecting their estimate of a 70% probability of realization. The buyer, on the other hand, might see it as a 30% chance that the tax attribute won’t yield a benefit, either with respect to the company’s current or future tax positions. The buyer’s tax advisor must understand the position in detail and seek consensus with the seller’s tax advisor on how it will pan out. Together, they inform the principals, who need to come to an agreement on the transaction price ramifications.

The buyer’s post-closing tax liability depends on the particular tax type being considered (income, property, etc.), the jurisdiction, and whether they are acquiring an interest in the company’s equity or its assets. Legal structure matters, but it is critical to identify how the entity is taxed for income tax purposes. The buyer of a U.S. corporation, for instance, may or may not be responsible for its entity-level income taxes. The buyer of a U.S. LLC won’t be liable for its pre-transaction income taxes if it is taxed as a partnership, in which case the obligation falls on the shoulders of the selling partners; but if the company is taxed as a C corporation, the pre-closing tax liability is the buyer’s responsibility. A purchaser may even be held liable upon audit for pre-closing obligations of a partner entity.

The obligation for property taxes follows the asset, so the parties need to build into the sales price the seller’s prorated portion of the next tax bill. But one of the reasons the buyer may prefer to structure the transaction as an asset purchase is that it can create more flexibility to cherry pick which assets and liabilities to take over, potentially leaving responsibility for pre-closing income taxes with the seller. The buyer will be cognizant, though, that the IRS may look to them if it cannot collect from the seller. So, to take the seller’s credit risk out of the equation, the buyer may prefer to assume responsibility for all such tax obligations for which it is at risk, and deduct them from the purchase price.

Scope

The scope and degree of the seller’s TDD will depend on a range of factors. For instance:

• Some buyers only examine tax positions that can have a material impact on the transaction price.

• The level of due diligence the buyer performs will reflect their appetite for risk with respect to different types of taxes. Some buyers conduct deep diligence on income taxes but rely on management inquiries for sales and use tax. An error in a sales tax obligation that is based on gross revenue could cause a significant hit to the buyer in that case. But the buyer may take some tax positions at face value.

• The buyer will also focus greater scrutiny on particular areas of concern. If the buyer wants to assure its ability to take interest deductions after the transaction, they will review debt agreements more carefully. If a new tax ruling is relevant to some of the company’s tax attributes, the buyer will spend more time researching it, clarifying the correct interpretation, and understanding its implications.

• If the target company is a major MNC, the buyer may have to scale down TDD to the significant jurisdictions.

• The buyer also needs to consider the statute of limitations, which can extend beyond three years in some cases. The buyer will feel less comfortable if it is concerned the seller has taken aggressive tax positions in the past.

• If the target has net operating loss (NOL) carryforwards the buyer is planning on using, and they are placing significant value on those NOL carryforwards, then they may need to extend their TDD. The reason is that using an NOL carryforward from a particular year opens up that particular year to audit, at least to the extent of the items that gave rise to those deductions. The seller’s TDD may need to go back many years to substantiate an NOL it intends to use.

Process

Your tax advisor will do the blocking and tackling for the buyer’s TDD. But having an idea of how the buyer’s advisor will go about it can’t hurt you.

The starting point for the buyer’s TDD team will be your confidential information memorandum (CIM), which gives them a high-level understanding of the type of target being acquired and helps them structure their successor liability questions accordingly. The CIM may even highlight material tax issues or benefits associated with the target’s business model. The letter of intent (LOI) is probably the next thing the TDD advisor will examine. It should describe any material impending stock or asset acquisitions the seller is undertaking and which the buyer cannot change. This will help the buyer shape its TDD planning and tax structure planning. The TDD team will also review your financial statements to identify material tax assets and tax liabilities and associated risks. The financial statements also expand the TDD advisor’s understanding of the company’s geographic range and operating structure.

The buyer’s TDD advisor uses this as a basis to prepare an initial list of questions for the seller, and an initial document request list. The buyer and its TDD advisor generally then have an initial call with the target’s management and tax advisor. They can use this time to determine which of their requests can be readily fulfilled and what may not be available, whether tax payments have been made on time, etc.. Any tax issues the target has been experiencing will also be discussed, as well as whether outside advisors have been brought in to help address them. Through the first discussions, the buyer’s team will get a sense of who on the seller’s side they will be dealing with and how interactions will be handled.

Sometimes, the seller will engage an outside party to conduct independent due diligence with the intent of providing potential buyers with a report that generates more indications of interest and takes pressure off of the buyer during due diligence. This is referred to as a vendor due diligence (VDD) report. Rather than paying to provide the most comprehensive VDD conceivable, the seller will use the 80/20 rule, partly meeting the needs common to most potential buyers, who will supplement with their own due diligence. Increasingly, VDD reports include TDD, so the buyer will review VDD if it is available and consider any tax analysis it contains. But before foregoing its own TDD altogether, buyers need to consider whether the scope of the tax analysis in the VDD report is sufficient for their needs.

Having laid out a game plan, the buyer’s TDD advisor will then commence their review, which may include the following areas:

• The buyer’s TDD advisor examines the history and background of the target. Reviewing the target’s tax returns along with its financial statements provides a good picture of the organizational structure and jurisdictional reach. The TDD advisor will be able to determine if there are significant cross-border payments, whether there is significant inter-company activity, and, if so, what the target’s transfer pricing is like. They will identify tax attributes generated or utilized within the target in the past, tax elections that have been made, and any special tax regimes in which the target has been participating. They will also be able to determine if there is any exposure from disconnects between the deferred tax assets (DTAs) and deferred tax liabilities (DTLs) reporting on the balance sheet and the book-to-tax adjustments reported in the tax return.

• The TDD advisor will consult the data room and confer with management to ensure it has identified any significant agreements to which the target company is a party and any significant planning documents the target has. They will also review the target’s history, if any, of acquisitions and dispositions, including any purchase agreements to which the target was a party, and any due diligence reports that included the target. This can be useful for a couple of reasons. For one, they will be looking for any tax exposures identified by due diligence and/or disclosure so that they can investigate whether these have been resolved or there is any continuing risk or potential liability from these in the target. They will also be looking for indemnifications. For instance, if the target had previously made an acquisition and obtained a pre-closing tax indemnity, how did the risk work out? Was the target able to collect from the seller in that transaction, or is the prospective buyer in the current transaction buying into credit risk because the previous seller hasn’t upheld its part of the bargain? Also, if the target has been dispositive in the past, does the target have any outstanding indemnifications that might still require payment? If so, the prospective buyer in the current transaction would be acquiring that contingent liability. Audited financial statements and associated auditor work papers, if available, can also help the TDD team identify these contingencies, whether or not they are specifically reported in the financial statements.

• The TDD team will review debt agreements to identify interest deductibility limitations, or any income tax pickups available because of special provisions of those debt agreements. The TDD advisor will assess whether they agree with the way the target has been treating that debt for tax purposes.

• Both the target and the buyer may have cross-border affiliates. The TDD team will review the target’s transfer pricing policies and agreements to see how well the target’s approach aligns with the transfer pricing arrangements within the buyer’s own corporate structure, and whether the target is in compliance with the reporting and record-keeping requirements in the various jurisdictions in which it operates.

• The TDD advisor will also review correspondence with tax authorities, including tax memoranda and tax opinions. The TDD team’s objectives will include identifying any aggressive or risky tax positions the target has taken, learning whether these have come up in audits, seeing how tax authorities have responded to the target, and seeing what kind of penalty protection the buyer will have from advice sought from third parties. These could represent a significant dollar impact, or they could represent distraction risks or reputational risks from buying into risky tax positions.

The TDD team can’t expect to form a reliable picture based on research and documentation alone. An essential step is to regroup with the target’s management and tax advisor on a call after assembling their findings. The TDD advisor will have both broad and specific objectives for this meeting. Broadly speaking, it gives the TDD team a chance to get a sense from the target’s tax advisors, tax preparers, and internal tax team—in their own words—of the organization’s history, what its tax policies and procedures have been, what some of the risky positions it has taken are, and why. The documents provided to the TDD advisor may have been revised many times by different parties, including tax lawyers, and may lack essential color that can impede the TDD advisor’s ability to form a full assessment. The tangents the seller’s side takes in these discussions provide the TDD team with a much better sense of the unvarnished truth. It also allows the TDD advisor to form opinions on the competence of the target’s internal tax personnel, and the advisability of integrating them into the buyer’s team post-closing. This discussion also affords the TDD team the opportunity to ask about specific matters they identified in the document review. Management may be able to explain why something that might look risky on paper really isn’t, and they may give more justification for why a particular tax position was taken.

Output

The TDD report

The TDD advisor then communicates its findings to the buyer’s tax team and deal team in a TDD report. This report conveys risks, exposures, and information that will inform the buyer’s decision, and may impact deal price, terms, and reps and warranties. TDD, therefore, both begins and ends with the SPA. The TDD advisor will have needed to construct its TDD plan after having read the initial draft of the SPA in order to know what tax structure is being contemplated. They then need to ensure that they plan and conduct TDD in such a way as to cover the risks created by that structure, that the TDD report provides proper analysis of the items identified during TDD, and that the SPA provides the buyer the protections they need based on the risks identified during TDD. The TDD report also needs to consider the financial model and assumptions that were used to arrive at the buyer’s offer price, and what impact the findings should have on it. For instance, if the price assumed utilization of the target’s NOLs, the TDD report should probability-weight utilization to value that price component fairly. Similarly, if interest deductions were assumed in the purchase price, the TDD needs to quantify a value for those benefits that considers the likelihood they will be accessible.

What the TDD report looks like needs to be driven by the buyer’s objectives. For instance:

• If the buyer only cares about pricing, i.e., verifying there are no findings that would have changed the buyer’s valuation, then the report will focus on key findings that identify significant exposures that should impact the pricing of the deal. This may be entirely appropriate if the buyer’s primary motivation for the investment is gaining the target’s proprietary IP or customer base. In this case, it is not worth the time to recommend minor price adjustments that could emerge from many small tax matters. Adopting this approach can ensure a higher level of focus on what matters most and allow the advisor to arrive at conclusions more quickly, thus delivering more value to the buyer.

• If the purpose is to obtain financing for the deal, this also argues for a more focused key findings report. The bank’s portfolio manager is not likely to understand the complexities that would be presented in a full-scope report, would probably be distracted from the important findings, and might not be able to distinguish the material from the immaterial.

• If the purpose is to support R&WI, then there are two things to consider. First, the buyer probably won’t be able to get a policy without a TDD report. Second, the policy won’t cover anything that is not identified to the insurer. The buyer needs to strike a balance between cost and benefit in defining the scope of the engagement.

• If the buyer is a strategic acquirer and really wants the full picture of the target from a tax perspective, then they may opt for a full-scope report that covers the entire history of the company, all the tax exposures that have been identified, and all policies and procedures that were evaluated.

Post TDD Support

Tax is more than a single, complex technical specialization. It is a range of complicated areas, requiring specialization by tax type, jurisdiction, taxpayer type, and specific code sections. The more complicated the transaction, the more likely that the prudent course for the buyer will be to hire a firm that specializes in bringing together the necessary expertise for M&A transaction support.

Business combinations can leave acquirers with unfamiliar new compliance requirements and filing deadlines don’t take a holiday for M&A transactions. A buyer can have trouble managing post-merger integration (PMI) of the tax function, even with the most well-written and actionable TDD report as a guide. The services of TDD advisors thus commonly include supporting the buyer’s short-term tax needs in the post-closing period. This may include:

• elections that need to be made to address the risks identified in the TDD report;
• returns that need to be amended;
• studies that may need to be done if some information proved to be unavailable during TDD; and
• assembly of a full compliance roadmap for each tax type in each jurisdiction, for the immediate post-closing period and beyond.

Summary

If you are a seller preparing for a small M&A transaction with few tax complexities, TDD may be a fairly circumscribed part of your buyer’s FDD. But as you move up market in your M&A experiences, understanding TDD from a non-technical, business standpoint can help you better understand your value proposition for buyers.

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