Tax Due Diligence

Tax Due Diligence: Focusing on Tax Risks and Opportunities

Tax Due Diligence is a key component of the comprehensive examination of a company prior to its purchase or sale. It focuses on the tax affairs of the target company with the aim of uncovering potential tax pitfalls and optimization opportunities. This creates transparency regarding the tax consequences of a planned transaction and significantly contributes to purchase price determination and contract structuring.

Objectives and Tasks of Tax Due Diligence

The overarching goal of Tax Due Diligence is to provide the prospective buyer with as complete and reliable a picture as possible of the target company's tax situation. This involves both identifying and assessing tax risks as well as uncovering tax-saving potentials related to the planned transaction.

Core tasks of Tax Due Diligence include:

1. Review of Tax Positions: Verification that the target company has properly fulfilled all tax obligations in the past. This includes analyzing tax returns, assessments, and payments, as well as ensuring the traceability of tax positions in the accounting records and financial statements.

2. Identification of Tax Risks: A focus is placed on uncovering potential tax risks, such as ongoing or imminent tax audits, disputed tax proceedings, or aggressive tax planning. Compliance violations, such as missing documentation or late filings, are also identified and assessed.

3. Analysis of Tax Loss Carryforwards: Existing tax loss carryforwards of the target company may hold value for the buyer but are often subject to restrictions in share transfers or usage conditions. Tax Due Diligence examines the existence, amount, and usability of such carryforwards.

4. Assessment of Tax Structures: More complex tax structures of the target company, for example in an international context or involving holding companies, are analyzed and evaluated for their robustness and sustainability. The risk of tax reclassification or non-recognition by tax authorities is also assessed.

5. Identification of Tax Optimization Opportunities: It is examined whether and how taxes can be optimized through the transaction itself or by adjusting the tax structure afterward. This may involve utilizing exemptions and thresholds, leveraging tax advantages of certain legal forms, or adjusting transfer pricing.

The findings of the Tax Due Diligence feed into the overall valuation of the target company and the structuring of the transaction. They form an important basis for purchase price determination, the drafting of guarantees and warranties in the purchase agreement, as well as tax planning for the post-closing period.

Areas and Methods of Tax Due Diligence

Tax Due Diligence covers various types of taxes and thematic areas depending on the transaction context and corporate structure. Typical areas of review include:

• Income Taxes: This primarily includes corporate income tax, trade tax, personal income tax, and solidarity surcharge. The completeness and accuracy of tax returns and payments, the adequacy of tax provisions, and any over- or underpayments are examined.

• Value-Added Tax (VAT): The correct remittance and input tax deduction of VAT are analyzed. Special attention is paid to compliance issues such as timely filings and payments, correct invoicing, and the treatment of cross-border deliveries and services.

• Payroll Taxes and Social Security: The review covers the proper remittance of payroll taxes and social security contributions for employees and managing directors. The correct tax and social security treatment of benefits and incentives such as company cars, corporate events, or stock options is also analyzed.

• Transfer Pricing: For transactions between affiliated companies, especially cross-border, the appropriateness and documentation of transfer prices are examined. The goal is to identify risks related to profit shifting or double taxation.

• International Aspects: For target companies with foreign subsidiaries or permanent establishments, the tax implications and risks of cross-border structures are analyzed. The applicability of double taxation treaties and compliance with reporting obligations are also reviewed.

• Transaction-Related Taxes: This mainly includes real estate transfer tax and inheritance/gift tax. It is analyzed whether the planned transaction triggers such taxes and how they may be optimized.

The review activities in Tax Due Diligence include both the analysis of documents (tax returns, assessments, contracts, transfer pricing documentation, etc.) and interviews with management, the tax department, and external tax advisors of the target company. Close coordination with other due diligence workstreams, especially Financial, Legal, and HR, is essential.

Process and Participants in Tax Due Diligence

Tax Due Diligence is usually led by experienced tax experts in transaction advisory, often supported by specialized tax lawyers. The process typically consists of the following phases:

1. Initiation and Engagement: Defining the scope, timeline, and reporting format of the Tax Due Diligence, assembling the review team, and sending requests for tax-related documents to the target company.

2. Data Collection and Analysis: Reviewing and evaluating the documents provided in the data room, identifying key focus areas and additional information needs.

3. Interviews and Presentations: Conducting interviews with management, the tax department, and advisors of the target company, attending management presentations, and consulting with other due diligence teams.

4. Reporting and Approval: Preparing a written Tax Due Diligence report outlining key findings, scenarios, and recommendations. Presenting and discussing the results with the client.

The entire Tax Due Diligence process can take from a few weeks to several months, depending on the size, complexity, and data quality of the target company as well as the transaction context.

Careful planning and prioritization of review activities are as important as close communication with decision-makers on the buyer’s side. Only when Tax Due Diligence findings are integrated early into negotiations and contract drafting can the full value creation potential be realized.

Challenges and Success Factors

Conducting Tax Due Diligence often involves particular challenges:

• Complexity and Dynamism of Tax Law: Tax laws and regulations are constantly evolving and contain numerous special rules and exceptions. Tax Due Diligence must master this complexity while maintaining focus on the essentials.

• Limited Data Availability: Tax-relevant documents in the data room are often incomplete or unstructured. Follow-up requests and clarifications consume time and resources and require good communication with the target company.

• Dependencies and Interfaces: Tax Due Diligence relies on information and assessments from other workstreams, such as earnings planning, contracts, or personnel matters. Close coordination and integrated time management are indispensable.

• Time Pressure and Resource Constraints: Tax Due Diligence often must be conducted under tight deadlines and with limited personnel resources, especially in competitive bidding processes. A streamlined project organization and clearly prioritized review activities become even more critical.

• Uncertainty and Discretionary Judgments: Tax risks and optimization potentials often cannot be quantified with absolute certainty and are subject to negotiations with tax authorities. Presenting ranges and scenarios along with supporting arguments is central.

To overcome these challenges and ensure effective Tax Due Diligence, several key success factors have emerged in practice:

• Expertise and Experience: The Tax Due Diligence team should possess broad and deep tax and business expertise combined with transaction and industry knowledge. Regular training and exchange of best practices are indispensable.

• Focus and Materiality: Given limited time and resources, Tax Due Diligence must concentrate on the material, value-relevant aspects. A risk-based approach and iterative review planning help achieve this.

• Close Communication and Coordination: Frequent exchange with the buyer’s management, other due diligence teams, and the seller’s advisors is essential. Clear communication channels, regular status updates, and integrated project management pay off.

• Pragmatism and Solution Orientation: Tax issues in the transaction context often cannot be solved academically. A pragmatic approach, entrepreneurial understanding, and offering practical options are required.

• Clarity and Audience Appropriateness: Tax Due Diligence results must be presented clearly, concisely, and decision-oriented. Recommendations should be structured by priority and feasibility. Technical depth and comprehensibility for non-tax experts are equally important.

In summary, a professionally conducted Tax Due Diligence is an integral part of every company purchase and sale. It creates transparency regarding tax risks and opportunities, contributes to realistic purchase price determination, and opens up structuring options for the transaction and post-closing tax management.

Buyers, sellers, and their advisors are well advised to devote the necessary attention and expertise to Tax Due Diligence. Few other areas can turn seemingly formal issues into consequences as significant for the value and cash flow of a transaction as tax matters.

Those who know how to properly leverage Tax Due Diligence and consistently apply its findings gain a critical informational advantage and greater certainty in investment decisions. At the same time, new levers for optimizing and increasing the value of the transaction and the target company emerge. And that is ultimately what M&A deals are all about.

A comprehensive step-by-step guide to conducting due diligence can be found in the article "Step-by-Step Guide to Conducting Due Diligence".