Tax Due Diligence

Key takeaways

• A tax due diligence is the systematic tax review of a company ahead of a transaction and is decisive for the purchase price, the structuring and the drafting of the contract.
  
• It uncovers hidden tax risks, assesses their size and likelihood of occurrence and translates the findings into concrete recommendations for buyer and seller.
  
• Typical findings are incorrect use of losses, undeclared permanent establishments (Betriebsstätten) abroad, critical transfer prices (Verrechnungspreise), unlawful input VAT deduction (Vorsteuerabzug) or risks arising from tax audits (Betriebsprüfungen) and criminal tax proceedings (Steuerstrafverfahren).
  
• Identified burdens and risks are regularly managed through purchase price adjustments, warranties, indemnities (Freistellungen) or specialist insurance products.

What is a tax due diligence?

A tax due diligence is the structured tax review of a target company ahead of, or alongside, a transaction, with the aim of identifying tax risks and safeguarding against them legally. It forms the basis for deciding whether a deal is viable from a tax perspective, which adjustments to the purchase price and the structure are needed, and how later disputes can be avoided. Unlike a classic audit of the annual financial statements, it is concerned not only with past compliance but always with the forward-looking question of what tax payments and disputes the acquirer may face after closing.

• Starting position: A tax due diligence first establishes the tax position of the target company. It captures the relevant types of tax (in particular corporate income tax (Körperschaftsteuer), trade tax (Gewerbesteuer), VAT (Umsatzsteuer) and wage tax (Lohnsteuer)) and identifies open matters from prior-year tax returns, tax audits (Betriebsprüfungen) or appeal proceedings. Buyers thus gain an overview of whether the company has been run in a tax-compliant manner or whether conflicts with the tax authorities already exist, or could arise in future tax audits, which may subsequently translate into back payments, interest of 6 % per year and additional payments.
• Quantifying risks: A central purpose is to translate hidden risks into concrete figures. Items with a risk character – such as aggressive arrangements, legally vulnerable loss carryforwards (Verlustvorträge) or questionable VAT structures – are valued in monetary terms and assigned probabilities of occurrence. On this basis, scenarios can be developed showing how high additional tax burdens or the denial of tax benefits could be in a worst case, and how strongly they would affect the company value.
• Contract negotiations: Finally, the tax due diligence serves as the basis for contract negotiations. Identified risks are summarised in reports and red flag reports that feed directly into the purchase price calculation, the catalogue of warranties and the indemnities. This makes it possible to delineate clearly which tax positions are to be borne by the seller, which the buyer assumes, and which are covered by insurance products.

How does a tax due diligence proceed?

A tax due diligence follows a clear sequence of phases in which information is gathered, evaluated and prepared for the transaction decision. From a client's perspective it is essential to know the individual steps and the time they take, and to complete one's own homework in good time. A focused tax review typically takes several weeks in mid-sized transactions, and considerably longer in complex international structures.

• Scope: The starting point is defining the scope of the review and the timetable. Buyer and advisers determine which taxes and years are in focus, whether the emphasis lies on current tax returns, tax audit risks or international matters, and which transaction objectives are to be achieved. In this phase the request list is drawn up, that is, a structured request for documents addressed to the target company. A properly prepared request list determines whether the review runs efficiently or is later marked by follow-up requests and time pressure.
• Analysis: Next comes the analysis of the documents. From the target company's perspective this means providing annual financial statements, tax returns, tax assessments, tax audit reports, appeal and litigation files and relevant contracts, and answering follow-up questions promptly. The advisers check the data for plausibility, compare tax returns with the results under commercial law and identify deviations, use of losses, unusual arrangements or unclear applications of the law. The more complete and structured the documents are, the more accurate and robust the due diligence report becomes.
• Due diligence report: The process concludes with the tax due diligence report, in which the findings are brought together and from which concrete recommendations are derived – for example purchase price adjustments, specific warranties, indemnities, an adjustment of the transaction structure or the commissioning of further expert opinions. The management summary sets out the central issues for the decision-makers. Clients can then decide whether to carry out the deal unchanged, renegotiate individual aspects or, in extreme cases, withdraw from the transaction.

Which tax risks are frequently discovered?

A tax due diligence almost always identifies tax risks arising either from incorrect filings, from creative arrangements or from an unclear legal position. The sums involved are often in the six- to seven-figure range and concern matters that feed directly into future liquidity and company value. Anyone who knows these typical risk areas can prepare specifically and limit surprises.

• Loss carryforwards: Problems arise particularly often in the use of loss carryforwards (Verlustvorträge). These include losses whose continued use is jeopardised by a change of shareholder or by structural changes, as well as uses of losses that are not covered by the legal position. If a loss carryforward in the millions falls away, the future tax burden rises considerably and the company value falls accordingly. In a tax due diligence it is therefore necessary to examine precisely whether the statutory requirements for using losses are met, how the loss carryforwards were declared in the tax returns and whether tax offices have already raised critical queries or made tax audit findings.
• VAT: A further focus is VAT risks. Typical issues are the incorrect classification of taxable and exempt supplies, unlawful input VAT deduction, the incorrect treatment of chain transactions (Reihengeschäfte) or intra-Community supplies, and risks arising from invoices that do not meet the formal requirements. Even individual errors can lead to substantial back payments, interest of 6 % and late payment penalties; in larger transactions seven-figure amounts quickly arise. A tax due diligence therefore examines both the systematics of the VAT processes and specific cases, and asks whether processes and documentation would withstand a tax audit.
  
• International matters: In an international context, permanent establishment risks, transfer pricing issues and withholding tax questions regularly come to light. This includes, for example, permanent establishments (Betriebsstätten) that exist in fact in foreign states but have not been declared for tax purposes, or transfer pricing models that are not supported by local documentation and arm's length prices (Fremdvergleichspreise). Such constellations lead to foreign and German tax authorities allocating additional profits, which can result in double taxation, lengthy mutual agreement procedures (Verständigungsverfahren) and considerable back payments.
• Audits and compliance: Finally, ongoing or impending tax audits and criminal tax risks play a central role. A tax due diligence frequently gains insight into audit orders, estimates or criminal proceedings that are already known and that lastingly shape the financial picture of the company. What matters here is not only the level of possible back payments but also whether certain risks need to be covered separately in the contract, for example through indemnities, tax warranties (Steuergarantien) or a letter of comfort (Patronatserklärung) from the seller, or through an adjustment of the purchase price.

What happens if tax risks are discovered during the due diligence?

If tax risks are identified in the course of a tax due diligence, this does not automatically mean that the transaction fails. Buyer and seller must decide how the financial burden is to be allocated and which security is required so that the deal remains viable despite the risks. Typical instruments are purchase price adjustments, indemnities and the use of insurance products.

• Purchase price: A purchase price adjustment is the most direct means of reflecting identified tax risks. The parties reduce the purchase price by the expected present value of the risks, or agree variable earn-out models under which future purchase price payments also take account of the actual tax burden that later materialises. The advantage of this solution is its simplicity and the clear economic allocation of the burden. The disadvantage is that it frequently rests on estimates and that later additional or reduced burdens can no longer be corrected retrospectively if no variable model has been agreed. Experience shows that an immediate purchase price adjustment is accepted by both parties only where a risk has definitively materialised. A good example is findings made in an ongoing tax audit.
• Indemnities: Indemnities (Freistellungen) shift specific risks contractually to the seller. The transaction documents provide that the seller assumes certain tax claims, interest and surcharges arising after closing. For the buyer this offers strong protection, because it can assert claims directly against the seller if tax offices raise demands. However, the enforcement risk remains: the seller must be solvent at the time the claim is made, the contractual claim must be clearly worded and the existence of its conditions must be capable of proof.
• Tax warranties: Tax warranties (Steuergarantien) are contractual assurances given by the seller about certain tax facts and circumstances of the target company and are agreed in the share purchase agreement (SPA). In them the seller declares, for example, that (i) all tax returns have been filed on time, (ii) the tax returns are complete and correct, (iii) taxes due have been paid, (iv) wage and withholding taxes have been properly withheld and remitted, and (v) there are no undisclosed tax audits or tax disputes. Tax warranties serve in particular to disclose relevant facts and exceptions, to protect the buyer against incorrect and incomplete information and to create a contractual basis for claims. The aim is to establish the warranted state of affairs, in particular through financial compensation for the disadvantage incurred.
• Letter of comfort: Where the selling company does not have sufficient financial resources, or at least the buyer has doubts about this, a letter of comfort (Patronatserklärung) from another group company or, ideally, from the parent company can secure the buyer's claim. Under a hard letter of comfort, the patron (the parent company) undertakes in a legally binding manner to be liable for the liabilities of the subsidiary in the event of insolvency.
• Insurance: Specialist insurance products, such as tax liability insurance or W&I policies, offer a further way of covering identified risks. In return for a premium, the insurer assumes part of the financial risk from certain tax positions, so that in the event of a loss the buyer receives a payment under the insurance contract. The advantage is that the solvency of the insurer takes centre stage and disputes with the seller are reduced. The disadvantages are the insurance premiums, the precise definition of the insured risk area and the exclusions, for example in cases of gross negligence or deliberate tax evasion. For the seller, the greatest advantage lies in concluding the sale as definitively as possible and thereafter being liable only to a limited extent for later claims. For the buyer, the insurance offers the advantage that a risk is priced unambiguously.

In addition, structuring measures come into consideration where risks concern particular parts of the company. A buyer may, for instance, decide to hive off risky business units before closing or to choose a different transaction form.