Tax due diligence for UK companies

What is tax due diligence

Tax due diligence is a review of a company’s tax affairs as part of a transaction or other significant business decision. It looks at whether the company has complied with UK tax legislation, whether there are historical liabilities and whether any of those liabilities could pass to a buyer. The review may also identify tax reliefs or other matters that affect the value of the company.

This is particularly important in a share purchase. The buyer acquires the company as it stands, including its tax history. Liabilities relating to periods before the acquisition generally remain with the company after completion.

Why tax due diligence matters

Tax due diligence is often described as a way to identify risk. That is only part of its purpose.

The findings can affect how much a buyer is prepared to pay, what protection it asks for in the legal documents and whether a share purchase or asset purchase is more appropriate.

Identifying historical liabilities

A review may uncover underpaid corporation tax, errors in VAT returns or problems with the treatment of employees and contractors. It may also identify unpaid PAYE and National Insurance, incorrect Stamp Duty or Stamp Duty Land Tax treatment, or tax positions that the company cannot support with appropriate records.

These liabilities may come with interest and penalties. In a share purchase, they may remain with the company after the buyer takes control. The buyer therefore needs to know what has happened, how much the possible exposure is and whether the underlying issue is still continuing.

Taking tax risks into account when agreeing the price

A tax issue does not necessarily prevent a transaction from proceeding. It does, however, need to be reflected in the terms of the deal.

The parties may agree a lower purchase price. The buyer may also ask for a specific indemnity, a warranty or an amount to be held in escrow in case the liability becomes payable. The appropriate response will depend on the nature of the issue and how reliably the potential cost can be estimated. For a seller, identifying these matters before going to market provides time to correct errors, gather supporting evidence or explain the position clearly to potential buyers.

Deciding how the transaction should be structured

Tax due diligence can help the parties decide whether the transaction should take the form of a share purchase or an asset purchase. In a share purchase, the buyer acquires the company with its existing liabilities. In an asset purchase, the buyer acquires selected assets and operations, which may reduce its exposure to some historical tax matters.

The review may also affect when the transaction takes place, whether tax losses and reliefs will remain available and how the acquisition is financed.

These points are easier to deal with when they are considered early. Once the commercial terms and legal structure have largely been agreed, the parties may have fewer practical options.

Reducing the risk of problems late in the process

Tax issues often take time to investigate. Records may need to be located, previous advisers may need to be consulted and the possible liability may need to be calculated. Starting the review early reduces the risk that an unresolved matter will delay completion or require the terms of the deal to be reconsidered at a late stage.

It can also give investors and lenders a clearer understanding of the company’s position and help the buyer decide what needs to be addressed after completion.

The main areas covered by a tax due diligence review

The scope of the work will depend on the company and the proposed transaction. Most reviews of UK companies cover the following areas.

Corporation tax

The review will consider whether historical corporation tax returns appear to be accurate and whether the company has treated significant transactions and restructurings correctly.

It may also examine tax losses and reliefs recorded by the company. A buyer will want to know whether those amounts are valid and whether they will still be available after the transaction.

VAT

VAT is a common source of errors because the correct treatment often depends on the precise nature of a transaction.

The review may cover partial exemption calculations, international supplies of goods and services, property transactions and options to tax. It may also consider whether the company has applied any relevant VAT schemes correctly.

An error repeated across several VAT periods can become a significant liability, particularly once interest and penalties are included.

Employment taxes

Employment tax risks often arise where a company uses contractors, operates share schemes or provides benefits to employees.

The review may consider whether contractors have been classified correctly under IR35 and the off payroll working rules. It may also examine Enterprise Management Incentive schemes, other share based incentives and the reporting of benefits in kind.

Incorrect treatment can result in unpaid PAYE and National Insurance. The buyer will also need to know whether the same arrangements will continue after completion.

Transaction taxes

The review may examine the Stamp Duty or Stamp Duty Land Tax treatment of earlier transactions.

It may also consider whether a transfer qualified as a transfer of a going concern for VAT purposes and whether any cross border transactions created additional tax obligations.

These matters may affect both the company’s historical position and the expected cost of the proposed transaction.

Tax governance and compliance

A tax due diligence review will usually consider any current or previous HMRC enquiries and disputes.

It will also look at the company’s tax processes and controls. Where relevant, this may include its compliance with the Senior Accounting Officer rules.

Weak processes do not automatically mean that tax has been underpaid. They do, however, make it more difficult to confirm that returns are complete and accurate.

International and group matters

Companies with overseas activities or more complex group structures may require additional work.

This may include a review of transfer pricing, group relief, thin capitalisation and liabilities in other jurisdictions.

The buyer needs to understand both the historical position and any ongoing obligations that will remain after the transaction.

Issues that regularly arise

Some problems appear frequently during tax due diligence. These include missing documentation, unresolved HMRC enquiries, workers who may have been classified incorrectly and VAT errors on more complex transactions.

A review may also identify tax planning that is not adequately supported or that relies on assumptions that are open to challenge.

The quality of the company’s records matters. Even where the original tax treatment was reasonable, it may be difficult to demonstrate that to HMRC or a buyer without the relevant documents.

Due diligence for buyers and sellers

Tax due diligence is useful to both sides of a transaction, although the focus will be different.

Due diligence for a buyer

A buyer will usually want to identify the company’s tax risks and estimate the possible financial exposure.

The findings may affect the price, the structure of the transaction and the protections included in the sale agreement.

They can also help the buyer plan what needs to change after completion, particularly where the review identifies continuing problems with processes or tax treatments.

Due diligence for a seller

A seller may carry out its own review before the formal sale process begins.

This provides an opportunity to identify problems, correct errors and prepare the documents that a buyer is likely to request.

It may also reduce the risk of a buyer seeking a price reduction after discovering an issue late in the process.

Companies considering a future sale may therefore benefit from reviewing their tax position before they appoint advisers or approach potential buyers.

Identifying tax reliefs and other opportunities

A tax due diligence review may identify more than liabilities.

It may find tax reliefs that the company has not claimed, including Research and Development tax relief. It may also identify unnecessary tax costs within the group structure or changes that should be considered before a sale.

Improvements to tax processes and record keeping can also make it easier for a seller to answer a buyer’s questions and support the positions reported in its tax returns.

Speak to Gravita about your transaction

If you are considering an acquisition, sale, restructuring or investment, involve Gravita’s tax team at an early stage. We can review the company’s tax position, identify issues that could affect the price or structure of the deal and help you address them before they become more difficult to resolve.

Speak to us before the transaction progresses further so that tax considerations can be factored into the decisions that matter.