Buying a business is rarely a straightforward decision. In order to get the most out of a potential deal, buyers need to be aware of key risks and pitfalls so they can incorporate mitigation strategies into their deal negotiations. The challenge for buyers is ensuring that no significant risks are missed when making their assessment. This can be difficult, particularly when buyers focus primarily on quality of earnings analyses or other non-financial and tax diligence reviews.
One area often overlooked during the evaluation and purchase of a target company is tax due diligence. Disregarding tax due diligence can put a buyer at significant risk, particularly with respect to a possible share purchase. Under a share purchase arrangement, all of the assets and liabilities of the target company remain with the purchased company. This means the buyer becomes responsible for any liabilities associated with the company, including those found after the sale is complete.
By conducting tax due diligence as part of the purchase assessment process, a buyer can be sure they are making a decision based on all the facts, including their potential tax exposures. This knowledge can help increase a buyer's ability to achieve their desired outcomes from the sale.
The importance of tax due diligence
Every company must work within a network of tax regulatory regimes depending on the nature and reach of their business. While companies operating solely in Canada only need to comply with federal and provincial tax regulations, international businesses must comply with tax obligations in all of the jurisdictions in which they operate.
The problem for buyers is that today's global income tax laws are complex, with different jurisdictions imposing a myriad of taxes on different types of businesses. Given these complexities, it can be difficult for a buyer to assess whether a potential target is complying with all relevant tax laws and fully understand any tax exposures.
If and when tax issues arise post-purchase, the value and benefits associated with the deal can rapidly degrade. Overstated non-capital losses, underreported tax liabilities, non-filing exposures, failure to charge GST or HST, payroll errors ¾ any one of these issues could cause significant problems for a purchaser who has not conducted the appropriate tax due diligence.
Using key information obtained from tax due diligence, a buyer can:
- make more informed purchasing decisions;
- obtain support for the negotiation of the purchase price and transaction documents;
- determine a deal structure; and
- define and structure transaction-specific representations and warranties, indemnities, and other agreement terms.
How tax due diligence works
Buyers primarily invest in tax due diligence to obtain an independent review of the tax profile of a target company in order to identify potentially material tax exposures in advance of a purchase. Tax due diligence can be critical for buyers contemplating either a share or asset deal. For buyers considering an asset purchase, depending on the transaction, tax due diligence may be less of a concern. This is because as long as the buyer and the seller are unrelated parties dealing at arm's length and the assets are being purchased at fair market value, there should not be any significant risk of a historical tax liability accruing to the buyer.
Typically, tax due diligence is conducted by accountants and lawyers with expertise in corporate tax, supplemented by professionals with specialized industry or jurisdictional expertise. The process involves a comprehensive examination of the different types of taxes that may be imposed upon a company in order to evaluate tax exposures. Tax due diligence extends far beyond the review of a corporate tax return, with activities specifically focused on high-risk areas, including:
- Business activities outside of Canada: includes the determination of any tax filing requirements and tax exposures in foreign jurisdictions due to business activities in other countries or passive income received from that company. Foreign tax exposures extend beyond corporate tax; exposures can also include foreign payroll taxes, foreign VAT, and sales tax.
- Foreign affiliates: includes the review of foreign owned entities, including their income, management, financing, surplus accounts, incorporation documents, and local financial statements and tax returns. This activity focuses on ensuring target companies are compliant with tax rules aimed at preventing taxpayers from deferring tax on certain types of income by arranging their affairs so that income is earned in a controlled foreign corporation.
- Transfer pricing: includes the review of all related party transactions a target has made with foreign entities, including transfer of services and technology to or from related parties. This activity also includes a review of Form T106 for each relevant year and understanding any transfer pricing strategy utilized in order to identify any risks of tax exposure.
In addition, tax due diligence generally includes a review of both tax and legal documents, such as foreign reporting forms, past audits and objections, GST/HST returns, related party transactions, and any pre-closing tax structuring steps.
Addressing tax due diligence concerns
In the event that the tax due diligence process uncovers one or more potential risks or exposures, buyers have a number of mitigation options. Four common solutions to resolve tax exposure concerns include:
- Updating representations and warranties: Most transactions include representations and warranties by the seller pertaining to the propriety and completeness of tax matters. These items can be modified or supplemented in order to address specific identified exposures. Buyers may also consider the added protection of representation and warranty insurance, an option that is gaining more traction in the Canadian market.
- Escrows: Escrows are common within many transaction documents. Both the amount and the duration of the escrow can be increased in order to provide the buyer with additional protection from tax exposures.
- Alternative transaction structures: If the tax exposures are very significant, an escrow may not be enough to remedy the situation. In these circumstances, buyers may insist on alternative transaction structures, a purchase price reduction, or an earn-out in order to obtain additional protection.
- Require additional filings: If a tax compliance issue is found (e.g., non-filing of a return), buyers should note that there is generally no time limit on the life of the exposure, as tax statutes of limitations do not apply when a return has never been filed. To address these issues, buyers can insist that the target company file or amend a particular return, or enter into a voluntary disclosure with the relevant tax authority, in order to mitigate the issue before the purchase takes place.
Sell-side tax due diligence
Although this article focuses on buy-side tax due diligence, it's notable that business owners are increasingly choosing to perform sell-side tax due diligence in advance of selling their business, as a way to avoid surprises and streamline the buy-side tax due diligence process.
Sell-side tax due diligence can uncover potential deal-breakers before a prospective buyer finds them. It's a health check from a tax perspective, and helps the seller maintain control over the sale process—potentially leading to a higher sale price. By detecting possible issues early in the process, sell-side tax due diligence provides the seller an opportunity to correct or quantify these issues before going to market.
Making the right purchasing decision
For buyers, the decision to purchase a company should not be made lightly. While the projected benefits associated with a target may be great, it's important not to lose sight of risks associated with a transaction. Undertaking tax due diligence is a critical way buyers can be sure they are making the right decision without exposing themselves to excessive risk. While investing in tax due diligence may be an upfront cost, it is critical for protecting the benefits the buyer expects over the long term.
Co-authored by Danvir Roopra BDO Canada
Co-authored by Paul Walker BDO Canada
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.