Enter Your E-mail

Matthew Peppitt outlines the importance of the due diligence process in business transactions, and some important factors to consider in determining the scope of a review.

Introduction

In many ways, tax due diligence is the most important of all the tax workstreams for any transaction. It informs all the crucial tax decisions which arise between the origination of a deal and its completion; and it provides the framework and support for:

• tax-efficient structuring and funding of the transaction;
• tax aspects of the share or asset purchase agreement (including in particular warranties and indemnities); and
• the tax assumptions on which the purchaser’s valuation model or hypothesis is based.

In short, without the factual underpinnings which tax due diligence provides, it is simply not possible to structure or fund a transaction tax-efficiently, nor to model its tax effects or to negotiate a favourable contract for its completion.

So tax due diligence should receive careful attention at the planning stage to ensure that it is exploited thoroughly and that its full value can be realised. It should never be regarded as a commodity and the temptation to treat it as such should be resisted when commissioning a tax due diligence exercise and agreeing its scope. The full benefits of a tax due diligence review are rarely realised when its scope has been defined imprecisely, for example as ‘high level’, ‘standard’ or ‘full’ scope or even, like catalogue shopping, as ‘small-’, ‘medium-’ or ‘large-scale’. Money is also often wasted on tax due diligence where its scope is defined by a limit on its cost, as in ‘as much tax due diligence as can be achieved for £20,000’.

This is not to say that tax due diligence should always be comprehensive and correspondingly expensive. Rather, it should be focused on the specific tax matters which are capable of affecting the value which the transaction in question is expected to generate. And it can be layered such that time and money is expended on investigating a tax issue or exposure only to the precise extent necessary to enable a particular transaction decision to be made. There is little point in analysing tax matters which, while interesting, will have no bearing on:

• the decision whether or not to proceed with a transaction;
• the transaction structure;
• price or value; or
• the terms of the contract.

Factors Defining the Scope of a Due Diligence Review

The following factors will all have a bearing on the definition of the scope of a tax due diligence review.

• The type of due diligence
• The value which the transaction in question is expected to generate
• The existence and extent of reliable tax warranties and indemnities
• The existence and extent of any vendor due diligence or vendor assistance report provided by the seller
• The existence and extent of any tax losses or other tax assets within the target company or group
• The opportunity to review the target’s audit files
• The specific jurisdictions, entities and taxes which are material to the person commissioning the tax due diligence
• The period(s) which are still potentially open to audit or adjustment by the tax authorities at the date of the tax due diligence review
• How much tax due diligence will actually be possible

The exclusion from scope of one or more less material jurisdictions or legal entities may be wholly appropriate to the circumstances of a particular transaction.  However, as an alternative to complete exclusion, it may be sensible instead to identify those jurisdictions or legal entities which, whilst not sufficiently material for a full scope tax due diligence review, nevertheless still merit some level of due diligence. This is commonly the case where the materiality of jurisdictions or legal entities declines in clearly defined steps.

The Initial Meeting

In any event, as a precursor to any level of substantive tax due diligence, it may be appropriate to commence with an initial meeting with the management of the target company or group (and possibly also its tax advisers) to explore what tax issues or exposures could exist in the target and which areas of its tax affairs might require detailed investigation subsequently.

Where the target management is receptive to this approach and is prepared to participate in full and frank discussion, such meetings alone can often enable the tax due diligence adviser quickly to achieve a number of objectives early in the transaction process:

•  to form a preliminary view of the material tax issues or exposures identified by management as currently affecting the target company or group;
• to form a preliminary view of the material tax issues or exposures which, although not yet identified by management as currently affecting the target company or group, are suggested by the facts disclosed to the purchaser’s tax due diligence adviser at the meeting;
• to enable an initial key issues status report to be provided to the purchaser at an early stage of the transaction; and
• to scope and plan the subsequent phases of tax due diligence fieldwork required -
  
  • to substantiate the principal conclusions drawn from the meeting by the tax due diligence adviser;
  • to substantiate the material facts, representations and assurances provided by management at the meeting; and
  • to investigate those matters which, for whatever reason, were not addressed at the meeting.

If and to the extent that the material facts, representations and assurances provided by management at the meeting cannot be substantiated by subsequent fieldwork, it may be appropriate for a purchaser to seek warranties to support them.

To derive maximum value from the meeting, the agenda and questions should be carefully planned in advance and the meeting itself should be managed effectively by the tax due diligence adviser.

Scope Should Be Monitored

Sometimes, the scope of a tax due diligence review needs to be agreed, at least in draft, within a very short period of time and/or with little or no information about the target and its tax position. Occasionally, not even the number and jurisdiction of the entities comprising the target will be known. In such circumstances, the initial scope can only be a general or standard one based on the experience of the tax due diligence provider of similar transactions, although it may be possible to make reasonable assumptions about the target, supported where possible by publicly available information.

In any event, it is important that scope should be revised as and when information becomes available to suggest that such revision is necessary. In practice, such information is often received throughout the course of a tax due diligence review such that agreeing scope tends to be a continuous process reflecting changing circumstances. For this reason, the document recording the formal scope of the due diligence engagement should necessarily be a living document. This should avoid any discrepancy between the tax due diligence report ultimately delivered and the client’s expectations of it.

Full scope tax due diligence is only possible with the co-operation of the seller and/or target. Generally, it assumes unrestricted access to:

• the target’s books and records insofar as they are relevant to tax;
• those members of the target’s management responsible for tax matters; and sometimes also
• the target’s tax advisers.

Inevitably, however, there will be occasions when such access is limited or even denied altogether.

Restricted Access to Information

Access limitations may only be temporary, e.g. until a particular phase of an auction process has been reached or until a particular member of target management is made aware of what, up to that point, may have been a confidential transaction.

However, access limitations may also be permanent. This will obviously be the case with regard to hostile bids for public companies; but even where a takeover bid for a public company is recommended to shareholders by the board, the company will be keen to limit the information made available to the bidder because of the obligation imposed by Rule 20.2 of The City Code on Takeovers and Mergers. Specifically, Rule 20.2 requires that ‘Any information, including particulars of shareholders, given to one offeror or potential offeror, whether named or unnamed, must, on request, be given equally and promptly to another offeror or bona fide potential offeror even if that other offeror is less welcome…’

In any event, whether or not access to information is to be restricted, some level of information about a target’s tax position is always helpful prior to the formal commencement of due diligence fieldwork. In particular, even a basic level of information can often provide an initial indication of the target’s corporate structure and possible areas of tax risk. This in turn can help the tax due diligence adviser to scope, plan and focus subsequent due diligence and to refine what would otherwise be generic information requests.

Information In The Public Domain

In most jurisdictions, private and/or public companies are obliged to make publicly available a certain level of information about their financial position (e.g. annual financial statements or summaries of them) and even sometimes their tax position. In Scandinavian countries, for example, the amount of publicly available information about a company’s tax filings, etc., is surprisingly extensive. Furthermore, many companies make available on their websites more information than is strictly required by law. The detail and extent of this publicly available information will vary from jurisdiction to jurisdiction and in some cases it may be of only limited value for the purposes of tax due diligence. However, at the very least it may indicate the areas of the world in which a target operates, the extent of its transactions with related parties, whether it is taxpaying, whether it has tax losses or other tax assets, whether it has subsidiaries, its effective tax rate, whether it has share schemes etc. Accordingly, such publicly available information should always be the starting point of any tax due diligence exercise; and sellers and purchasers alike will expect their advisers to have made use of it.

Matthew Peppitt is author of ‘Tax Due Diligence’ published by Spiramus Press, from which the above article is extracted. For further details of the book and to purchase, please visit TaxBookShop (Tax Due Diligence).