A company's tax risks and assets are generally evaluated in two situations:
- During transactions to acquire a new business/assets; in this case, the buyer checks the tax risks of the target company (or companies) by ordering an expert overview, a so-called tax due diligence review;
- In order to get an independent opinion on the existence of tax risks in one's own company, generally such audits (they're also called self-checks) are done by order of the company's management or owners.
Tax Due Diligence
A buyer who orders a tax due diligence review before acquiring a company wants to get information not only about the tax risks that may exist for that company, but also about its existing tax assets (both those assets that the seller is declaring in the transaction, and assets not declared by the seller).
What is the importance of timely discovery of a company's tax risks and tax assets (before purchasing the company)?
If the target company has tax risks, this means that after the transaction the buyer may be confronted with the fact that at the next tax audit of the acquired company it may be assessed significant amounts of unpaid taxes (and, possibly, fines and late payment interest), in connection with which the buyer will have to incur additional expenses to finance the tax liabilities of the acquired company. Such additional expenses will mean that the buyer has acquired a "defective" asset and the buyer will demand that the seller reimburse its losses associated with the acquisition of the asset.
Performing a tax due diligence allows the buyer to assess ahead of time the amount and likelihood of tax risks (for example, refusal to allow tax deductions, refusal to recover VAT or denial of use of tax incentives), and, if significant and likely risks are discovered, then either to agree with the seller to reduce the transaction price, or obtain a guarantee from the seller that the seller will reimburse the buyer for losses if the risks materialize.
Tax assets (such as overpayments to the treasury, losses carried forward, or amounts of VAT recoverable from the treasury), on the contrary, are generally declared by the seller itself as a reason to increase the transaction price. Such price increase is based on the fact that the company being sold will later realize that tax asset and receive funds from the treasury, which will be an additional benefit for the buyer. In this situation the purpose of tax due diligence is to check the validity of the seller's representations and to determine whether the company really does have a tax asset, as well as the likelihood of getting funds from the treasury. Often when tax due diligence is performed it is established that the declared asset has serious defects (for example, losses carried forward may have a considerable share of expenses the deduction of which for tax purposes is questionable), which means that the increase of the transaction price requested by the seller by the amount of the tax asset should be adjusted taking into account the problems identified with that asset.
Thus, the results of a tax due diligence of a target company are very important tools when negotiating a transaction, and also at the stage of drafting the agreement for sale and purchase of the company and agreeing on the transaction price and seller's warranties.
In recent years "self-check" of the status of tax liabilities at the company's request has been very popular: the client gets the opportunity to assess its tax risks and tax assets through the eyes of an outside independent expert and, if necessary, to promptly take steps to address any problems identified:
- If the experts discover underpayment of tax (for example, improper deduction of expenses for profit tax purposes), the company may file an amended tax return and pay the tax and late payment interest, thereby avoiding liability (a fine) being imposed on the company for nonpayment of tax.
- In disputed situations (when the legality of a deduction is unclear and opinions of the regulatory authorities and the courts differ) the experts assess the company's chances of proving its position to the auditors (both out of court and in the event of a dispute) and, if necessary, recommend additional steps to strengthen the taxpayer's position.
- Often during such self-checks the experts identify so-called tax assets for the company being audited (such as undeducted expenses, unrecovered VAT, unused incentives). Such assets generally arise when the company's financial department takes too conservative an approach to computing tax bases. Timely (within three years) identification of tax assets allows the company to recover overpaid taxes and credit them toward future tax liabilities.
As our practice shows, the additional benefits to the company from doing such self-checks are often worth many times more than the cost of conducting them.
A distinctive feature of tax audits carried out by a law firm (both as part of a due diligence review and self-checks) is their careful planning and concentration on key areas of risk for a specific company. In contrast to audit firms, lawyers do not do a "full and complete audit" with massive research of source documents and involving "junior specialists" to handle files. Only experienced experts take part in tax due diligence and, at the first stage, they determine the key risk areas for the company and possible areas where tax assets can be identified, and then work only in those areas. This makes it possible to optimize not only the budget for the audit, but also the time it takes to do the audit, which is of no small importance, especially in M&A transactions, when the buyer of the target companies often devotes a minimal amount of time to the audit.