Tax due diligence in M&A – more than a box-ticking exercise

Tax due diligence – what is the deal?

Tax due diligence involves a tailored review of a target's adherence to tax lodgements, payment of tax liabilities, and the way tax is addressed within a business. Importantly, it equips a buyer with a comprehensive understanding of the tax history they will inherit when acquiring a business.

Identification of tax risks

Due to the inherent ambiguity of tax law and the improbability of addressing all tax obligations and issues perfectly, no business is without tax risk. The tax due diligence process aims to determine whether the tax risk embedded within a target is acceptable given the buyer's risk appetite, and how to rectify tax issues identified (either through the deal process or post-acquisition). 

A typical tax due diligence considers corporate income tax, GST, employment taxes (particularly superannuation and payroll tax), and where relevant, R&D, customs, and stamp duty. Generally, the ATO has a period of review in respect of tax-related matters of up to four years. For this reason, a due diligence exercise will usually cover a four-year period. 

Although all businesses are unique, there are areas that are more likely than others to be scrutinised in a tax due diligence process. These include:

• Substantiation for major transactions: A lack of formal advice regarding major transactions not only creates uncertainty around the treatment of those transactions, but also raises broader concerns about the target's tax governance framework and tax risk appetite.
• Tax consolidation: A failure to consider the implications of tax consolidation, and the lack of detailed tax consolidation calculations, increases a target's tax liability risk, both at the time of consolidation and in the future.
• Mining expenditure: Misclassification of exploration or mining expenditure is commonly identified and has permanent tax impacts when the target enters a tax consolidated group, as the tax base of the target’s assets are reset as part of this process.
• Tax losses: The rationale behind the historical use of tax losses should be evidenced, as this is an area that is often scrutinised by the ATO. Consideration should also be given to the availability of unused tax losses, particularly where the vendor is claiming that the losses may have value to the buyer and, therefore, should be considered as part of the deal consideration.
• Government stimulus incentives: The lack of substantiation for JobKeeper and Temporary Full Expensing claims has been a recent focus of the ATO. Thus, it’s not surprising that buyers want to understand the process and see evidence of the basis for these stimulus claims.
• Superannuation: Unpaid or late-paid superannuation (particularly for contractors) is a common error and a key focus for buyers due to directors' personal liability for underpaid amounts.
• Payroll tax: Misapplication of payroll tax grouping provisions commonly results in the target underpaying payroll tax where they have operations in multiple states.
• International taxes: The world of international tax is increasingly complex. Issues such as permanent establishments, withholding tax, transfer pricing, and tax residency, along with new rules like hybrid mismatches, debt deduction creation, and thin capitalisation, make this area a minefield of potential tax issues.  

Remediation options

As mentioned above, no business is without tax risk, so a buyer should expect some tax risks to be identified. These don't, however, need to be dealbreakers. There are several mechanisms to address tax risk while progressing the deal:

• Renegotiation of purchase price or embedded adjustment mechanism: Adjusting the purchase price compensates the buyer for potential future tax liabilities arising from identified risks. This provides a variable component of the purchase price while the tax liability exposure is being calculated. 
• Rectification of error: The target can agree to amend the applicable tax error and pay any top-up tax or penalties prior to, or as part of, the transaction.
• Pre-transaction advice: Where material tax risks have not been addressed, tax advice (or if time allows, a tax ruling) can be sought to formally opine on the matter in question.
• Indemnities and warranties: Buyers often seek indemnities or warranties from the seller. These legal assurances protect the buyer against specific tax liabilities that may emerge after the transaction is completed.
• Escrow accounts: In this case, a portion of the purchase price is held in escrow until the tax issues are resolved, providing a financial buffer against potential liabilities. 
• Alternative transaction structures: Sometimes, restructuring the deal can mitigate tax exposure. For instance, opting for an asset purchase instead of a share purchase can mitigate the risks to the buyer's satisfaction.

Conducting thorough tax due diligence not only protects the buyer but also enhances confidence among stakeholders of the buyer.

Parties looking to undertake tax due diligence should seek a tax adviser with experience in the industry of the target, enabling a sound understanding of any industry specific issues. 

Grant Thornton has specialist financial and tax due diligence teams throughout the country, covering all industry sectors. Where the target is a group of companies that spans multiple tax jurisdictions, Grant Thornton can also work with our network of international member firms to provide a seamless due diligence deliverable. 

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