Tax Due Diligence - How it works

If you are looking to buy a company, tax due diligence is a vital step to take.

Tax due diligence is an important process where a professional will carefully check the historical tax compliance and existing tax exposures relating to a transaction target.

While it is usually for purchasers, tax due diligence can also be a useful process for exiting shareholders looking to ensure their business is in good order before selling up.

Identifying and quantifying tax exposures can be complex, and it is the job of a due diligence expert to sift through issues in order to provide detailed, tailored and commercially focused due diligence reports to prospective buyers.

So, what do we look for when carrying out tax due diligence on your behalf?

VAT Compliance

Did you know VAT is one of the least widely understood of all taxes? This is despite a third of all revenue collected by the UK government coming from VAT. It stands to reason, then, that VAT is easy to get wrong, and therefore a primary focus of a tax due diligence report.

Getting VAT wrong can lead to all manner of headaches and can lead to significant exposures to underlying VAT and often penalties. International sales, the difference between services and goods, and VAT accounting are all areas where issues can arise. A proper due diligence exercise can identify risks for a buyer in these areas.

More generally, HMRC may choose to visit your premises to check themselves whether a company’s VAT returns are being completed correctly, and whether the company has adequate VAT procedures in place.

Ongoing due diligence for VAT compliance can prevent several difficult situations, such as a VAT assessment being carried out by HMRC (this is a VAT estimate from HMRC that must be paid, subject to potential appeals).

Other consequences of improper VAT accounting include joint liability for companies in the same trading chain as a defaulting company and, in some cases, criminal proceedings stemming from deliberate tax avoidance or fraudulent activities, should these be identified.

Employment status of contractors

Employment tax risk can be significant for businesses that engage with contractors.

The IR35 legislation was introduced to ensure so called ‘disguised’ employees pay a similar rate of tax to proper employees. Prior to this, these workers could receive payments from a third party via a limited company, or other intermediary, and take money as dividends, which aren’t subject to National Insurance payments.

In April 2021, this legislation was extended to large and medium sized private sector companies, who must now determine the employment status of their contractors.

This means companies engaging with contractors are now responsible for checking the employment status of any off-payroll workers they do business with. Companies engaging with contractors are also responsible for accounting for, and paying, related taxes and National Insurance contributions to HMRC.

Failure to comply with IR35 can result in penalties, such as the back payment of taxes, as well as fines. A proper tax due diligence exercise can identify risks and exposures in this area.

Previous company reorganisations

Companies often reorganise, often in complex ways. A reorganisation of a business structure can occur because of ownership changes, company splits, mergers, or addressing financial difficulties. Successful reorganisation can increase profits and improve operational efficiencies.

When reorganisation is done badly, or simply doesn’t prove effective, major issues can occur, including tax risk.

This is why it is very important to carry out due diligence of a company’s previous reorganisation activities, to identify potential exposures.

Share schemes

Employee share schemes are a popular performance incentive used by many companies; they may give employees shares in the company, or the option to purchase them in future, thereby giving them a direct interest in the long-term success of the company.

However, if implemented incorrectly, share schemes can lead to significant tax exposure for the employing company (and the employees).

When acquiring a company that is operating an employee share scheme, tax due diligence is vital to identify any potential areas of risk relating to the scheme.

Corporation tax compliance

When buying a company, it is essential that due diligence is carried out to check whether the company’s corporation tax compliance is up to date and accurate, and to ensure that tax figures outlined in the company’s financial accounts are reasonable.

Like VAT compliance mentioned previously, errors or issues with corporation tax compliance can lead to numerous problems, including underlying tax, interest charges, and penalties.

Summary

Buying a business is an exciting time, and an enormous opportunity, but one that brings various tax risks with it. A tax due diligence report provides comfort and assurance for both you and those funding you and will clearly communicate any potential areas of concern before the deal is made.

The Shorts Corporate Finance team has extensive experience in delivering commercially focussed due diligence reports to a wide range of business buyers, including banks, venture capitalists, acquisitive companies, and public sector bodies.

Full financial Due Diligence reports will include tax, but it is also possible to undertake standalone tax due diligence exercises. The Shorts Business Tax team has extensive experience of undertaking tax due diligence, and often works side by side with our Corporate Finance team.

We can make tax due diligence a seamless element of your acquisition project and welcome you to get in touch if you need assistance.