Five tax issues to address in advance of due diligence

When undertaking a transaction, such as a disposal, merger, or refinancing it is highly likely that the business will be subject to tax due diligence.

If any issues are not remedied prior to a transaction but are instead picked up during the due diligence process, this can lead to significant delays - to resolve them, renegotiate the price or both.

Preparing for a transaction

Whilst transactions are all unique, in our experience there are common tax issues that arise. Understanding and addressing these key areas in advance of a transaction can help stakeholders to ensure that value is maximised and disruption to the business is minimised.

An 'exit readiness' review in advance of a planned transaction can help to identify any issues, allowing the time to deal with these before a due diligence process commences. This exercise can also identify tax assets which may deliver value on an exit.

Current tax risks

In recent tax due diligence exercises for tech and media businesses, we have seen the following tax issues emerge frequently:

1. Share schemes/equity rewards

It is often the case that Management are making significant gains on equity rewards and, therefore, the tax risks attached to these are likely to be material. As a result, the arrangements will likely undergo detailed scrutiny from both the tax advisors and lawyers.

Common issues arising are:

  • No or limited valuation support
  • S.431 elections not entered into
  • Qualifying criteria for HMRC tax-advantaged options not met, e.g. independence, no. of employees, gross assets.
     

The above issues can result in some or all of the Management team's proceeds being subject PAYE and NIC (c.60% tax cost) which can result in significant reductions in value and also demotivate key members of the team.

However, if done correctly, share rewards are a great tax-efficient tool. In certain scenarios, for example on the exercise of share options, they can generate significant corporation tax deductions which, dependent on the profile of the Target, can help to reduce the tax paid on the transaction.

2. Off Payroll Workers

Off payroll workers include self-employed individuals, contractors, consultants, executive and non-executive directors, and involve payments made via personal service companies or other intermediaries (e.g. agencies).

If the status of these workers has not been properly assessed or simply incorrectly documented, then a buyer can often insist on a price reduction to cover any PAYE and NIC (plus penalties and interest) that they could assume as the purchaser.

Therefore, it is important to ensure that the status of any off-payroll workers has been robustly assessed and documented (ideally using HMRC's CEST tool) and status determinations issued to all relevant parties.

3. Export VAT evidence

Businesses that export goods overseas are required to hold specific evidence documentation to support the UK zero-rated VAT treatment of any exports made.

The requisite export evidence must be obtained and held within 90 days following export to ensure the zero-rated treatment can apply - otherwise the export becomes standard rated and attracts 20% UK VAT. This is particularly important for indirect exports, i.e. customer collects, as the evidence required is more comprehensive and explicit.

If a business cannot demonstrate it has adequate evidence procedures in place a buyer may insist upon withholding 20% of all export sales for the last four years until this can be satisfied. Therefore, it is important to ensure robust export evidence procedures are in place to avoid this becoming a potential permanent loss of value or at best a distraction on the deal process.

4. Director's loans/Upstream Loans

Overdrawn director's loan accounts are often used in advance of a transaction to put the shareholders in funds pre-transaction and the 'loan to participators' temporary s.455 tax charge and benefit in kind implications are often well understood.

However, where there has been a previous transaction e.g. a management buyout, there may be legacy ‘loan to participator’ tax issues created by the use of company cash to pay out previous 'participators'. This is ordinarily addressed via way of intercompany dividend but, if missed over a number of years, it can lead to a cash flow impact in respect of the temporary tax charge identified, equal to 32.5% of the intercompany balance, plus late payment interest.

Therefore, it is important to ensure that the reason for any intra-group balances are properly understood and the tax position considered and documented.

5. Overseas operations, in particular US sales tax

Operating or selling goods and services overseas brings different tax jurisdictions into play. The US is a key market for a lot of UK businesses, but they may not have sought US tax advice on expansion.

Businesses operating or expanding into the US may be subject to US sales tax on the sale of goods and services to US customers. US sales tax differs from state to state and requires payment to different tax authorities, making it highly complex.

Failure to collect and remit US sales tax to the appropriate tax authority can result in significant sales tax liabilities and can be subject to penalties and late payment interest for non-compliance. So, it is beneficial to proactively demonstrate compliance in this area - especially where US sales are significant (or likely to be significant for future growth).

Tax due diligence can identify valuable tax assets held by a business. Many independent financial services businesses use tax-advantaged share schemes to incentivise their employees, especially during the start-up phase. Share options are often exercised when a transaction is completed, potentially crystallising large corporation tax deductions.

These tax deductions often result in tax losses which may be carried forward. You should carefully consider what value is given for these assets. It will also be important to establish when they are forecast to be utilised, taking into account factors like the purchaser’s funding structure.

Real estate investors often use an element of leverage to finance their investments and ensuring that the cost of this debt is deductible for tax purposes is always an area of focus.

Historically, financing costs tended to be deductible where they were at market rate. However, more complex rules can now restrict interest deductions, including the corporate interest restriction, the anti-hybrid rules and the unallowable purpose rules.

For due diligence, these will be key areas of risk which can have impact on price. You should conduct a pre-sale review of historic financing deductions and get expert advice on the deductibility of financing. This will identify issues ahead of any due diligence process.

Renewables business have higher capital expenditure and a larger asset base compared to other high growth companies. This will be an area of focus in tax due diligence.

Capital allowances.

Eligibility to claim capital allowances is a key risk area for many renewables projects given their capital intensive nature. Issues occur when the company undertaking the development does not have the necessary interest in land to claim allowances. Problems also arise when project rights and costs are recharged rather than being transferred to new, special purpose vehicles.

Failing to commission formal capital allowances surveys can also present risks as businesses are then not correctly identifying eligible expenditure and allocating costs appropriately between capital allowances pools.

Construction industry scheme (CIS)

The CIS is a tax deduction scheme which covers any ‘construction operations’ undertaken in the UK and applies to any business or entity, such as a contractor, that pays any other business or entity to undertake construction work in the UK. The requirement to register for and operate CIS needs to be kept under review by renewables companies with construction activity. Failing to register for and operate tax CIS withholdings where these are required can lead to increasing liabilities for the contractor making the construction payments.

International factors

Transfer pricing difficulties arise where businesses finance operations across multiple territories and have not applied an appropriate arm’s length rate for quantum or rate of interest for debt. Incorrect transfer pricing can lead to large changes in taxable profits.

Withholding tax can be an issue on repatriating funds where holding companies have limited substance and are unable to access preferential tax treaty rates.

R&D claims

R&D tax relief is an invaluable financial support for TMT businesses investing in innovation and developing new processes, products or services. It allows businesses to claim back a portion of their qualifying R&D expenditure. These claims are for either a reduction in their corporation tax bill or a cash payment.

R&D claims are under increased scrutiny from HMRC and the recent changes add an additional layer of complexity. We recommend a review of historical claims as well as the forecast position to help improve a business’ positioning in advance of a due diligence exercise.

Transfer pricing

Many TMT businesses experience rapid international expansion but their transfer pricing policies and procedures often lag behind as they focus on commercial priorities.

It is good practice to ensure that related party transactions are conducted on arm’s length terms and appropriate documentation is maintained. This if particularly important when policies change – for example, as a result of the recent changes in international customs tariffs.

You should consider any possible exemptions, such as the UK’s SME exemption, on a country-by-country basis.

Any understatement of tax can lead to significant non-compliance penalties.

The recent changes to customs tariffs in the USA and elsewhere highlight that keeping supply chains and all related tax issues under review will be vital for both the ongoing business and for any prospective buyer.

When tariffs are in a state of flux, it is essential to have both immediate tactical plans to cover a range of scenarios and a process to investigate and plan for longer term options once turbulence has subsided.

We can help you build both tactical plans and research and develop longer-term options taking into account the tariff, transfer pricing, withholding tax, VAT and other potential tax implications.

How we can support you

Our team of experienced tax professionals can undertake a health check of your tax compliance and make sure that it is ready for a rigorous due diligence exercise to help all stake holders protect value.

If you have any questions regarding any of these common tax due diligence issues, please do not hesitate to get in touch with Sam Boundy, Carol Hindle or Nick Millward.

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