Amid all the excitement that comes with finding an attractive target portfolio company, it’s easy for tax to become little more than an afterthought as the deal nears completion, says Nick Gruidl, M&A partner in McGladrey’s Washington national tax practice. But when that happens, GPs take on some significant risks, he explains.
“Tax due diligence is as critical to the deal as financial due diligence. Income and non-income based taxes are generally the largest item on any P&L statement, and uncovering tax exposures can stop a deal in its tracks.”
In fact, there are a number of potential tax risks involved – and they can pop up at any and every phase of an acquisition. According to Gruidl, there are six to watch in particular:
1. Bringing in your tax team too late
To prevent tax matters from derailing a transaction, Gruidl recommends that dealmakers consult with their tax advisers as early in the acquisition process as possible – sometimes even before a letter of intent (or LOI) is even signed with the target company management.
“The reason for this is that your due diligence is going to largely depend on what type of acquisition is being planned. Are you buying the equity or assets of a business? A division within a larger company?”
For example: Gruidl explains that a deal team may mistakenly believe that purchasing the assets of a company avoids the need to perform tax due diligence, because an asset acquirer generally does not inherit tax liabilities of the target company. However, as he points out: “Significant non-income based taxes such as employment taxes, transfer taxes and sales and use taxes could follow the assets.”
Moreover the legal and deal teams can sometimes move too far along in the structuring process for an acquisition without sufficient consultation with the tax team, adds Gruidl. “The risk here is that tax matters will have an impact on what the ideal deal structure will look like. Maybe for instance it’s discovered that buying the assets of a company instead of its equity makes more sense from a tax perspective – and if you’ve already negotiated the deal under a particular transaction structure, something that could have been handled easily in the beginning of the process becomes a potential deal killer.”
2. Underestimating international problems
Gruidl points out that the US mid-market is spreading into new territories at an unprecedented pace. The risk here is that fund managers focused on growing their portfolio companies internationally may not pay enough attention to the tax implications of expansion into places like China, India and other foreign hot spots.
There’s another element to this risk, too: “While a company may have reputable tax and legal advisers in their domestic market, we often discover in our due diligence that fast-growing companies have outgrown these advisers,” says Gruidl. “And that can result in significant domestic and international tax exposure.”
One of the biggest growing risks for multinational companies relates to transfer pricing, Gruidl continues.
Governments looking to limit erosion of their tax base are taking a closer look at how related companies do business with one another, particularly when it results in shifting of income to low-tax jurisdictions. “Most fundamentally, tax due diligence should include a review of the target company’s documentation that explains how transfer prices are reached.
Failure to properly document policies can lead to significant exposure. More concerning is that sometimes a quickly growing company doesn’t even have this documentation in place, or has not changed its policies despite significant changes in the business.”
3. Ignoring the tax reach of different states
Domestically, state and local tax authorities are posing a bigger tax threat to US fund managers’ M&A activity, says Gruidl.
GPs looking at businesses with operations and sales all across the country have the challenge of figuring out how much income should be apportioned to each state for tax purposes. At a time of shrinking state coffers and budget deficits, Gruidl says there is a growing risk that states will perform tougher audits on companies they feel owe them a bigger tax bill.
“With states clamouring for revenue anywhere they can get it, you’re going to see revenue agents going after companies they feel have a ‘nexus’ or presence in their state, to drive in tax revenue. Therefore tax due diligence must include a thorough review of state income and franchise tax filings, to make sure the company is filing and paying state taxes everywhere it should be.”
4. Overestimating a company’s tax shield
At the US federal level, Gruidl says a company’s net operating losses (NOLs) and credit carry-overs are something GPs are (at times) tripping up on – primarily related to their estimates of how much of those losses can be used to offset future profits.
“Most private equity players know that there’s going to be some limitation on how much NOL can be utilized post-acquisition as a result of a change in ownership. But one of the risks often overlooked here is that the company could have prior unknown limitations on those NOLs, which could result in a lower post-acquisition utilization, or even exposure to prior income tax liabilities related to the use of those NOLs. Identification of any such limitations prior to the acquisition is critical, especially when compensating the target shareholders for delivery of the tax shield.”
5. Classifying independent contractors correctly
Often times US businesses will hire independent contractors to complete a job rather than hiring a new employee, who brings additional costs such as health insurance. Another advantage of this approach is that businesses do not generally have to withhold or pay any taxes on payments to independent contractors, whereas with employees, they pay Social Security and Medicare taxes, among other things. Unfortunately for GPs, this represents another tax risk, says Gruidl.
“The Internal Revenue Service is looking closely at the independent contractor vs. employee classification issue. Failure to properly classify an individual as an employee can lead to tax exposure on employment taxes and withholding. Depending upon the extent of the misclassification, the liability can be significant.”
Accordingly, as part of their tax due diligence, GPs “need to speak with portfolio company management about the type of work independent contractors are performing, how they’re paid and the amount of control management has over their activity,” says Gruidl.
6. Looking past ‘golden parachutes’
Any merger or acquisition also brings with it the “golden parachute” risk, says Gruidl. Basically golden parachutes are compensation arrangements given to employees (often executives) in the event of a sale, merger or some other change in ownership. If subject to the golden parachute rules, a large portion of these payments would not be tax-deductible.
“It’s an issue that’s not always been on GPs’ radars when completing an acquisition,” cautions Gruidl. “But over time more and more managers are becoming aware of it, because they’ve experienced the potential cratering of a deal because of it.”
As with many issues that arise early in the due diligence process, golden parachute payments can generally be avoided with proper planning and advice, says Gruidl.
To conclude, Gruidl says tax due diligence is slowly creeping up to the agenda of most fund managers, such that it’s being accorded a similar level of importance as legal and financial due diligence. And ultimately, he says: “Those ahead of the curve stand to reap better returns as a result of their bottom line not being eroded by unnecessary tax liabilities.”
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