Due Diligence and the Corporate Income Tax Provision—How to Prepare for M&A Activities

by Gary Kell

In hot M&A market, the devil is often in the tax details.

There are all kinds of reasons that companies choose to merge or acquire other businesses. M&A activity allows corporations to do everything from expand into a new country or industry to diversify products, cut costs, or increase capabilities. Yet not all mergers and acquisitions are successful in terms of meeting their original goals. In fact, some fail to get off the ground at all. 

According to the Institute for Mergers, Acquisitions, and Alliances (IMAA), more than 15,000 mergers and acquisitions have been announced thus far in 2023. But don’t look for any new corporate logos just yet—many will experience a failure to launch. 

Where do things tend to go south? Often, it’s the due diligence process—the in-depth review and audit process of the seller by the buyer in an acquisition. 

What is Tax Due Diligence?

Due diligence dives deep into a company’s legal, financial, operational, IT, and tax operations, and it’s a critical piece of the M&A process as it helps stakeholders test strategic and operational assumptions and evaluate potential synergies and scalability that could occur after the M&A takes place. Phoning in due diligence can mean trouble—a study by Deloitte found that more than 90% of M&A deals fail to meet their original goals due to inadequate due diligence. 

Given how tax directly impacts a company’s bottom line, not to mention, its reputation, tax due diligence is one of the most important pieces of the process. A recent KPMG survey estimates that more than half of M&A deals fail due to discoveries made in environmental, social, and governance (ESG) due diligence, which includes scrutinizing a company’s tax position. Stakeholders want to examine which liabilities companies will have after an M&A transaction before the deal goes through—and given wild cards like today’s changing regulatory environment and fingers-crossed transfer pricing positions, not to mention, the Organisation for Economic Co-operation and Development’s (OECD) looming Pillar One and Pillar Two, significant tax implications can really tip the scales in terms of crossing the finish line.

What’s Involved?

M&A tax due diligence is conducted by internal and external experts, and typically takes 30 to 60 days. However, the process can last up to six months, depending on the type and size of the company and the complexity of the deal. A major holdup? Lack of information—if a company fails to produce necessary documentation (or doesn’t have it at all), it can slow the whole process. Along with corporate income tax returns and financial statements, the income tax provision is often requested during the due-diligence process. Auditors will use it to examine the following the areas: 
  • Tax Liabilities: A buyer will want to assess the target company's current and potential tax liabilities, including any outstanding tax assessments, disputes with tax authorities, and potential future liabilities. Make no mistake: Tax liabilities aren’t a dealbreaker, but a buyer will want to know when and where they will arise. 
  • Tax Credits and Deductions: What are the target company's current and potential tax credits and deductions? These can have a significant impact on the company's tax liability, and therefore the company’s bottom line.
  • Transfer Pricing: Has the target company been diligently documenting intercompany transactions? Which policies and procedures are in place?  Are there agreements to support them? The due-diligence review will examine agreements with the policies and procedures to see if they align, as well as review county-by-country reporting for additional insights.
  • Deferred Tax Assets and Liabilities: How will the target company's deferred tax assets and liabilities impact the consolidated group’s balance sheet and future tax liabilities?
  • Tax Risks: Does the target company have exposure to potential tax risks? Are they under tax audits? Do they have uncertain tax positions? Do changes in tax laws and tax litigation make the company vulnerable to adjustments or penalties? The due-diligence team will also determine whether there are any unfiled tax/information returns in all tax types (i.e., sales and use, property, VAT, withholding, etc.).

The Global Impact

Once the target company’s tax position has been carefully examined, it gets folded into the group, so stakeholders can understand the effect of the acquisition on a group’s global effective tax rate. Depending on the size of the acquisition, the effect could be material. Again, that doesn’t mean the deal should screech to a halt, but knowledge of potential future tax implications ahead of time, places the buyer in a proactive position. 

Of course, nothing puts a taxpayer in the driver’s seat more than planning for changes ahead—a challenge given today’s constantly evolving landscape. Two significant gamechangers are on the not-so-distant horizon—Pillar Two, the OECD’s proposed global minimum tax of 15%, will debut in many countries in 2024, and the implementation of Pillar One won’t be far behind. Where will these laws come into effect and how could they impact the group post-M&A?  Great questions—ones that your due-diligence auditors will strive to answer, using the information reported on your income tax provision and other tax documents.

Due diligence related to the income tax provision is an integral part of the acquisition process. By carefully assessing the target company's tax position, risks, and opportunities, acquirers can minimize the potential tax risks and maximize the tax benefits of the merger or acquisition. By carefully evaluating the potential impact, acquirers can ensure that they are making informed decisions about their acquisitions. Granted, new regulations, including Pillar One and Pillar Two, will always add a new layer of complexity to the process.

However, considering how these rules will affect multinational companies is exactly what makes the due-diligence process so important In the first place.

Gary Kell, Director – Tax Provision Solutions, Exactera
Gary Kell has over 30 years of corporate tax experience, both in public accounting and publicly traded companies. Kell started his career at a then—"Big-6” firm and worked his way up the chain from senior to director at companies in the telecommunications, transportation, financial services and pharmaceutical industries.