It’s not the typical tax liabilities that can hurt you after an acquisition — it’s the hidden ones. Executives often inherit tax liabilities because unpaid federal, state, local and foreign taxes follow the acquired company, and those liabilities do not go away just because the company has new shareholders or owners. Also, many buyers have a false sense of security because they obtain representations, warranties and indemnifications for tax-related liabilities during the acquisition. But potential liabilities covered by a warranty should still be identified, as the best security involves setting aside funds in an escrow account to cover potential tax debts.
The only way to expose hidden tax liabilities is by conducting a thorough due diligence.
“In these tough economic times, staff reductions can hit tax departments hard, so acquirers don’t always have the resources to conduct due diligence,” says Gary Curtis, corporate tax partner with Haskell & White LLP. “In some cases, companies haven’t been examined for years, yet they remain subject to audit at any time. Given today’s budget deficits, taxing authorities are stepping up examinations in search of additional revenues.”
Smart Business asked Curtis about the problems of hidden tax liabilities and how due diligence can help.
What situations contribute to hidden tax liabilities?
Many middle-market companies do not have large internal tax staffs, yet those companies are dealing with multistate and multinational operations, which frequently results in overlooked tax issues. Public companies have been subject to financial reporting standards requiring them to inventory their uncertain tax positions and disclose potential liabilities. But private companies have been granted an extension to that requirement through 2009; so the chances of encountering an unrecognized tax liability increase when acquiring a private company. Also, if you acquire a company that was part of an affiliated group, which has been filing a consolidated income tax return, the acquired company remains liable for the group’s prior taxes after its acquisition.
Which state and local taxes are often overlooked?
Employing out-of-state personnel may result in hidden income tax liabilities. For example, if a sales representative is soliciting business in another state and the product used to fill the orders is warehoused outside the state, under federal law the company isn’t required to file a state income tax return. If that salesperson performs other duties, such as warranty and repair work or issuing sales credits to customers, then the federal law does not apply and the company must file a state tax return. If separate state returns have not been filed, the liability for unpaid taxes, penalties and interest can mount up quickly. Frequently, companies are able to negotiate a reduction in this liability, but they must initiate the discussion prior to an examination and there are still the professional fees of negotiating, correcting and filing the returns to consider. It’s also possible that sales and use tax as well as franchise returns may be required, even when state income tax returns are not.
Which foreign tax liabilities are frequently overlooked?
When companies price and sell goods in another country, how the transfer pricing is established can result in significant U.S. or foreign tax liabilities. It should be a red flag to buyers if a company has not conducted a recent transfer pricing study by a credentialed professional. Another problem is failing to withhold tax on interest or dividends paid to foreign companies that are not exempted by tax treaties. Sometimes the company may not have filed the required federal informational returns with respect to its foreign affiliates and the penalties for failing to file these returns can be up to $10,000 per failure. The IRS has announced that it intends to crack down on this problem during 2009, so buyers should be aware of the potential liability.
What steps should executives take to avoid financial surprises from hidden tax liabilities?
- Conduct tax, financial and business
due diligence concurrently and budget for
those costs when considering the total
- If significant tax exposures are uncovered, consider converting to an all asset
deal or reducing the purchase price.
- Require the seller to deposit funds into
an escrow account covering any potential
liability revealed during due diligence.
Funds should only be released when the
statute of limitations expires or when the
tax issues are resolved.
- If you are unable to implement any of these solutions, consider passing on the deal.
Remember that due diligence doesn’t just uncover hidden tax liabilities. It can identify and quantify tax assets, such as net operating loss carryforwards, that can be used to offset post-acquisition taxable income, and it can also identify unclaimed refunds. Conducting tax due diligence often pays for itself.
GARY CURTIS is a corporate tax partner with Haskell & White LLP. Reach him at (949) 450-6311 or firstname.lastname@example.org.