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
transaction expenditures. - 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 [email protected].
