2013-Issue 11—The pace of activity for mergers, acquisitions and spin-offs is heating up. When purchasing, selling or spinning off an entire company, a segment of a company or a substantial asset, each party to the transaction should recognize the importance of performing the proper amount and type of due diligence prior to completing the transaction. It is equally important that both the acquiring company and the target company perform enough due diligence to ensure that future sales and use tax exposure is minimized. Unlike an income tax, a sales tax is transaction-based and applies to any sale or purchase whether the target company is in a profit or loss situation.
Although those on both sides of a significant transaction typically perform some level of sales tax due diligence, many times when evaluating the sales tax implications of a proposed "deal," the acquirer is focused primarily on the application of sales or other transfer taxes on the overall purchase. While this aspect of the deal is very important, performing true due diligence goes well beyond determining whether the actual transaction is subject to sales or use tax. This edition of Tax Advisor Weekly provides a practical discussion about identifying and quantifying the unanticipated sales or use tax liability in connection with a transaction to acquire a company or a significant portion of a company.
So how do you determine potential sales or use tax liability while performing the necessary amount of due diligence? Typically, the right amount of due diligence to perform before a deal closes is a factor of the amount of time given to those performing the diligence. Performing too much due diligence is usually not an issue because of the pace at which these transactions occur. However, too little diligence is a common occurrence. The acquiring company should ensure a "practical" amount of diligence is performed, focusing on the most important aspects of a sales tax situation and catching the big issues.
Given that diligence teams typically have a limited amount of time to review a lot of information, the big issue will be to determine the materiality of an issue(s) that is uncovered or revealed during the diligence process. What can be done about it is secondary, as part of the remedy may be cured through contractual indemnification. Identifying an issue is the first step; quantifying the tax due associated with the issue is the next and possibly most difficult step.
The following are some of the more important factors that the buyer and seller should consider when performing due diligence.
From the Perspective of the Buyer
- Understanding the business activities of the target: When the team performing the diligence does not understand or is unfamiliar with the target's business operations, the diligence is likely to be less thorough and potentially compromised. Your team must be versed in each aspect of the target's business so that you can properly identify potential exposure issues.
- Ongoing audits: Determine how many audits are in progress and what is the stage of each audit review, and obtain (and independently determine) an estimate of preliminary or expected results. Getting your arms around the audits in progress is one of the most important aspects of the diligence process. In addition, determine whether the target company has been notified of any upcoming audits and whether it has secured the appropriate statute of limitation extensions, if necessary.
- Closed audits: Determine the status of any recently closed audits and evaluate whether unresolved contentions may warrant future protests. Confirm deadlines to file for redetermination on recently closed audits. Also, discuss audits that are already in the administrative hearings or redetermination process to determine the likelihood of resolution and potential taxes due.
- Nexus issues: Determine where the company is located and where it is conducting sales activities. What is the target's sales process? And has the target appropriately determined where it has nexus based on sales activities (and is permitted for sales tax purposes, if necessary)? If the target has potential exposure in a particular jurisdiction and is not permitted to collect and remit sales taxes, is it undergoing any procedures for voluntarily disclosing any sales taxes owed?
- Proper documentation of exempt sales: Any sales made by the target that are otherwise subject to sales tax and on which no taxes have been collected must be supported by a proper resale or exemption certificate. Determine the company's procedures for identifying customers on which a certificate is due, acquiring the certificate and verifying its accuracy, and properly maintaining the certificates to recover in the event of an audit examination.
- Taxability of sales or purchases: Discuss how the seller has determined what sales it charges sales tax on and what it pays or accrues on purchases of assets and expenses. Has the target historically taken aggressive tax positions on transactions?
- Reserves: Review whether the target has established proper reserves for potential audit assessments or on transactions where it expects a potential liability in the future. What is the amount of potential underpaid sales or use taxes? And has the target booked an appropriate reserve amount?
- Sales tax compliance or determination technology: If there is time, it is always helpful to understand whether the target company has multiple financial accounting systems for which sales and purchase data must be identified and preserved (and/or multiple sales tax compliance or determination mechanisms) to avoid the potential loss of data for future audit examinations.
- Past guidance on taxability determinations: Again, assuming time is not a factor, it is wise to review and preserve any documentation regarding guidance that the target has received about the taxability of sales or purchases either from a taxing jurisdiction or tax consultant.
- Certificate of no tax due: Many states allow the acquiring company to seek a certificate of no tax due from the Department of Revenue of the particular state(s) where the target company transacts business. This process may take some time but it can be a very worthwhile exercise.
- Tax holdback: If you determine there is a potentially large amount of exposure, you should seek to either adjust the sales price or negotiate a holdback on the purchase price to cover future contingencies for uncollected or unremitted sales or use tax.
Although the buyer may seem more at risk for undocumented sales or use tax issues, the seller also has some risk in connection with a transaction.
From the Perspective of the Seller
- Refunds of taxes paid on past transactions: The seller will typically stipulate that it has all rights to any outstanding or future refunds claims for overpaid sales or use tax during its period of ownership. As the seller, you should immediately take appropriate steps prior to the deal close to identify and recover potential overpayments, especially while you have access to the historical data. Plus, gaining the cash from overpayments sooner rather than later is always welcome.
- Audits in progress: The extent of responsibility for completing the audit and paying for any assessed taxes should be clearly defined. An important point to clarify is who has responsibility for the continued coordination of the audit and who has to pay any assessment due.
- Assistance provided to buyer: Occasionally, the buyer must negotiate assistance from the seller during a period of transition to provide compliance assistance or other tax services. If the buyer needs your assistance, it is important to clearly define the extent of your responsibility for filing appropriate tax returns, meeting compliance deadlines and dealing with ongoing audits.
- Professional services provided during transition: Sometimes the buyer may require services from the seller during a period of transition. Depending on the type of services provided and the jurisdiction where the services are provided, those transition services may be subject to sales tax. As the seller, you should act prudently by performing extensive research in the jurisdiction(s) where the transition services will be performed so as to avoid potential liability.
- Negotiation of the purchase price or seeking a "holdback" for future sales tax exposure: Countering claims of potential exposure from the buyer is very important. Perform your own extensive diligence on potential exposure issues on which the buyer is asking for advanced compensation through a reduced purchase price or holdback for future assessments. If you agree to a holdback for future potential exposure, you should clearly define what measures must be met to gain the release of the holdback once the potential exposure period has passed.
Alvarez & Marsal Taxand Says:
Although the approach to due diligence differs from the perspective of the buyer and the seller of the company or asset(s), each side must take the time to perform due diligence during the acquisition process to avoid or minimize sales and use tax headaches down the road and, more importantly, unanticipated tax payments. With enough time, consideration of each of these factors should at least result in an awareness of potential sales tax issues beyond what is normally anticipated.
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Gina Pizzo, Senior Director, contributed to this article.
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