The 2017 Tax Cuts and Jobs Act which reduced the U.S. corporate federal income tax rate to 21 percent and created an incentive for companies to repatriate foreign earnings, also helped boost interest in domestic investment. The U.S. became a more attractive option for inbound M&A activity as 2018 saw more deals, including several “mega deals” across many industries. While some observers have voiced concerns about an impending economic correction or downturn, many economists predict that both corporate and private equity investors will continue to enjoy record access to capital as they continue to invest heavily in the technology, healthcare, and energy sectors.

As deal teams rush to provide proper valuations and conduct financial and tax due diligence, sales and use tax due diligence is more important than ever and can even be the most significant tax exposure uncovered in the due diligence process. Thus, neglecting sales and use taxes in due diligence can result in an unpleasant surprise for the acquirer after the deal closes and can become a major pain point for the Chief Financial Officer, whose team will then need to identify, quantify, and remediate the exposures.

How can you evaluate potential sales and use tax exposure prior to an acquisition?

Detecting potential exposure in the sales tax due diligence process is a matter of determining whether the target was filing sales and use tax returns in jurisdictions where it had nexus, and whether Target under-reported its sales and/or use tax liability in the jurisdictions it filed returns. The following key areas should be addressed:

• Sales Tax Nexus Analysis
• Taxability Analysis on Sales, Purchases, and if applicable, Self-Consumed Inventory
• Quantification of Sales and Use Tax Exposure

Sales Tax Nexus Analysis

A business is required to collect and remit sales tax on taxable sales in states where it has nexus. Nexus is now more frequently acquired as a result of the U.S. Supreme Court decision in South Dakota v. Wayfair, Inc. on June 21, 2018. The Wayfair case overturned the long-standing “physical presence” rule, last reaffirmed in Quill Corp. v. North Dakota (1992), which was the national standard for determining when a remote-seller was obligated to comply with a state’s use tax. Since the Wayfair decision was announced, over 30 jurisdictions have enacted economic nexus legislation requiring remote sellers to collect and remit use tax based on certain sales or transaction thresholds. Therefore, a seller without an in-state, fixed physical presence may, as before the Wayfair decision, acquire sales tax nexus via physical presence e.g. sales visits; and as of the Wayfair decision can now also acquire sales tax nexus via exceeding a state’s economic nexus threshold. Given the inconsistent economic nexus thresholds among states, it is becoming increasingly more important that a nexus analysis be performed more frequently by sellers. With the Wayfair decision, diligence teams are expected to now find even more targets that had previously undetected sales tax nexus. Many jurisdictions do not have a statute of limitations when a sales tax return was required but has not been filed. Accordingly, a non-compliant target can be exposed for unreported sales and use tax for as many years as the company has had nexus in the jurisdiction, thereby resulting in tax, interest and penalty liability that builds over an extended period.

Taxability Analyses

Once the target’s sales tax nexus footprint has been identified, the diligence process should address the potential for tax exposure related to the target’s sales, purchases, and if applicable, self-consumed inventory. For any non-registered jurisdictions, the review may entail evaluating the taxability of the target’s sales into the jurisdiction, and the potential for transaction-level exemption or customer-level exemptions which may apply, and the quantification of any taxable purchases or self-consumed inventory which may apply in the non-registered jurisdiction. For a target’s registered jurisdictions, the due diligence team should review the target’s product taxability determinations, for example, the diligence team may request the target’s product taxability matrix and/or “mappings” in the target’s automated sales tax solution (i.e., Vertex, One Source, Avalara, etc.). For some targets and/or industries, high purchase-activity and/or self-consumed inventory withdrawals may be cause for consideration by the diligence team. Diligence teams typically review sample sales tax returns to understand if the returns are complete, if the target timely applied statutory and regulatory changes which took effect, and reviews customer exemption documentation the Company collected, or didn’t.  

Quantification of Sales and Use Tax Exposure and Implementation of Corrective Measures

After identifying the target’s non-filing nexus jurisdictions and any compliance gaps the target may have had in the jurisdictions where it filed, potential sales and/or use tax exposure should be quantified by jurisdiction, along with interest and if applicable, penalty. The quantification phase should consider any audit notices, prior assessments, preliminary taxing authority audit workpapers, and pending litigation. If the Company’s balance sheet reflects an ASC 450 contingent reserve related to sales and use tax, the diligence team should understand the issues which are the subject of the reserve and review all workpapers and memoranda related to the reserve.

Having evaluated the target’s exposure areas at a high level, the diligence team will usually be well-positioned to recommend exposure remediation and/or process improvements for buyer’s consideration after the deal closes if not part of the terms of the deal itself. For example, pursuit of a Voluntary Disclosure Agreement (VDA) and/or participation in amnesty programs may be recommended.

The Impact of Sales Tax Exposures on Deal Negotiations

The identification of a material sales tax exposure may impact deal negotiations between a buyer and seller. As part of contract negotiations, the buyer may consider negotiating for the seller to provide an indemnification provision in the purchase agreement for pre-acquisition sales and use tax liabilities. Additionally, a buyer may also seek to negotiate a lower purchase price by the amount of the potential sales tax exposure, or alternatively, withhold a portion of the purchase price in an escrow account pending the remediation or resolution of any material sales tax exposures identified.

Alvarez & Marsal Taxand Says

An acquisition requires careful consideration during the due diligence phase because the last thing any buyer wants is a surprise material tax exposure that should have been identified during due diligence. Similarly, the integration of the acquired company is made that much smoother by having undertaken thorough due diligence. Preparation is key. Ensure that you have the correct resources to address sales tax diligence so that deals are made from a well-informed perspective and so that realistic post-acquisition integration plans for the acquired company can be made. Alvarez and Marsal notes that industry-specific and jurisdictional expertise and most of all, deep sales tax technical experience is key to identifying, quantifying, and remediating sales tax exposure as well as improving sales tax processes after the acquisition. Timely identification of sales tax issues in the sales tax diligence process keeps cash from unexpectedly leaking away to a taxing authority over an undetected sales tax issue. In any economic downturn, be it sooner or later, cash is king. Properly addressing sales and use tax diligence as well as properly addressing sales tax compliance keeps cash in the door.

Alvarez & Marsal’s broad expertise in sales and use tax helps us resolve issues for our clients as quickly as possible. Contact us today to see how we can help.