Hidden Tax Pitfalls In M&A Deals That Can Derail The Transaction

Paying careful attention to the hidden tax pitfalls in M&A deals is crucial. Such transactions typically involve an exchange of equity and other assets. And these transfers attract tax obligations that dealmakers must pay. You’ll also focus on the accurate valuation of the assets you’re exchanging.

Valuation techniques in financial due diligence are not just vital for negotiating the company’s pricing. But also to calculate the applicable sales and income taxes aside from the federal, state, and local taxes. You’ll also scrutinize any unpaid tax liabilities that the target company has accrued in the past.

These tax liabilities along with any fines and penalties may transfer to you, the acquiring entity. The hidden tax pitfalls can affect the transaction’s viability and potentially derail the M&A deal. Factoring in the taxes should be a part of the valuation process and final company pricing.

Aside from assessing the current tax considerations, don’t forget to factor in additional liabilities from previous collaborations. The target company may have entered into partnership, merger, or acquisition deals in the past. In that case, you’ll examine the tax implications of those deals also.

Read ahead for an overview of the typically hidden tax pitfalls in M&A deals and navigating them.

Employee Benefits

Acquiring a company also involves taking over its workforce and the salary and benefits packages. These packages come with tax liabilities that you’ll have to pay. For instance:

Taxes on Employee Benefits

Companies typically have various benefits plans for their employees such as healthcare, dental, retirement contributions, and pension plans. These packages are unique to every organization and integrating the incoming workforce’s benefits can be complicated.

The Federal Insurance Contribution Act (FICA) tax regulations determine which employee benefits are taxable and non-taxable. As part of due diligence, you’ll understand how the target company designed its compensation structure. And if it has any outstanding taxes.

This step is essential when aligning the packages with your company’s existing structure since it may require detailed planning. Early termination fees or restructuring the deductibility of contributions may attract unexpected taxes.

Stock Option Pools

Startups typically offer employees stock options with vesting periods as part of their compensation packages. Accordingly, employees have the option to purchase stock during a fixed interval. The company may also have deferred compensation plans.

These benefits may attract tax obligations when employees exercise their vesting rights. Or when they sell the stock. Your team should examine the contracts and their structure.

As the new owner, you are now responsible for paying applicable taxes. Integrating the options into your existing company structure may also attract tax dues.

Restructuring the Workforce

Integrating the workforce post-merger typically involves restructuring and eliminating redundant and duplicated positions. Working out severance packages and canceling employee stock options may have tax implications. You’ll also want to factor severance costs into the deal pricing.

State and Local Taxes (SALT)

Cross-country mergers and acquisitions must account for the taxes and rules prevalent in the two companies’ jurisdictions. Some of the hidden tax pitfalls in M&A deals include property taxes, sales and use taxes, and payroll taxes. You’ll also factor in income and franchise taxes.

These SALT liabilities can influence the ultimate costs of the company’s sale. Dealmakers on both sides of the table must identify unpaid taxes, tax incentives, and credits that transfer to the buyer. These tax liabilities may apply not only to the current financial year but also to the past and future.

You must structure the purchase agreement with a balance of stock and assets exchange for tax efficiency. An accredited CPA can help devise strategies to minimize payable taxes.

Cross-Border M&A Taxes

Tax obligations in cross-border M&A deals can be complex since the transaction must comply with diverse tax regimes. Since deals can take several months to close, buyers and sellers should be ready for the possibility of changes. Like, in tax regulations, government policies, and regimes.

International M&A transactions may involve transferring stock and assets and pricing them accurately is challenging especially in different currencies. Any errors in pricing these assets, goods, and services can have tax implications in different jurisdictions.

In some deals, the acquirer may choose to maintain the target company as a subsidiary. However, this process involves working out details like foreign tax credits the buyer can claim for the taxes the subsidiary has paid. Claiming these credits requires careful planning and documentation.

You’ll also plan for the possibility of selling the subsidiary at a future date. That includes withholding taxes on dividends and capital gains that you’ll calculate and plan for. The process will depend on the current tax regime and sale terms and conditions.

Valuing Intellectual Property (IP) and Intangible Assets (IA)

Valuing IP and IA for the M&A deal or calculating applicable taxes is a complex process involving several variables. Arriving at a fair market value is highly subjective and reliant on factors like market demand, uniqueness, and revenue potential,

Entities wanting to purchase or subscribe to the IP will have varying criteria for arriving at reasonable pricing. Then again, issues like economic conditions, the competitive advantage buyers get from the IP, and its life cycle also matter.

The potential period for which the asset will remain viable before it becomes obsolete because of newer technology is also a factor. IP and IA owners may also want to reassess their value year over year for accounting and taxation purposes.

Intangible assets like goodwill, customer trust, and brand value are difficult to quantify. Tax authorities may not agree with the value perceptions dealmakers present resulting in higher tax liabilities and adjustments.

Intangible assets have amortization periods of 15 years from the taxation perception, though this period may be different in GAAP. Transferring the assets and the prices at which the transfers take place involves calculating and remitting taxes.

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Sales Tax Considerations

Some transactions may involve asset sales where the buyer purchases the target company’s assets. Dealmakers should be aware of the hidden tax pitfalls in M&A deals when transferring ownership. That’s because selling buildings, real estate, inventory, vehicles, and equipment attracts sales tax.

The amount of tax depends on factors such as where the asset is located and its purpose and usage. Whether or not, the asset buyer paid the applicable taxes when purchasing the asset will also count. If the asset is exempted from sales tax, its owners should have the proper documentation to prove it.

Sales tax and how assets are treated for taxation purposes vary significantly according to the state. Dealmakers should prepare for the tax authorities to scrutinize the exemption and other documents to check for liabilities.

As part of the financial due diligence, it is crucial to check for casual or isolated sales. The criteria for claiming de facto exemption varies from state to state and incorrectly presuming a tax relief attracts penalties.

Since these penalties will transfer to the acquirer in the transaction, you’ll examine purchase deeds carefully.

Carbon Footprint and Tax Exemption

Newer regulations centering around environmental protection have tax penalties for companies that are not compliant. These regulations depend on the state and location where the company operates. The OECD (Organization for Economic Co-operation and Development) defines environmental taxes.

Before purchasing a company, you’ll examine its operating status to check if it has paid its taxes. Make sure to examine compliance not just for the current, but also past and consecutive years. On the other hand, companies that are compliant can avail of tax credits and incentives.

Local, state, and federal government rules provide incentives to generate higher revenues and promote environmentally conscious businesses. If your target company qualifies for these tax breaks, you’ll check for solutions to maintain that credit.

Acquirers often allow their target companies to continue functioning as before and only take on the financial decisions. Accordingly, you’ll work out if the tax credits apply to the buyer company also and how to align the balance sheets.

Ensure that the target company will maintain its compliance credits after the acquisition. Any errors and discrepancies could attract hefty penalties that you’ll want to avoid. On the other hand, if the acquired company has a significant carbon footprint, you’ll work out how to roll back the issues.

The investment you’ll make toward turning the company around can factor into the pricing you pay for it. Also, examine any liabilities the company may have accrued in the years preceding the sale.

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Acquiring a Specific Division

If you’re purchasing only a particular division of a corporation, look for the hidden tax pitfalls in M&A deals. You’ll acquire only the specific assets that the division owns, which is why it is crucial you scrutinize applicable taxes.

Pay special attention to the sales taxes and other dues, preferably by retaining the services of an accredited accountant. Your due diligence should focus on the division’s tax obligations and the future steps you’ll take for compliance.

For instance, you may have to apply to register the acquisition, set up its taxation systems, and file future returns. Organizing these requirements before the deal is closed is advisable. You risk incurring tax liabilities, interest, and penalties if they transfer to you after the deal closes.

Alternatively, you can negotiate with the seller for a transition services agreement (TSA). According to this agreement, the seller is liable for preparing and filing tax returns for a pre-determined interval. This time may extend to even after the deal closes.

You can include information about the TSA in covenants in the merger agreement so the seller is liable for reporting. This process absolves you from being responsible for the interim period until the deal closes and the assets are transferred.

How to Identify and Manage Hidden Tax Pitfalls in M&A Deals

Unexpected tax obligations arising after the M&A deal closes are real possibilities. You’ll undertake the necessary due diligence and other practices to identify the pitfalls and mitigate them. Here’s what you can do:

• Retain the services of an expert team to help you navigate the M&A transaction. The team of professionals includes an M&A advisor, an accredited CPA, a qualified attorney, and lawyers well-versed in M&A taxes. Ensure you have experts on international and national laws, valuation, and transfer pricing at the negotiation table. They should also advise you on the complexities of the deal.
• Include Voluntary Disclosure Agreements (VDA) in the merger agreement to secure your interests. The VDA indemnifies you for any tax penalties that the local, state, and federal tax departments may levy.
• Typically, the VDA specifies a look-back period which ranges from three to five years. Conduct detailed due diligence on the target company’s financial and taxation process to detect any hidden tax discrepancies and liabilities. These dues may transfer to you, the buyer post-merger. Also review tax returns, employee benefit plans, and transfer pricing,
• Leverage the expertise of your tax consultants to structure the M&A deal for maximum tax efficiency. Use best accounting practices to incur the minimum dues.
• Taxation regulations evolve from time to time. Before negotiating the M&A transaction, take the time to research updated laws and work out the deal accordingly.
• Plan the post-merger carefully vis-a-vis taxation systems and accounting techniques. Work out in advance how to align balance sheets and other financial statements and the potential tax dues you’ll incur.
• Use any of the tax modeling tools now available to help you explore different models. You can simulate different structures to assess liabilities and choose the right approach.

Wrapping Up!

Tax due diligence is a crucial aspect of the whole discovery process and acquirers should be aware of tax implications. Any liabilities and penalties will likely transfer to the buyer in the transaction. Hidden tax pitfalls in M&A deals can ultimately derail the transaction.

Don’t overlook the historical reporting liabilities the target company may have accrued. Also, examine any dues pending from past M&A transactions the seller may have entered into. Ensure complete compliance for the success of the collaboration.

Note: The information in this article is only designed to give you an overview of the applicable taxes and is not comprehensive. We suggest relying on the advice and expertise of qualified professionals to guide you.

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