Five tax issues to address in advance of due diligence

Original content provided by BDO United Kingdom

When undertaking a transaction, such as a disposal, merger, or refinancing it is highly likely that the business will be subject to tax due diligence.

If any issues are not remedied prior to a transaction but are instead picked up during the due diligence process, this can lead to significant delays - to resolve them, renegotiate the price or both.
 

Preparing for a transaction

Whilst transactions are all unique, in our experience there are common tax issues that arise. Understanding and addressing these key areas in advance of a transaction can help stakeholders to ensure that value is maximised and disruption to the business is minimised.

An 'exit readiness' review in advance of a planned transaction can help to identify any issues, allowing the time to deal with these before a due diligence process commences. This exercise can also identify tax assets which may deliver value on an exit.
 

Current tax risks

In recent tax due diligence exercises for tech and media businesses, we have seen the following tax issues emerge frequently:

1. Share schemes/equity rewards

It is often the case that Management are making significant gains on equity rewards and, therefore, the tax risks attached to these are likely to be material. As a result, the arrangements will likely undergo detailed scrutiny from both the tax advisors and lawyers.

Common issues arising are:

• No or limited valuation support
• S.431 elections not entered into
• Qualifying criteria for HMRC tax-advantaged options not met, e.g. independence, no. of employees, gross assets.
   

The above issues can result in some or all of the Management team's proceeds being subject PAYE and NIC (c.60% tax cost) which can result in significant reductions in value and also demotivate key members of the team.

However, if done correctly, share rewards are a great tax-efficient tool. In certain scenarios, for example on the exercise of share options, they can generate significant corporation tax deductions which, dependent on the profile of the Target, can help to reduce the tax paid on the transaction.

2. Off Payroll Workers

Off payroll workers include self-employed individuals, contractors, consultants, executive and non-executive directors, and involve payments made via personal service companies or other intermediaries (e.g. agencies).

If the status of these workers has not been properly assessed or simply incorrectly documented, then a buyer can often insist on a price reduction to cover any PAYE and NIC (plus penalties and interest) that they could assume as the purchaser.

Therefore, it is important to ensure that the status of any off-payroll workers has been robustly assessed and documented (ideally using HMRC's CEST tool) and status determinations issued to all relevant parties.

3. Export VAT evidence

Businesses that export goods overseas are required to hold specific evidence documentation to support the UK zero-rated VAT treatment of any exports made.

The requisite export evidence must be obtained and held within 90 days following export to ensure the zero-rated treatment can apply - otherwise the export becomes standard rated and attracts 20% UK VAT. This is particularly important for indirect exports, i.e. customer collects, as the evidence required is more comprehensive and explicit.

If a business cannot demonstrate it has adequate evidence procedures in place a buyer may insist upon withholding 20% of all export sales for the last four years until this can be satisfied. Therefore, it is important to ensure robust export evidence procedures are in place to avoid this becoming a potential permanent loss of value or at best a distraction on the deal process.

4. Director's loans/Upstream Loans

Overdrawn director's loan accounts are often used in advance of a transaction to put the shareholders in funds pre-transaction and the 'loan to participators' temporary s.455 tax charge and benefit in kind implications are often well understood.

However, where there has been a previous transaction e.g. a management buyout, there may be legacy ‘loan to participator’ tax issues created by the use of company cash to pay out previous 'participators'. This is ordinarily addressed via way of intercompany dividend but, if missed over a number of years, it can lead to a cash flow impact in respect of the temporary tax charge identified, equal to 32.5% of the intercompany balance, plus late payment interest.

Therefore, it is important to ensure that the reason for any intra-group balances are properly understood and the tax position considered and documented.

5. Overseas operations, in particular US sales tax

Operating or selling goods and services overseas brings different tax jurisdictions into play. The US is a key market for a lot of UK businesses, but they may not have sought US tax advice on expansion.

Businesses operating or expanding into the US may be subject to US sales tax on the sale of goods and services to US customers. US sales tax differs from state to state and requires payment to different tax authorities, making it highly complex.

Failure to collect and remit US sales tax to the appropriate tax authority can result in significant sales tax liabilities and can be subject to penalties and late payment interest for non-compliance. So, it is beneficial to proactively demonstrate compliance in this area - especially where US sales are significant (or likely to be significant for future growth).