Tax Risks in Financial Due Diligence
How FDD analysts identify and present tax risks in due diligence: common areas of exposure, interaction with tax DD, and the impact on deal structure.
Tax risks are a significant area of exposure in any M&A transaction, and FDD analysts play an important role in surfacing them — even though the deep tax analysis is typically handled by a specialist tax due diligence team. Understanding the financial statement indicators of tax risk, and knowing when to flag items for the tax team, is an essential part of the FDD skill set.
Why Tax Matters in M&A
In a share deal, the buyer inherits the tax history of the acquired company. Any prior year tax understatements, penalties, or disputes become the buyer's problem post-acquisition. This makes tax diligence critical.
Even in an asset deal, tax risks embedded in acquired assets (e.g. assets with large latent capital gains, VAT recovery positions) can be material.
How FDD Analysts Identify Tax Risks
FDD analysts are not tax experts, but they review the financial statements and identify indicators that require further investigation by the tax team:
Effective Tax Rate Analysis
Build a schedule of the effective tax rate (tax charge / PBT) for the last three years. Deviations from the statutory rate require explanation:
- Rates significantly below statutory: may indicate aggressive tax planning or temporary timing benefits
- Rates significantly above statutory: may indicate non-deductible costs or prior year adjustments
Deferred Tax Positions
Review the deferred tax asset and liability schedule:
- Large deferred tax assets (DTAs) may reflect accumulated tax losses — are they recoverable? Is there sufficient future taxable profit to absorb them?
- Large deferred tax liabilities (DTLs) represent future cash tax outflows
Tax Payables
Review the tax payable and prepayment positions. Unusually large balances may indicate disputes or delayed settlements.
Related Party Transactions and Transfer Pricing
Inter-company transactions between group entities at non-arm's-length prices can create transfer pricing risks. Flag these for the tax team.
Common Tax Risk Areas
- Employee tax: Misclassification of employees as self-employed (IR35 in the UK, similar rules elsewhere), resulting in PAYE/NICs exposure
- VAT: Incorrect partial exemption calculations, VAT treatment of cross-border transactions, VAT group registrations
- R&D tax credits: Inflated R&D claims that may be challenged by tax authorities
- Withholding taxes: On dividends, royalties or intercompany interest payments
- Corporate tax computations: Items included in EBITDA that may not be tax-deductible
Interaction Between FDD and Tax DD
FDD and tax DD teams work in parallel but with different scopes:
- FDD highlights financial statement anomalies and refers them to the tax team
- Tax DD provides a detailed assessment of the company's tax compliance and exposure
- The two teams share findings to ensure consistent presentation in the report
In the equity bridge, tax exposures identified by the tax DD team may be included as debt-like items or addressed via specific indemnities in the SPA.
Conclusion
Tax risks are a material component of deal risk. FDD analysts who can identify financial statement indicators of tax exposure, and communicate clearly with the tax team, contribute significantly to the quality of the overall due diligence.
The Transaction Services Interview Programme (€119.99, one-time) covers tax risk identification in FDD, with examples from real case studies and interview preparation. Enrol today.