My company is buying the stock of another company? What should I be looking at as part of my tax due diligence process?
The most important thing to remember is that in acquiring the stock of another company (either through a taxable or tax-free acquisition) the buyer takes on all liabilities (including the tax liabilities) of the stock being acquired. As a result, your job is to identify all significant tax exposure items as well as kick the tires on all tax assets. Below is a list of items to items to consider.
TAX EXPOSURE ITEMS
Federal Income Tax
During the due diligence process you will want to review all tax returns still open by the statute of limitations. Be aware of when these returns were filed (e.g. did the seller catch up on outstanding tax compliance immediately before the company was put up for sale?) Review all accounting method changes (Form 3115) that the seller has historically made. Review any IRS correspondence as well as prior issues raised on examination. Have the financial statements been restated in the past 5 years? If so what was the treatment on the tax return? Obtain a copy of all tax elections that have been made. If the stock is being purchased from a consolidated group, review the tax sharing agreement to understand which tax liabilities will go with the company.
State Income Tax
Review all state returns and if these returns should have been filed as part of a unitary group. Obtain Next information regarding the sales, payroll and property for each company. Ask questions about state activity where there is no property or payroll to determine if the company has economic nexus that may have caused them to file in that state. Review all past state tax audits as well as state tax notices and nexus questionnaires prepared by the company. Compare sales tax filings and payroll withholding reports with the apportionment information.
International Tax
If you will be claiming foreign tax credits (FTC) does the seller have OFL’s (overall foreign losses). OFL’s can have a significant impact on your ability to take FTC’s even if the seller never claimed FTC. OFL’s can occur where a seller had net operating losses, high interest expense and a high tax basis in its controlled foreign subsidiaries (CFC’s) due to not distributing earnings. You should ensure that any seller with CFC’s has not had Sec. 956 deemed repatriation of earnings in the past. Review loan agreements as well as supplier agreements to make sure there are no cross guarantees. Finally, you should review the earnings and profits on the Form 5471’s in the U.S. return. These are more often done incorrectly and could cause adverse consequences down the road when the CFC needs to repatriate earnings. Transfer pricing policies should also be investigated. Oftentimes, the methodology of a buyer vs. a seller can be conflicting once brought in under the same group.
Information Returns
Look beyond the income tax filings to other required tax filings. Has the company been compliant with its foreign bank account (FBAR) filings? Is the company compliant for FATCA and information reporting purposes? These items are being heavily scrutinized by the IRS and could result in heavy penalties for errors and non-compliance.
TAX ASSETS
Net Operating Losses and Credits
Anytime there is an ownership change of stock, the losses are subject to Sec. 382. This limitation essentially takes the stock value of the company times the long-term tax exempt applicable federal rate and determines the amount of NOL that can be taken each year. This concept is usually considered as part of the current stock acquisition being contemplated. What sometimes gets ignored are ownership changes prior to the acquisition. Sec. 382 looks at any ownership that occurs within a three year period. Because of the complexity of the tax law companies can have a more than 50% ownership change over a three year period without knowing it. It is essential that a Sec. 382 study be done prior to acquisition to be sure there are no prior limitations to losses under Sec. 382, credits under Sec. 383 or unrealized losses under Sec. 384. You should also be aware of large foreign tax credits that may go unused if there is major U.S. tax reform. Make note of separate return limitation year loss (SRLY loss) rules that can further limit the ability to utilize NOL’s and credits. For state tax losses you need to make sure that there will be sufficient apportionment and taxable income in a state in the future for the losses to be utilized.
Escrow or Tax Indemnification
I would recommend that the buyer hold back on a portion of the sales price into escrow for unforeseen tax risks. If escrow is not a valid option, then there should be a tax indemnification process that is spelled out in the purchase agreement. I would also encourage the buyer to review the tax returns thoroughly right after the acquisition to determine if the buyer and seller are taking consistent tax filing positions on the returns.