Tax due diligence: Uncovering risk and protecting value

The scope of tax due diligence should be driven by the transaction, rather than using a standard checklist. The buyer’s risk appetite, the sector in which the target operates, the complexity of the group structure, the jurisdictions involved, the proposed deal structure and the overall timetable can all influence how an appropriate review should be undertaken.

A proportionate scope focuses time and budget on the points most likely to matter to price, SPA protection or post-deal integration. For example, principal UK trading entities may need full-scope review of corporation tax, VAT, employment taxes and share incentive arrangements, while less material overseas subsidiaries may initially be covered by a targeted desktop review unless the facts indicate a higher-risk profile.

Typical areas considered include historic corporation tax filings, R&D claims, transfer pricing, VAT and other indirect taxes, PAYE/NIC and contractor arrangements, employment-related securities, transaction history, overseas tax filings, withholding tax and customs duties. Not every area needs equal attention, but each should be assessed by reference to materiality, deal relevance and the buyer’s wider objectives.

A typical process starts by agreeing the review period, materiality threshold and scope, followed by a targeted information request and management calls to understand the tax control environment, historic transactions and known exposures. For cross-border groups, work can be tiered by materiality or risk in each jurisdiction.

For example, this might involve full UK tax due diligence for the principal trading entities, with overseas subsidiaries covered by a limited-scope desktop review, focused on filing status, tax payments, local adviser input, permanent establishment, withholding tax, transfer pricing and known disputes or penalties.

This approach identifies material overseas risks cost-effectively at an early stage, while allowing fuller local due diligence to be scoped separately where the desktop review flags significant exposure or a strategically important entity.

Our experience highlights several recurring areas of concern that may not be apparent from the headline tax filings but can affect pricing, SPA protections and pre- or post-completion disclosures.

Common examples include:

• Unsupported R&D claims or ongoing HMRC enquiries.
• VAT misclassification or VAT processes with limited independent review.
• IR35, PAYE and NIC exposure from contractor arrangements, benefits, cars and expenses with poor documentation.
• Employment-related securities issues from equity incentive arrangements, share issues, reorganisations or rights changes made without proper valuation or HMRC filings.
• Connected party balances or transactions that have not been properly documented or priced.
• Management expenses, recharges and deal costs not properly analysed for deductibility.
• Transfer pricing policies that do not reflect operational substance.
• Unrecognised permanent establishment exposure in overseas markets.
• Overseas filings, withholding tax, sales tax or equivalent indirect tax positions not fully documented.

The key is not simply to list these issues, but to explain which ones are likely to affect value, require a price adjustment, justify a specific indemnity or need to be addressed quickly after completion.

Tax due diligence should feed directly into the structure and the SPA, rather than sit in a separate report that is only read after the main commercial points have been agreed. For example, the choice between a share purchase and an asset purchase can affect historic liabilities, stamp taxes, de-grouping charges, the buyer’s ability to access losses or reliefs and the future tax profile of the business.

The pricing mechanism also matters. In a locked-box deal, tax leakage definitions, permitted leakage and the tax covenant need careful review. In a completion accounts deal, tax-related working capital items, timing differences and post-completion true-up mechanics should be clearly addressed and, where necessary, reflected in the closing balance sheet.

 The funding structure can also create additional tax considerations, including interest deductibility, corporate interest restriction and withholding tax where funding is provided from outside the UK.