Tax Due Diligence – typical cross-border tax risks

In essence, a tax due diligence serves two purposes: Risk reduction for the potential buyer with regard to the target, and tax optimisation of the transaction process. Insofar as significant tax risks are identified, this can lead to concrete purchase price adjustments or even the termination of the transaction (red flags) in addition to the contractual safeguards in the purchase agreement via tax guarantees and tax waivers.

Special attention is paid here to tax risks in the area of cross-border transactions, as these can lead to genuine cases of double taxation, and also to considerable additional administrative costs. In this article, we would like to offer an overview of typical problem areas, but this cannot be exhaustive given the complexity of the taxes involved.

Transfer pricing

International groups of companies must structure their transfer prices in accordance with arm's length principles, otherwise there is a risk of transfer price adjustments and thus additional tax payments. There is also a risk of double taxation, which must be eliminated through a lengthy mutual agreement procedure, typically involving the use of advisers. In addition, internationally active companies are required to document their transfer prices using formal criteria (3-tiered approach). If no such documentation was prepared, there is a risk of penalties and a considerable administrative effort involving external consultants, which also eats up internal resources.

As part of a tax due diligence, special attention is therefore paid to transfer price risks. Lack of due care in structuring transfer prices is normally covered by a tax waiver. In addition, the buyer will try to shift the indirect administrative costs back to the seller, e.g. via a purchase price adjustment.

Risks relating to permanent establishments

A very typical problem found during tax due diligence is that of unregistered permanent establishments abroad. If a company operates in another country, e.g. through a fixed place of business, or if a local sales representative has (de facto) power of attorney to conclude contracts, a permanent establishment must be registered. Even if there is no formal permanent establishment as such, there may be local registration obligations abroad, where non-compliance can lead to penalties. You must also not forget service permanent establishments, which are included under some double tax agreements (DBAs).

In addition to the not insignificant additional costs created by retrospective registration of a permanent establishment abroad, tax arrears may need to be paid and, as a rule, also punitive interest and penalties. In some countries there is also the threat of criminal tax proceedings, which should be avoided if possible.

Establishing a permanent establishment means that, in addition to the corporation taxes, payroll taxes for local employees also have to be deducted in the respective country, unless this is already being done for other reasons. In such cases, the employer often assumes liability for payment of taxes on behalf of the employee. In these cases, the back taxes paid by a company can multiply by considerable amounts.

The goal of performing tax due diligence, as well as identifying the risks in advance, is to ensure that potential tax arrears and in some cases sizeable penalty payments, can be avoided by negotiating a tax waiver. This also needs to include the administrative costs. Care needs to be taken that negotiations include payroll taxes, VAT and other sales taxes and - depending on the selected purchase price payment arrangements in the purchase contract - the period up to the actual transfer of ownership under civil law.

Through a tax waiver, you can also contractually ensure that no foreign permanent establishments exist. 

Payroll tax risks

In addition to the payroll tax risks arising from permanent establishments abroad, there are also domestic income tax risks in the cross-border context. It is frequently overlooked that foreign employees who have an employment contract with a German company, are subject to German income tax for every day that the employee spends in Germany. These include, for example, sales representatives who regularly spend time at the parent company.

In addition, it should be pointed out that many countries have similar regulations to prevent bogus self-employment to those under German law. Bogus self-employment means people who claim to be self-employed, but are actually dependent on employers. From a German perspective, a bogus self-employed person will be classified as an employee. Employment law (e.g. protection against dismissal, paid leave), tax law (income from non-self-employed work) and social security law (contributions to social security) all apply to them. Special attention must therefore be paid during tax due diligence to regularly recurring consultancy invoices from natural persons, both domestically and overseas.

In addition to the numerous legal risks that bogus self-employed status may entail, the income tax risk and the social security risk should be pointed out and must absolutely be covered by a tax waiver. The tax waiver should also cover the period up to the statutory transfer of ownership.

VAT risks

A potential area of risk for internationally active companies is also failure to register for VAT and other sales taxes abroad. Registration may be necessary if, as a result of a work supply, e.g. the assembly of a plant at a foreign customer's premises, the place of supply is relocated abroad and the foreign jurisdiction does not provide for a reverse charge procedure, i.e. no shift of the tax liability to the customer.

Services in connection with real estate are also typical use cases. In online trading, reference should be made to the mail order regulation, which leads to registration obligations abroad if delivery thresholds are exceeded.

As the turnover tax is linked to ongoing business activities, errors very quickly lead to significant tax arrears. Late registrations, notifications and tax payments attract penalties in almost all countries and may incur significant penalties or other fines. Here, security should be achieved through the purchase contract, using a combination of tax waivers and tax guarantees, and should cover the period up to the transfer of statutory ownership.

Customs risks

Finally, we would like to draw your attention to potential customs risks in relation to third countries, meaning all countries outside of the European Union (EU) or the European Economic Area (EEA).
In practice, this often affects online traders who exceed exemption limits and therefore should be liable for customs duty.

Furthermore, there are global problems with determining the customs value of items, including: transfer pricing, licence fees, bonus free-of-charge items or packaging costs.

And further taxes 

Last but not least, do not forget excise duties (e.g. energy, alcohol, tobacco or coffee tax) which we will not address in more detail here. We would also like to just note the existence of real estate transfer tax (stamp duty) and other transaction taxes.