Tax due diligence in times of the coronavirus epidemic

Tax due diligence normally focuses on the investigation of historical tax assessment periods that may be subject to change in the course of a tax audit. As regards assessment periods subject to verification, tax returns and tax assessment notices are evaluated. Tax due diligence usually does not involve the current financial or calendar year also because, in most cases, no tax documentation is yet available for this period. Moreover, the investigative analysis has mainly been limited to income taxes so far, whilst VAT, payroll tax and social insurance contributions are most often subject to plausibility checks performed as part of tax audit report assessments. This has changed, now, due to COVID-19.

Focus on 2020

Several state measures aimed at supporting companies affected by COVID-19 have been made available and can already be used in the current year 2020. It is expected that e.g. adjustment, deferral or even refund of tax advance payments as well as extended options for utilisation of losses will improve the liquidity situation of the affected companies.  Tax due diligence should include the examination of whether the eligibility criteria are met in the specific case. This is because filing an unjustified application implies that an incorrect  declaration has been filed with the tax authorities, which, in the worst case scenario, can trigger criminal law consequences for the management of the company affected by COVID-19.

A prerequisite common to all tax aid measures is that a company must be directly and significantly affected by COVID-19 (financial impact) in a verifiable manner.  The financial impact on the company should be analysed in collaboration with financial due diligence auditors. Since the requirements regarding the application procedure and prove of eligibility are different in the federal states, the examination of whether the criteria are met is complex on the national level already. If a company uses aid package measures abroad, foreign tax experts should participate in the tax due diligence.

New subject areas come into focus of the investigative analysis

Intra-group restructurings have always been the focus of tax due diligence audits. For example, companies affected by COVID-19 carried out intra-group restructuring measures in order to satisfy bank requirements regarding collateral or – the opposite – ensure asset protection.

The Restructuring Tax Act opens up opportunities to carry out intra-group restructuring measures on an EU-wide level, ideally in a tax-neutral manner. Their implementation should be analysed as part of tax due diligence so as to take into account later tax claims and mandatory holding periods under tax law.
In addition to the Restructuring Tax Act, restructuring measures can arise from a negative development of revenues. This is possible if the “bad” year 2020 can be made part of a company valuation process. In this case, tax due diligence should verify the tax assessment used as the basis for the (reduced) taxation of hidden reserves.

If companies affected by COVID-19 use intra-group financing, it is important from the tax point of view that the underlying conditions comply with the arm’s length principle. Otherwise, tax corrections might be required. In an international context, this might apply not only to the interest rate but to the loan amount itself, if granted. Depreciation of non-performing loans is normally not recognized under tax law. If these matters are treated incorrectly for tax purposes, the tax authorities may impose additional tax levies for the misstated period.

If a company pursues the cash repatriation strategy, attention should be paid whether withholding taxes are correctly deducted and paid abroad. This liquidity outflow may be avoided by using certificates of exemption, if applicable. If a company does not hold such certificates (has not obtained them in due time), retrospective WHT claims should be taken into account.
 
Companies affected by COVID-19 can use temporary loss carrybacks from 2020 at a flat rate of 30% of the tax assessed for 2019. At the same time, the maximum amount of loss carrybacks was increased from EUR 1 million (or EUR 2 million for spouses) to a maximum of EUR 5 million (or EUR 10 million for spouses). It can be used on condition that the tax advance payments for 2020 were reduced to zero. Should it turn out later that the prerequisites had not been fulfilled and a correction is required, the company might also face high penalty interest.

VAT is becoming the focus of the audit and for the first time this happens across all industries. Apart from many individual measures, in particular the temporary VAT reduction aimed at boosting consumption in the second half of 2020 is of importance. Many companies find themselves facing very high requirements that must be met by their IT departments to implement the regulations. Since any mistakes in this area may lead to severe financial consequences it is advisable to involve VAT experts in the tax due diligence.

Depending on the objects of the company, payroll tax and social insurance contributions may become the subject of a separate audit. This is because as travelling has been restricted and people work more from home, companies may (unintentionally) create permanent establishments in international matters. This triggers consequences not only in terms of corporate taxes payable in the country where the permanent establishment is created  but also the employees working in this country become subject to taxes and social insurance contributions. Since the employer is normally liable for employees’ contributions these additional staff costs should be identified during tax due diligence. Financial implications may also arise if an enterprise or owner conducts activities for a longer period of time outside the country where the registered office of the company is located. In such a situation, the place of such activity might be deemed to be the effective place of management. Residing in two countries may have costly consequences in terms of double taxation.

Conclusion

If the COVID-19 aid measures provided for under tax law at home and abroad are correctly used, they may relieve companies from financial burdens. Otherwise, they may lead to high additional tax payments and even criminal law consequences. The changed risk and tax situation should be thoroughly examined and in consultation with our Legal colleagues be appropriately considered in the underlying contracts.