Taxes as a Deal Breaker in M&A Transactions

Every buyer is advised to closely examine the target in  preliminary stages of the transaction. Later tax claims or criminal tax proceedings that are only discovered after  the transaction can be time-consuming and very expensive. The so-called “tax due diligence process” is conducted to identify tax risks of the target company, that already exist or will occur in the near future. Typically, tax due diligence includes the analysis of the tax history of the last three to five years, depending on which tax assessment notices can be amended by thetax authorities (tax assessment notices issued under subject to review provision).

The risks identified during the tax due diligence are usually covered by an extensive tax clause in the company purchase agreement: The seller indemnifies the buyer with regard to all taxes up to the time of the transfer of company’s shares (so-called “tax exemption”). The tax exemption is complemented with tax guarantees. As a result, the seller generally bears the tax risks with regard to the past.

Example: When acquiring incorporated companies, tax due diligence focuses on analysing the related party and intercompany transactions between the target and its shareholders. In many cases, such intercompany transactions carry the risk of being classified by the tax authorities as non-arm's length. The result of this may be a denial of the deduction of operating expenses at the level of the target and a reclassification as a so-called hidden profit distribution. Such risks are usually covered by the tax clause in the company’s purchase agreement. 

When drafting and negotiating the purchase agreement, the buyer must ask himself whether the seller will also be able to afford the tax exemption if the risk materialises at a later date (e.g. in the course of a tax audit). Therefore, it is advisable to quantify the amount of the tax risks as far as possible, e.g. in the case of hidden profit distribution – using an estimate of the arm's length remuneration. Depending on the amount of the tax risk and the creditworthiness of the seller, it might be advisable to agree on a purchase price retention at least in the amount of the calculated tax risk.

Risks in current assessment rarely lead to the breakdown of the transaction. However, if there are serious discrepancies, such as deliberately undeclared sales revenues – and consequently tax evasion – seller and buyer are often no longer able to reach an agreement due to a lack of trust. Significant tax risks can also become a Deal Breaker. These include false self-employment – see also wage tax and social security as Deal Breakers | Rödl & Partner (roedl.de), extensive, accidentally undeclared foreign activities or a lack of tax deduction for construction services. In the latter cases, the seller and buyer usually cannot agree on a corresponding retention of the purchase price.

The biggest tax Deal Breakers often occur on the seller’s side and namely involve the lack of early structuring of the company sale. A well-advised seller has already optimised his tax situation long before the sales process begins in such a way that he can sell the shares in the target with no or only a very low tax burden. This may be achieved through the interposition of, for example, a German corporate holding company, which, in principle, can sell shares in subsidiaries almost tax-free.

However, this requires appropriate preparation. If a natural person holds shares in an incorporated company today, the interposition of such a holding company leads to the more favourable tax effect not earlier than after 7 years. Unfortunately, there are still sellers who assume that comparable tax models can be applied in the short term to reduce the income tax burden on sale. In these cases, the tax burden can become a Deal Breaker.

For well-advised sellers of partnerships, restructuring measures conducted in the past can become a pitfall. The pitfall here often involves the trade tax. Supposedly simple structural adjustments, such as an upstream merger of an incorporated company into the parent partnership, can block the trade tax exemption that is actually associated with the sale of the interest in the partnership. In such, often controversial cases, advance tax rulings from tax authorities help to prevent the deal from failing. However, here, too, a lead time is urgently needed.

In the current market environment, the target's unused losses and whether the buyer can realise them are a common subject matter of the audit. Due to the tax savings associated with loss utilisation, the losses of the target represent an economic value. The seller usually wants to be compensated for this tax advantage. 

In the case of the acquisition of shares in incorporated companies in Germany, however, a change of ownership of more than 50% triggers a complete forfeiture of losses. Nevertheless, in many cases losses can be (at least partially) preserved if, for example, the purchase price covers so-called hidden reserves (“hidden reserves clause”) or if the acquisition is made for the purpose of restructuring the target (“restructuring clause”). Comparable regulations on the utilisation of losses are also found in the acquisition of foreign companies. If the planned acquisition of a company involves such risks to a great extent, it must therefore be considered whether the deal structure should be maintained or changed (e.g. acquisition of less than 50% or asset deal) or whether an exemption can be used. This prevents loss utilisation from becoming a Deal Breaker.

Especially in the case of tax risks, the breakdown of the transaction can be avoided through good preparation. From the seller's point of view, this requires an optimal preparation of the tax documents as well as dealing with the transaction structure in time. In particular, the seller should know the tax burden that will be imposed on him as a result of the proposed sale before approaching investors. If the tax burden is to be optimised (e.g. through a holding structure), the restructuring required for this must be implemented well in advance due to the applicable lock-up and holding periods. 

From a buyer's perspective, a detailed tax analysis of the target is recommended in order to identify tax risks before closing the transaction. Generally, there are numerous means of covering tax risks in the purchase agreement (e.g. tax clause, purchase price retention, change in transaction structure). The difficulty often lies in weighing up the level of tax risk and discussing it with the seller. If neither the seller nor the buyer wants to bear the tax risk, insurance policies (e.g. “tax indemnity insurance”) can contribute to the successful closing of the transaction.

In summary, it should be noted that in a well-prepared company acquisition always the right remedy can be found for tax risks to prevent taxes from becoming a Deal Breaker.