Tax Due Diligence

The DD list has arrived. Most of it you can answer from the data room you already built, but then there's the section headed Tax, with three or four items in it that nobody on your side can produce in an afternoon. Welcome to tax due diligence.

Tax due diligence is the review an investor or acquirer runs on your group’s tax setup before they invest or buy. It covers the tax returns each entity has filed, the tax it has paid, any tax still owed or still open with a tax authority, and the arrangements between the entities that decide how the group's costs and income are dispersed. You'll meet it in a priced round, and again if the company is ever sold.

Why does it become a transfer pricing question?

If you have one entity it's far simpler, mostly a check of what's been filed and paid. If you have two or more, the attention moves to what happens between the entities: which entity owns the IP, what the entities charge each other and on what basis, why there's a large balance between two of them with no agreement behind it.

Each of those answers decides where profit pools to once entities become profitable, and that's transfer pricing, folks! Set the price of what your entities do for each other, and through that price, where the (eventual) profit gets taxed.

When the justification doesn’t exist in writing, the DD team doesn't reject the deal but prices the gap - a price chip. A loan between two entities with no agreement behind it is a liability that the company still carries the day the deal closes, so it discounts the price. You think of your intercompany agreements as mere compliance paperwork, but they ultimately affect your valuation.

The tax due diligence checklist

The tax section of a request list varies by investor and by deal. For a group, the intercompany part of the checklist usually looks something like this:

• A group structure chart, with each entity's country, ownership and purpose.
• Every intercompany agreement: services, licences, loans, cost sharing. Signed, dated, and covering the period the money actually moved.
• The transfer pricing policy behind those agreements, and the documentation that supports it where a country requires a local file.
• Intercompany balances at the last year end, agreed between both sets of books, with a note on how each balance arose and how it will be settled.
• The IP trail: assignment agreements from founders and contractors, and evidence that the entity which owns the IP is the one that paid to build it or is paying to use it.
• Where the people are: directors, senior staff and anyone working from a country where you have no entity. This is the permanent establishment question.
• Filings and open matters for every entity, including anything a tax authority has asked about and not yet closed.
• R&D claims, and whether the costs claimed sit in the entity that made the claim.

A story from this year

A CFO came to us this year with an Austrian parent, a small Hungarian subsidiary and a US entity about to open (countries changed for privacy). The subsidiary existed because an early investor had wanted one, and it had kept a handful of developers employed on a research grant ever since. For three years, the parent had simply sent the subsidiary money, but there was no agreement behind it and no invoice. In the books, it sat as an advance on a future capital increase, because nobody had decided what else to call it.

In the CFO's words, they had managed it naively, and every investor in the current round had asked for a proper intercompany framework before closing. The company was also opening a US entity, and one of the founders was moving there to run US sales, so the new agreements had to cover the US entity as well.

The Hungarian subsidiary's job is software development for the Austrian parent. Until the grant ended, the developers were working on the grant project. After that, they'd be building the parent's own product, which is work the parent pays the subsidiary for, just as it would pay an outside developer.

So the two entities needed a services agreement, with a pricing method that sets what the parent pays for the development work. The US entity needed the same treatment before its first sale. It would be selling a product that the parent built, so it would need a licence from the parent that says so and sets the payment for the right to sell it.

What to have in place, in this order

1. List every flow between your entities. Cash sent down, costs paid on another entity's behalf, people working for one company while employed by another, customers signed in one country and served from a second, and so on. If a flow crosses a border inside the group, it's on the list.
2. A transfer pricing policy: a document that sets out which entity does what, why the money flows the way it does, and where the decisions get made. The agreements in the next step follow from it, which is why it comes first.
3. Determine the pricing method for each flow and write the agreements. Don't backdate. Date each agreement on the day it's signed. If the arrangement was already running before the day the agreement was signed, say it in the agreement and state when it started.
4. Agree the intercompany balances between both sets of books, decide what each balance is (a loan with terms, a service charge that was never invoiced, or equity) and book the accounting entries that make the policy true in the accounts.
5. Put the IP trail in one folder. Founder assignments, contractor assignments, and the agreement under which any other entity uses the IP.