5 key red flags in tax due diligence: Identifying tax risks in transactions

Unfiled or late tax returns 

Tax filings which are consistently delayed may signal underlying issues, such as financial distress, poor management, or a history of non-compliance or tax evasion. Also, late filings could lead to penalties or interest charges from the tax authorities, which is a risk for the buyer. 

Outstanding tax liabilities 

Unresolved tax debts to the tax authorities raise direct red flags. They demonstrate either financial mismanagement and cashflow issues, or potential liabilities such as legal claims and debt collection.

Questionable tax positions and pending or historical tax audits and disputes

Questionable to aggressive tax positions can lead to discussions with tax authorities. If a tax position turns out to be unacceptable, the tax authorities won’t just scrutinise this position and levy tax, they also can charge penalties, fines, and interest. Examples of such tax positions are hybrid mismatches, transfer pricing (TP), and/or the use of tax incentives and credits. A careful review of the tax positions is crucial to mitigate the risk of unexpected tax liabilities in the future. 

A history of audits or ongoing disputes with tax authorities also signals risk. If the target is under audit or engaged in litigation over tax matters, it could face significant adjustments, interest, and penalties. Reviewing audits and disputes reveals patterns in compliance and helps determine if issues may reoccur post-acquisition.

Transfer pricing issues

For entities which have cross-border intercompany transactions, TP is crucial. Inadequate compliance with TP regulations can result in fines and potential double taxation. A DD should confirm that intercompany transactions align with the arm’s length principle and are well-documented. If TP issues go unresolved, tax authorities in either jurisdiction could levy additional taxes.

Underreported wage taxes

Wage tax is in general a large liability to a company. If the payroll administration falls short, this could lead to substantial adjustments, especially if it concerns several years. Tax authorities are increasingly scrutinising wage tax compliance, and penalties for violations can be substantial. Assessing wage tax compliance and agreements with contractors ensures the target adheres to wage tax regulations, reducing exposure to fines or reclassification risks. 

In a DD, spotting red flags early is crucial. It is wise to involve a tax specialist at an early stage to signal potential risks that could impact the value or pose financial and legal challenges post-transaction. By addressing these warning signs and implementing effective risk mitigation strategies, buyers can ensure a smoother transaction and protect their investment.