Acquiring a business is a significant investment, and understanding its tax position is an important part of making an informed decision. While financial, commercial, and legal due diligence often receive the most attention, tax due diligence can be equally important in identifying liabilities that may otherwise go unnoticed until after completion.

In the UK, complex tax legislation and increasing HMRC scrutiny mean that historic tax issues can have financial consequences for a new owner. A review of tax returns and statutory filings alone may not be sufficient to identify these risks.

Tax due diligence helps buyers understand the potential tax exposure associated with an acquisition, assess the target’s compliance history and negotiate appropriate protections before the transaction completes.

Why is tax due diligence important?

Tax due diligence is more than a review of whether a business has submitted its returns and paid its taxes on time. It involves examining the underlying transactions, business practices and tax treatments to identify areas where liabilities may arise.

The findings can influence several aspects of a transaction, including:

Purchase price negotiations: Potential tax liabilities may justify a reduction in the agreed consideration.

Contractual protection: Specific tax indemnities or other safeguards may be required to protect the buyer against identified risks.

Post-acquisition planning: Weaknesses in tax processes can be addressed following completion to reduce the risk of future non-compliance.

Tax attributes: The availability and continued use of tax losses and other reliefs may affect the expected value of the acquisition.

Although a share purchase agreement (SPA) will usually contain provisions dealing with historic tax liabilities, relying on these protections after completion can be time-consuming and costly. Recovery may also be complicated by disputes over the scope of the indemnity, the amount claimed or the seller’s ability to meet the liability.

Identifying potential issues before completion allows the parties to address them as part of the transaction, rather than dealing with unexpected tax bills later.

Common tax risks identified during due diligence

The scope of a tax due diligence review will depend on the nature, size and structure of the target business. However, several areas regularly warrant closer examination.

Employment taxes and off-payroll working

Businesses engaging contractors, consultants or temporary workers may face exposure where employment status has been incorrectly assessed or payroll obligations have not been met.

Under the off-payroll working rules, including IR35, responsibility for determining employment status and accounting for PAYE and National Insurance contributions depends on the circumstances and the relevant arrangements. Where the rules have not been applied correctly, the business or another party in the labour supply chain may face historic liabilities, interest and penalties.

The position can become more complicated where workers are engaged through personal service companies, recruitment agencies or umbrella companies. A review should consider the contractual arrangements, the working practices in reality and whether the relevant responsibilities have been properly discharged.

International contractor arrangements can create further exposure, including overseas payroll and social security liabilities, corporate tax obligations and potential permanent establishment risks.

Employment-related securities and share schemes

Share arrangements involving employees and directors can give rise to unexpected tax liabilities, particularly in owner-managed and high-growth businesses.

Shares or options may have been issued without the correct tax treatment, elections or reporting being put in place. For example, where employees acquire restricted securities, the absence of a valid section 431 election may result in an income tax charge arising when restrictions are lifted or in connection with a disposal, depending on the circumstances.

Other areas to investigate include:

• Shares acquired by employees or directors for less than market value.
• Enterprise Management Incentive (EMI) options that do not meet the relevant conditions or have not been administered correctly.
• Outstanding employment-related securities reporting obligations.
• Share options or awards that vest or are exercised as part of the transaction.

These issues can affect both the employees and the company. Amounts expected to qualify for capital gains tax treatment may instead be subject to employment income tax, potentially resulting in PAYE and employer National Insurance liabilities.

A review before completion can help establish whether the share arrangements have been implemented correctly and whether the transaction itself will trigger additional tax charges.

Cross-border tax exposure

International activities can create tax obligations even where the business has no overseas subsidiary or registered branch.

For example, employees or directors working overseas may create payroll, social security or corporate tax exposure in another jurisdiction. Payments to overseas suppliers, lenders or group companies may also be subject to withholding tax requirements.

Where related companies operate across borders, transfer pricing arrangements should be reviewed to establish whether the pricing is commercially supportable and whether appropriate documentation is maintained.

A failure to identify these obligations can lead to additional tax assessments, interest, penalties and compliance costs after completion. Buyers should therefore consider not only the target’s UK tax position but also the jurisdictions in which it operates, employs people or conducts business.

Turning findings into transaction protection

Identifying a tax risk is only part of the process. The next step is to assess its potential financial impact and determine how it should be addressed.

Depending on the circumstances, the buyer may seek a purchase price adjustment, a specific tax indemnity, an escrow arrangement or remediation before completion. The findings may also influence the warranties included in the SPA and the buyer’s plans for managing the business after acquisition.

It is equally important to distinguish between a historic liability and a weakness in the target’s ongoing tax processes. The former may require contractual protection, while the latter may call for changes to systems, procedures or professional oversight.

A well-conducted review provides the buyer and their advisers with a clearer understanding of the risks, supporting more informed negotiations and helping to reduce the likelihood of unwelcome surprises.

How we can help

We support businesses, investors and prospective purchasers with tax due diligence as part of acquisitions and investment transactions. We assess the target’s tax position, investigate areas of potential exposure and help quantify the financial implications of identified risks.

Our advice can also assist with purchase price negotiations, appropriate tax protections in the transaction documentation and post-completion tax planning.

If you are considering acquiring a business or investing in a company, contact us to discuss how our tax due diligence services can help you understand the risks, protect your investment and proceed with greater confidence.