**3. The importance of accounting, tax and legal due diligence in merger and acquisition (M&A) processes**

It is usual in commercial practice, mainly in mergers & acquisitions, to carry out a procedure for collecting information and reviewing and analyzing documents, with the function of verifying the legal and economic situation of the companies involved in the business, called due diligence [26].

Due diligence, used in mergers and acquisitions processes, as one of the last stages of the transaction, from the accounting, tax, and legal point of view, aims primarily to identify contingencies that are capable of affecting the value of the assets involved in the business, as is outlined in **Figure 3**. It is not too much to remember that, in the legislation of several countries, there are several situations in which the buyer becomes responsible for the seller's liabilities [27].

From a tax perspective, the economic advantage of an M&A transaction depends on the potential tax risks and opportunities of the targeted transaction that are identified during the transaction stage, the costs that are incurred on account of conducting the due diligence itself, as well as the tax savings that may be realized when consuming the target transaction, minus the requisite restructuring costs that are incurred during the integration stage. The latter are determined by the extent of pre-acquisition and post-acquisition measures [28].

From the seller's point of view, due diligence, prior to the signing of the closing of the transaction, may be used as a defense against future (any) claims by the buyer. Thus, it aims to ensure that the information has been audited by the buyer, serving to protect the seller from any claim of ignorance from the part of the buyer [29].

Due diligence is of the buyer's priority interest, as it is verified, at this stage, whether the data provided in the information memorandum are compatible with *The Management of Tax Risks in Mergers and Acquisitions - The Importance of Tax Due... DOI: http://dx.doi.org/10.5772/intechopen.96964*

#### **Figure 3.**

*Verifying procedure company's situation from several angles. Source prepared by the author.*

the reality. Buyers seek to protect themselves from optimistic projections from sellers through earn out mechanisms and possible non-compliance of current and past data through due diligence. Due diligence grants the acquirer access to sensitive information about the object to be acquired, for the purpose of being able to conduct a comprehensive audit [30].

Due diligence is conducted by the buyer and accompanied by the seller. The latter should be diligent in the provision of information so that the earn out mechanisms are not applicable at a future date. It is therefore advisable to conduct the work in such a way as to ensure that the parties have extensive knowledge of what is being negotiated and the risks involved [31].

In that regard, due diligence has some important functions. Firstly, it serves to uncover risks of various natures and helps in the decision-making process in terms of shaping the agreement and finding a realistic price for the acquisition, because it allows for a better assessment of the target object. The slighting of asymmetries of information may be a direct effect of due diligence [32].

#### **3.1 The relationship between the parties involved**

The opposition of interests between the parties involved ends up being reflected in the performance of due diligence work. Generally, the due diligence is interested in detailing the legal, accounting, tax, labor, social security, financial, etc. situation of the target company. On the other hand, the latter always has the interest to protect itself [33].

The wear and tear in the relationship can be minimized through the establishment of confidentiality agreements, agreed before the start of the due diligence work, as well as by the stipulation of rules for the flow of documents and information between the parties, to avoid delays and conflicts [34], as summarized in **Figure 4**.

#### **3.2 The formation of a multidisciplinary team of specialists**

Given the scope and diversity of aspects to be observed during due diligence for the purpose of conducting a work of this nature, it is necessary to hire a

multidisciplinary team of professionals, usually composed of auditors, tax consultants and lawyers (specialized in the most diverse areas of law) [35], as show in **Figure 5**.

The role of accounting auditors, objectively speaking, is to verify how the operations of the investigated company are processed (through its accounting system, which gives rise to the financial statements), from the point of view of meeting the fundamental principles of accounting and accounting agreements. For this, they will perform, among others, the following steps: examination of corporate documentation, operational plans, product description, financial statements, contracts, accounts relating to suppliers and customers, physical inspection of facilities, etc., addressing of matters to be analyzed in more detail by tax consultants and legal advisors, as well as receipt of inputs from the latter, which may represent adjustments for the purposes of the pro forma balance sheet [36].

#### **Figure 4.**

*The relationship between the parties involved. Source prepared by the author.*

#### **Figure 5.**

*Multidisciplinary team of specialists. Source prepared by the author.*

*The Management of Tax Risks in Mergers and Acquisitions - The Importance of Tax Due... DOI: http://dx.doi.org/10.5772/intechopen.96964*

Speaking specifically of the due diligence work in the tax area, it can be said that the primary objective of tax consultants will be to identify - through the review of the tax procedures adopted by the company under review (compliance) - potential tax contingencies not yet identified by the company itself, since the contingencies already effectively identified will be analyzed and confirmed by the lawyers who will participate in the due diligence process [37].

The main role of legal advisors will be to discuss, analyze and confirm judicial issues and contingencies already effectively identified and known by the company investigated. They must comply, among others, with the following steps: verification of the nature, validity and adequacy of existing contracts, analysis and confirmation of active debts, lawsuits, infringement notices, installments, etc., verification and review of operating licenses, registration certificates, tax authority negative certificates, etc. [38].

### **3.3 Areas to be examined**

The multidisciplinary team will examine from the various angles of observation that their academic background and professional experience allow to evaluate, the following aspects of the target company, among others, as **Figure 6** displays:

#### *3.3.1 Corporate aspects*

Counsel for the buyer will invariably undertake a careful review of the organizational documents and general corporate records of the target company, including (among others): charter documents (certificate of incorporation, bylaws, etc.), good standing and (if applicable) tax authority certificates, list of subsidiaries and their respective charter documents, list of jurisdictions in which the company and its subsidiaries are qualified to do business, stockholder and voting agreements, minutes of stockholders' meetings since inception, including written consents to action without a meeting and minutes of board of directors and any board committees since inception, including written consents to action without a meeting [39].

#### **Figure 6.**

*Areas of the target company to be examined. Source prepared by the author.*

#### *3.3.2 Contractual relations*

It refers to the examination of contracts signed by the company, which have their execution in progress, with emphasis on financial and operational contracts, with a view to identifying possible default clauses in the event of disposal of controlling interest or other clauses that may affect the business. Legal proceedings involving the discussion of contracts should also be analyzed, with a view to identifying and quantifying possible contingencies [40].

The buyer will be concerned with all the target company's historical financial statements and related financial metrics, as well as the reasonableness of the target's projections of its future performance. One of the most time-consuming (but critical) components of a due diligence inquiry is the review of all material contracts and commitments of the target company. The categories of contracts that are important to review and understand include the following: guaranties, loans, and credit agreements, customer and supplier contracts, agreements imposing any restriction on the right or ability of the company (or a buyer) to compete in any line of business or in any geographic region with any other person, equity finance agreements and non-competition agreements [41].

#### *3.3.3 Property*

A review of all property owned by the target company or otherwise used in the business is an essential part of any due diligence investigation, with such review including deeds, leases of real property, deeds of trust and mortgages, title reports, other interests in real property, financing leases and sale and leaseback agreements, conditional sale agreements and operating leases [42].

This is the assessment of the documentary regularity of the main assets and the possible costs for the correction of irregularities found. Identification of the burden and encumbrances (mortgages, penhoras, servitudes, disposals, etc.) that fall on the properties. Supporting documents of the ownership of the main movable property should be analyzed to identify contingencies, burdens and encumbrances that may fall on them [43].

#### *3.3.4 Environmental issues*

Environmental due diligence is the other common workstream in a typical due diligence approach and focus on exposure in this area, as well as potential changes in run rate costs post-acquisition [44]. The buyer will want to analyze any potential environmental issues the target company may face, the scope of which will depend on the nature of its business [45].

The situation of environmental permits required for the exercise of the activity of the target undertaking should be examined. It is also necessary to analyze the judicial and administrative proceedings, to identify possible responsibilities for the repair of damage caused by it to the environment, as well as the regularity of the practices adopted in the context of its operations [46].

#### *3.3.5 Consumer right*

It is necessary to verify the situation of the relations maintained by the company with its consumers and with the consumer protection agencies. The existing cases against the company, whether in the administrative or judicial sphere, should also be analyzed to establish contingencies and the effects arising from possible irregular practice [47].

*The Management of Tax Risks in Mergers and Acquisitions - The Importance of Tax Due... DOI: http://dx.doi.org/10.5772/intechopen.96964*

#### *3.3.6 Labor aspects*

Human resources due diligence typically includes a detailed review of the company's relationships with its employees, such as union agreements, regular benefits, executive compensation, and post-employment obligations. In addition to flushing out exposures, it can help identify cost structure changes that can occur if the target's employees join the buyer's benefit plans postacquisition [48].

It refers to the evaluation of administrative and judicial processes, their routines adopted to identify possible contingencies and possible problems that may arise from the changes arising due to the proposed operation [49].

#### *3.3.7 Tax and social security aspects*

Tax due diligence may or may not be critical, depending on the historical operations of the target company, but even for companies that have not incurred historical income tax liabilities, an understanding of any tax carryforwards and their potential benefit to the buyer may be important [50].

This is the analysis of administrative and judicial processes, their tax and social security routines, to verify any problems, and those that may arise from the changes made with the implementation of the business [51].

Thus, in addition to the legal aspects, financial, strategic, technical, operational issues are analyzed, among others, so that, at the end of the entire analysis, a report is prepared that reflects the combination of the results found in all these different matters [52].

#### **3.4 The pro forma balance sheet**

After the completion of the exams by the multidisciplinary team engaged in the due diligence work, it is necessary to propose the appropriate adjustments in order to arrive a pro forma balance sheet, which will serve as the basis for financial projections (which will feed the business plan), the negotiation of the acquisition price, as well as the establishment of guarantees and escrow-account (in the case of acquisition), or for the determination of the exchange of shares (in the case of merger). A pro forma balance sheet is a financial document that discloses a business's assets, liabilities, and equity at a specific point in time. This financial statement is not prepared in accordance with Generally Accepted Accounting Standards (GAAP). It is considered more of a balance sheet projection [53].

#### **3.5 The report**

Due diligence work usually results in the preparation of a report, the form of which may vary depending on the interests of its recipient. Should the report describe the contingencies found, including, where possible, an estimate of theirs.

A due diligence report is the final report of the review conducted by the company in which the summary of the research done by the company is included [54].

Among the main objectives of due diligence are the identification of the main characteristics of the company; identification of possible obstacles to the conduct of the business and the quantification of existing contingencies; risk assessment; assistance in setting the price of the business; and assistance in the negotiation of contractual clauses [55].

Due diligence report is one of the most important records of conducting due diligence as it will be the final report that you will send to members of the executive team who will evaluate it. Without proper due diligence reporting, all the effort that you have put in conducting the due diligence will go astray [56].

It is necessary to highlight the agreed upon procedures scope used in the evaluation of the analyzed information, since the content of the report involves the evaluation of possible future effects of the situations, in fact, found, which rarely allows absolutely accurate estimates [57].

The agreed upon procedures scope differs from that of an annual audit [58]. A due diligence inspection must be quite separate from the annual audit because it is less profound [59].

Agreed upon procedures engagement is a type of engagement which auditor performs certain procedures that are agreed upon in advance. In this engagement, the auditor and specified parties agree that the auditor will perform specific procedures and report the findings. Likewise, there are usually three parties involved in the engagement, including the auditor, the client, and another third party. Unlike an audit, auditors do not give an opinion on subject matters in the agreed upon procedures. Auditors only report of findings based on the agreed procedures performed on the subject matter. Hence, the clients need to make their own conclusion on the subject matter [60].

Often, the interested party ends up assuming the risks of a limitation of scope due to its budget constraints or even the obligation to comply with time limits – an important fact, because due diligence is a time-consuming procedure, although it must be subject to the imposition of relatively short deadlines. Due diligence is also expensive for the party that must bear its costs, which increase in proportion to the size of the business and the number of problems found in it [61].

#### **3.6 The sizing of the guarantees**

The report shall indicate what guarantees would be required in the final contract to be signed between the parties. Thus, contingencies that are not quantifiable can be subject to specific guarantees, with a view to specifying value references to them, to be subject to subsequent adjustments, if they prove to be inaccurate. Those quantifiable can be directly deducted from the price, or in the event of uncertain occurrence, may be the subject of escrow accounts – a kind of deposit account, administered by a third party, whose values are released in the circumstances that the parties agreed to [62].

Where the purchaser determines that the seller is unlikely to have the resources to meet potential liability claims in connection with the transaction, the purchaser may seek the ability to hold-back (or escrow) a portion of the purchase price until the indemnity period (or as is more likely the case, a portion of the indemnity period) has expired [63].

Escrows are another common feature of transaction document, both the amount and duration of which can be increased as necessary to provide protection. Sometimes potential exposures can be so significant or clear as to the outcome if the target is audited that escrows will not provide a sufficient remedy. In these circumstances, alternate transaction structures, purchase price reductions, installment sales, and earn outs can all provide effective protection to a buyer.

The earn out clauses are defined by the parties and are detailed in the final contract. The payment method is detailed, and the use of escrow account can be established to ensure that if the earn out mechanisms are triggered, the buyer will obtain the adjustment in the amount to be paid [64].

Alternatively, when none of these remedies are sufficient, desirable, or obtainable (due to seller objections), buyers can consider purchasing tax risk insurance [65].

*The Management of Tax Risks in Mergers and Acquisitions - The Importance of Tax Due... DOI: http://dx.doi.org/10.5772/intechopen.96964*

**Figure 7.**

*Due diligence process flow. Source prepared by the author.*

Thus, we can summarize the due diligence process through the flow shown in **Figure 7** above.

### **4. The main aspects of due diligence in the tax area**

In today's corporate environment, acquisition transactions often occur on an aggressive time schedule or not at all. In addition, tax practitioners are often not consulted with respect to the tax sensitive aspects of the transaction until the final stages of the transaction, i.e., at the closing. For these reasons, familiarity with the basic tax framework for analyzing acquisition documents is essential [66].

Tax due diligence has its own importance, for two reasons. Firstly, tax risks often present significant hindrances for transactions [67]. Uncovering tax risks must be of special interest to the management of the corporation. Secondly, contrary to other fields of due diligence, tax law is subject to frequent, dynamical changes and puts rather complex demands on the inspection. It may not only have to deal with significantly different past, current and future tax regimes, but, in the case of international concern structures, it also must take the tax requirements of other countries into account. Therefore, efficient inspecting and auditing is of paramount importance in the tax arena.

Tax is one of the most important components that determine the overall profitability of a company. It is so important that it has its own place in the company's financial report in the name of items such as net profit before tax, net profit after tax, deferred tax, etc. Therefore, it goes without saying that the tax aspect cannot be overlooked in the due diligence during mergers and acquisitions [68].

Specifically, regarding the aspects to be observed in a due diligence work in the tax area, to be conducted by tax consultants, we could highlight the following.

#### **4.1 Measurement of liabilities and assets accounted for**

This is the due diligence of a research work, whereby the procedures and strategies of the tax area of the company under examination are evaluated, to verify whether the assets and tax liabilities accounted for are properly measured or if they are undervalued or overvalued [69].

#### **4.2 Identification of unaccounted assets and liabilities**

It seeks due diligence, also, to identify and measure unaccounted liabilities (hidden liabilities). Although it is not the main object of the work, attention should be paid to the possibility of identifying possible unaccounted or recognized tax assets that may be relevant to the negotiation process [70].

#### **4.3 Disclosure of contingencies not quantified**

Due diligence should report all tax procedures and strategies adopted by the company under investigation that may result in contingencies, but which, for various reasons (usually, lack of information and data), could not be quantified [71].

### **5. Conclusion**

In view of the foregoing, it can be noted that the accounting, tax and legal due diligence consists of a work of investigation and analysis of the procedures, practices and strategies of the company under examination in several areas, carried out within the scope and materiality agreed upon procedures, in order to determine whether the assets and liabilities were properly recognized, the degree of realization of these assets, the degree of risk of these liabilities, as well as identifying the existence of other unrecognized liabilities or unidentified assets, thus providing the company that is demanding due diligence, with the elements necessary for a correct pricing, negotiation and overall assessment of the merger or acquisition operation [72].

The tax review essentially begins with the following question: "Has the seller paid all its tax liabilities on a current basis, and has a reasonable reserve been accrued for known and anticipated adjustments likely to arise in current and future audits by various taxing authorities?" Although the procedures used to examine these questions will vary depending on the size of the deal and the complexity of the target's particular tax situation, these inquiries will generally entail a review and analysis of tax returns for all open years with special emphasis on the reconciliation between financial statement and taxable income and analysis of book and tax basis balance sheets, together with a review of the most recent revenue agent's reports made by relevant taxing authorities [73].

Once completed, these results are then compared to reserves for taxes, or the so-called "cushion", to determine whether the seller has adequately provided for any tax exposures. When representing financial buyers, another analysis that will often need to be done is a determination of when contingent tax liabilities may become due and payable. This obviously can tie into determining whether the buyer's cash flow projections with respect to the target are correct [74].

Succession to the seller's tax attributes is also an important area to review. Many companies today have net operating loss carryforwards and unutilized investment tax, foreign tax, and other credits. Depending on the type of acquisition structure, these tax attributes can represent significant cash savings to the buyer after the acquisition [75].

In view of all the exposed in this chapter, it remains clear the importance of the tax due diligence of the target company, as a way to minimize risks in the decision-making process of the managers of the purchasing company that may compromise the success of the merger and acquisition operation, as well as subjecting them to administrative and judicial processes, for non-compliance with their fiduciary duties of diligence and loyalty in relation to the company of which they are executives.

#### *The Management of Tax Risks in Mergers and Acquisitions - The Importance of Tax Due... DOI: http://dx.doi.org/10.5772/intechopen.96964*

Additionally, the study's results suggest that companies—in compliance with the guidelines and limits set by the board—choose the appropriate and specific techniques of risk management, especially those related to minimization, immunization, and transferring these risks. The recommendations derive from the need to identify and manage tax risks, from the point of view of good corporate governance practices.

This study may serve as a reference to companies in general, when studying, developing, and implementing recommendations for the identification and minimization of tax risks, as well as in the development of a work program that allows them to conduct due diligence work in target companies.
