When raising finance or selling your business, the other party will normally undertake financial and tax due diligence on the business.

During a tax due diligence, tax advisors will ask questions relating to the tax attributes of the business and review various source documents to identify any tax issues or uncertainties which have not been addressed ahead of the transaction. The potential outcomes can include buyers or investors requesting indemnities, a retention of the consideration, a reduction in price, a delay, or in a worst-case scenario, if the issue is significant enough, they withdraw from the deal.

In this article, our Transaction Tax team discuss six of the most common issues that they have identified whilst undertaking tax due diligence on target businesses in 2024.

R&D Tax relief claims

Recently, HMRC introduced new rules to help identify inaccurate or fraudulent R&D claims. HMRC’s "volume compliance" approach has increased the likelihood of discovering claims based on tenuous grounds or pushing boundaries on qualifying costs. Consequently, R&D claims are now considered a heightened risk and therefore increased due diligence on the R&D compliance profile of target companies is being undertaken. 

R&D claims should be supported with contemporaneous documentary evidence and disclosure to HMRC. Where an enquiry has been raised and the company is unable to agree the eligibility of claim with HMRC it is important to get specialist advice to reach resolution. In the current market, buyers or investors are unlikely to take the risk on R&D unless claims have been dealt with appropriately. 

Transfer pricing

Transfer pricing rules govern the prices at which related entities transact, covering supplies, inter group loans, administrative functions and other areas. Exemptions may be available for Small or Medium-Sized Enterprises (SMEs). Where exemptions are unavailable, entities must prepare corporation tax returns based on ‘arms’ length’ prices and document adherence to this principle.  

Often there is no documented transfer pricing approach which leads to uncertainty over whether the arm’s-length principle has been applied and whether the company would be able to demonstrate the position should HMRC raise an enquiry in future.

Overseas tax compliance

When companies operate overseas, such as making supplies or employing staff, compliance with foreign tax regimes is crucial. Common due diligence issues include triggering overseas VAT or indirect tax liabilities and reporting obligations, incurring employment tax and social security liabilities for non-domestic employees, inadvertently creating a permanent establishment with the associated tax obligations, and management of withholding taxes.

Careful attention is essential when starting activity overseas to ensure adherence to all local tax rules, to mitigate the risk of issues arising.

Off-payroll working

The off-payroll working rules are a prevalent area in diligence. The rules target tax avoidance by workers who provide services to clients through intermediaries. Accurate classification and documentation of these workers, such as directors and contractors, are essential to satisfy a tax due diligence review. Misclassification or poor documentation can lead a buyer requesting a price reduction to cover potential liabilities for PAYE and NIC, including penalties and interest, which they could inherit. There can be some simple and pragmatic protective measures that companies can take in advance of a due diligence.

Tax deductibility of corporate interest expense

Debt efficiency relies on the tax deductibility of interest which is subject to numerous legislative pitfalls. We have seen examples, where restrictions could have applied in relation to tax legislation on thin capitalisation, corporate interest restriction, hybrid mismatch rules and unallowable purposes. This typically results in a potential corporation tax liability with a buyer or investor seeking a price reduction or indemnity.  

Individuals holding shares or options

Companies often operate share incentive plans to attract and maintain talent. At the time of a transaction, it is usually the case that the employees or directors obtaining shares under the plan will make a significant gain. It is therefore often a key tax risk as the value could be subject to tax cost of c55% (PAYE and NIC).

The main issues we have identified are:

• Qualifying share options having not been notified in time or no evidence of notification
• Shares issued without s431 elections
• Lack of support for the valuation of share options or shares issued
• Issues with the legal documentation not meeting qualifying share requirements

Where shares are provided to employees or directors, employment related securities (“ERS”) tax charges may arise. It is important to note that ERS legislation is widely written and without due care it is easy to inadvertently create a tax liability under this legislation.

How JC can support you

If you are considering selling your business, we can help ensure opportunities are explored and potential risks are managed, pre-transaction. Carrying out a health-check can help make sure the business is ready for a due diligence and the shareholder value is protected. This provides peace of mind and a smoother transaction process where potential issues have already been addressed.

If you are interested in acquiring a business and would like our support with understanding the tax risks within the target business, our Transaction Tax team have the experience and expertise to support you.

If you would like to discuss any of the top six common issues or have any questions, please do not hesitate to get in touch with any of our Transaction Tax team members: Suzanne Brownie, David Rome, Cen Pang, or Indy Singh.