Due diligence investigation during a company takeover: complete explanation

What is Due Diligence?

Due diligence (DD) is a systematic investigation into the legal, financial and fiscal situation of a company prior to an acquisition or merger. The buyer — and sometimes also the seller (vendor due diligence) — thereby identifies risks that affect the purchase price, the guarantees and the structure of the deal.

You're about to buy or sell a company. Or you've heard the term “due diligence” and want to understand exactly what it means, how it works and what it costs. We would be happy to explain it to you.

Due diligence is the thorough preliminary investigation that takes place before a company takeover is finally completed. The goal: identify all relevant facts, risks and opportunities so that buyer and seller can make an informed decision — and pay the right price.

In this article we cover all aspects of due diligence: the meaning, the different forms, the step-by-step process, the checklist and the specific tax risks to look out for.

1. Due diligence: meaning and origin

The term “due diligence” comes from Latin and literally means “due care”. In business, it refers to the care that can be expected from a reasonably acting buyer before making a significant investment.

From a legal point of view, due diligence also has a protective function: by conducting thorough research, the buyer limits his risk of error or fraud. If the buyer discovers a problem after the purchase that he could have found upon thorough investigation, it is more difficult to hold the seller liable for it.

In Dutch acquisition practice, due diligence is standard in almost all transactions, from small family businesses to large listed companies. The scope and depth vary with the size and complexity of the deal.

2. Forms of due diligence: an overview

Due diligence is not a single investigation. Depending on the nature of the company and the deal structure, one or more types are executed:

In most medium-sized transactions, financial, tax and legal DD are carried out in combination. Commercial and technical DD are added as deal value and complexity increase.

3. Vendor due diligence: being prepared even as a seller

A vendor due diligence (VDD) is a due diligence investigation that the seller has carried out himself before potential buyers start their own investigation. This sounds contradictory, but it has major advantages:

• The seller knows exactly what risks there are — and can proactively address or price them.
• It speeds up the sales process: buyers can build on the VDD report instead of re-examining everything.
• It increases buyers' confidence and therefore usually leads to a higher sales price.
• In an organized auction procedure (multiple bidders), a VDD is almost standard.

Port Sight Tax provides vendor due diligence reports that present tax risks transparently, without causing unnecessary damage to the seller's negotiating position.

4. The due diligence process step by step

A due diligence investigation into a company takeover usually takes place in five phases:

Phase 1: Preparation and Data Room

The seller sets up a (digital) data room with all relevant documents: financial statements, tax returns, contracts, personnel files, permits and correspondence with supervisors. Parties sign a confidentiality agreement (NDA) before access is granted.

A well-organized data room benefits the seller: it exudes professionalism and reduces the lead time of the investigation.

Phase 2: The questionnaire (“request list”)

The buyer's advisors send a detailed questionnaire to the seller. This typically covers hundreds of questions divided into legal, financial, tax, commercial and operational issues.

Incomplete or slow response to the request list delays the process and arouses suspicion among the buyer. Timely and complete delivery of documents is therefore also in the seller's interest.

Phase 3: Analysis and Interviews

The advisors analyse the documents, identify inconsistencies and ask additional questions. For more complex issues, they conduct interviews with the management of the target company. In doing so, the tax advisor focuses specifically on tax returns, ongoing procedures and tax deferments.

Phase 4: The Due Diligence Report

The findings are compiled in a DD report. A good report not only includes an inventory of risks, but also quantifies them where possible and distinguishes “deal breakers” from manageable issues.

The tax part of the report — tax due diligence — deserves special attention: tax risks can be significant and must be explicitly included in the negotiation of price and guarantees.

Phase 5: Translation to the deal

Based on the DD report, parties negotiate adjustments to the purchase price, specific guarantees, indemnities or escrow arrangements. Sometimes a finding leads to the cancellation of the deal — but more often, risks are priced in or contractually covered.

5. Tax due diligence: the most underestimated risks

For us, tax due diligence is the heart of every DD process. Tax risks are often not visible on the balance sheet, but can still lead to significant additional taxes, fines and interest after a takeover.

What does tax due diligence investigate?

• Corporate income tax: have all returns been filed and taxes paid? Are there ongoing discussions or book investigations by the tax authorities?
• Sales tax (VAT): are there additional tax risks, for example due to incorrect application of exemptions or pro-rata deduction?
• Payroll taxes: are all employment relationships properly qualified? Are there risks related to freelancers, stock option schemes or expense allowances?
• Transfer tax: is there property that may not be taxed enough in previous transfers?
• Fiscal unity: is or was the target company part of a fiscal entity? If so, what are the joint and several liabilities?
• Tax deferments: are the temporary differences between commercial and tax valuations correctly included in the balance sheet?
• Compensable losses: how large are the deductible losses, and can they still be used after the acquisition?
• Transfer pricing: are intercompany transactions executed and documented on business terms?

Recovery and additional tax periods

An important point of attention is the period within which the tax authorities can levy. Most taxes are subject to a period of five years after the end of the tax year. For foreign tax debts, this period is even twelve years. This means that the buyer must stipulate a period of indemnification in the purchase agreement that covers at least these terms.

Tax risk example

For years, an offeree company has wrongly applied a VAT exemption to a service that should have been taxed. With an additional tax period of five years, this can lead to a claim of hundreds of thousands of euros — including tax interest and a possible offence penalty. Without a fiscal DD, the buyer only discovers this after the takeover.

6. Due diligence in the event of takeover: special points of attention

Due diligence in an asset/liability transaction

In principle, in an asset/liability transaction, the buyer does not take over a “tax history”: the tax debts and risks remain with the seller. However, fiscal DD is also relevant here: the buyer wants to know whether the transfer has the correct consequences for VAT (continuation requirement), transfer tax and any investment deductions that lead to a divestment addition for the seller.

Due diligence in a stock transaction

In a share transaction, fiscal DD is indispensable. The buyer inherits the entire tax history of the target company, including any debts and ongoing proceedings. The due diligence report forms the basis for the tax guarantees and indemnities in the purchase agreement.

Real estate due diligence

In real estate transactions — or in acquisitions where immovable property forms a significant component — the tax treatment of the property deserves extra attention. Examples include the VAT status of the property (leased or exempt), the review period for previously deducted VAT, the transfer tax position and any leasehold or building rights.

7. Due diligence checklist: the most important documents

Below is a brief due diligence checklist for the financial and tax side of an acquisition. This is a selection; a full request for information is considerably more extensive.

Tax documents

• Corporate tax, VAT and payroll tax returns (5 years)
• Final assessments and any objection and appeal procedures
• Correspondence with the tax authorities (book inquiries, rulings, agreements)
• Fiscal unit documentation (decision, termination, tax sharing agreements)
• Transfer pricing documentation (master file, local file)
• Compensable loss overview
• Documentation of investment deductions (energy, environment)

Financial documents

• Financial statements (3-5 years), including auditor's report
• Management information and recent monthly results
• Overview of all loans and securities
• Working capital analysis
• Overview of off-balance sheet liabilities and provisions

Legal documents

• Articles of association and shareholders' agreements
• Key customer and supplier contracts
• Key employment contracts, pension plans
• Ongoing legal proceedings
• Permits and Intellectual Property
  

8. How long does a due diligence investigation take?

The lead time depends heavily on the size and complexity of the company and the completeness of the data room. As a guideline:

• Small transactions (up to €5 million): 2 to 4 weeks
• Medium transactions (€5 — 50 million): 4 to 8 weeks
• Larger complex transactions: 8 to 16 weeks or more

A well-prepared data room significantly reduces the lead time. Sellers who have their due diligence documentation in order in advance are able to accelerate the process and thus reduce the uncertainty period.

9. Due diligence example: a case study

To illustrate the due diligence process, we describe an example case that we encounter in practice.

Situation

A family business in the manufacturing industry (turnover €8 million) is for sale. The purchase price is indicatively set at €4.5 million. The buyer requests us to carry out a fiscal and financial DD.

Findings of the tax DD

• In earlier years, the “target company” (the company being purchased) had wrongly claimed an investment deduction for assets that were partly used privately. Estimated risk: €85,000 in additional tax and penalty.
• Two freelancers who had been working for the target company for five years had all the characteristics of employment. Payroll tax risk: €140,000.
• An intercompany loan to an affiliate was never in writing and did not bear interest. This resulted in a transfer pricing risk of approximately €60,000.

Outcome

Based on the DD report, the purchase price was reduced by €250,000 and three specific tax indemnities were included in the purchase agreement for the identified risks. The buyer was thus protected against additional taxes that — if they had materialized — would have been directly borne by his return.

Port Sight Tax guides your due diligence — from A to Z

Thorough due diligence protects you as a buyer against unpleasant surprises and helps you, as a seller, to position your company optimally. The tax component is usually the most complex — and the most underestimated.

The Port Sight Tax team offers:

• Tax due diligence (tax DD) for buyers and sellers
• Vendor due diligence for a controlled sales process
• Tax structuring of the transaction
• Assistance in translating DD findings into a purchase agreement — together with legal partners.

Feel free to contact our team for an introductory meeting.