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Tax Due Diligence: What is it and why is it conducted?

Publication date/update: 24.06.2024
Tax Due Diligence is a comprehensive examination and identification of all risks associated with acquiring, absorbing, or merging a business. It is crucial to acquire only a "clean" business, meaning companies with a solid reputation. Typically, the absence of tax liabilities is considered one of the aspects of a reliable reputation.

Tax due diligence is conducted before significant commercial transactions or long-term partnerships with counterparties. In this article, we will thoroughly examine tax due diligence and its procedures.

Objectives of Tax Due Diligence

Typically, due diligence involves three parties: the client (bank, investor, company), the firm being audited, and the independent company conducting the audit. What is its objective? To identify and assess tax risks that could impact the company's profitability and financial status. The results of the audit can significantly influence the transaction, potentially leading to a price reduction or the imposition of other conditions by the buyer. An independent expert must analyze the company's operations over the past three years, with particular attention to the most recent reporting period.

If the identified tax risks materialize, the company's financial condition could deteriorate. Timely ordering an audit and heeding the independent expert's opinion can help take measures to prevent issues swiftly and efficiently. The buyer should conduct due diligence to diagnose deal-breaking factors or to seek reasons for price reduction. Identifying tax risks allows for including loss compensation clauses in the contract if these risks materialize. We believe professional audits should be regularly ordered. The more active and complex the firm's operations, the more attentively tax risks should be identified and optimized.

The procedure is best performed before transactions with counterparties, third parties, offshore companies, or online transactions. The report can aid in deciding whether to sign a contract with a dubious counterparty offering attractive terms. The final scope of tax due diligence depends on the company's field of operation and materiality level.

What is important to review during the audit?
  • The taxation system under which the enterprise operates
  • The accuracy of tax calculation and payment. This primarily concerns profit tax, VAT, property tax, personal income tax, and insurance contributions. The audit may also analyze the correctness of calculating land and transportation taxes if these amounts are significant.
  • The use of tax benefits and other special tax regimes. 
  • The search for ongoing and closed tax-related court cases.
  • Compliance with transfer pricing rules.
  • The analysis of carried-forward losses.
  • The analysis of the availability of all primary documents.
It's equally important to focus on unusual transactions that the company might engage in, including loans and credits, intra-group transactions, and expense analysis without properly documented records. Experts will necessarily review the course and results of desk and field tax audits.
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Basis for Conducting Due Diligence

Tax due diligence relies on data obtained from the company under review. What might interest the expert?
  • Accounting and tax reports.
  • Tax registers.
  • Data from electronic document management systems.
  • Information on accounting policies.
  • Agreements with counterparties – suppliers and buyers.
  • Data on settlements with the Federal Tax Service.
  • Decisions resulting from tax audits.
  • Audit reports.
  • Internal regulations, including employment contracts and rules for dealing with counterparties.
  • Transfer pricing documentation.
  • Primary documents, which may be requested as originals or copies.
During due diligence, experts may send requests to any company divisions and branches to obtain documents. Additionally, the specialist may work on-site, examining all necessary records and papers. Specific information can be gathered through employee interviews. The expert will also utilize open sources and databases.
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Features of Analyzing Tax Accounting Policies

Reviewing this aspect helps determine the extent to which accounting practices comply with tax regulations. If conducted according to outdated rules, operations are automatically considered risky in terms of potential disputes. Comments from previous tax audits or auditor reports are grounds for assessing future work risks. For instance, an auditor's report might indicate uncertainties in fully assessing the quantities of raw materials and finished goods. Expenses on raw materials are accounted for in profit tax deductions during their release to the production line. If it's found that the quantities of produced goods and used raw materials do not match for a given production cycle, there could be grounds for tax manipulation. In such cases, documents must be meticulously checked to ensure the correlation between the volume of produced goods and consumed raw materials.

Analysis of Tax Audit Risk Appointments

From the perspective of the Federal Tax Service of Russia, there are 12 risk criteria that may warrant a tax audit. The most significant include:
  • Low tax burden compared to peer enterprises.
  • Significant deviation in profitability levels in financial reports from industry norms.
  • Losses over several tax periods.
  • Higher growth rate of expenses compared to the growth rate of sales revenue.
One factor alone poses a low risk for an audit. However, the concurrence of multiple conditions increases the likelihood of a field audit.

Results of Tax Due Diligence

Upon completion, the independent expert will prepare and send a comprehensive report to the client, detailing identified risks and estimating the potential scale and impact of any issues. All risk factors that could affect future tax audits and other procedures will be highlighted.

The report's format can vary based on prior agreements: it could be a paper or electronic document, a presentation, or a table. It's crucial to thoroughly detail all existing risks.

Common Issues Uncovered During the Audit
  • Risks related to intra-group operations: This includes signs of business fragmentation, gratuitous transactions within the group, intra-group services not supported by documentation, often associated with large service expenses.
  • Calculation risks: Human error in manual calculations, the use of incorrect indicators for tax calculation, etc.
  • Documentary risks: Loss of original documents, contracts, or primary documents lacking counterparty signatures.

Differences from Audit

Audit and due diligence have different objectives. Audits prepare for tax authority inspections, whereas due diligence aims to verify the accuracy of dealings with the Federal Tax Service. Due diligence also assesses the legitimacy of tax benefits and preferences. If any organizational schemes appear dubious, it may lead to the cancellation of a transaction.

Audits cover the entire enterprise, while due diligence can focus on specific aspects, investment projects, transactions, or managerial decisions. Transaction analysis can be conducted before or after the transaction's completion.
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