Tax Due Diligence: It’s Not Just for Acquisitions

11-1-13-Crowe.pngWhen you hear the phrase “tax due diligence,” you probably think about investigating the tax situation of a target company in a potential acquisition transaction. But what about performing due diligence on your own management’s ability to accurately administer, account for, and report your company’s tax positions? Taxes are typically one of a bank’s largest expenses. Deferred tax assets are often a sizable balance sheet asset and regulatory capital component. Taxes also are a key focus of Securities and Exchange Commission financial statement reviews and a frequent cause of financial statement restatements and material weakness citations. So perhaps a bank’s board of directors, or at least its audit committee, should perform periodic tax due diligence on its own organization.

But what questions would you ask, particularly given a board’s role is one of policy-setting, strategic direction, and high-level oversight rather than daily management? If you understand what management should be doing to control risk in this area and where or why controls malfunction, you can tailor your queries to effectively address your organization’s tax complexity profile.

What Should the Controls Be?

Consider these four areas of risk and control in the administration and financial reporting of income taxes:

  • Are the bank’s tax expense and balance sheet positions accurately computed?
  • Are these positions recorded in the general ledger and reported in financial statements accurately and adequately?
  • Are tax payments and tax filings made timely and accurately? Are tax notices responded to promptly?
  • Are the individuals involved in tax administration staying abreast of and adequately addressing developments in tax law, accounting rules, and the company’s own activities?

Critical to the first three items are adequate checks and balances. That means management should be making sure that tasks are actually completed and completed correctly, and that there is a reconciliation of general ledger tax activity to the financial statement computations and to the return filings, particularly if the three areas are handled by different people or groups.

Vital to the fourth item is knowledge about changes in tax or accounting rules and the firm’s activities. For instance, the bank might have opened a loan production office in a new state or bought an investment banking firm in a new country that will affect the company’s taxes. Do the relevant people have a process to discover the event, the requisite skills and resources to understand how it affects the company’s taxes, and the ability to incorporate those effects into tax computations and returns?

Another due diligence focus for the board is oversight of the company’s internal controls.

Where or Why Do Internal Controls Malfunction?

There are myriad reasons controls break down, but consider these three factors:

  • Personnel turnover might lead to replacements who might not bring the same level of tax knowledge and who need time to learn the company and establish internal communication channels. Additionally, balls could drop while vacated positions are being filled.
  • The company is large and dynamic, has many personnel in many divisions and locations, is taxable in many jurisdictions, and undertakes numerous acquisitions or other changes in processes, service offerings and markets. It has a complex tax profile where application of the law is not always clear and tax authorities could easily disagree.
  • Internal auditors, whose job it is to test the effectiveness of company processes and controls, might lack the requisite specialized tax knowledge to adequately assess the tax function and controls, thus missing potential warning signs.

Tailoring Queries to Your Organization

For a smaller community bank, the personnel issue might be most critical and the board more hands on about tax matters. Ask about the tax qualifications of the people performing the work, particularly those reviewing it, and what management’s process is for making sure there is adequate internal tax knowledge and coverage. Ask whether outside experts are involved if needed.

For a large organization with sizable tax and finance departments, the ever-changing and complex environment might lead you to ask about management’s process for identifying and determining whether to take any aggressive tax positions and how tax personnel learn of corporate developments.

For an organization of any size, you might inquire how comfortable the internal auditor is with assessing the effectiveness of the tax function and its controls and whether a third-party expert should be used for this purpose. Don’t hesitate to ask the financial statement audit team for comments on management’s tax processes and abilities.

Consider the potential for sizable error in your company’s tax positions, and don’t hesitate to perform a little in-house tax due diligence.

What’s Under the Hood: The Audit Committee’s Role in M&A Due Diligence

As the regulators become more inquisitive about the due diligence process during an M&A deal, audit committee members should play a role when reviewing a proposed transaction.  In this video, Justin Long, a partner with the Bracewell & Giuliani law firm, discusses some key areas and red flags that the board should focus on when evaluating a target bank’s compliance environment.

Avoiding Valuation Problems During an Acquisition

Crowe_WhitePaper.pngAll too often after an acquisition, an acquirer’s management team is surprised by the difference between its pro forma balance sheet projections and the final independent, third-party valuations. These unexpected changes in valuation could have a significant impact on the acquiring institution’s regulatory capital requirements and future earnings potential.

To avoid such last-minute surprises, more institutions are involving their third-party valuation teams earlier in the process—during the due diligence phase—in order to provide preliminary valuations. Involving valuation teams earlier in the process has grown more popular as the pace of Federal Deposit Insurance Corporation-assisted acquisitions has slowed and as banks accelerate the pace of open-bank transactions, which allow more time for planning and due diligence.

An acquiring bank’s management team needs a clear understanding of the valuation issues that are likely to arise during the due diligence process.  Read more from Dan McConaughy and Chad Kellar from Crowe Horwath LLP on the benefits of making valuation an early part of the due diligence process.

M&A Post-Closing Legal Claims: Negotiating the Best Deal

Baird_Holm_1-28-13.pngOne of the most important issues for a buyer in an acquisition is the handling of legal claims following the closing. It is very common for issues to arise after the closing of a purchase of a business that can result in burdensome and expensive lawsuits. The parties tend to focus on negotiating indemnification provisions in the contract late in the negotiation process, and these provisions are often the last significant issue agreed upon by the parties. These provisions generally provide that the seller will indemnify (or hold harmless) the buyer from any and all liabilities incurred after the closing to the extent such liabilities arise in connection with a breach of the representations and warranties made by the seller in the definitive agreement, a breach of the post-closing agreements made by the seller or as a result of the actions of the seller prior to the closing.

As the post-closing liabilities incurred by the buyer can significantly undermine the value of the acquired business, and many of the seller’s liabilities can be difficult to discover in the due diligence process, it is important for buyers to understand the post-closing indemnification provisions and make sure that the indemnification provisions are clear and understandable. In that regard, below are some key considerations with which all buyers should be familiar before negotiating the post-closing indemnification provisions.

No. 1: Require the seller’s principals stand behind representations and warranties.

Sellers will typically prefer that representations and warranties that are subject to indemnification be made solely by the selling entity. As the overall liability of the selling entity will often be limited to any amounts held back or placed in escrow, the incentive of the selling entity to confirm that all representations and warranties are 100 percent accurate may be limited. To the extent that the seller’s individual principals are required to make the representations and warranties with the selling entity, the risk of personal liability will often not only provide another source of funds to pay indemnification claims, but will cause the seller’s principals to take a much more active role in confirming the accuracy of the representations and warranties and any disclosure schedules.

No. 2: Require adequate credit support.

As the selling entity will likely distribute the sale proceeds to its owners shortly after the closing, it is important that the buyer not rely solely upon the credit of the selling entity for the payment of post-closing indemnification claims. The most common method of credit support is for a portion of the purchase price to be placed in an escrow account with a third-party escrow agent to be used to pay future indemnification claims. Buyers should generally request that amounts be held in escrow for a period of not less than 12 to 18 months, and escrowed amounts should not be released to the seller until any and all potential indemnity claims have been fully and finally resolved. An alternative to setting up a potentially expensive and complicated escrow process is to hold back a portion of the purchase price to be paid over time and allow the amounts of any indemnified claims to be set-off against amounts otherwise due as the deferred purchase price. As sellers will be required to rely upon the credit of the buyer to pay the deferred purchase price, it is likely that a buyer will require security with respect to the amounts owed by the buyer as deferred purchase price.

No. 3: Make sure caps and other limits on indemnification make sense.

One of the most highly negotiated aspects of indemnification arrangements is the liability caps, baskets and other limitations on indemnity. Buyers should typically request that the indemnity cap be as high as possible, but no lower than 20 percent of the overall purchase price. In addition, sellers will often request baskets requiring individual indemnity claims and/or the total amount of indemnity claims to be in excess of a specified amount before claims may be made against the seller. While these types of baskets are generally a reasonable protection against small harassing claims by the buyer, buyers need to make sure that the individual amounts are appropriate given the likely nature of the indemnity claims. For example, to the extent a buyer expects a large number of small claims, a basket based upon the total amount of all indemnity claims would be more appropriate than a basket relating to each individual indemnity claim. In addition, to the extent baskets are used, there is no need for a “materiality” qualifier, because the parties have already agreed to what constitutes material damage.

No. 4: Don’t agree to cap claims relating to fraud.

While it is reasonable for the seller to request certain baskets and caps on indemnification claims, buyers should not agree to allow such limits and caps on any breaches of representations and warranties that are fraudulent or intentionally misleading. These types of breaches should be excluded as the potential damages for such claims could be significant and the seller and its principals should be strongly incentivized to act in an ethical manner.

No. 5: Do your due diligence.

While buyers sometimes believe that strong language in the representations and warranties and indemnification provisions will provide adequate protection for undiscovered liabilities, liabilities that turn up post-closing are typically larger and more material than the parties anticipate. In addition, the caps and other limitations on indemnification provisions, as well as qualifications contained in the representations and warranties, may leave the buyer without an adequate remedy. In addition, indemnification claims can be costly and time consuming to enforce. Accordingly, to the extent feasible, buyers should independently verify all information contained in the representations and warranties during the due diligence process. As we often tell our clients, there is simply no alternative to good due diligence.