Accounting, Analysis and Governance in Complex Deals
Due Diligence
BMME303
Accounting, Analysis and Governance in Complex Deals
Roadmap
Due Diligence
- Motivation for and basics of Due Diligence (DD)
- Applying DD-Frameworks with focus on Risk Assessment
- Tax DD incl. tax basics
- EBITDA Adjustments in Financial DD
- Advanced DD in Guest Lecture: Commercial/Strategic DD & Synergies
- Economic Effects of DD
Starting at the End
Due Diligence
Let’s start asking questions:
What are we reading?
Who reads it (when)?
Why was it written?
Due Diligence
Definition
Systematic (i.e., appropriate & required) analysis of a transaction
Purpose and Objectives
- Reduce information asymmetries: understand business (of target)
- Risk identification / risk reduction
- Establish liability framework & document evidence
- Shape structure of transaction
See Dreher and Ernst (2022) for additional details
Analysis of a Transaction?
Due Diligence
Due Diligence Streams
Financial
Tax
Commercial/Strategy
Legal
IT
HR
[…]
Who Cares?
Due Diligence Streams
Example: Bayer acquires Monsanto
2016 for \(>\) USD 60bn
The deal led to major financial and legal troubles, especially due to lawsuits over Monsanto’s Roundup weedkiller
USD 10bn - 20bn to settle claims/proposed settlements/provisions set aside
Acquisition heavily strained Bayer’s finances
See also this Ask FT summary
→ we can only speculate about the diligence in the acquirer’s legal due diligence
Who Cares?
Bayer acquires Monsanto
Asking Better Questions?
Our Approach
Develop questions & answers along a specific DD stream: Tax Due Diligence
→ Tax issues/efficient tax planning matters in any transaction: always among DD streams
→ Add: understand basic tax triggers in transactions
→ Easy to apply concepts to streams with other focus, such as Financial DD
Tax Due Diligence
Selected DD Streams
Throwback
Menti: What Factors Lead Firms To Acquire a Firm in Another Country?
Tax Complexity & Relevance in Complex Deals
Tax Complexity & Relevance in Complex Deals
Selected DD Streams
Tax Complexity
Significant driver of deal complexity
Ability to better assess the after-tax cash flows resulting from a transaction offers strategic and financial value
Tax complexity can impact economic decisions (e.g., on (structure of) transaction)
But why are taxes that important?
Step Aside: Taxes
Why are taxes that important in complex deals?
Tax A tax is a levy by a public entity which does not constitute an entitlement to something in return and is imposed on everyone who meets the criteria of a tax act
Who is Taxed? Taxable entity is the entity deemed liable to taxation by a tax act. In the case of corporate income tax, the taxable entity is the corporation
What is Taxed? Tax basis is the factual situation to which the respective tax act links a tax liability. In case of the corporate income tax, tax basis is the taxable income
Corporate Income Taxation
Overview Taxes
Note: tax law is country-specific. This overview is not country-specific but captures the essence of many tax systems around the world.
Corporate Income Taxation
Overview Taxes
Tax basis/taxable income of a business (e.g., corporation) is its profit
Profit is determined by measuring a change in net assets from \(t_{-1}\) to \(t\)
Profit = net assets\(_t\) – net assets\(_{t-1}\) + withdrawals – injections
Profit in Transactions?
Overview Taxes
Example: Merger
Assets are “moved” from transferring to receiving entity
BCo: all assets/liabilities are withdrawn and net assets decrease to zero
How does tax law value such transfers? Impact on Profit?
Hidden Reserves
Overview Taxes
Profit in Transactions?
Withdrawals (e.g., all assets in a merger) are generally considered to take place at Fair Value
Book Value of assets are based on historical costs & adjustments (GAAP & Tax Acc.)
If fair value exceeds book value, this Hidden Reserve causes an increase in profit
If BCo’s assets contain hidden reserves (e.g., from IP) → merger causes profit
Taxes & Transactions
Overview Taxes
Taxable Events
Rule of thumb: consider transactions as a disposal of what is transferred at fair value
Hidden reserves in what is transferred cause taxable gain from transaction
Applies to any transaction (e.g., acquisition, reorganization) and any level (e.g., shareholders of target)
What is the underlying economic problem when transactions (e.g., mergers) are deemed as taxable events?
Taxes & Transactions
Overview Taxes
What is the underlying economic problem when transactions (e.g., mergers) are deemed as taxable events?
Liquidity Effect
- Transactions/withdrawals trigger taxes (outflow of liquidity) but do not generate liquidity
- Companies might refrain from economically viable transactions
- Taxation locks business in current state of the world
→ Solution?
Tax Free Transactions
Overview Taxes
Carryover Basis
Implement selected exemptions in tax law that allow transactions to take place in a tax-neutral manner: tax-free transactions at carryover basis
Example cont’d
Upon approved request: consider withdrawal at BCo from merger at book value
Book values of assets are carried over to receiving ACo
Tax is effectively deferred, not free. Carryover exemptions apply often to reorganizations and stock-paid acquisitions.
Efficient Tax Planning
Tying Things Back to Tax DD
→ Consider the role of taxes when maximizing after-tax returns in transactions
All Taxes
- Explicit Taxes (taxes payable to taxing authorities)
- Implicit Taxes (taxes that are paid indirectly)
All Parties (consider tax implications for all parties: global/multilateral, rather than unilateral approach)
All Costs (consider all costs of the transaction (e.g., restructuring costs))
Tax Minimization Strategies \(\neq\) Effective Tax Planning!
Implicit Taxes
Tying Things Back to Tax DD
Implicit Tax on a tax-preferred/free investment is the tax rate that, if applied explicitly to a fully taxable investment, would leave a return equal to the before-tax rate of return on the alternative investment
Since taxes might influence deal structure, parties to the transaction might be inframarginal
Mechanism? Minimum- and maximum-prices demanded and offered can diverge → taxes have a valuation implication
Tax Due Diligence
Stepping back
Tax Due Diligence
Selected DD Streams
Where are we?
Due Diligence is a systematic analysis of the transaction
→ Transaction can trigger taxes: Recommend Actions to be taken in tax DD report?
→ Tax DD goes beyond as it (always) is a Tax Impact Analysis: conclusions from this anticipated tax audit?
Step #1: By whom am I mandated for what?
Information Requirements Differ
Tax DD
By whom am I mandated?
Financial Buyer: participation only for limited time and scope → tax cash effects
Strategic Buyer: long-term tax effects → tax optimized integration
Scope of Work
Tax DD
By whom am I mandated for what?
Tax Due Diligence under tight deadlines
Timely evaluation of available information: efficiency is key
Scope of Work of tax due diligence: restricted by time and content/subjects
Add: different requirements for buy side and sell side clients
Scope of Work
Tax DD
By whom am I mandated for what?
| Buy Side | Sell Side |
|---|---|
| Focus on protecting the acquirer from inheriting/creating tax issues | Tax Fact Book or Vendor Due Diligence |
| Identification of (pre & post-acquisition) tax risks | Creating a clean tax narrative to maximize selling price |
| Identification of (post-acquisition) effective tax planning | Preparation of information for potential acquirers to support negotiation |
Step #2: Where do/don’t I find relevant information?
Internal Information
Sources of Information
Target provides information (but hostile takeovers exist!) that is needed to perform (tax) due diligence.
Always ask for
Financial Statements incl. Management Report and P&L of past five financial years
Tax Balance Sheets of past three assessment periods
Tax Assessment Notices of past three assessment periods
[…]
External Information
Sources of Information
Acquirer can employ information from external sources (e.g. commercial register)
Advantages of limiting information to external sources first?
External Information
Sources of Information
Advantages of limiting information to external sources first?
Notes
Internal information may be classified as trade secrets
Often employee representatives must be involved: speculations among employees
Data Room
Sources of Information
Required information for examination can be made available to prospective buyers by means of a virtual or physical (on-site) data room
How to protect sensitive data?
Establish data room rules
Personalize access & accounts
Document (by way of implemented protocol) access
Restrictions to multiplication of information (e.g., restrict downloads)
Virtual Data Room (VDR) service provider example dataroomx.de
Tax Due Diligence
Tax Risks
Step #3: How do I identify Tax Risks?
How to identify effective post-acquisition tax planning?
How and why identify historical tax risks?
Check this guide by Bain & Company on important steps in DD
Ex Post Perspective
Tax Risks
Tax effects & risks that are determined and predominantly influenced by economic decisions that take place at/ex post the transaction
Efficient Tax Planning
Structure of the transaction
Carryover possible/beneficial?
Financing strategy (e.g., debt push down)?
Integration & eventual disposal of the target?
Tax Impact Analysis
Tax Risks
Historical Perspective
Tax effects & risks that are determined and predominantly influenced by economic decisions that take place ex ante the transaction
→ determined by a third party (target)
→ why relevant for acquirer?
Acquisitions & Tax Risks
Tax Impact Analysis
- Scope of tax DD covers entire target
- b/c tax risks transferred (!) to acquirer as a whole:
- Determine Magnitude
- Determine Propensity to Materialize
- Determine Timing
Selected Tax Risks
Selected Tax Risks
Tax Impact Analysis
Broad
Non-compliance with tax regulation by target / its management
- Misdeclaration
- Pending Payments
Compliance with tax regulation by target / its management
- Tax treatment assets/liabilities
- Target’s structure
Changes in the underlying facts and circumstances with tax effects
Misjudgment of facts and circumstances for tax purposes
Selected Tax Risks
Tax Impact Analysis
All Time Favs
- Tax Loss Carryforwards / Change of Ownership
- Group Tax Regime(s)
- Transfer Pricing
- Vesting Periods from prior reorganizations
- Interest Deduction Limitations
- Real Estate Transfer Tax
- Value Added Tax Compliance
Selected Tax Risks
Magnitude, Propensity, Timing
(i) identify a material tax risk, (ii) determine propensity to materialize, (iii) timing?
Selected Tax Risks
Magnitude, Propensity, Timing
Arm’s length Principle: an arm’s length interest rate (loan agreement with bank) would have been 10%. In this case, the interest would have amounted to EUR 1m (arm’s length portion). However, the actual interest amounts to EUR 2m and is therefore EUR 1m too high (non-arm’s length portion)
The portion of the interest payments that does not meet the arm’s length principle constitutes a “hidden profit distribution” → may not reduce the income of the target but did!
Taxable income of target needs to be upward adjusted by EUR 1m (→ material tax risk)
Tax audits (→ timing) with heavy focus on transfer pricing (→ very high likelihood of detection)
Tax Check List
Sources of Information
- Tax balance sheets or tax reconciliation accounts for the last three to five years of the target and its subsidiaries
- Last tax audit report of the fiscal authorities, including wage tax external audit/sales tax special audit reports
- Tax returns and tax assessment notices (including loss assessment notices) for the last three to five years
- Shareholder resolutions and minutes of shareholder meetings, in particular profit distribution resolutions of the last three to five years
- Organizational chart of the group structure with complete name designation (shareholders in the target company, subsidiaries, sub-subsidiaries) with details of the participation quotas and excerpts from the commercial register
- List of all branch offices and other offices or places of business
- Contracts, agreements and arrangements between the company and its affiliated companies (such as control agreements, profit and loss transfer agreements, transfer pricing documentation, loan agreements)
- Documents on intra-group transactions (disposals), restructuring or acquisitions (contributions) within the last seven years
- Contracts between shareholder-managing director and company
- List of the company’s real estate, including the relevant purchase agreements, stating: a brief description of the respective real estate, the respective address, the land registry office and the land registry number, the last determined market value
- Annual financial statements of the company (balance sheet, profit and loss statement and notes to the financial statement) together with the management report and the auditor’s report for the last three to five financial years
- Information on independent auditors appointed by the company
- List of outstanding tax liabilities
- List of tax benefits/rulings
- Disputed tax claims/List of disputes with the fiscal authorities and proceedings in front of tax courts
- List of current or pending criminal tax proceedings
Due Diligence Report
Magnitude, Propensity, Timing
Step #4: How do I document the tax risks that I could (not) identify?
Due Diligence Report serves documentation purposes
- Timing (deadlines & scope!) and addressees must be considered
- Issuing the report in time allows for (necessary) adjustments to the scope of the tax due diligence
A Full Scope Due Diligence requires a DD report; a Red Flag Report instead highlights material tax risks only.
Due Diligence Report
Magnitude, Propensity, Timing
Step #4: How do I document the tax risks that I could (not) identify?
- Executive Summary with most material insights, often in keywords
- Comprehensive presentation of the analysis:
- reviewed documents
- identification and quantification of the resulting tax risks (?)
- proposals for risk mitigation and recommendations for further action (?)
→ tax risk assessment follows a staircase design
Staircase Design
First Stage
May material tax risks be mitigated/avoided/triggered by designing the structure of the transaction?
Second Stage
Quantification of material tax risks per period
Third Stage
Guarantee for identifiable tax risks
Fourth Stage
Abstract Guarantee for presumed tax risks
Staircase Design
DD Outcomes
Efficient Tax Planning
h, p and t known
→ Purchase Price Reduction
→ Quantificationh, p or t unknown
→ Guarantees
→ Contract Designh, p and t unknown
→ Abstract Guarantees
→ Contract Design
Contract Design
DD Outcomes
Acquirer and Seller must (?) agree on who carries tax risks economically
Acquirer is usually subject to material tax risks of target. If caused by seller, acquirer wants to protect by means of a corresponding guarantee. Material tax risks of a target are therefore usually reflected in tax clauses
Tax Clauses
Contract Design
Tax Indemnity
- Relate to identifiable tax risks of target ex-ante to the transaction
- Usually, seller is obliged with respective payments
Abstract Guarantees
- Aim at unknown/not-identifiable tax risks of target
- Contain assumptions about the target’s tax risk profile that are priced into the acquisition
- Tax clause settles payments if assumptions are violated
Financial Due Diligence
Selected DD Streams
Financial Due Diligence
Why?
“[…] we’ve seen experienced acquirers take a blank-sheet approach to foster creativity, rather than anchor the exercise in a financial due-diligence model, which often leads to incremental synergies.”
Koller, Goedhart, and Wessels (2025)
Financial Due Diligence
What?
“The function of financial due diligence is to provide the potential buyer with an accurate and objective picture of the target company’s net assets, financial position, and results of operations”
Dreher and Ernst (2022)
Financial Due Diligence
What?
Balance Sheet Verification: Confirm existence and valuation of assets, equity, liabilities, and provisions
Performance Assessment: Determine sustainable profit and cash flows based on historical financial data
Scope
Financial Due Diligence
→ Focus on historical, current, and planned goes well beyond a financial audit (i.e., one year of historical information)
EBITDA Adjustments
Selected (Historical) Topic in FDD
Profitability as Key Valuation Metric
Widely used in transaction multiples (EV/EBITDA)
Enables comparability across companies and industries
Adjust (historical) EBITDA by: (i) normalizing for one-time, anomalous, or non-recurring items, and (ii) incorporating forward-looking or deal-driven adjustments (“pro forma”) \(\Rightarrow\) assess the sustainability and quality of earnings
EBITDA Adjustments
Selected (Historical) Topic in FDD
Adjustments as Drivers of Dispute?
- No standardized methodology exists for EBITDA adjustments
- Calculations are inherently subjective in nature
- Adjustments must be case-specific to target company circumstances
- Requires careful professional judgment in financial due diligence
Example
EBITDA Adjustments
| Description | FY \(t_{-3}\) | FY \(t_{-2}\) | FY \(t_{-1}\) |
|---|---|---|---|
| EBITDA as per Financial Statements | 205.0 | 220.0 | 230.0 |
| Normalizations | |||
| Restructuring Expenses | 10.0 | - | 2.0 |
| Gains from Asset Sales | (3.0) | - | (8.0) |
| Release of Provisions | - | 1.0 | (1.0) |
| Warranty Costs | 6.0 | - | - |
| Bad Debt Losses | - | 1.0 | - |
| Payment Received from Written-Off Receivable | - | 1.0 | (1.0) |
| Repair Costs | 4.0 | - | - |
| Consulting Costs | - | 1.0 | - |
| Legal Costs | 4.0 | - | - |
| Transaction Costs | 0.5 | - | 1.0 |
| Non-Recurring Income | - | 1.0 | (1.0) |
| Non-Recurring Expenses | (2.0) | 2.0 | - |
| Non-Operating Income | (2.0) | (2.1) | (2.2) |
| Total Normalizations | 17.5 | 4.9 | (10.2) |
| Normalized EBITDA | 222.5 | 224.9 | 219.8 |
| … | … | … | … |
Example
EBITDA Adjustments
| Description | FY \(t_{-3}\) | FY \(t_{-2}\) | FY \(t_{-1}\) |
|---|---|---|---|
| … | … | … | … |
| Pro Forma Adjustments | |||
| Acquisition of Company A | 1.0 | 1.0 | 0.5 |
| Discontinuation of Business Unit B | 1.0 | 1.0 | 0.2 |
| Ramp-Up Losses | 6.0 | - | - |
| Synergy Effects | 0.8 | 0.9 | 1.0 |
| Carve-Out Effects | (4.0) | - | (4.0) |
| Currency Effects (Translation Effects) | (1.0) | (3.3) | (0.1) |
| Total Pro Forma Adjustments | 3.8 | (1.4) | (2.4) |
| Pro Forma Adjusted Normalized EBITDA | 226.3 | 223.5 | 217.4 |
Example
EBITDA Adjustments
Notes
Example shows the presentation of a normalized pro forma adjusted EBITDA for the historical period under review. The starting point is EBITDA, which was derived from the audited annual financial statements. In the EBITDA adjustments, a distinction is made between normalizations and pro forma adjustments.
Based on the annual financial statements, EBITDA improved continuously between FY \(t_{-3}\) (EUR 205m) and FY \(t_{-1}\) (EUR 230m). However, the quality of earnings analysis reveals that adjusted EBITDA has fallen rather than risen over the historical period under review. Normalized pro forma adjusted EBITDA decreased from EUR 226.3m to EUR 217.4m.
Wrap Up
Due Diligence
Due Diligence
Wrap Up
Due diligence is ultimately about enabling better decisions with imperfect information under time pressure
What we did: frameworks and techniques that help you approach these challenges systematically
What you add: judgment, creativity (?), and clear thinking about complex deals
Thank You!
Appendix
Definitions
Tax Value Concepts
Book Value: value of an asset as recorded on a company’s balance sheet
Fair Value: The amount of money for which it is assumed an asset or liability could be exchanged in an arm’s length transaction between informed and willing parties.
Partial Value: pro rata amount of a fictitious purchase price for the entire business that an acquirer would allocate to an individual asset.
Hidden Reserve
Difference between book value and partial/fair value.
Hidden reserves stem from an undervaluation of assets, an overvaluation of liabilities, the unjustified formation of provisions, or from the omission of step-ups in the event of an increase in the value of an asset.
Tax Free & Taxable Transactions
Tax Free Transaction
In a tax free transaction, there is no immediate tax event, and hence, there is no immediate taxable gain or deductible loss at the completion of the transaction. Instead, the tax consequences are deferred until taxable gain/loss is realized.
Taxable Transaction
In a taxable transaction, a taxable gain (or deductible loss) is realized at the completion of the transaction. The gain is equal to the difference between the partial/fair value of the consideration received and the tax basis (book value) of what is transferred → basis step up
Implicit Taxes
Example in Scholes et al. (2020)
Consider two types of bonds. Type B (benchmark) is a corporate bond that is fully taxable (i.e. interest income is taxable income and taxed by applying a (specific) tax rate, e.g. 30%). Type A (alternative) is a tax-exempt bond (e.g. a tax-favored municipal bond in the US).
Implicit Taxes
Example in Scholes et al. (2020)
cont’d
The implicit tax rate, \(t_{Ia}\) on a particular investment, \(a\), is that tax rate that, if applied explicitly to fully taxable bonds, \(b\), would leave a return equal to the before-tax rate of return on the alternative investment:
- \(R_b\) risk-adjusted before-tax return on fully taxable bond
- \(R_a\) risk-adjusted before-tax return on the alternative investment
\[ R_b \times (1-t_{Ia}) = R_a \] \[ t_{Ia} = (R_b - R_a)/R_b \]
Implicit Taxes
Example in Scholes et al. (2020)
cont’d
With \(R_b = 10\%\) and \(R_a = 7\%\): although investors do not pay any explicit tax on the interest earned from holding municipal bonds, they pay the tax implicitly (here to the issuer of the tax-exempt bond) at a tax rate of 30% through a lower before-tax return.
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Titlepage photo by Dennis Möller on Unsplash
References