There was a time when only the giant corporations would be involved in situations such as mergers and acquisitions (M&A) requiring extensive due-diligence investigation. Today, the need for due diligence is occurring on a regular basis at all levels of business enterprises. Business ventures are pooling their resources in mergers to expand or survive. Tentative alliances are formed in search of product and regional growth. Exploratory attempts to establish feasibility of a union of corporate cultures are required more commonly in this global economy.

What Is Due Diligence?

Due diligence is the investigation by an investor or its advisors of the complete character of a target business. This target might be a prospective acquisition, a joint venture, a strategic alliance partner, a prospective public offering registrant or a potential investment. A target company might also perform due diligence on a potential investor, especially if the deal involves consideration other than cash. Even in a cash transaction, nonfinancial factors should be investigated to determine factors such as corporate cultures and strategies for future compatibility.

Financial Due Diligence

Once the lawyers and consultants conduct the strategic, operational and legal due diligence, financial due diligence becomes the major focus of investigation during a due diligence transaction. Financial due diligence involves analysis of the company’s historical, current and prospective financial statements, as well as tax returns and other financial data. Review of these documents can reveal the following crucial information: trends in revenue, profits, investor returns, growth rates and profit margins; contingent liabilities; transfer pricing issues; capital structure and financing terms; and balance sheet ratios, to name some of the major issues addressed. In an international situation, reconciling financial statements to U.S. based generally accepted financial principles (GAAP) might be necessary to achieve comparability.

Tax Due Diligence

In a cross-border transaction, tax due diligence can be an extremely onerous task. Not only is federal tax an issue, there may also be provincial, territorial, value-added and goods-and-services taxes. When multistate operations are involved, the focus widens to include state, city, county and parish taxes. The taxes involved would include sales and local, income, gross receipts, business activity, capital stock, employment and withholding taxes.

A tax due diligence would investigate the following areas of concern:

• Tax accounting issues: income recognition methods, inventory methods, accounting for research and development costs, depreciation methods and elections, amortization methods, related-party transactions, interest expense limitations and other methods of accounting for income or expense.
• Transfer-pricing issues: descriptions of intangible assets and ownership, documentation from target’s domicile country detailing intercompany transfers and cost-sharing agreements among affiliates.
• Sourcing of income — foreign: source of income by category or type of transaction, foreign country permanent establishment nexus, treaties in force and prior foreign losses deducted domestically.
• Sourcing of income — domestic: state tax nexus review, sales sourcing methods, apportionment factors and business vs. nonbusiness income determinations.
• Tax return filing positions — consolidated, unitary or separate return filing, federal and state tax credits and incentives, intercompany transactions and eliminations and deferral and exemption of income.
• Non-federal tax issues — provincial, territorial, state and local tax, internet sales, franchise tax issues, property tax issues, transfer tax issues, sales and use tax issues, value added tax issues and tax exemptions.
• Economic nexus issues — issuance of credit, use of intangibles, website hosting and internet solicitation.
• Unclaimed property issues — state of domicile requirements and exposure in states with business activities.
• Special purpose entities — pass through entities and treatment of “check the box” entities in the US where local treatment differs from federal treatment.
• Audit issues — prior and ongoing federal, state or local tax examinations, including sales, income and non-income based taxes, as well as unclaimed property audits.
• Reserves issues — income, franchise, business activity, gross receipts, sales and use taxes and unclaimed property reserves.
• Ancillary issues — successor liability, letter of good standing, bulk sales, casual sale exemptions and tax on the transaction.

Conclusion

These areas of investigation are only the tip of the iceberg. A complete due diligence project will investigate a vast amount of issues before concluding the feasibility of the transaction. International mergers require extensive review of the national cultures, as well as all legal and financial issues required in domestic mergers. With the shrinking of the globe, these cross-border endeavors will certainly become more commonplace.