Tax Due Diligence.
Mapping liabilities and contingencies.

When to perform tax due diligence

• M&A — buyer: before signing the SPA (Stock Purchase Agreement) — DD identifies liabilities that become a holdback/escrow clause or a price reduction
• M&A — seller: before starting the sale process — vendor DD (“sell-side DD”) prepares the company, anticipates critical points, avoids surprises at closing
• Capital investment (VC, PE): before the contribution — protects the investor from assuming historical liabilities
• IPO: part of the prospectus required by the CVM — reports material liabilities
• Change of corporate control: it changes the party liable for taxes — DD ensures the buyer knows the exposure
• Corporate restructuring: spin-off, merger — liabilities may migrate between entities under specific rules

Typical scope of tax DD

1. Mapping of covered taxes

All federal, state and municipal taxes applicable to the target company’s operation:

• Federal: IRPJ, CSLL, PIS, COFINS, IPI, Employer INSS, IOF, II
• State: ICMS, ICMS-ST, ITCMD
• Municipal: ISS, IPTU, ITBI

2. Analysis of ongoing administrative and judicial proceedings

Mapping of:

• Tax assessments at DRJ or CARF
• Ongoing writs of mandamus
• Annulment and refund actions
• Tax foreclosures
• Classification by probability of success (favorable, partial loss, total loss)

3. Mapping of contingencies

Risks not yet materialized in an assessment but that may become a liability:

• Operations relying on a contested thesis
• Exposure in an ongoing audit
• Risks from an aggressive structure
• Pending ancillary obligations

4. Analysis of ancillary obligations

SPED, eSocial, EFD-Reinf, ECF, ECD, DCTFWeb over the last 5 years. Identification of systematic discrepancies that may trigger an audit.

5. Recovery opportunities

Unused tax credits that can be recovered — Theme 69, Theme 779, Theme 163, late credits. Generally enhances the value of the company pre-acquisition.

Methodology in 4 phases

Phase 1 — Information gathering (1-2 weeks)

Request to the target: supply contracts, corporate acts, tax returns (IRPJ, ECF, ECD, SPED), financial statements, administrative and judicial proceedings, structured planning acts.

Phase 2 — Analysis (3-4 weeks)

The team reviews documentation, cross-checks data, identifies liabilities and contingencies. For large companies, it may involve access to the target’s system (virtual data room).

Phase 3 — Q&A with the target company (1-2 weeks)

Clarification of specific questions, request for supplementary documents, analysis of contested technical issues.

Phase 4 — Consolidated report (1 week)

The deliverable contains:

• Executive summary (1-2 pages) with classified risk
• Detailing of each identified liability (description, amount, probability)
• Table of contingencies by class (probable, possible, remote)
• Recovery opportunities
• Recommendations for the SPA (holdback, escrow, indemnity clauses)

Typical total time: 6-9 weeks for a mid-market company.

Impact on the deal

The result of the tax DD feeds directly into the negotiation:

• Price reduction — an identified liability becomes a discount on the enterprise value
• Escrow clause — a portion of the price held in a restricted account for 5 years (the tax statute of limitations) to pay liabilities that materialize
• Indemnity clause — the seller commits to reimburse liabilities identified in the DD that materialize
• Gross-up clause — the seller is liable for the tax on the indemnity, guaranteeing a net amount to the buyer
• Walk-away — in extreme cases (a material liability that compromises the transaction), the buyer can withdraw from the deal

A well-conducted DD can save 5-30% of the enterprise value in deals where there are material hidden liabilities.