Due diligence: quantification of tax risks

While direct tax rates are decreasing everywhere across the world, the rates for indirect tax keep rising.

An average multinational company has amounts of over five billion euros of indirect tax flowing through the books. A small error of one percent can make the difference between profit and loss, and thus poses a material risk at a due diligence investigation, in the event of an acquisition.

The Big4 audit organizations report in their indirect tax surveys on the increasing risks of additional tax assessments, substantial penalties and loss of reputation, as the amounts of indirect tax keep rising and KPIs and controls of indirect tax are lacking. Extremely large amounts of money without appropriate control are at stake.

The internal indirect tax function within companies – if present at all – is typically unstaffed and is no budget is available to effectively manage the indirect tax position globally.

A due diligence investigation not only serves the purpose of mapping the material risks, but quantification of these risks is also essential.

A traditional due diligence investigation normally involves completion of standard questionnaires and retrieval of standard information, which is provided by the vendor via a specially designed data room. When possible incorrect VAT determination is detected, a rough estimation of the magnitude of the VAT risks is made on the basis of turnover and sales figures. This is not ideal for both vendor and purchaser, as it concerns much guesswork and thus usually provides an insufficient framework in price negotiations.

The question is whether there is a method of determining the exact additional tax assessment in an efficient and effective way.

It should first be noted that the starting point is always the identification and recognition of material indirect tax risks. Every industry has its own specific risks and further differentiation is necessary due to the complexity of the implemented business model, and the risks arising therefrom with respect to indirect tax.

Roughly speaking, the largest VAT risks in the following areas are:

Cross-border transactions: legitimate application of the 0% rate
Inter-company transactions: correct application of the VAT determination in the chain
Input VAT: justified input VAT deduction

In order to quickly gain insight into the level of tax risks (i.e. calculation of the potential assessment), statistical sampling can be used. By selecting a few elements (euros), the reliability of the composition of tax items can be determined to a high degree of certainty, and on the basis of identified errors in the sample, the exact amount of additional tax assessment can be calculated.

The strength of this method lies in the fact that statistical sampling is the tax audit method used by the Dutch Tax Authorities. Calculation is done on the basis of the parameters that the Tax Authorities apply themselves in their tax audit. This method is explicitly approved by the highest Dutch court.

Statistical sampling requires a different approach and process of information retrieval compared to the traditional method. In practice, this means the following steps are to be taken:

Defining the scope (see aforementioned main VAT risks);
Defining the required data from the systems;
Defining the sample size based on parameters of the Tax Authorities;
Obtaining the data file provided by the vendor on the basis of instructions;
Drawing the sample;
Obtaining the selected (physical) invoices, claims, documentary evidence or other documents provided by the vendor on the basis of instructions;
Fiscal assessment of the tax items;
Calculating the amount of potential additional tax assessment on the basis of detected errors.
Defining the scope and correctly designing and drawing the sample requires a multidisciplinary approach. In addition to knowledge on indirect tax, expertise in statistical sampling demanded.

A sample is not solely relevant for due diligence of the purchaser. Also the selling party can benefit from sampling with regard to preparatory work for a prospective takeover. When a statistical sample is drawn and the results are acceptable, the conclusions can be proactively taken into a data room. This can serve as extra evidence of implementation and maintenance of an effective control framework.

Moreover, in the Netherlands the possibility exits to align the results of the findings with the Tax Authorities, which provides more certainty regarding the adopted tax position. All this can positively contribute to the sales negotiations, including the amount of guarantees and/or discounts that are to be provided.

A good start is half the battle, and can lead to significant cost reductions in the future.

Read more: Pre audit via statistical sampling