Cross-border M&A readiness starts long before a company goes to market. Companies with international operations that haven’t addressed their cross-border tax compliance before going to market risk having deals restructured, devalued, or even killed.
Imagine spending years working and investing capital in a US corporation, hoping to exit at a substantial gain. Assuming you’ve done strategic tax planning ahead of time, you’d expect to pay little to no tax on that gain under IRC Section 1202. Then the buyer’s due diligence surfaces serious red flags related to international tax compliance. What happens next? The buyer may seek a material discount, request an expensive insurance policy, or worse, demand an asset sale instead of a share deal. In some cases, these issues and the negotiations that follow can put an end to the deal. Below, we outline the most common international tax issues that surface during due diligence.
International Tax Compliance Forms
Failure to file certain international information returns can carry steep penalties. For instance, failure to file forms associated with investments in foreign corporations (Form 5471 – Information Return of U.S. Persons with Respect to Certain Foreign Corporations) and foreign partnerships (Form 8865 – Return of U.S. Persons With Respect to Certain Foreign Partnerships) is subject to a penalty of $10,000 per form, per year.
For foreign-owned corporations, the failure to file Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business, carries an even greater penalty of $25,000. For more information, refer to this WG article here. Simply including these forms in the US tax filings is not always sufficient, as incomplete filings may also trigger these penalties. The submitted forms must be complete, accurate, and supported by the required records.
What makes these exposures particularly significant in an M&A context is the statute of limitations. When a required international information return is not filed, the statute of limitations for the entire tax return can remain open indefinitely. A buyer acquiring the equity of a company will inherit the risk associated with these open years and the full penalty exposure that comes with them.
Transfer Pricing
Failure to properly price intercompany transactions between US and foreign entities can result in significant tax deficiencies. IRC Section 482 requires that transactions between related parties be priced at arm’s length, meaning on terms consistent with what unrelated parties would agree to in similar circumstances.
For example, if a US company purchases materials from its foreign subsidiary at a price above fair market value, the IRS may adjust the US company’s taxable income to reflect an arm’s-length price, resulting in higher taxable income and taxes owed. This is what occurred in GlaxoSmithKline Holdings (Americas) Inc. (“GSK”) v. Commissioner, where the IRS determined that GSK’s US subsidiary had overpaid its UK parent for drugs. The case settled for $3.4 billion, the largest tax settlement in IRS history at the time.
In a due diligence context, the absence of transfer pricing documentation is a significant red flag, as it signals to a buyer that intercompany pricing was not carefully considered.
Withholding Tax Exposure
Certain payments of US source income (referred to as FDAP – fixed, determinable, annual or periodical income) made to foreign persons can trigger withholding tax obligations under IRC Sections 1441 and 1442 for the person making the payment. In the course of running a business, a US company may be making payments to foreign persons, such as dividends, royalties, or license fees, without recognizing the obligation they have to withhold and remit tax to the IRS.
Even though the withholding tax is technically imposed on the foreign recipient, the US company, as the withholding agent, can be held directly liable for the full amount of tax that should have been withheld, plus interest and penalties. These issues are often discovered late in the deal process, precisely because they tend to fall outside the scope of a company’s routine domestic tax compliance.
Permanent Establishment Risks
A permanent establishment (“PE”) is a concept under international tax law and most tax treaties that determines when a country has the right to tax a foreign company’s business profits. A PE can be created by maintaining a fixed place of business abroad, such as an office, warehouse, or workshop, but can also arise in less obvious ways. For instance, employees working remotely from a foreign country or a related person who habitually executes contracts on behalf of the US company can create a PE. The former has become more common after the pandemic, and some may think the use of a PEO shields the PE risk, but the reality may be otherwise.
Thus, US companies with cross-border activities may have unknowingly created a PE in a foreign country and have never filed tax returns or paid tax there. From an operational standpoint, this may have seemed inconsequential until the company decides to sell.
Sellers should proactively assess their PE exposure well before going to market. This includes reviewing where employees are located, how sales activities are conducted internationally, and whether any treaty positions have been relied upon without proper analysis or documentation.
International Tax Savviness Before Going to Market
All of the issues discussed above are discoverable during a deal process, and thus, they are preventable. A pre-sale international tax compliance review, conducted before engaging an investment banker or initiating a sale process, allows sellers to identify these exposures, remediate what is fixable, and develop a defensible position on what is not. Coming to the table with clean records and documented positions results in a stronger negotiating posture than being surprised during due diligence.
This is especially critical for sellers who structure their investment to take advantage of IRC Section 1202. The significance of the Section 1202 exclusion, allowing a qualifying shareholder to exclude up to 100% of gain from the sale of Qualified Small Business Stock (“QSBS”), has driven a growing number of founders and investors to plan for their exit through a share sale in a US C-Corporation. The potential tax benefit is extraordinary and is only available on the sale of stock, not assets. In practice, we’ve seen buyers forcing an asset deal when the due diligence risks are more than insignificant. If IRS Section 1202 was at play, the seller loses not only on the deal economics, but also on the tax benefit they structured their entire investment around.
Our International Tax team works with business owners, founders, and their advisors to identify and resolve these issues before they surface in a deal. Whether you are starting a new business, expanding operations abroad, preparing for a sale, or evaluating the acquisition of a foreign target, getting ahead of cross-border compliance gaps can be a significant investment for the future. Please contact a WG advisor for more information or if you have any questions.
