Sales tax consequences of mergers and acquisitions (M&A) are often overlooked. Potential sales taxes, both upon the transaction itself and historical liabilities, become material issues if not addressed during the due diligence phase of an M&A transaction. Identifying and quantifying unsettled sales tax concerns provides a buyer additional negotiating power to potentially decrease the purchase price. Knowing potential obligations also provides greater confidence with respect to understanding potential sales tax liabilities, post-acquisition compliance, and in the overall decision whether or how to proceed with the merger or acquisition.

Every M&A transaction consists of two sides that may hold adverse interests -- the buy and sell sides. Most key issues and areas of concern arise from the buy-side perspective and if neglected can be costly. Issues may arise at any point in M&A transactions; however, sales tax liabilities or traps most commonly arise as a result of the actions or inaction on the part of the selling company.

Developing a Due Diligence Team

When considering whether to engage in an M&A transaction, it is critical to establish a qualified due diligence team that can assist in identifying potential sales tax issues, as well as developing a plan for addressing or resolving issues. The potential benefit of investing in the development of a due diligence team and the time necessary to flush out any hidden issues far outweighs the cost. The issues discussed below are some of those that, if not proactively identified and addressed can result in one or both participants being subject to unnecessary sales tax liabilities.

When contemplating an M&A transaction, the primary focus should be the deal structure and the target's operations. There are many elements in how a deal is structured that can contain hidden sales tax issues, including whether the transaction is an asset or stock deal and whether the buyer is acquiring all or only a portion of the target.

Asset Acquisitions

Asset acquisitions involve purchasing some or all the specific assets of a company, including equipment, inventory, buildings, and vehicles. Significant tax issues can arise as a result of an asset transaction due to the possibility of underlying transfer taxes including sales tax. It is critical to evaluate and understand where each material asset is located, how the assets are used, and whether sales tax was paid on the original purchase. Sales tax is generally due on the transfer of assets unless a specific exemption exists and the applicable exemption is properly documented. It is common to believe that because assets, such as inventory and equipment, are used in an exempt manner, they are not subject to sales tax. For example, when acquiring machinery, equipment, and inventory located in a state with an established machinery and equipment exemption, a party may believe the assets are not subject to sales tax, and there is no additional documentation needed to substantiate the exemption. However, disregarding the exemption requirements, including documenting the exemption via an exemption and/or resale certificate may result in sales tax liabilities if the transaction is reviewed by state tax authorities.

Aside from incorrectly assuming assets are de-facto exempt, improperly relying on general exemptions can result in hidden sales tax liabilities. One example of these hidden sales tax liabilities can arise due to a purchaser improperly relying on casual or isolated sales tax exemptions. Casual or isolated sales tax exemptions typically provide relief from sales tax for sales occurring outside the normal course of business. However, the scope of casual or isolated sales tax exemptions varies by state. Washington State provides an exemption from the Business & Occupation tax for casual or isolated sales but does not afford the same exemption against sales tax when the entity is engaged in the business of selling tangible personal property. In contrast, Texas provides for a sales tax exemption for casual or isolated sales so long as the transaction is limited to one or two transactions over a 12-month period and the entity does not habitually engage in such business. Therefore, researching the applicability of the exemption and following the prescribed steps to document the exemption is critical to ensure the assets acquired are not subject to sales tax. Additionally, some states such as New York, do not offer a bulk sale exemption. However, the state requires bulk sale compliance forms which, if not filed, can result in the acquirer being responsible for any unpaid taxes incurred by the seller prior to the acquisition. Such forms are often required to be populated and/or signed by both parties and may require significant time for review by the state taxing authority prior to the sale being finalized. These requirements should be identified and addressed early.

Stock Acquisition

Stock acquisitions involve purchasing only the equity of the selling company. Such transactions contain many benefits that include avoiding re-titling transferred assets that remain with the transferred entity, retaining the entity name/EIN, and maintaining current sales tax registrations. Nevertheless, any existing and unresolved sales tax liabilities may transfer to the buyer as a successor. The buyer may be required to absorb the historical sales tax liabilities of the seller to the extent any exist, barring the filing of bulk sale forms that protect the buyer from being responsible for unsettled sales tax liabilities of the seller. Proper due diligence can reduce acquired risks, including reviewing the historical sales tax compliance of each company to ensure they are in compliance with required tax rules and regulations, reviewing the taxability of products and/or services which generate the target's revenue, reconciling taxes collected to taxes remitted to the proper jurisdictions and evaluating the exemption certificate management system to ensure valid customer exemption certificates are retained for exempt transactions.

Understanding the target company's revenue streams and assessing the sales taxability of such streams is critical during the due diligence process to minimize the possibility of absorbing past or incurring future sales tax liabilities. To the extent past sales tax liabilities are identified, the liability may be minimized by pursuing voluntary disclosure agreements (VDAs) with one or more state tax authorities, as well as considering adjusting the purchase price of the target and/or establishing an escrow until such items are resolved. Possible future liabilities can be minimized by properly evaluating the taxability of all future transactions and ensuring proper prospective tax compliance.

Generalizing revenue stream(s) of the seller can result in a false sense of security with respect to sales tax. For example, a company providing complex cloud computing services (e.g., Software as a Service or digital automated services) may have taken the position that the company is merely providing a non-taxable sale of services. However, many states impose taxes to broadly reach these transactions, and the trend is an increase in taxing digital services and digital goods. Another example relates to whether the buyer is exempt from tax. A company may assume that operating as a subcontractor and making sales to a prime contractor working for the federal government is exempt from sales tax due to federal government exemptions. However, the federal government immunity requires a direct sale to the federal government and does not extend to sales to contractors that are later used in the performance of contracts with the federal government. Failing to properly analyze the selling company's revenue streams and material customer contracts can result in undiscovered tax liabilities.

Division Acquisition

Generally, when an entire company is acquired, the company's tax function, systems, and personnel are also acquired. In contrast, when only a division of a company is acquired, often particular business operations are the only assets transferred. Acquiring a division of a company contains many hidden sales tax issues that may not be apparent until late in the deal process or even after the deal is closed. When a portion of a company (i.e., division) is purchased, the acquirer may need time to establish a tax department and/or finance department to handle the division's tax obligations. Further, significant time may be required to apply for and establish tax registrations, implement tax engines and systems for proper tax calculations, and implement a process for collection and remittance of the tax due. Without ample time to establish the required tax functions/processes, the buyer is at risk of incurring tax liability, penalties, and interest.

In these circumstances, the parties may negotiate a transition services agreement (TSA) during the M&A process, whereby the seller continues to prepare, and file required tax returns for a stated period of time post-closing, while the buyer establishes or stands-up a new tax department or retains a third party to prepare future returns. The TSA may help minimize the risk of falling short of their collection, filing and reporting requirements post-closing. The TSA can be included in closing documents and include covenants such as requiring the seller to document the tax functions, processes, and timelines, as well as maintain tax collection and filing obligations. A buyer may need to explicitly ask for a TSA when the transaction closes quickly, when the acquiring company is not prepared to undertake the compliance function, or when the information required to prepare the returns is not readily available. Poorly drafted TSAs can result in future disputes, so carefully consider all needs, expectations, and requirements, including the solicitation of outside counsel or advisors.

Company Footprint and Exemption Certificates

Acquiring a company can inherently alter the buyer's nexus footprint (i.e., activity triggering taxation within a jurisdiction) and sales tax filing obligations. Ignoring whether the additional assets, employees, and sales establish nexus in new jurisdictions may create future liabilities if not addressed early in the transaction.

When reviewing whether a company has nexus either prior to or after the closure of an M&A transaction, both physical and economic nexus must be considered. Physical nexus includes payroll as well as real or personal property within a taxing jurisdiction. Some states include specific thresholds for the determination of physical presence. However, the nexus standard is less clear in many other states. As a result, nexus standards should be reviewed on a state-by-state basis.

Like physical presence, economic nexus rules vary widely from jurisdiction to jurisdiction based on a multitude of factors that include the total number of transactions, the total revenue generated, the type of transaction generating the revenue, and whether the revenue generating activity is subject to tax. In recent years these rules and regulations have become more standardized as a result of the U.S. Supreme Court's 2018 Wayfair decision in which the Court approved the use of a sales or transaction threshold. However, the interpretation of these rules is likely to create nuances and disparities among jurisdictions in the coming years. By determining whether nexus was established and identifying distinct revenue streams, a company can evaluate whether they have a registration requirement in a state and subsequently determine if there is a collection and remittance responsibility based on their revenue generating activity. A registration requirement may exist even where a tax liability does not, and in this instance, M&A participants should determine if the target company has been filing correctly pre-acquisition and how to register and file correctly post close.

Once the locations in which a company has had or will have nexus are known, evaluating the steps necessary to either maintain or achieve compliance can reduce these liabilities. These steps often include the pursuit of a VDA, which as mentioned previously, can serve to limit the liability of the acquiring company inherited by the buyer from prior periods. In preparation for closing an M&A transaction where a material liability is known to exist, the parties should be aware of any covenants or restrictions on the pursuit of VDAs subsequent to the deal closing.

Another commonly ignored step which can result in unnecessary sales tax or administrative costs is failing to de-register the prior existing legal entity if their operations are to be absorbed into a new company. This can often lead to the receipt of notices on accounts that an acquirer may not have access to, and in such a case, a liability may arise and increase unbeknownst to the company. De-registering a taxpayer in a jurisdiction may trigger a desk audit, account reconciliation, or notice as part of the process.

The Takeaway

The issues that arise prior to, in relation with, and after any M&A transaction are varied and nuanced. The structure of the acquisition, state(s) of operations, including the location of assets, employees, and customers, can all affect the possibility of incurring hidden sales tax liabilities. By reviewing the activities of the acquired company, both individually and in combination with the buyer's activities, it is possible to identify those areas that can give rise to potential sales tax liabilities so that an action plan can be put in place to address them. Contact an Andersen advisor to learn how to evaluate the potential sales tax consequences of any M&A transactions you may be considering.