Tax due diligence in carve-out transactions

The strategic value of tax due diligence in carve-outs

Tax due diligence plays a different role in carve outs than in traditional acquisitions. The business being sold has often operated for years inside a larger corporate group, with shared systems, intercompany arrangements, and historical restructuring that may not be fully visible at first glance.

For buyers, diligence helps confirm whether expected tax benefits, such as net operating losses (NOLs) or interest deductions, are actually usable and whether there are hidden exposures that could impact both pre- and post-acquisition tax filings.

For sellers, diligence provides clarity around what tax attributes are truly being delivered with the business and helps avoid last minute surprises that can disrupt pricing or delay closing.

In both cases, diligence informs deal structure, purchase price adjustments, escrows, and indemnities—directly affecting transaction economics.

Inside the diligence process: What to expect

A robust diligence process is collaborative and data driven. Here’s what executive teams generally should expect from those conducting due diligence:

1. Data Collection: Gather historical tax returns, past acquisition agreements, schedules of tax attributes, and documentation of prior tax positions.
2. Attribute Analysis: Assess what tax attributes exist (e.g., NOLs, credits, asset basis, etc.) and whether there are limits to their use.
3. Exposure Identification: Review ongoing audits, uncertain tax positions, and any potential liabilities across all tax areas that could transfer to the buyer.
4. Structuring: Use these insights to inform deal structure, purchase price adjustments, indemnities, and integration plans post-close.

A cautionary tale: The perils of scoped-down diligence

To illustrate the risks of insufficient diligence, consider the following real-world scenario:

A private equity firm (Buyer) acquired a carved-out business unit from a large multinational corporation (Seller) for $200 million. It was a classic carve-out deal and was structured as an asset purchase, which Buyer believed would largely insulate it from Seller’s historical tax exposures. The target business had substantial U.S. operations, but a relatively small footprint across several foreign jurisdictions. Seller had undergone an internal restructuring prior to the carve-out.

To expedite the deal and reduce costs, Buyer's executive team decided to limit the scope of tax due diligence. They focused heavily on U.S. federal and state tax matters, assuming the international activity was immaterial. Believing the risk was low, they agreed to a general tax indemnity from Seller, capped by a $1 million escrow.

Several months after the transaction closed, Buyer's new finance team began integrating the foreign operations. They discovered that, as part of the pre-carve-out internal restructuring, Seller had eliminated substantial intercompany account balances between the foreign entities that Buyer had acquired and entities that Seller had retained.

This "cleanup" of intercompany accounts, which seemed like a simple accounting entry, had triggered significant, unforeseen tax consequences in the respective countries. Foreign tax authorities deemed the elimination of these balances to constitute constructive dividends or capital contributions, resulting in an unexpected tax liability of $5 million for withholding taxes and other local indirect taxes.

Because Buyer had not identified this specific risk during its limited diligence, this risk was not carved out for special treatment in the purchase agreement. Buyer’s only recourse was the general tax indemnity, which was capped at $1 million.

While Buyer was able to recover $1 million from the escrow, it was left responsible for the remaining $4 million in tax liabilities. The assumption that an asset purchase and a "small" international presence mitigated risk proved to be a multimillion-dollar mistake. While the $4 million liability was not large in the context of the overall deal, this multimillion-dollar liability discovered post-transaction constituted a material sunk cost to Buyer.

Key diligence focus areas for executives

Here are some key due diligence areas in carve-outs:

Information as a negotiation lever

The value of tax diligence lies not just in risk identification, but in how findings are used. Well supported diligence insights allow leadership teams to:

• Negotiate purchase price adjustments or escrows tied to identified risks.
• Allocate responsibility for known issues through targeted indemnities.
• Make informed decisions between asset and stock structures.
• Reduce reliance on broad, capped indemnities that may offer limited protection.

Once a transaction closes, negotiating leverage disappears. Diligence is the point at which value can still be preserved.