Regrets and retentions: international expansion in the M&A context

May 2025  |  SPECIAL REPORT: MERGERS & ACQUISITIONS

Financier Worldwide Magazine

May 2025 Issue

As important as the UK is to the world’s gross domestic product, according to the International Monetary Fund, it represents just over 2 percent of the global total. International expansion therefore represents one of the greatest value-creating opportunities for UK businesses.

In pursuit of this opportunity, the effort put into chasing revenue abroad is often not matched by ensuring that the back office keeps up with this expansion. Businesses can expect things to catch up with them, often during a sales process, resulting in some regrets and possibly a retention.

In October 2024, the first Labour government budget in 14 years rocket-boosted the M&A market. Yet multiple deals did not make the budget day deadline due to internationalisation compliance problems highlighted in due diligence. In several deals intended to complete pre-budget, this lack of international expansion experience led to many regrets and several retentions against claims imposed on sellers under sale and purchase agreements.

So how can companies go about things differently, to prepare for the sale process or the next round of investment?

Taxable presence

A company’s first foray into a new territory is often to follow the activities of existing clients. As those clients internationalise, so do some suppliers. Alternatively, as a company’s reputation grows, it starts to field enquiries from abroad, leading to its first client win outside its home country.

This is great for the business and bodes well for the opportunities to grow in new markets, but it raises many valid, logistical questions. Who is going to spend time away to service this new opportunity? How long will they be there? Where will they stay? How often will they return to the UK?

What is commonly overlooked is an understanding of whether the activities of serving that first client are sufficient to create a taxable presence in the country. When due diligence gets into full swing and questions start coming about the activities in these new territories, there is a scramble to reconstitute records and understand whether tax should have been paid abroad on those international customer wins. Too often, the answer turns out to be ‘yes’ or ‘probably’.

A sale of the company does not usually follow that first international client success. By the time of the company sale, there are often several countries where this ‘permanent establishment’ exposure exists, and the group has unwittingly created a permanent establishment in several countries.

This leaves the seller having to navigate a failure to comply with payroll obligations, unfiled tax returns, late payments of tax on locally generated profits and a need to claim double tax relief to offset the overseas tax against the UK tax already paid.

Tax residence

Commonly, the increasing scale of international opportunities leads to a discussion about whether a new local entity should be set up to house those local operations.

At first blush, this is a good thing. It helps to mitigate the risk that the parent company is operating through a permanent establishment and has created a non-UK taxable presence. But who should be on the board of the new local entity?

Generally, those best qualified to carry out the role should be appointed. For many businesses just starting to expand into new territories, it is usually the same people who are responsible for driving the business in the home territory.

If the local entity’s key strategic decisions are being made by UK-based individuals, it creates a risk that management and control of the local entity is being exercised in the UK. In turn, that creates a risk that the local entity might be, or become, tax resident in the UK, as well as tax resident in its country of incorporation. That creates a Pandora’s box of issues, which surface in due diligence. Fixing dual residence is challenging and potentially expensive, possibly crystallising an exit tax charge.

Even if a business has UK-based directors of the new local entity, it should be possible to operate in a way that minimises or eliminates the risk of the local entity becoming dual resident. Operating within some clear guidelines and keeping well-documented evidence of sticking to those guidelines should enable local entities to be run effectively, as well as avoiding the dual residence trap.

It is easier to set up a system for how to operate a non-UK entity so that arguments around residency can be avoided than it is to unpick the problem in the heat of a deal.

Sales taxes

It is a common misconception that the way it works at home is mirrored in other countries. However, taking a UK mindset to the tax system in other countries, the US in particular, can be a very expensive leap. Nowhere is this truer than when it comes to sales taxes.

Sales tax compliance is both complex and expensive. It is, however, a cost of doing business in the US and getting it right from the outset is a lot less burdensome than trying to remediate the problem retrospectively.

As transactions were completed at speed in the run-up to the budget, the impact of poor sales tax compliance came up repeatedly. The non-compliance was not really arguable. Sellers were left with few options but to agree that the unreported and unpaid sales taxes were to be treated as a debt-like item in a locked box or completion accounts. This often included the costs of correction which, post-deal, sometimes meant a second adviser overseeing the corrective action on behalf of the seller, adding to the cost and disruption.

It will not always be possible to fix everything before a deal, but it should be possible to stop non-compliance and address previous issues so that the corrective cost is minimised. Otherwise, sellers must deal with the argument that the price adjustment should include the maximum amounts due, including penalties, interest and duplicated costs of professional oversight for both buyers and sellers.

Withholding taxes

The UK has a relatively benign regime for withholding taxes. It benefits from an extensive network of double tax treaties, a limited number of taxes in respect of which withholding tax is applied and no withholding tax on dividends. The same cannot be said of other jurisdictions.

In the run-up to the budget, a failure to withhold tax on cross-border payments was a common theme. It can be easy to miss this when expanding into new geographies, many of which impose withholding taxes on payments of interest, royalties and even fees for technical services.

Withholding taxes are a particularly painful area to unpick after the event, in part because there are two sides to the debate: the withholding tax that should have been remitted to a tax authority and the credit for the recipient.

While problems are navigable, in the context of an M&A deal, complexity comes from how to make sure that if or when the credit arises, it is available to the sellers to mitigate the final tax bill split between two jurisdictions and prevent the buyer gaining a windfall benefit.

Transfer pricing

For decades, multinational corporations have played a game of financial chess, shifting taxable income across borders to minimise tax liabilities. At the heart of this strategy lies transfer pricing (TP). While designed to ensure fair taxation, TP rules have become a battleground of conflicting regulations and mounting compliance burdens.

Mismatches between TP rules in different jurisdictions create tax headaches. Take a UK-incorporated company that qualifies for an exemption from TP rules as a small and medium-sized enterprise (SME). Its foreign counterparty, however, operates in a jurisdiction where no SME exemption exists, resulting in a compliance nightmare.

While the UK entity may not be required to make TP adjustments, the counterparty could still be subject to them, leading to tax mismatches, double taxation and potential disputes. With no global standard, businesses operating cross-border will continue to bear the brunt of these inconsistencies.

Directors’ emoluments

Despite the amount of legislation, directors’ emoluments is a common area for error. This is especially true with directors’ emoluments where directors are operating in more than one country, which is exacerbated by the ever-growing appearance of non-UK based directors providing their services through personal service companies.

Too often entrepreneurs are advised to keep their annual tax bills down by routing payments through personal service companies and not complying with the UK’s laws on directors’ remuneration, probably because it is such a specialised area of tax and easier to get wrong than right.

For decades, tax due diligence reports have highlighted profit ‘extraction’ as a high-risk area and identified specific activities that lead to price chips, specific indemnities and retentions. It is clear that nowadays this area of focus in due diligence reports has more of an international flavour. It was bad enough unpicking this in one country; to do so cross-border is often an expensive and painful process.

When establishing operations abroad, it is important to take advice on how to establish new overseas operations correctly to prevent issues arising in the first place. However, for business owners looking to sell that may not have got everything right, it is better to find a cure today, before getting to the due diligence stage of a sale.

Fixing these problems in the middle of a transaction is an unsatisfactory process, creating friction between buyer and seller, distracting the seller from running and growing the business, leading to suboptimal outcomes in terms of overall costs, liabilities and delays, or sometimes jeopardising the deal entirely. Prevention is better than cure, and early treatment is better than crisis management.

 

Bernhard Gilbey is a partner and Rachel Palmer is a solicitor at Gateley Legal. Mr Gilbey can be contacted on +44 (0)20 7653 1608 or by email: bernhard.gilbey@gateleylegal.com. Ms Palmer can be contacted on +44 (0)161 836 7731 or by email: rachel.palmer@gateleylegal.com.

© Financier Worldwide

BY

Bernhard Gilbey and Rachel Palmer

Gateley Legal

©2001-2025 Financier Worldwide Ltd. All rights reserved. Any statements expressed on this website are understood to be general opinions and should not be relied upon as legal, financial or any other form of professional advice. Opinions expressed do not necessarily represent the views of the authors’ current or previous employers, or clients. The publisher, authors and authors' firms are not responsible for any loss third parties may suffer in connection with information or materials presented on this website, or use of any such information or materials by any third parties.