Recently a client approached me and sought my advice about buying and selling a business. He is in the midst of buying a company and the financial due diligence was conducted by a consultant he had hired. When it came to the target company’s tax position, the consultant advised him to ask his tax agent (namely, me) to ‘review the past 2 years tax computations of the target company to reconfirm that the computations are done correctly’.
On the contrary, when it comes to buying a business or a company, the tax function encompasses more than what the consultant had advised. Instead, as it involves the acquisition of a major corporation which involves a LOT of money, what I advised my client to do was to conduct a proper due diligence exercise of the target company.
Rather perplexed, he asked what the benefits of a tax due diligence exercise are.
Tax due diligence is essentially a risk review of a company’s tax position and its exposure to potential and uncrystalised tax liabilities. It focuses on assessing risk to ensure that the buyer is getting, what he thinks he’s getting. It is particularly important as tax is a substantial cost of doing (or buying into) any business. The findings from a tax due diligence exercise would eventually be used to support the sale and purchase negotiations of the company.
By purchasing the shares in an existing company, the buyer would essentially be inheriting the company’s tax history. The buyer will be responsible for whatever tax skeletons that may be lurking in the closet and this without a doubt, be an important piece of information to know!
The Inland Revenue Board (IRB) has the authority to seek to re-assess any return filed generally within the last six years (assuming returns have been filed on time), or without time limit if a company’s tax return is fraudulent or wilfully misleading. Therefore, understanding tax risk exposures for the years not ‘time-barred’ under law is crucial as the buyer is effectively assuming this risk for periods where they had no responsibility for the tax function. In addition to that, any tax undercharged discovered, as a result of a tax audit will attract a penalty of not less than 45%.
In the years that the company has tax losses, a tax audit may result in the available losses of the company being reduced substantially, due to expenses not substantiated by the necessary evidence or income which had not been declared.
A few examples of the tax issues which will be looked at during a tax due diligence exercise are:
- Have all tax returns been submitted on a timely manner and if not, have penalties relating to the late submission of those returns been raised by the IRB and duly paid by the company?
- Are the claims for deductions duly substantiated by evidence?
- If the company is entitled to tax incentives, have all the conditions of the claim for those tax incentives been met by the company?
- Has the company been subjected to a tax audit before? If so, have the adjustments due to the tax audit been reflected in the subsequent years of tax returns which have not been audited by the IRB yet?
Yes, indemnities and warranties executed through a legal contract are great ways to minimise risk when purchasing a company. However, those tools would be much more effective when the buyer know what he is protecting himself from. Besides, if any tax debts occurring prior to the purchase are discovered by the IRB, the buyer may still have challenges in enforcing the indemnities against the seller on those tax debts. However, in the meantime, the taxman wil still be breathing down the buyer’s neck to chase for those tax debts as the company is a separate legal tax entity and the present shareholders (ie. the buyer) will be responsible for them!
Regardless of the size of the business/company being acquired, a tax due diligence exercise is always recommended. The scope of the tax due diligence can always be tailored to address the areas of tax concerns of the buyer, yet providing sufficient value and protection for the buyer.
As a seller, there too, are tax implications. By understanding any uncrystalised tax exposure of the company, it will put the seller in a better position to object to any unreasonable requests for indemnity by the buyer.
If you are buying or selling a business or company, do remember to seek the advice of your tax consultant!