M&A
Introduction:
Devising an M&A strategy is the first critical step for any
business contemplating a transaction. Armed with a plan and knowledge of the
competitive marketplace, companies are ready to practise the art of the deal.
But the need for a speedy transaction and post-merger integration should not
entice companies to take short cuts along the way. Companies should follow
necessary steps to execute an M&A transaction in a way that drives shareholder
value. All transactions — whether mergers, acquisitions, joint ventures, private
equity investments, etc., are full of complex business and tax issues that
require an expert to get on top of the transaction process and to reach the best
solution that is tax-efficient and meets commercial and business expectations.
The Indian tax regime is as complicated as any other matured
regime. Over the years, the Indian regulations have provided sufficient leverage
to foreign investments and at the same time, have ensured a closely controlled
mechanism on these investments.
In the M&A world, some of the typical tax challenges faced
today include non-availability of interest deduction for funds borrowed for
investment in shares of Indian companies, restricted group relief on asset
transfers, restricted debt push down mechanism and existence of high tax
compliance.
Every deal is unique in itself. It brings with it a basket of
complexities and issues, be it accounting, regulatory or taxation. Given the
complexities, it has become incumbent upon a good service provider to have a
dedicated and experienced team to provide tax due diligence services.
This write-up seeks to provide an overview of the key
features of a tax due diligence; it touches upon the procedure to be followed;
and it provides some ground rules for reporting findings so as to meet the
expectations of all stakeholders to the transaction.
Scoping of work:
One of the initial steps to be undertaken is to formulate the
scope of the assignment. One’s drafting skills are tested to the core whilst
formulating the scope for the tax piece of the due diligence. An essential
aspect of this is to explicitly provide for areas which would not be covered as
part of the due diligence process (generally referred to as ‘scope
limitations’).
Given the complexity and the time required to resolve
disputes with the tax authorities, it is of utmost importance to clearly bring
out the period of coverage as part of the scope of work to be covered in a due
diligence assignment. As a general practice, the tax returns filed by the target
company in the last 2 to 3 years are reviewed. Further, the status of all
pending assessments, disputes is obtained and reviewed for the earlier years.
One of the reasons for reviewing the last 2 to 3 years tax returns is that the
audit by the tax authorities for these years is typically not complete on the
date of carrying out the due diligence exercise.
Apart from the coverage, the scope of the tax piece of the
due diligence process needs to be very case-specific i.e., it would
depend upon the Industry to which the target company pertains, the age of the
target company, the shareholding pattern, etc.
For example, in a transaction in the power sector, it would
be critical to examine the continuity of availability of tax holiday and
incentives claimed by the target entity. Further, in case the target is a
private limited company, it would be essential to review the movement in its
shareholding pattern with a view to assess the continuity of availability of
business losses.
Characteristics and key features:
The tax specialists who are part of the due diligence team need to work very closely with the financial and accounting
specialists.
Before discussing the methodology to be adopted to conduct a
tax due diligence, it is imperative to understand the characteristics and
features of conducting the tax due diligence. The main objectives can be
classified as under:
Understanding the target:
its legal structure, cash flow mechanism and its operational strategy.
Assessment of tax impact arising from ‘change in control’
- carry forward of past tax losses, relevant exchange control regulations
(especially recent developments)
- availability and continuity of tax holidays/concessions
Assessment of
historical tax exposures
- pending tax litigations, aggressive tax positions adopted in the past (possible
consequences)
- risk of disallowance of expenditure for tax purposes
- interest and penal consequences
Assessment of current
tax position
- ramification of past tax audits.
Tax benefits
- There are various direct and indirect tax benefits in India for
companies/businesses. The conditions attached to such benefits are
important.
Contingent liabilities — disputed tax demands
These are largely potential liabilities (i.e., tax demand + interest + penalty which could extend to 300% of the tax sought to be evaded) arising on account of disputes with tax authorities. Since it is difficult to predict the outcome of such disputed demands, it is likely that in some businesses, even genuine tax demands may not be provided on the ground that such liabilities are ‘contingent’ and are being disputed (depending upon the likelihood of the company succeeding in defending these disputes).
Tax litigation procedure:
The tax litigation procedure in India is cumber-some and time consuming (the average time frame for an appeal to attain finality is in the range of 10-15 years). Further, positions adopted by the tax authorities in the initial years are generally followed by them in the subsequent years as well, unless there is a strong reason or a judicial/appellate pro-nouncement to change the position earlier adopted. Accordingly, disallowances made in a particular year are likely to be a routine occurrence in future years as well and the only option in such a scenario is to litigate. Hence, it may be advisable to be cautious while evaluating targets which are engulfed in too many tax litigations involving sizeable tax demands.
Current assets:
These may include balances that may not be realisable in the short term — such as (i) tax refunds due (ii) deposits with various tax authorities, etc. — such deposits generally are not realised for a very long time. These would consequentially have an impact on the working capital financing needs of the target.
Various tax compliances (including withholding tax):
The Indian tax laws prescribe several tax compliances for Indian companies. Failure to comply with these could inter alia give rise to penal consequences. Especially, in case there is a default in withholding taxes on payments made, it could have several con-sequences for the payer, such as recovery of the tax not so with held/deposited, interest thereon, penalty (which could be equivalent to the tax amount) and disallowance of the expenditure in relation to which tax has not been withheld/deposited. Hence, one should ensure that the target is tax compliant (more importantly, the withholding tax compliant).
Typical areas prone to income-tax litigation: While there is surfeit of issues that is prevalent in the tax litigation environment in India, there are some issues that typically arise during a tax due diligence, viz.:
- ramification of past tax audits.
- Depreciation for income-tax purposes and its impact on the deferred tax calculations.
- allowability of expenses which are quasi-capital in nature (e.g., non-compete fee payments).
- computation of various tax deductions/exemptions available.
- disallowances on account of failure to withhold tax on payments (especially in cases where payments are made to non-residents).
- levy and computation of interest on tax demands and refunds.
- income characterisation (say, business income v. income from house property).
- carry forward and set-off of tax losses.
- taxability under presumptive taxation provisions.
- computation of tax liability as per ‘Minimum Alternate Tax’ provisions, etc.
Transfer pricing adjustments:
Given that the tax authorities have commenced reacting to the transfer pricing report, policy and documentation filed by the taxpayers, it is very important to consider the rationale and reasoning behind determining the arm’s-length price, level of compliances and filings as required by the regulations. These are particularly important in the context of the potential future impact of similar transactions.
Fringe Benefit Tax:
In the short span when Fringe Benefit Tax was applicable, there were emerging controversial issues, some of which were resolved by the circulars/clarifications issued by the tax authorities. Although this legislation does not exist today, there is litigation which is gradually surfacing on this count.
The mechanics:
Tax is a complicated subject and to carry out a tax review which involves an understanding of the tax disputes, challenges faced from the tax authorities by the target entity, tax positions taken by the target entity, and to formulate a view on the basis of the documents reviewed and analysis performed normally within a short span of time is an uphill task. This is the precise reason that the tax due diligence team members need to be experienced, and should be well equipped to dissect and digest the flow of information and documents provided to them in the data room within the stipulated time.
Success, in the backdrop of the above challenges can be achieved by following an appropriate methodology while conducting the tax review.
Activities to be performed while conducting a tax due diligence would mainly include?:
- Examination of status of tax assessments — cur-rent tax position, open years and evaluation of past liabilities.
- Review the income-tax/fringe benefit/wealth tax returns filed for the open years.
- Study the disputes between the entity and the tax department.
- Identify potential liabilities on account of pending assessments and disputes.
- Discuss the various direct tax benefits availed and attached conditions for continuation of the same with the target management and tax advisors.
- Analyse the withholding tax compliance.
- Examine the applicability of the double taxation avoidance agreements entered into by India while reviewing the tax treatment given to various transactions entered into by the target and analyse the implications arising thereof.
- Read opinions obtained by the target management from external counsel and stands taken by the target/target’s advisors during assessment.
- Peruse transfer pricing policy adopted.
- Examine the various tax balances (particularly the deferred tax asset/liability) reflected in the financial statements.
The procedure to be followed while conducting tax due diligence has to be very discreet and well planned. There is an expectation of providing comments on the tax position adopted by the target entity. Given the areas to be covered in the tax due diligence, one is saddled with a large number of tax documents, records in relation to tax matters of the target. The tasks to be performed in the above context would include carrying out a review and check of the following:
- Correspondence with the tax authorities.
- Current and deferred tax calculations — reconciliations with the amounts disclosed in accounts.
- All tax payments made within due dates — if not, check interest/penalties arising on account of the same.
- Calculations supporting advance tax payments made.
- Carry forward losses schedule — both as returned and also as assessed — also confirm the expiry dates/restrictions on utilisation of the same.
- Details of transactions with related parties (interacting with the team carrying out the financial due diligence on this aspect should be useful as at times identification of all ‘related parties’ itself raises challenges).
- Transactions with related parties from the transfer pricing perspective and confirm the pricing method/documentation maintained.
- Details of permanent establishments in other countries.
- Whether withholding tax provisions are being adhered to — also examine as to whether the withholding tax returns are filed in time.
- Tax findings of non-India jurisdictions, if any, in which the target company operates — this may require liaising with local tax experts.
- Potential implications of the existing tax position for future years considering the proposed Direct Taxes Code Bill, 2010, which has been recently introduced.
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Years
subject to statute of
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Limitation
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Outside
scope (entities,
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years, taxes)
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Controlling
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tax due
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Materiality
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diligence
risk
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External
advice
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Low
risk areas
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- Applicability of Wealth-tax.
Like any other due diligence process, the tax due diligence is also prone to risk. Con-trolling the tax due diligence risk therefore becomes a key aspect of the process. The elements of a tax due diligence risk can be addressed by considering the aspects shown in the diagram?:
Submission of findings and reporting:
It is always easy to document a detailed analysis arising out of the due diligence process. However, this may not serve the purpose of the report and the investor’s expectations. It is therefore advisable to articulate and document the findings in a reader- friendly manner. In addition to the complexities and the volume involved whilst carrying out the tax due diligence process, some ground rules which need to be followed include?:
Anticipate problems and opportunities
Early identification of and discussion of preliminary issues with client.
Measure exposures and seek solutions
Quantify estimated amounts and likelihood of exposures resulting in future cash outflows (range/sensitivity analysis).
Interpret findings in ways clients can use
- Focus on material issues.
- Use plain English — many of the decision-makers may not understand or appreciate a detailed technical tax answer to a question.
Timely communication of findings:
In order to generate a report which meets the expectations of all stake-holders, certain ground rules need to be followed as under:
One needs to
- classify tax exposures into high/medium/low risk category and estimate the quantum.
- consider additional verbal feedback.
- issue a draft for comment and discussion prior to finalising the report.
- add additional information as appendix.
- be mindful of other readers e.g., financiers.
An integral part of the tax due diligence process is to identify issues and more importantly discuss the same with the target management, their advisor, as the case may be. This ensures that the tax findings given in the due diligence report do not give rise to surprises when these are discussed with the target management.
Tax Issues could primarily be classified as:
Deal breakers — Those issues which would impediment the consummation of the proposed transaction. For example, sizeable risk on account of various tax disputes, some of which may be quite material, could act as a ‘Deal Breaker’.
Negotiation points — Those issues which would be necessary to consider in the valuation of business/negotiation of bid price.
Issues for agreements — Those issues which would warrant indemnities and identify conditions precedent for happening of the transaction
Commercial override — Those risks and issues which are knowingly taken over as a calculated commercial decision.
In summary:
The due diligence exercise maps the way forward for transaction closure. Tax-related findings would form the bases of valuation of the target and aid in negotiating for a better price. These are also relevant for consideration in some of the key areas of the transaction documents. Tax indemnities and conditions precedents incorporated in the agreements are based on the due diligence exercise. Some of the observations and areas falling out in a tax due diligence report could also be relevant whilst structuring the transaction.
Studies suggest that tax factors are of significant magnitude in less than 10% of merger transactions. Be that as it may, there have been some large transactions which have fallen apart primarily due to adverse tax findings as a result of the due diligence exercise.
Therefore, the onus is on the tax specialist to identify the potential tax risks and exposures and to document them appropriately in order to provide adequate visibility to the investor.
