2. Observations in completed assessments and audits:
Completed assessment orders and audit memos provide opportunity to observe the acceptance or otherwise of the critical tax positions taken by the company. Tax positions include exemptions, abatements, incentives, reliefs, set-off claims, etc. claimed the company.
It may be noted that even though the assessments and/or audit memos finally do not result in any litigation, it is important to observe any disallowance or rejection of tax relief claimed which resulted into demand, which in turn have been accepted and paid by the company. These observations form the basis for analysing the tax positions in open assessments. At times, companies have been known to claim the benefit of inter-state sales at concessional tax rate against declarations in Form C, etc. in the return, but the collection and furnishing of these forms are not pursued aggressively until assessment (which generally takes after a period of three years or more) and results in some differential tax liability along with interest and penalty, when assessments are concluded. Hence, based on past trend of the company in completed assessments, the potential liability, if observed on this account, needs to be indicated.
3. Potential issues in open/unassessed periods:
The best way to tap the open assessment periods is to peruse the tax returns and filings including VAT Audit reports. However, it is not practical to peruse all the tax returns, payments and filings done say on monthly basis for excise, VAT and service tax for each of the locations where the indirect tax registration has been obtained. This needs to be done judiciously on sample basis.
The focus here should be applied on the tax claims and tax positions not yet tested in the assessments/audits. On a case-to-case basis, if the stake involved in adopted tax positions is significant, focussed interaction with management is desired to know the rationale and compliance to conditions for taking such positions. When found relevant, key customer contracts and/or vendor contracts may be perused on sample basis. This helps in gathering some comfort about tax positions adopted in the open assessment period which carries higher element of uncertain risk as compared to the risk in the matters already under litigation.
4. Positions vis-à-vis industry issues:
At times, it would be difficult to argue that merely because many/most players in the industry have adopted the same practice, the tax position would be acceptable. However, one cannot afford to ignore this altogether. It is because, there have been instances in the past where mere clarifications to the provisions of law (which otherwise is deemed to have been effective with retrospective effect) have been articulated in the Departmental circular or clarification so as to implement prospectively by providing relief for the past in indirect manner. The one example I recollect here is about clarifications on service tax liability in the case of international roaming under various scenarios of inbound and outbound roaming which provided some relief to telecom operators for the positions taken in historical period. This has happened generally when the issue involved is an ‘industry issue’ and contended on bonafideness. Thus, providing information on industry positions provides different level of business comfort.
5. Tax incentives — eligibility, admissibility, fulfilment of terms, conditions & obligations and continuity:
Tax incentives, specifically area-based tax incentives (say, available to manufacturing units in Uttaranchal, Himachal, Kutch, North Eastern States, etc. and/or to units in Special Economic Zone, Electronic Software/Hardware Technology Park and/ or to units in specified backward areas in States for VAT incentives, etc.) are subject to complying with specified terms and conditions. In this regard, it is important to gauge the continuity of tax incentives post transaction. This is because the quantum of unused tax incentives and its entitlement play a vital role in valuation of the transaction and hence its fate.
When the transaction structure is known at the time of due diligence, it is appreciated if the things found critical for continuation of tax benefits post transaction are briefly but appropriately communicated along with major concerns and listing of broader compliance steps for continuation.
6. Tax balances — perusal of reconciliation statement:
Understanding the quantum of tax balances accounted as ‘income’ (e.g., tax incentives/refunds), ‘expense’ (e.g., tax paid during audit observations), ‘assets’ (e.g., tax paid under protest and tax credit balance) and ‘liabilities’ (e.g., provision for periodical tax amount and for tax disputes) is important. It is because at the end of the due diligence exercise, one needs to identify the appropriateness of their accounting and the impact on profitability, net-worth and working capital.
After seeking reconciliation of tax balances, attention here needs to be paid on the rationale/ justification for each of the items forming part of the reconciliation statement. Post analysis, the resultant adjustments in terms of computation of profitability, net-worth, working capital, etc. should be identified and reported. The illustrative list of such adjustments includes (i) service tax refund for export of services, VAT refund for export, export incentives like duty drawbacks, etc. though entitled, not actually claimed before the appropriate authorities and accounted as ‘income’ and ‘receivable’, should be highlighted (ii) VAT/CST, etc. for March payable in April not accounted as ‘expense’ and ‘liability’ in the accounts for financial year, should be highlighted.
7. Related-party transactions:
Transactions with related party(ies) desire twofold attention i.e., (i) when the provision of law (say governing excise duty and VAT in some states), require transactions between related parties to be at fair market value, and (ii) when the provision of law is silent (say, service tax law or VAT in some states).
In the first scenario, the potential exposure should be identified. While in the second case, it needs to be understood that if the proposed transaction is structured in such a way that the benefit of ‘related party’ may not continue post transaction (say, where only one of the related entities is proposed to be acquired and hence the concessional transaction value regime shall come to an end in commercial terms). In such situations, the consequential tax implications need to be identified, analysed and discussed.
8. Important compliance procedures:
Verifying and reporting compliance matters is generally outside the work scope of due diligence as they generally do not give birth to any deal-breaker or significant valuation/risk issue. Besides, this requires greater amount of time and cost which always are constraints. However, understanding and providing broad flavour of tax compliance management (in terms of tax filings, tax payments, withholding tax on payment to works contract, etc.), tax team (in terms of qualification, level of competencies, etc.) and related systems (say, to undertake tax computations, to monitor collection of declaration forms, etc.) helps the client specifically in transactions envisaging change of management whether partially or completely.
In this regard, the indirect tax team would be well advised to clearly state the ‘exclusions’ from the scope of work of the indirect tax diligence so that there are no gaps in client expectations. Normally exclusions from an indirect tax diligence are review of tax compliance/procedural matters, providing tax advisory/planning services, etc.
Reporting:
Reporting is very critical to the entire exercise. Without adequate and smart reporting, the due diligence exercise may prove futile. While discussing the key issues, it needs to be ensured that though the approach and substance should suggest advisory role, the form in which the report is articulated should in no way appear as advisory deliverable like tax memo or opinion. The reason is obvious; the primary intention is not to repair the potential issue but to understand the worth and implications of the issues correctly.
For the foregoing reasons, the report is generally divided into three parts i.e.:
(i) Key issues (i.e., ‘must to know’ issues involving significant implications on the financial state-ments based on historical issue or from future perspective (say, continuity of tax incentives in special industrial areas, view on high-value litigation matters, etc.)
(ii) Other issues (involving non-key but ‘need to know’ issues) and
(iii) Informative issues (i.e., help in understanding overview of business from indirect tax perspective).
It is important to note that when the key issues could be in the nature of potential deal-breakers, there is no formal or structured way to communicate them for the first time during the diligence exercise. It means, such deal-breakers must be communicated ‘as and when’ they are observed without waiting for due date.
For each of the issues explained in the report, it must cover, inter alia, the exposure period, the quantum of exposure along with interest and mandatory penalty. When the penalty is not mandatory, a broad range should be indicated. Each issue needs to be analysed on merit by classifying risk as ‘probable’, ‘possible’ or ‘remote’ with agreed weightage for valuation adjustments, say for arriving normalised earnings, net-worth and/or working capital.
Lastly, reporting the issues without mitigation a strategy may leave the client clueless. Hence, it is equally important to provide a risk mitigation strat-egy in terms of obtaining warranty/indemnity, or in making a valuation adjustment, or deferring a part of the consideration in escrow account, etc. till a more definitive resolution of the issues concerned.
Conclusion:
It may be said that though there may not be a standard error-proof approach for carrying out a relatively subjective exercise of due diligence under different circumstances, the foregoing should help practitioners in carrying out an indirect tax due diligence exercise in a more structured manner to bring out the value to the client along with building efficiency and superior risk management to the whole diligence process.
A misperception at times amongst clients and their advisors is that indirect tax does not have the same flamboyance as a direct tax or a legal issue which then dangerously leads to a lack of adequate focus by the client on the unresolved indirect tax issues. We, indirect tax practitioners are well aware of the unending complexities of the indirect tax acts, rules, notifications and clarifications in our country and the multitude of judicial interpretations. And I humbly submit that a majority of my fellow direct and indirect tax practitioners would also acknowledge that more often than not, the potential tax liability arising from an indirect tax issue can be far more crippling than any other demand!
It remains the responsibility of the indirect tax team to correct any such misperceptions of the client or his advisors about ‘indirect tax’ and to ensure that the client has a true and fair appreciation of the indirect tax issues in the proposed M&A transaction.
