Tax due diligence

Any merger and acquisition transaction has to be carefully planned and executed ; therefore, before closing a deal and to make more informed decisions, the buyer normally carries out certain agreed upon procedures to assess the deal from commercial, financial, tax and legal standpoints. Beside important issues,
this includes a spectrum of tax and regulatory issues such us exchange control, income taxes, indirect taxes and capital market regulations.

The agreed upon procedures are normally described as a ‘due diligence exercise’. The expiration ‘due diligence’ is not define by any statute, nor is there any legal binding to carry out the same; on the contrary, it is a creation of conventional practices.

The need for a due diligence exercise can perhaps be linked to the phrase forewarned is forearmed’. Although due diligence is not a panacea against investment failures, it provides the potential buyer with relevant information and business/targets proposed to be acquired and helps manage associated risks.

Due Diligence versus Statutory Audit/Internal Audit

In India, companies are statutory required to get their accounts audited by an independent Chartered Accountant (known as statutory audit). In certain cases, companies are even required to carry out an internal audit relating to their processes.

Due diligence is quite distinct from statutory and internal audits.

The keys differences between due diligence and statutory/internal audit are tabulated below.

Parameter	Statutory	Internal	Due Diligence
Appointed by	Shareholders of a company	Management of the company	Normally by the buyers and, in certain cases by the management of the target.
Reader of the Report	Shareholders, regulatory authority	Management	Deal Making Parties
Extent of Reliance on information provided by management	Relatively high	Relatively high	Low to medium; the information is first challenged/tested for its reliability.
Mandatory	Mandatorily required under statute	Mandatorily required under statute	Not Mandatory
Objectives	To report on the truth and fairness of the financial statements	To report on specific issues with the internal processes of the company	To highlight exposures and upside of the targets
Scope	Defined by the statute	Defined by the management	No specific scope defined by the buyer or seller(in case of vendor due diligence).The scope largely depends on deal mechanics and the agreement among the parties involved
Perspective and focus	Focuses on historical information	Adopts a futuristic approach	Blend of both historical and futuristic perspectives
Confidentiality	Low; in the case of listed companies, the audit report is publicly available	High normally, only management has access to the report	High; only the deal making parties have access to the report

Types of due diligence

Due diligence can be typically categorized into various types from two
Perspectives. Firstly, from the perspective of who actually carries out the due diligence, secondly, from the perspective of ‘what’ is being carried out as part of the due diligence.

Primary interest perspective

Based on the first perspective (i.e., ‘who’ actually carries out the due diligence or the ‘primary interest’ perspective), there are two types of due diligence.

• Buyer due diligence
• Vendor due diligence

Buyer due diligence

When one refers to ‘due diligence’, it normally means a buyer due diligence. It is the acquirer or the buyer who is interested in getting a better insight into the exposures or upsides of the target. Hence it is in the acquirer’s/ buyer’s interest that he carries out the due diligence before closing the deals. Normally all buyers carry out a due diligence before making their acquisition. The buyer generally appoints consultants to carry out the due diligence and provide expert advice on the implication of the findings of the due diligence.

Vendor due diligence

In recent years, vendor due diligence is gaining popularity. This is when the target’s management carries out a due diligence on the target. The target’s management, on its own accord, appoints consultants to carry out the due diligence on the target. The consultant would provide management with its vendor due diligence report highlighting the exposure or upside in the targets. Vendor due diligence is useful in cases where the target’s management proposes to invite more than one investor /acquirer. The target’s management would provide this vendor due diligence report to prospective investors/acquirer.
This prospective investors/acquirer place reliance on the vendor due diligence report and make their investment acquisition decisions. In certain cases, the investors/acquirer may want to investigate into a particular area that may be discussed in the vendor due diligence report to gain a better insight into the area.

Functional Perspective

Based on the second perspective (i.e., ‘what’ is being carried out as part of the due diligence or the ‘functional’ perspective), there can be various types of due diligence. Different situations may call for varying types of due diligence. The most commonly carried out due diligence in India are as follows:

• Commercial
• Technical
• Environmental
• Human resource
• Legal
• Financial tax (direct and indirect tax)

The ensuring paragraphs discuss the various aspects relating to the last item
of the above list, viz, tax diligence.

Tax due diligence – significance

Tax is one of the material and unavoidable costs. Hence, tax due diligence plays a significant role in M&A decision making,
though tax is normally not the primary consideration in the context of M & A transaction.

Conventionally, tax due diligence is carried out to understand the tax profile of the target and to uncover and quantify tax exposures. However, tax due diligence also encompasses identifying any tax upside (potential tax benefits that are not being claimed/envisaged by the target) which may be available with the target. It also assists in identifying and developing a suitable acquisition structure for the deal in question.

In practice, the most common form for tax risk mitigation is through tax warranties and indemnities in the agreement. The buyer needs to be balanced while negotiating for this tax protection to ensure that it does not impact the commerciality of the transaction for the seller.

To summaries, a tax due diligence is normally carried out to:

• Validate the representation made by the seller at the time of pre-deal negotiations.
• Validate the assumptions made by the buyer in valuing the target.
• Identify any material tax exposures that may be residing with the target.
• Identify any material upsides (potential tax benefits that are not being claimed/envisaged by the targets)
• Structure the deal in a tax-efficient manner.

Full Scope Tax due Diligence Approach- Income tax

A typically tax due diligence exercise (in the context of a full scope due diligence) entail a review of relevant documents wherefrom the tax information can be sourced. The typically sources of obtaining the relevant tax information are as follows:

i) The financial statements of the targets
ii) Its related tax records

i. Review of financial statements

Relevant tax information is normally available in the balance sheet and
Related schedules, which disclose the aggregate tax provision and aggregate taxes paid by a company. It is also accessible from the profit and loss account, which discloses the current tax charge and deferred tax charge for the relevant year. The notes to the account reveal information regarding accounting policy relating to income tax and deferred taxes, and contingent liability with regards to tax disputes demand against the company. The auditor’s report discloses details of outstanding tax dues. In certain cases, the director’s report discusses the status of ongoing tax litigations/assessments.

A review and analysis of each of the items of the tax informationdisclosed by the financial statements provides the reviewer a fair insight of the tax position of the target concerned. Needless to state, the review and analysis, coupled with intelligent discussion with the management of the targets, would go a long way in obtaining a better perspective in this regard.

The items of tax information available in the financial statements are as follows:

a) Review of contingent liabilities
b) Review of tax provision and tax paid in the balance sheet
c) Analysis of deferred tax
d) Analysis of effective tax rate
e) Review of MAT paid and MAT credit

The ensuing paragraphs discuss how the review and analysis of each of the
Items of tax information available in the financial statements prove to be of relevance and significance.

a) Review of Contingent liabilities

The disclosure about contingent liabilities in the notes to the accounts of
Financial statements reveal significant tax information about the target. The reviewer gets a fair sense of pending tax disputes/demands by reviewing the contingent liability schedule. As a next step a reviewer may want to analyze the related tax assessment/appellate records to better understand the disclosure made in the contingent liability schedule.

b) Review of the tax provision and taxes paid in the balance sheet

Normally the balance sheets of targets disclose the tax provision and taxes paid as of the balance sheet date in two possible formats, as given below

Format 1- The tax provision is disclosed separately under the current liability section of the balance sheet, and the taxes paid are disclosed separately under the loans and advance’ section of the balance sheet.

Format 2- The tax provision and taxes paid are netted off, and the net figure is shown in the balance sheet. Where the net figure represents the excess of taxes paid over tax provision, it is disclosed under the loans and advances section of the balance sheet. Where the net figure represents the excess of tax provisions over taxes paid, it is disclosed under the current liability section of the balance sheet.

Normally, analyzing the tax provision and taxes paid as appearing in the balance sheet is not of much assistance to the reviewer. However, where a year-wise breakdown of these numbers is available, it provides a better insight into the tax position of the targets.

Once the year-wise details are received, the first flush impression that one gets about the targets tax position is regarding the longevity of the tax assessments/disputes of the targets. For instance in a case where the year-wise breakdown provides details of the last 15 year as against a case where the details are from the last 4 years, normally the tax position of the target with a 15 year tax assessment/dispute history are found to be relatively more complex than those of the target with a 4-year tax assessment/dispute history.

A detailed review of the tax provision and taxes paid for each of the year would be either confirm or dismiss this prima facie impression of the tax position.

Without discussing technical details about the Indian tax laws, it would be relevant to state a specific provision of the Indian tax laws. A tax payer is required to pay income tax on a progressive basis during the year in question, known as a advance tax mechanism. In view of the above, in an idealistic scenario, all of the taxes provided by a company should be paid within the year in year in question. However, in practice, such an ideal situation is rarely achieved.

It is possible that in a particular year, the tax provision is more than tax paid and simultaneously in another year taxes paid are more than the tax provision. On a detailed analysis of each of these situations, a reasonable perspective of the tax position of the target can be understood.

In practice there could possibly be three situations that could arise in this regard:

1. Tax provided is more than taxes paid
2. Tax provide is less than taxes paid
3. Tax provided is equal to taxes paid