Tax Due Diligence
Tax Due Diligence
A due diligence on the tax liabilities and position of the target company is essential in a share purchase. The target company may have hidden tax liabilities arising from the previous trading. It may be subject to contingent liabilities due to past transactions. Tax issues may arise from pre-sale steps taken by the seller.
The tax due diligence will require that all tax types be reviewed. This will include income tax, PAYE, corporation tax, payroll obligations, capital gains tax, value-added tax, capital acquisitions tax (in unusual cases), customs duties and other levies where applicable.
The target company may have foreign tax liabilities which requires taxation law review under the law of another jurisdiction. This may arise where it has a branch or subsidiary in another jurisdiction.
If there is a significant tax problem, the transaction may not proceed or may require to be re-negotiated. If there are too many potential liabilities, the alternative may be to purchase the company assets or to hive down certain assets to a new company and purchase it.
If significant risks are involved, arrangements for the retention of consideration pending the appropriate review or elapse of the appropriate return periods, until the relevant risk of review has passed may be required. A specific indemnity may be required.
Scope of Tax Due Diligence
The tax due diligence will require a review of tax returns and affairs over a number of years. Ultimately a tax due diligence report may be prepared for the buyer to review. Issues may arise which require specific resolution.
Generally, a tax deed of indemnity is given in respect of potential unpaid tax liability. This deed is usually in very general terms covering most forms of taxations. The outcome of the tax due diligence may inform the negotiation of the terms of the tax deed. If specific issues are identified, further provision may be required for the tax liability risks which are revealed.
As with legal due diligence, the tax due diligence should be the subject of a letter of engagement or appointment. It should define the terms on which the tax advisors review the target company’s tax affairs. The buyer’s tax advisers will need to liaise with the tax advisers of the target company and have full access to the relevant records.
Review Process I
It may be useful to commence the process of review by considering all communication in the most recent Revenue audit. This will highlight potential issues raised by Revenue.
Ongoing tax accounting obligations in relation to VAT and PAYE are usually dealt with by the target company in-house. There may be a questionnaire for review by the appropriate parties.Corporation tax returns are usually made by the company’s tax advisor. A separate questionnaire may be appropriate and necessary.
The company’s accounting for tax in its financial accounts must be considered. The accounting policy for deferred taxation should be reviewed. The basis on which provisions have been made need to be considered relative to the liabilities that are disclosed by the review and in fact, exist.
Review Process II
Tax returns, notices and assessments should be reviewed back through the 4-year periods in which Revenue have a right to reassess the returns. If there is any question of fraud, recklessness or negligence, the Revenue may review the retrospective tax liability indefinitely.
The key objective of the due diligence is the discovery of any unpaid tax liability. Tax liabilities will usually carry significant interest and penalties, which would have an adverse effect on the value of the target entity.
Expressions of doubt and correspondence with Revenue must be carefully considered. The taking of aggressive views on matters without Revenue clearance / consent poses significant risks.
Certain transactions require specific elections to be made to Revenue at a certain point. It must be verified this has been done in each such case.
Range of Issues to be Reviewed
The range of issues that potentially arise run the whole gamut of the company’s recent historical trading and affairs. There are time limits on the reopening of tax returns, but they do not apply where there is negligence, recklessness or fraud.
If for example, a claim for a particular treatment has been made over a period which is vulnerable to challenge by Revenue, there may be a risk of significant liability in the assessment of historic underpayment with interest and possible penalties. The matter may also affect the future net taxable profit and the basis of the price paid.
The requirement for a capital gains tax clearance certificate should be ascertained at an early date if the majority of the company’s value may derive from real property, mineral or exploration assets in Ireland. The certificate must be obtained in order to avoid the obligation to pay 15 percent of the consideration to Revenue Commissioners.
The company’s accounting for tax in its financial accounts must be considered. The accounting policy for deferred taxation should be reviewed. The basis on which provisions have been made need to be considered relative to the liabilities that are disclosed by the review and in fact, exist.
Information Commonly Sought
Typically, the buyer’s tax advisor will issue a questionnaire requiring basic information relevant to taxation. This would include at a minimum
- financial accounts adjusted for taxation,
- corporation tax assessments,
- corporation tax returns,
- Revenue clearances,
- Revenue rulings,
- P30 and P35 returns for employees,
- VAT returns,
- review of treatment of purported independent contractors.
Particulars should be sought of any Revenue audits together with details of issues arising, settlements made and all relevant correspondence.
The corporation tax computations themselves should be checked in terms of the treatment of items; in particular claims for relief which may be marginal and subject to review, double taxation relief, capital allowances, motoring expenses, entertainment and other possible areas of contention.
Close Company, Losss, Withholding Taxes
Where the company is a close company, as the vast majority of companies are, possible liabilities arising from the close company regime must be considered. Where it is a professional service company, there may be surcharges payable on undistributed profits. In the case of a close company, any distributions, payment of expenses, loans, interest paid to controllers and connected persons (so-called participators) are deemed distributions and subject to dividend withholding tax by the company.
The position with respect to losses should be reviewed. A change of ownership may cause the denial of relief for losses carried forward where there is a change in the nature of the company’s trade. Capital allowances calculations should be reviewed. The possibility of significant balancing charges in the future should be identified.
Withholding tax obligations should be reviewed including in particular dividend withholding tax relevant contract tax (retention of payments to subcontractors) and on interest paid in some instants to non-financial entities, rents and payments to non-residents and patent royalties
Value Added Tax
A review should be undertaken of the company’s VAT liabilities. The rates applicable to its supplies should be reviewed historically and from the future perspective. If goods are given free or supplies claimed at zero, the matter should be carefully reviewed from the perspective of the risk of a future adverse assessment.
The claiming of input VAT credits should be reviewed. Companies sometimes reclaim VAT on inputs, which are not properly allowable. The relevant basis should be the subject of a ruling or agreement with Revenue if there is uncertainty.
International supplies both inside and outside the EU have special VAT accounting requirements. Authorisations, where required, should be checked in respect of export sales.
Vat on expenditure which is not for the purpose of the vatable trade is not reclaimable. Some inputs are restricted or disallowed generally. In particular, inputs related to financial and capital transactions are not generally allowable. The position should be carefully reviewed.
VAT on property is complex, and records must be kept for each asset. The regime changed significantly in 2008. The relevant records are required to be delivered, as they will be necessary to show its VAT status on future leases and sales.
Payroll Taxes
A comprehensive review of payroll taxes should be undertaken. In particular, the obligations to operate PAYE and withhold income tax USC and PRSI on employee’s income must be carefully reviewed. Employee expenses must be vouched. There may be arrangements for payment of employee expenses. Some require specific Revenue approval.
Payments to alleged independent contractors, who might, in fact, be employees must be critically reviewed. If a person has been wrongly treated as an independent contractor, then there may be a significant retrospective liability to account for tax by way of PAYE on the basis that he should have been properly classified as an employee.
Benefits in kind and the appropriate taxation thereof should be carefully considered. The tax status of share options, pension funds and pension fund contributions are complex and require detailed review.
Past Restructures
Where corporate reorganisations or other tax planning has taken place in the past; very careful review will be required of the relevant conditions. In some cases, a change of ownership may trigger liabilities.
Areas with complex company and tax relief conditions include the following
- reorganisations of the shares or undertakings in the group,
- purchase back of shares,
- transfers of assets between group members,
- employee share option agreements
- pension schemes; pension payments and contributions.
Funding and Shareholder Issues
The tax treatment of the company’s funding may require review. Interest paid, in some instances, must be treated as a dividend (subject to DWT) and in some instances may be deductible as an expense. The exact nature of the interest and applicable conditions should be reviewed and considered.
Dividends paid and deemed distributions trigger dividend withholding tax obligations. In a “close company”, benefits paid to participators are treated as dividends. The relevant returns and payments must be made.
If any Employment Incentive Scheme SURE, or historical BES investment has been made, the applicable conditions must be carefully reviewed. If there are any such investors, then questions may arise as to the acquisition of their shares and the financial consequences. The acquisition of their shares within a certain period may trigger significant tax liability such as to make it commercially impossible, at least without compensating the “tax” investors concerned or leaving them in situ.
Acquisition Structure
In more sophisticated transactions, consideration may be given to the ultimate post completion holding structure. Commonly companies are acquired by newly formed holding companies. Issues may arise in relation to the residence of that entity from a tax perspective. Companies may be acquired by a non-resident entity in other jurisdictions as part of a structure which is designed to optimise the overall tax position of the acquiring group and shareholders.
Strategic issues may arise for an international buyer in relation to the tax treatment of the repatriation of dividends. Questions may arise as to whether the overseas jurisdiction has legislation which deems income arising in a subsidiary company in Ireland to be income in that country under controlled foreign companies legislation.
Tax Due Diligence Report
Ultimately, a due diligence taxation report may be prepared by the tax advisor. It should set out its terms of reference, scope and objectives. It should set out, in particular, the years reviewed, inquiries made and the extent of meetings.
It should set out summaries of basic tax computations and schedule them for clarity as appropriate. It should give details of liabilities rolled over, deferred liabilities that will remain with the company and the potential liability involved, in particular, if it is not provided for in the balance sheet.
The report should set out the key tax issues and risks. It should identify risks from previous tax liability not provided for or paid together with a summary of the potential interest and penalties. It may identify other broad issues that impact on the current and future tax treatment of the particular business.
The contents of the report should be considered with reference to the warranties. Specific non-standard warranties and indemnities may be required in respect of particular issues.