Due Diligence in Indirect Taxes
CA Madhukar Hiregange
Indirect Tax Consultant
GST has been in place for almost a year now. The need to grow exponentially makes acquisitions and mergers a very important aspect of business. Adding a synergy may make a whole lot of difference. However the downside is that one may end up holding large liabilities and uncertain future if one is not careful. Due diligence exercise in all aspects of business including taxation is therefore imperative. The prospective buyer normally carries out certain agreed upon procedures to assess the deal from commercial, financial, tax and legal standpoints. The business aspects aside a spectrum of tax and regulatory issues such as exchange control, old indirect taxes, new GST benefits under Foreign Trade Policy and capital market regulations are also highly impactful. There is no legal binding to carry out the due diligence.
The confirmation after due diligence, that there are no hidden liabilities and that the balances as stated with respect to the indirect taxes ( old laws + GST) are correct would be a matter of comfort.
The well run corporate in normal course would like to ensure that their compliance under indirect taxes is complete. In addition they would be keen to see that there is no loss of margin due to excess payments or eligible credits not availed.
The users of financial statements are becoming more demanding and the liability and responsibility of auditors is being questioned. Auditors appointed for conducting a due diligence may not in some cases be competent to examine areas relating to compliance with respect to indirect taxes especially in GST which is different from the old laws.
Hence, this article focuses on providing an overview of different methodologies of conducting due diligence under the indirect taxation for the benefit of statutory auditors, investors, financial institutions, governmental organizations and other users of financial statements.
Due diligence is normally associated with takeovers, amalgamations, mergers of entities. It can be said to be a comprehensive appraisal or audit of a business undertaken by a buyer to establish the assets and liabilities of the seller. At times tax considerations are an afterthought which may prove to de-stabilize the amalgamated business especially when the shares takeover route has been followed and the new entity is responsible for the past liabilities.
In the past era ( prior to 1 July 2017) the fact that indirect taxes accounts for about 25- 30 % of the turnover has prompted medium and large industries to choose to get a due diligence to safeguard their margins. Similarly service sector after getting rude shocks at the time of revenue audits where the cost of IDT could be about 15- 20% have also felt a similar need. In GST this has reduced by a few percentage points for goods anicnreased for services.
The impact of indirect taxes in businesses is quite substantial. The impact for various industries before and after the introduction of GST would be even more as follows:
For manufacturing industries could be upto 1st July 17 30% as on date and under GST maybe around 25%.
The trader would also see an impact of 30% in old regime which be around 25% under GST.
Service providers would be presently impacted upto 20% but under GST they would also rise to 22%.
The net operating loss in the entity to be taken over can be a tax attribute of that entity which can be carried over and may be a sole reason for the takeover. The accumulated credits [Cenvat, Input Tax Credit- tranistion], existence of tax free status may also be attributes of an entity which are important from the point of a potential advantage to the next entity.
The main objective is to “extract” and “build knowledge” about the target company’s business operations and weave that knowledge into the important areas of the proposed transaction.
Objectives in relation to indirect tax laws could be as under:
Liability for past acquisitions, reorganization, disposals, restructuring prior to take over need to be stated at proper value.
Liabilities for possible disputes, existing disputes, indemnification or obligation like advance license, open EPCG scheme, export obligations, non receipt of H, I & C forms.
Assets like credits of Excise, Input Tax Credit (VAT), GST ITC credit, unexpired tax holiday, retaining tax collected fully or partially.
Tax sharing agreements for the past existing as on date. In certain cases the successor is liable for the predecessor’s liabilities. ( Section 11 in Central Excise & 87 in Service Tax)
Tax planning opportunities like accumulated credit utilization, huge refunds.
Utilizing sellers tax structure to advantage.
Structuring major transactions to manage indirect taxes.
Managing indirect tax opportunities to enhance the cash flow.
Planning to manage future indirect taxes.
Preparing tax ruling and interpretation requests.
Designing and reviewing systems to help ensure indirect taxes are appropriately collected.
Test billing or point of sale systems.
Managing indirect tax audits and other related issues.
Educating procurment heads, tax managers through workshops, seminars and manuals.
Review of significant tax incentives and government subsidies enjoyed.
Review of deferred taxes.
When a business opportunity first arises, it continues throughout the talks, initial data collection and evaluation commence. Thorough detailed due diligence is typically conducted after the parties involved in the proposed transaction have agreed in principle that a deal should be pursued and after a preliminary understanding has been reached, but prior to the signing of a binding contract.
To confirm that the business is what it appears to be.
To identify potential “deal killer” defects in the target and avoid a bad business transaction.
Satisfies the officers’ and directors’ fiduciary duty to make sure any decision made would maximize values to the organization.
A due diligence audit is equivalent of checking references before hiring. In general, it focuses on information outside of what is freely presented.
To verify that the transaction complies with investment or acquisition criteria.
To gain information that would be useful for valuing assets, defining representations and warranties and / or negotiating price concessions.
It assesses the risks and opportunities of a proposed transaction.
It helps to reduce the risk of post – transaction unpleasant surprises.
It is vital that the results of any due diligence process are relevant to the transaction including:
Valuation of the target and therefore the purchase price.
Sale and purchase agreement (e.g. accounting definitions, accounting and tax warranties, indemnities etc.)
Integration plan (e.g. deal synergies)
There are a range of circumstances in which companies can benefit from externally provided acquisition due diligence:
Where any organization is considering an acquisition, merger or joint venture.
Where the organization or deal manager has limited experience in its undertaking. Where existing advisors face a conflict of interest or are not well placed to undertake it.
Where its requirement demands technical capabilities and commercial experience beyond the organization’s internal resources.
How to Conduct Due Diligence
Start with an open mind – Do not assume that anything wrong would be found and look for it. What needs to be done is to identify trouble spots and ask for explanations.
Get the best team of people– If you do not have a group of people inside your firm that can do the task (e.g. lack of staff, lack of people who know the new business because you are acquiring a business in unrelated areas etc.), there are due diligence experts that you can hire. When hiring such professionals look for their experience record in the industry. Very few knowedlgeable in GST- need to take care.
Get help in all areas– Finance, tax, accounting, legal, marketing, technology and any other relevant to the assignment so that you get a 360 degree view of the acquisition candidate.
Talk to customers, suppliers, business partners and employees – Who are great resource points for the preparatory work necessary.
Take a risk management approach-While doing your researches you also need to make sure that you do not antagonize the team of people of the target company by bogging them down with loads of questions.
Prepare a comprehensive report detailing the compliances and substantive risks / issues.
Due diligence is a process of obtaining sufficient reliable information about the proposed acquisition to help to uncover any fact, circumstances or set of conditions that would have a reasonable likelihood of influencing the offer or decision to acquire business.
The internally generated information obtained during this process would help to:
Verify seller representations.
Assist in the determination of value (assets and liabilities).
Uncover problems, issues and concerns (current and future).
Gain a better understanding of the business and industry, key customers, trends and regulatory requirements.
Evaluate management and key employees.
The externally generated information would focus on:
Public information regarding the company, its principals, key employees and key customers.
Market research to gain a better understanding of the dynamics of the marketplace.
At the beginning of the due diligence process, following documents are normally requested:
The latest business plan.
Product data sheets and literature.
Analysis of competitors.
Organizational chart and tax filings.
Description of lease and detailed budget and revenue forecasts.
Capitalization structure and shareholder information.
Historical balance sheet, cash flow and income statements since inception.
Forecast balance sheet, cash flow and income statements (possibly upto 5 years).
Current operating budgets compared to actual.
The purchase of a business in many instances is the largest and most expensive purchase asset in lifetime Therefore, assessing the businesses fair value includes:
Reviewing and reporting on the financials submitted by the target company.
Assessing the business first hand by a site visit (if applicable).
Working through the due diligence process with the acquiring company or investor by defining the key areas.
Helping prepare an offer based on completion of due diligence.
Important points to be kept in the mind:
It is about managing risk– Double-check financials, reconcile tax returns to books, patents and customers lists and make sure the company does not face a lawsuit or criminal investigation. Extra caution needs to be exercised if the company has never undergone an audit from an outside accounting firm.
Prioritize the people– Background checks on the company’s key officers should be undertaken.
Carry out the checks- With reference to documents and third party verification as appropriate.
Prepare to fix the price– The investor can and do use any flaws that the due diligence uncovers to negotiate the sale price. Due diligence is chance to get “a better deal”.
Transactions Requiring Due Diligence
Mergers and Acquisitions – The prospective purchaser conducts extensive due diligence. He sends a questionnaire to the target company requesting full details of the business’s financials, licenses and collaboration agreements and a whole host of other information. The team doing due diligence then reviews regulatory and press filings, media reports etc. to find out any whether there are any legal and regulatory issues, existing and pending lawsuits and other litigation involving the entity. The team may look for conflicts of interest, insider trading and other problems. In this case, the due diligence is both for buyer and seller.
Partnership – Some of the different types of partnerships where due diligence investigations are appropriate include:
Strategic alliances and strategic partnerships.
Business partners and alliances, partnering agreements, business coalitions.
Just in time suppliers and relationships, sole suppliers, outsourcing arrangements and customers.
Technology and product licensing, joint development agreements, technology sharing and cross licensing agreements.
Business partners, affiliates, franchisees and franchisers.
Value added resellers, value added dealers, distribution relationships.
Joint Venture and Collaborations – Before entering into a major commercial agreement like a joint venture or other collaboration with a company, a collaboration partner would want to carry a certain amount of due diligence. This may not be as extensive as on an acquisition, but the larger company would be seeking comfort that its investment would be secure and the small company has the systems, personnel, expertise and resources to perform its obligations.
Health Check of organisation – Today with thinning margins and millions of transaction tax rate, levy or credit mistakes can be disastrous. In IDT, the GST law being new and vague, possible interpretation can lead to huge demands and fortunes spent on resolving them. It is not uncommon that in the revenue / CAG audits crores of demands are raised which have not been factored in the costs. Many organisations also loose out due to erring on the side of caution.
Transition to Goods & Service Tax- There may be severe impact downwards as well as upwards. The vigilant is expected to take advantage while the unwary may have to pay a big price. Many well run organisations would have closed out the past and make a fresh start without carrying old baggage. They may have got get a comprehensive due diligence of the IDT aspects done for smooth transition.
One may have to examine the methodology to conduct a due diligence under indirect taxation by way of:
General Checklist – For completing the diligence exercise effectively.
Specific Checklist – After understanding of the important aspects of indirect taxes.
Understanding industry and the clients business.
Indirect tax disputes in industry and current status.
Corporate structure of the company/ group in India and outside.
Internal Control specific to IDT like limits, authorizations, written procedures and inbuilt extent of preventive, detective and corrective checks in place.
Extent of IDT reporting in the Management Information System.
Extent of information technology system integration to the indirect tax filing.
Extent of qualified competent officers in – charge of IDT.
External health check/ inclusion of IDT in internal audit scope.
Estimate of risk appetite of the company. Review of Contingent liabilities, tax provisions and tax paid in the balance sheet.
Analysis about effective tax rate and drawing a cost benefit analysis in indirect taxation.
Status and aging of refunds if any under old and new GST.
Major agreements including those which are cross border – impact of GST.
Customer and vendor profiling and changes in the past year.
Last 3 years returns under Central Excise/ CST/ VAT/ Service Tax & GST to be reviewed.
Reconciliation of returns to financials including carried forward balances.
Any advance ruling applied for and obtained / pending before any state or central authority.
Past due diligence report if any.
Indirect tax review as health check / internal audit if any report to be perused.
Each tax file to be checked for adequacy of compliance, completeness and replies examined.
Investigation and audits by revenue- reports and their replies to be examined.
Any contingent liability in the notes to accounts.
Past disputes status, audit queries outstanding not cleared examined.
Exception report on management override [putting through special transactions not in compliance with the system] possibilities and listing of instances.
Is there any existence of internal audit system at the company? If yes, review the internal audit reports to study the excise implications.
Information systems audit report internal/ external if any.
Review and analysis of the past 3 years balance sheet as well as profit &loss account other than reconciliation.
Tax holiday and period for which available along with value limits if any.
Non compete amount paid, transfer of technology, brand and other intangible property impact under CST/ VAT / Service Tax.
Obtaining tax representations and warranties from the seller organizations. Possible tax sharing agreements.
Tax indemnity for the pre transaction taxes as well as in between the handing over process.
Review for registration obtained under Central Excise, Service tax, VAT, Customs & GST provisions.
Review the classification of goods sold and rate of tax applied for sale of goods under VAT/CST/ GST provisions to ensure accuracy of the same.
The specific checklist under each of old laws as well as GST would also be useful in arriving at the proper conclusions.
The successful performance of a due diligence investigation is dependent upon the scoping, co-ordination and planning of the review and the use of a highly skilled team. The cost of the preparation of a quality due diligence exercise is insignificant when compared to the cost of a bad acquisition.
In today’s competitive world the cost of dispute or loss of credit could make a difference between profit or loss. Consequently many medium and large scale manufacturers and service providers consider a due diligence of indirect taxes a value additive effort. It is also called a limited review of indirect tax compliance or IDT health check. Thus, the due diligence of indirect taxes could be a critical ( especially this year with huge differences in transitional credit, ITC availment availment suspected).