Tax Due Diligence: Pressing Issues, Material Concerns

By Paulo A. Paulino

First Published in Business World (8/13/2012)

Due diligence, it has been said, is the means by which an informed decision is made.

In an acquisition, while it would be a folly for the acquirer to ignore the tax liabilities of the target company, the tax assets (such as unutilized input VAT, prior years’ excess withholding tax credits, excess minimum corporate income tax (MCIT) credits, and the balance of the net operating loss carryover [NOLCO] account) should command equal scrutiny, as these may survive the acquisition and may be used to mitigate future tax liabilities.

Tax due diligence (TDD) usually commences with an information request list (IRL) sent by the acquirer to the target company. There are target companies that readily provide the information requested, and allow the acquirer to interview their financial and tax officers and consultants. However, there are also those that provide documents sparingly and allow only their transaction advisor to relay filtered replies to the acquirer. What then should be done?

Here, in broad strokes, is a high level TDD process for the acquisition of the shares of a target company.

First, determine the tax regime of the target company. If it is registered with the Board of Investments (BOI) or with the Philippine Export Zone Authority (PEZA), check if it has complied with the reportorial requirements which are prerequisites to enjoying the special tax regime and incentives.

Second, inquire about observed discrepancies: (a) between the tax base in the audited financial statements and the tax base in the tax returns; and (b) among the values declared in the various tax returns (such as sales reported in the VAT returns versus sales reported in the income tax returns, or values reported in the monthly versus the annual withholding tax returns. Then, determine the nature of expenses deducted from gross income and check if the payor, as the withholding agent, withheld the tax due thereon on a timely basis and at the correct rate; failure to do so triggers the disallowance of the expense with the resulting deficiency income tax exposure.

Third, ascertain timeliness not only of filing tax returns and payment of taxes, but also of tax treaty relief applications (TTRAs) in the case of payments to non-residents resident in tax treaty countries. There has been a wave of assessments issued to companies which withheld taxes on dividend payments, interest payments, and royalty payments to non-residents at preferential rates provided under the relevant tax treaties, without first having filed a TTRA. The assessments are for deficiency withholding taxes, i.e., the difference between such preferential rates and the withholding tax rates provided in the Tax Code for payments to non-residents.

Fourth, ask about prior transactions of the target company. With the recent Supreme Court decision in one case, intercompany loans and shareholder advances are now subjected to the 0.5% documentary stamp tax (DST) on the issue value of the loan, due not later than five days following the end of the month when the “loan agreement” was executed. The sale or transfer of Philippine company shares (if any) held by the target company is subject to capital gains tax (CGT) on net gains realized. The target company selling or transferring Philippine company shares could also be liable for donor’s tax if the fair market value of the shares sold or transferred is greater than the cash and/or the fair market value of the property received in exchange, as such excess could be deemed a gift subject to donor’s tax.

Fifth, check for tax audits which are pending or which the target company considers as “closed.” Most companies just pay deficiency tax assessments after receiving a Post-Reporting Notice or after executing a Taxpayer Agreement Form. Neither document guarantees that the audit is terminated for a given tax year. Only a Termination Letter provides such comfort, since it states that the case is considered closed and terminated and filed for future reference.

The absence of a Termination Letter is cause for concern if prescription has not set in. The BIR has three years to issue a Formal Letter of Demand and Final Assessment Notice for deficiency taxes, counted from the last day prescribed by law for the filing of the return. If a return is filed beyond the period prescribed by law, or if an amended return is filed, the three-year period shall be counted from the day that the return or amended return was actually filed. However, in the case of a false or fraudulent return with intent to evade tax or a failure to file a return, the tax may be assessed, or a proceeding in court for the collection of such tax may be filed without assessment, at any time within 10 years after the discovery of the falsity, fraud, or omission. A substantial under-declaration of taxable sales, receipts, or income, or a substantial overstatement of deductions, shall constitute rebuttable evidence of a false or fraudulent return. A failure to report sales, receipts, or income, in an amount exceeding 30% of that declared per return, and a claim of deduction in an amount exceeding thirty percent 30% of actual deductions, shall render the taxpayer liable for substantial under-declaration.

Inevitably, the acquirer will want to quantify the target company’s tax exposures. Sometimes the tax exposures are such that the acquirer will re-think the deal structure and consider the purchase of the assets rather than the shares of the target company. The assets may consist of real property, receivables, intangible assets, and customer lists. Some issues to be considered are: (1) the characterization of certain machinery and office equipment as real property, in which case any unpaid real property tax would attach as a lien on such real property; and (2) the possibility that the acquirer can amortize, for tax purposes, the transfer value of the customer lists and intangible assets, and the period of such amortization.

A TDD, therefore, is useful in determining and deciding on the deal structure, setting the purchase price, and formulating the extent of the seller’s representations and warranties that would be acceptable to the acquirer. Thus, a TDD is imperative to any acquisition, and will have to be conducted in a purposeful manner in the case of competitive acquisitions where the due diligence period is limited and the target company is not very forthcoming with the information requested.

Paulo A. Paulino is a Tax Director of SGV &Co.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.