Approach To Tax Due Diligence

INDIA
Approach to Tax Due Diligence

February 25, 2009
M&A TAX
Contents of the presentation
 Tax Due Diligence – An overview
 The Process
 Deliverables – Report-drafting &

Conclusions
 Key Considerations
 Identifying business opportunities
 Annexures
© 2009 KPMG, an Indian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All
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What is “Due Diligence”
American Management Association
“Process for seeking sufficient information about a business entity to

reach an informed judgment as to its value for a specific purpose”
• Potential investors should have an understanding of the risks

associated with the business he proposes to acquire
• Knowledge of the Target and a detailed understanding of its

business risks critical in price negotiations
• Tax Due Diligence helps in identifying potential tax exposures

pertaining to the Target
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Tax Due Diligence – An overview
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Which HAT should we DON???
Tax Advisor Consultant Auditor
Open Tax Integration Valuation

Issues Issues Issues
Our scope is restricted to highlighting the potential tax issues and report
non-compliance by the Target
We are not to advise the client on Tax Strategies to mitigate any risk
during the due diligence process
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Want of a Due Diligence
Buy-side
 Cases where we have been appointed by the INVESTOR to perform a diligence on the TARGET
 Strategic investment by investors for acquiring controlling stake in the Target
 Financial investment by investors without acquiring control of the Target
 Investments by Private Equity Funds / Venture Capital funds in the Target
 Acquisition of an undertaking or a part of an undertaking of the Target
Sell-side
 Cases where we have been appointed by the TARGET to perform a diligence on itself
 Sale or hive-off of an undertaking or a part of an undertaking by the Target
 Divestment or sale of stake by the Target to potential bidders
 Vendor Due Diligence to identify potential buyers

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Key Drivers from a Direct Tax perspective
Acquisitions
 Critical to highlight open tax issues & the underlying tax risks
 Significant tax-outflow / potential tax liability in the hands of the Target may be a factor in
consummation of the transaction
 Comment on the provision towards tax in books and the nature of contingent liability, if any
 Section 79 issue in case of closely-held companies
Sale of undertaking / asset sale
 Significant contingent liability on account of taxes could be an issue – Section 281 of the Act
 Continuity of any tax-benefits in the hands of the buyer to be ascertained
 Potential tax exposure to the buyer as a successor of business to be highlighted
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Due Diligence – The Process
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Under the scope
 As a first step, obtain the Letter of Engagement and understand the following;
 Exact scope of work and expectations of the TS Team / Client
 Limited DD vis-à-vis Detailed DD?
 Our client – Buyer or Seller…
 Critical to understand the “Historical Period” covered in the scope of work
 Fact finding exercise should be restricted to the Historical Period
 Open tax assessments and tax liability pertaining to period prior to the “Historical Period” should
be highlighted
 Potential Tax exposure on consummation of transaction may be highlighted though outside the
“Historical Period”
 Communicate the projected time-cost and time-overruns if any at the outset
 Find out the deadlines to issue report and obtain a format of the DD report
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Familiarizing the Transaction
Prior to meeting the Target
 Obtain an understanding of the Target, its business, Promoters, etc.
 Understand the business sector and common tax issues relating to that sector
 Peruse the financial statements / corporate presentations if the Target is publicly

traded
 Hold discussions with TS Team and obtain an understanding of the Transaction
 Background and the proposed transaction structure;
 Promoter tax liability or implications;
 Obtain the ‘Term Sheet’ or ‘Transaction Memorandum’ if any to understand the

mechanics
 Obtain other related documents available including financial statements, Target PPTs, etc.
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Knowing the Target
 Get a detailed understanding of the business of the Target and the proposed transaction
structure
 Critical to understand the rationale of the proposed transaction viz.
 Fund raising exercise through strategic / financial investment
 Divestment to raise funds for other business
 Sale of non-core businesses
 Focus on key tax issues while holding discussions with CFO, key management personnel,
etc.
 A detailed IRL to be provided to the Target and TS contact on conclusion of meeting
 Ask for all information needed to quantify exposures
 Agree time-lines with the Target for provision of information

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Information Requirement List – An overview
 Audited Financial Statements for the Historical Period
 Tax Audit reports for the Historical Period
 Returns of Income for the Historical Period
 Copy of orders, notices, documents, etc. issued by the Revenue
 Copy of TDS returns
 Assessment Status with a description of the amounts involved, demand raised, tax paid, tax authority
involved, etc.
 Details of contingent liability reported on account of tax demand raised and the nature thereof
 Critical agreements entered into by the Target, as deemed relevant for the transaction
 Ledger extracts, if relevant, of the following;
 Related party transactions;
 Provision for tax;
 Expense heads with significant sums
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Deliverables – Report-drafting &
conclusions
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What to report
 Comment on direct tax filings for the scope period, including:
 Timeliness of filings
 Aggressive positions adopted - should be highlighted with judicial precedents
 Review documents relating to open assessments / appellate proceedings and comment on potential
tax exposures
 Exposure to be quantified on an estimate basis
 Comment on possibility of tax exposures in foreign tax jurisdictions
 Comment on TDS filings, if within scope
 Comment on adequacy of provision for tax
 Comment on tax benefits and their availability in the future
 Output in the form of:
 Summary of issues
 DDR report
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Report format – Points for consideration
 Executive Summary – Headlines
 Meant to highlight key issues for Management / CEO / Promoters, etc.
 Should highlight key & significant tax issues and quantify the potential exposure
 Should not be verbose and should not contain references to sections/citations
 Executive Summary – Key Findings
 Meant to highlight issues / finding to CFO / Finance Team
 Should report all the key findings of the review and quantify the potential exposure
 Should not be verbose and detailed in nature
 Supporting Analysis to Key Findings
 Detailed analysis to support the key findings
 Should include details of documents reviewed, discussions with Target officials, judicial
precedents, quantification of exposure, etc.
 Scope & Limitations
 Should highlight the documents / details that were provided for our review
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Concluding an issue
 Conclusions should be fact-based and based on the inputs given by the Target
 Supporting analysis to the key findings should clearly highlight the following points
 Case laws including citation, year, and jurisdiction of the concerned tax authority
 Circulars, instructions, etc. issued by the Revenue
 Documents provided by the Target should be clearly communicated
 Management information or information provided by the Target’s personnel
 External sources of information – Websites, etc.
 Research resouces for drawing conclusions include;
 Provisions of the Act;
 Case laws pronounced by judicial authorities;
 Commentaries on the provisions of the income-tax act
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Tax findings significant in decision-making
 Deal Breakers
 Where the potential issue could derail the consummation of the transaction – Tax
issues may be a deal breaker
 E.g. Non-compliance with key regulations, etc.
 Valuation Issues
 Where the potential issue would be relevant in determining the valuation of the
business – Significant tax issues may in some cases impact the valuation of the
business
 E.g. Non-availability of tax benefits under section 10A/10AA, etc. – Could potentially
increase tax outflow by 33%
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Tax findings significant in decision-making
 Warranties and Indemnity
 Parties to transactions typically seek reps and warranties to cover issues over which
they are concerned
 Where the consummation of the transaction would warrant seeking an indemnity for
potential future tax liability
 Other tax findings
 Tax risks knowingly taken over on the basis where other commercial parameters for
consummation of transaction are in favour
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Key Considerations
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Key Considerations…
 Identify key issues at an early stage and discuss the same with the TS contact / Client
 Seek clarifications from the Target prior to commenting on potential tax exposures in the
report
 Refrain from communicating potential tax exposures with the Target officials prior to
conclusion of the DD
 Quantify estimated amount and the likelihood of exposures resulting in future tax cash
outflow
 Report should be in plain English – should avoid technical jargon as far as possible
 Address the parties as ‘acquirer’ and ‘target company’
 Liaise with the identified contact of the target
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Key Considerations…
 Do not discuss details of assignment with identified contact or any employees of the
Target
 End each day with a list of pending information
 Escalate if information not flowing through
 Seek information needed to quantify exposures
 Avoid commenting on deferred taxes unless specifically asked for
 Discussion with target company only along with supervisor
 Maintain confidentiality
 When in doubt, seek help either from supervisor or TS
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Identifying Business Opportunities
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Identifying Business opportunities
Buy-side opportunities
 Understand the proposed investment structure of the investor – Potential tax and regulatory issues to
be identified
 Alternative structures could be evaluated to mitigate any pain points
 E.g. Jurisdiction analysis and capital structuring where the buyer is a non-resident
 Tax issues identified during the DD could be significant – possible to suggest ways to mitigate tax
exposure
 E.g. Section 79 issue where losses cannot be carried forward
Sell-side opportunities
 Evaluate possible mechanics for hive-off of business or company
 E.g. Sale of business through demerger, slump sale or itemized sale
 Promoter taxability may be an issue where the promoter exits the business or dilutes stake
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Annexures
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Annexure 1 – “Reps & Warranties” and “Indemnity”
“Reps & Warranties”
 Reps & Warranties means “statements by which one party gives certain assurances to the
other, and on which the other party may rely”
 E.g. Rep is given with respect to carved out financial statements that they are correct
(mostly unaudited numbers)
 Where the Rep / Warranty is breached, parties have remedies under the agreement to
seek relief from the other party
Indemnity
 Indemnity means “to compensate another party to a contract for any loss that such other
party may suffer during the performance of the contract”
 Indemnity is a protection mechanism, when you have a quantifiable estimate of any

contingency that you will like to safeguard yourself against
 E.g. Buyer may seek indemnity against contingent tax liability that may devolve, tax
liability pertaining to the seller required to be borne by the buyer, etc.
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Annexure 2 – Illustrative Check List of Issues (1/2)
 Implications of deemed dividend
 Restructuring (if any) and its implications on carry forward of tax losses and depreciation
 Tax benefits (if any) claimed by the company and conditions as to its eligibility
 Implications of change in shareholding in case of closely held companies
 Applicability of Section 14A of the Act
 Regulatory approvals, if any
 Transfer pricing implications if any
 Applicability of section 40(a)(i) / 40(a)(iii)
 Examination / verification of the reconciliation of TDS claim with taxable income
 Eligibility to claim foreign tax credit in India tax return
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Illustrative Check List of Issues (2/2)
 Deductibility of interest u/s 36(1) (iii) of the Act
 Deductibility of bad debts / provision for bad debts
 Examination of whether the deduction claimed in respect of contractual/statutory liability is

allowable in the year under consideration
 Examination of whether provisions made on an estimated basis are allowable as

expenditure in computation of business income
 Examination of details of Miscellaneous/Sundry expenses for ascertaining whether the

said heads contain certain expenditures not allowable under the Act
 Examination of whether the payments made for expenses are disallowable under section
40A(3)
 Examination of tax treatment of “Provision for doubtful debts” while computing “Book
Profits” under MAT
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Thank You
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Approach To Tax Due Diligence

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INDIA

Approach to Tax Due Diligence

 Tax Due Diligence – An overview

 Deliverables – Report-drafting &

 Identifying business opportunities

American Management Association

“Process for seeking sufficient information about a business entity to

• Potential investors should have an understanding of the risks

• Knowledge of the Target and a detailed understanding of its

• Tax Due Diligence helps in identifying potential tax exposures

Tax Advisor Consultant Auditor

Open Tax Integration Valuation

 Strategic investment by investors for acquiring controlling stake in the Target

 Financial investment by investors without acquiring control of the Target

 Investments by Private Equity Funds / Venture Capital funds in the Target

 Acquisition of an undertaking or a part of an undertaking of the Target

 Sale or hive-off of an undertaking or a part of an undertaking by the Target

 Divestment or sale of stake by the Target to potential bidders

 Vendor Due Diligence to identify potential buyers

 Section 79 issue in case of closely-held companies

Sale of undertaking / asset sale

 Continuity of any tax-benefits in the hands of the buyer to be ascertained

 Potential tax exposure to the buyer as a successor of business to be highlighted

 Exact scope of work and expectations of the TS Team / Client

 Limited DD vis-à-vis Detailed DD?

 Our client – Buyer or Seller…

 Critical to understand the “Historical Period” covered in the scope of work

 Fact finding exercise should be restricted to the Historical Period

 Communicate the projected time-cost and time-overruns if any at the outset

Prior to meeting the Target

 Obtain an understanding of the Target, its business, Promoters, etc.

 Peruse the financial statements / corporate presentations if the Target is publicly

 Hold discussions with TS Team and obtain an understanding of the Transaction

 Background and the proposed transaction structure;

 Promoter tax liability or implications;

 Obtain the ‘Term Sheet’ or ‘Transaction Memorandum’ if any to understand the

 Critical to understand the rationale of the proposed transaction viz.

 Fund raising exercise through strategic / financial investment

 Divestment to raise funds for other business

 Sale of non-core businesses

 A detailed IRL to be provided to the Target and TS contact on conclusion of meeting

 Ask for all information needed to quantify exposures

 Agree time-lines with the Target for provision of information

 Audited Financial Statements for the Historical Period

 Tax Audit reports for the Historical Period

 Returns of Income for the Historical Period

 Copy of orders, notices, documents, etc. issued by the Revenue

 Copy of TDS returns

 Ledger extracts, if relevant, of the following;

 Related party transactions;

 Provision for tax;

 Expense heads with significant sums

 Comment on direct tax filings for the scope period, including:

 Aggressive positions adopted - should be highlighted with judicial precedents

 Exposure to be quantified on an estimate basis

 Comment on possibility of tax exposures in foreign tax jurisdictions

 Comment on TDS filings, if within scope

 Comment on adequacy of provision for tax

 Comment on tax benefits and their availability in the future

 Output in the form of:

 Executive Summary – Headlines

 Meant to highlight key issues for Management / CEO / Promoters, etc.

 Should not be verbose and should not contain references to sections/citations