Navigating a tax due diligence

Background

A tax due diligence is a comprehensive review of a company’s historic tax affairs. It is typically associated with mergers and acquisitions (M&A) activities and conducted either by a potential buyer during a transaction to purchase shares/a business (purchaser due diligence) or by a seller prior to concluding a transaction to sell shares/a business (vendor due diligence)

The primary goal is to identify potential tax exposures and/or risks that could impact the transaction and to ensure that the target company is compliant with all tax laws. The target company is the company whose share or business is being acquired/sold.

In a South African context, key legislative provisions and concepts relevant to a tax due diligence include the Income Tax Act, the Value-Added Tax Act, and the Tax Administration Act. Understanding these provisions is essential for identifying and managing tax exposures and/or risks effectively.

Some common practical aspects

During the tax due diligence process, several tax issues may be identified. These can include a variety of items, but some examples include:

• Discrepancies in tax filings;
• Unresolved tax disputes;
• Unreported income for tax purposes;
• Incorrect VAT claims; and
• Non-compliance with tax laws.

Issues identified can lead to adjustments by SARS, resulting in additional tax liabilities as well as significant penalties and interest charges. Identifying these issues early in the due diligence process is crucial for mitigating strategies to be considered by the parties. These strategies may include contractual protection (for the buyer) in the form of warranties and indemnities in the Sale & Purchase Agreement, and/or remediation of tax non-compliance through available legislative mechanisms.

Another challenge is when there is a misalignment between the agreed-upon scope of work and what the buyer/seller expects to be covered in the tax due diligence report. From a buyer’s perspective, this can lead to gaps resulting in additional potential risks that need to be addressed. For example, the report may not cover all relevant tax liabilities, leaving the buyer exposed to unforeseen risks.

Another common area that may be overlooked when scoping a tax due diligence, is the potential tax risks in respect of intercompany transactions. Ensuring that these transactions are conducted at arm's length and are properly documented, is essential to avoiding disputes with the tax authorities. Failure to do so can result in significant tax liabilities and penalties for an unsuspecting buyer post-deal.

Post-deal resolution with SARS

When tax issues are identified during a due diligence exercise, it is essential to have a clear strategy for resolution (i.e. usually by the seller pre-deal or the buyer post-deal). SARS provides several mechanisms for resolving tax disputes, including the voluntary disclosure regime and the objection and appeal process which includes alternative dispute resolution (ADR), and litigation. Understanding these mechanisms and knowing when to use them can help resolve disputes efficiently and effectively.

The takeaway

Navigating a tax due diligence requires a combination of thorough upfront preparation, careful scoping and expert involvement so as to identify and appropriately mitigate key tax risk areas.

Authors

Marilize de Kock, Senior Manager

Graham Molyneux, Partner