The Role of Tax Due Diligence in South African M&A Transactions

With the intricacies of South Africa's tax environment and the stringent enforcement policies of the South African Revenue Service (“SARS”), presenting challenges that can undermine the success of these transactions, a tax due diligence (“Tax DDs”) can help mitigate risks by identifying potential exposures, ensuring compliance, and unlocking tax efficiencies that contribute to the transaction’s overall value.

This article explores the importance of Tax DD in M&A, sector-specific tax considerations, the critical treatment of grants and incentives, and common pitfalls with actionable recommendations to address them effectively.

Why a Tax DD is Crucial in M&A Transactions

In any M&A transaction, understanding the tax position of the target company is a cornerstone of informed decision-making. The Tax DD process provides the buyer with a clear picture of potential tax exposures, compliance gaps, and optimization opportunities. This enables buyers to make strategic decisions regarding the transaction’s pricing, structure, and risk allocation.

One of the primary objectives of a Tax DD is to identify and quantify hidden tax liabilities that may not be disclosed in the target company’s financial statements. These liabilities could include unpaid income taxes, VAT discrepancies, customs duty exposures, or payroll tax irregularities. Undisclosed liabilities can result in significant financial penalties, interest charges, or reputational damage for the acquiring entity post-deal.

Beyond liabilities, a Tax DD validates the target company’s tax assets. These assets could range from deferred tax balances to carry forward assessed losses, government grants, and tax incentives.

Ensuring that these assets are accurately calculated and remain usable post-acquisition is critical to protecting the transaction’s value. Additionally, a thorough tax DD process also identifies inefficiencies in the target’s tax strategies and provides recommendations for minimising future tax exposure and remediating current tax risk.

Key Industry-Specific Trends in South Africa’s M&A Landscape

South Africa’s M&A activity spans a diverse range of industries, each presenting unique opportunities and challenges from a tax perspective.

Technology and Telecommunications

• The technology sector in South Africa has seen substantial M&A activity, driven by the need for innovation, digital transformation, and market consolidation. Companies in this sector face complex tax issues related to the classification and amortization of intangible assets such as software and patents. Transfer pricing is another critical area, particularly for multinational entities engaging in intercompany licensing agreements. VAT compliance on digital services also poses challenges, especially for cross-border transactions.

Energy and Renewables

• The energy sector, particularly renewables, is experiencing rapid growth, fueled by the government’s commitment to sustainability and programs like the Renewable Energy Independent Power Producer Procurement Programme (REIPPPP). M&A transactions in this sector often involve significant capital investments, requiring careful analysis of capital allowances, carbon tax liabilities, and green energy incentives. A Tax DD in this sector also evaluates the impact of environmental levies and depreciation allowances on the transaction's financial outcomes.

Mining and Resources

• South Africa’s mining sector, while mature, remains a cornerstone of the economy. M&A transactions in this industry often focus on cost reduction and operational efficiency. Tax DD in mining is particularly challenging due to the sector’s exposure to royalties, transfer pricing issues for intercompany services, and the tax implications of rehabilitation liabilities. Additionally, VAT refunds on exported minerals and the impact of the Mineral and Petroleum Resources Royalty Act are critical considerations.
• Another critical yet often overlooked aspect is the diesel rebate system for mining companies. The South African government provides diesel rebates to qualifying mining operations to mitigate fuel costs. However, incorrect claiming or historical non-compliance can create significant liabilities for an acquirer. Any discrepancies in the amount of the rebate claimed can result in claw backs, penalties and/or interest being levied, ultimately affecting the financial viability of the transaction.

Healthcare

• The healthcare sector has become a focal point for private equity investments, driven by rising demand for healthcare services and the need for specialized facilities. Tax DD in this sector often focuses on VAT implications for healthcare services, customs duties on imported medical equipment, and withholding taxes on cross-border licensing arrangements. Ensuring compliance with SARS regulations on these aspects is essential to avoid exposure to additional tax and penalties .

Retail and Consumer Goods

• Shifting consumer preferences and the growth of e-commerce are reshaping the retail landscape in South Africa. M&A transactions in this sector typically involve complex supply chains, necessitating a detailed review of VAT compliance, customs duties, and excise taxes. Tax DD also evaluates the tax implications of integrating legacy systems and processes in post-deal operations.

The Complexities of Grant Treatment in M&A Transactions

Government grants and incentives often form a significant component of a company’s tax position, particularly in sectors such as manufacturing, renewable energy, and technology. Mismanagement or misclassification of these grants during an M&A transaction can result in substantial financial and tax exposure.

From an income tax perspective, grants are categorized as either revenue or capital in nature. The classification depends on the purpose of the grant and its intended use. Misclassification can result in tax disputes or adjustments post-transaction. The VAT implications also require careful consideration.

Compliance with grant conditions is another critical aspect. Many grants come with stringent requirements, such as job creation targets or specified uses for the funds. Non-compliance can trigger claw backs, creating liabilities for the acquiring entity.

Common Tax Pitfalls in M&A Transactions and Recommendations

Historical tax compliance gaps are one of the most common issues uncovered during Tax DD, often stemming from non-compliance with SARS regulations. To address this, it is crucial to conduct a detailed review of the target company’s tax history, including filings, payments, and SARS assessments, for a minimum of five years. Reconciling SARS statements of account with the company’s financial records helps ensure accuracy and identify potential discrepancies early.

Cross-border tax risks present additional challenges, especially for multinational entities exposed to transfer pricing adjustments or permanent establishment risks. A comprehensive review of intercompany pricing policies is essential to ensure alignment with OECD guidelines and South African regulations. Evaluating applicable tax treaties can further help minimize the risk of double taxation.

Overlooking the tax implications of transaction structuring could result in unintended tax exposure which is a  common but avoidable oversight  Whether a transaction is structured as an asset purchase or share acquisition has significant tax consequences, including the impact on capital gains tax (CGT), transfer duty, and VAT.

Conclusion

A Tax DD is an essential component of successful M&A transactions, particularly in a complex environment like South Africa.  It helps identify potential tax leakages within the target business and formulate warranties and indemnities for inclusion in the Sale and Purchase Agreement (SPA). This adds immense value to clients by protecting them from unforeseen losses when acquiring or selling a business. Tax due diligence provides an acquirer with a comprehensive understanding of the seller's tax processes, thereby facilitating a smoother integration with the newly acquired business.

It lays the foundation for seamless post-transaction integration by identifying synergies, harmonizing tax processes, and mitigating risks that could disrupt operations.

In a rapidly evolving M&A landscape, companies that prioritize comprehensive and industry-specific tax due diligences are better positioned to navigate risks, maximize value, and achieve long-term success. For South African businesses, meticulous tax planning and due diligence are not just best practices—they are strategic imperatives.

Engaging tax specialists early in the process allows for a tailored evaluation of the transactions, ensuring the deal is optimized and any future tax risks are mitigated through remedial actions or covered by suitable indemnities and warranties.

Authors:

Devs Moodley, Senior Manager

Althea Soobyah, Partner