Tax Due Diligence in M&A Transactions
In our many years of practice in advising on M&A transactions, we did not see many instances of tax due diligence being conducted by the acquirer before concluding a deal. One of the most common perceptions for this is any tax exposure that may exist can be easily covered by a catch-all indemnity clause. This is somewhat true but recovering from the vendor post-acquisition is not easy and will usually involve litigation proceedings.
It is always good for the acquirer to include tax due diligence in the due diligence list so as to enable it to identify any potential tax liabilities before completion of the deal. This will help the acquirer to analyse on whether the issue is negligible and should not hinder the completion of the deal, or is a matter of concern that is likely to have a significant impact on the key terms of, or timescale for completing, the transaction, or present a significant risk to the operation of the business following completion of the transaction.
Some of the tax issues that may exist in a M&A transaction include:
(1) Real Property Company
It is important for the acquirer to ascertain whether the target company is a real property company (“RPC”). A RPC is defined as a controlled company holding real property or RPC shares as a major asset (defined value not less than 75% of the value of its total tangible assets on the date of acquisition). Real properties include land and buildings located in Malaysia. If the company is a RPC, the gains on the disposal of the RPC shares by a corporate shareholder would be subject to real property gain tax (“RPGT”). If real property is acquired closer to an incorporation date of the target company, there is a risk that the target company may be a RPC. The risk would be reduced if on the date of acquisition, there are other substantial tangible assets in the books of the target company such that the value of land does not exceed 75% of the target company’s total tangible assets.
The RPGT shall be paid by the vendor but both the vendor and purchaser of shares in RPC are required to complete and file the requisite RPGT forms to Lembaga Hasil Dalam Negeri (“LHDN”) within 60 days from the date of disposal of shares in the RPC, failing which a penalty may be imposed. The purchaser is also required to retain 3% of the consideration sum and remit the amount to LHDN within 60 days after the date of such disposal. Given this, the purchaser should be satisfied that there are no or there were no real property or real property company shares owned by the target company that may lead to the target company being considered an RPC under the Real Property Gain Tax Act 1976.
(2) Tax Incentives
The purchaser should also verify whether there is any tax incentive granted by the authorities to the target company, for example investment tax allowance (“ITA”) which is granted to companies engaged in promoted activities or producing promoted products, as listed by Malaysia Investment Development Authority. In the case where there is any ITA given to the target company, the purchaser must verify on whether the target company has satisfied all conditions imposed by the authorities and has sufficient documentation to support its claims. If ITA claims are disallowed by LHDN due to the non-compliance of the conditions, the ITA incentive will be withdrawn and any amounts used to offset income in prior year of assessments will be clawed back.
(3) Goods and Services Taxes
If the target company enjoyed the Approved Trader Scheme and Approved Toll Manufacturer Scheme facilities for goods and services tax (“GST”) purposes, the purchaser must verify whether the target company had complied with all the conditions attached. Though GST had been abolished, the target company will still be liable for all historical non-compliance with conditions of GST incentives granted and any adverse GST audit findings.
(4) Transfer Pricing
Under the Income Tax Act 1967, a person who enters into a transaction with an associated person for the acquisition or supply of property or services, must determine and apply the arm’s length price for the acquisition or supply, failing which, the Director- General of LHDN is empowered to make adjustments to the transaction to reflect the arm’s length price, by substituting the transaction price with an arm’s length price. The law requires taxpayers to have in place contemporaneous transfer pricing documentation as a form of substantiation that the transfer prices are transacted on arm’s length basis.
Therefore, it is important that the purchaser verify that transfer pricing methods applied by the target company are properly documented, and the basis of charge is commercially justifiable. If transfer pricing policies are in place but are not being followed, this may be a red flag that needs to be properly assessed. In terms of financing transactions between associated companies which are interest free, the LHDN may potentially impute interest at market rate on the interest-free amounts owing and seek to tax the deemed interest income on the lender for providing interest-free loans/advances to its related companies unless there are commercial justifications as to why interest has not been imposed on the related party balances.
(5) Tax Filing
Under the Malaysian tax legislation, companies are required to submit their tax returns within 7 months from the close of the accounting year (with a 1 month grace period for electronic filing). Violation of this requirement shall, upon conviction, be liable to a fine of up to RM20,000.00 or to imprisonment for a term not exceeding 6 months or to both. The purchaser must be satisfied that the target company has complied with this requirement.
(6) Withholding Tax
Generally, when a resident makes a payment to a non-resident, such payment would be subjected to withholding tax in Malaysia which the resident payer should pay out of the payment to be made, to LHDN. Where the resident payer fails to pay this amount, the amount which it fails to pay shall be increased by a sum equal to 10% of the amount which it fails to pay, and that amount and the increased sum shall be a debt due from it to the Government and shall be payable forthwith to LHDN.
Given this, it is important for the purchaser to verify whether the target company had made any payments to a non-resident which would be subject to withholding tax during the tax due diligence review period.
(7) Tax Dispute
There may also be existing tax disputes between the vendor/target company and LHDN as well as the potential disputes that may occur. The disputes and the extent of exposure must be properly analysed and should not be easily dismissed by a catch-all indemnity clause. While tax advisors are the most appropriate professionals to review the numbers-related documents, lawyers on the other hand would be able to provide valuable perspective vis-a-vis the target company’s compliance/ non-compliance with tax laws based on their review of the non-tax documents such as minutes of meetings of board of directors and shareholders of the target company, financial statements and related footnotes and employment contracts.
Thus, it is important to note that in a tax due diligence, both tax documents and non-tax documents are relevant to the review as they can lead to the discovery of a variety of potential tax issues.
Suhara Mohamad Sidik (Partner) firstname.lastname@example.org
Khairul Anwar Mohamed (email@example.com)