Danvir Roopra:
Hi everyone. Welcome to the latest episode of our Cross-Border Tax Podcast Series. My name is Danvir Roopra and I am the National Tax Due Diligence leader for BDO Canada.
Buying a business is rarely a straightforward decision. In order to get the most out of a potential deal, buyers need to be aware of key risks and pitfalls so they can incorporate mitigation strategies into their deal negotiations. The challenge for buyers is making sure that no significant risks are missed. This can be difficult, particularly when buyers focus primarily on quality of earnings or other non-financial and tax diligence reviews.
One area often overlooked is tax due diligence. Ignoring tax due diligence can put a buyer at significant risk, particularly with respect to a share purchase. Under a share purchase, all of the assets and liabilities of the target company remain with the purchase company. This means the buyer becomes responsible for any liabilities associated with the company, including those found after the sale is complete.
By conducting tax due diligence, a buyer can be sure they're making a decision based on all the facts, including their potential tax exposures. This knowledge can help increase a buyer's ability to achieve their desired outcomes from the sale.
In today's podcast, we'll be focusing on the importance of tax due diligence when acquiring a business and common issues we see from a corporate income tax and indirect tax perspective. Joining me today is Steve Pereira, a transaction tax partner, and Fred Wong, a senior manager in our indirect tax team.
Today's global income tax laws are constantly changing and are complex with different jurisdictions imposing a myriad of taxes on different types of businesses. Given these complexities, it can be difficult for a buyer to assess whether a potential target is complying with all relevant tax laws and fully understands if any tax exposures exist. Steve, can you share with our audience how tax due diligence works?
Steve Pereira:
Thanks Danvir. Usually, buyer and seller have several talks where under the terms of a nondisclosure agreement, the potential buyer has access to financial information from the target company and starts to put together the parameters of the offer that he's willing to make. The offer usually is in the form of a letter of intent, which outlines the conditions of the sale, one of which is the undertaking of a due diligence during a certain period before the closing date.
Various versions circulate until the final version is signed by the seller, which gives us the go ahead for the tax due diligence of the target. We start off by circulating a request list where we basically ask for tax returns, financial statements, and basically all tax filings and planning memorandums. We usually cover the normal reassessment period, which is usually three years for income tax and four years for indirect tax, but clients might ask for a smaller or a longer period.
Once we get the information, we begin our review and typically send complementary questions. At this stage, a call with management of the target usually takes place in order to speed up the process. This whole process leads to us issuing a report of our findings. Depending on the issues uncovered and how material they are, this can lead to adjustments to the purchase price. It's not often the amount of the purchase price is reduced. Usually, the parties will negotiate a hold back or will negotiate on its quantum, but it could also lead a buyer to go from a share purchase agreement to an asset purchase agreement due to the potential liabilities.
Our findings are also often used to populate the disclosure schedules for the tax reps and warranties in the share purchase agreement. So, we are also often asked to review certain portions of the share purchase agreement.
Danvir Roopra:
Thank you, Steve. That is very helpful. What are some common issues you see?
Steve Pereira:
Obviously, each target is different. But a lot of issues we have come to see over the last few years are in relation to what we call foreign reporting and cross-border transactions. And this is as a consequence of tax authorities increasing over the years, compliance requisites in that area. Many corporations in the mid-market have their tax compliance performed by local firms that may not have the resources to properly comply with all these requirements, so when a potential sale comes along, such issues are often uncovered.
For example, many Canadian corporations carry on business in the US, but are often unaware that their activities there can create a nexus or even a permanent establishment, which could trigger a filing requirement in the US. When these things are uncovered, it often goes back many years so that the combination of tax liability, interest, and penalties may cost for significant exposure.
Also, for targets that are more structured and do business abroad through foreign subsidiaries or sister companies, transfer pricing is often something we look at closely. Many of those corporations do not have a transfer pricing study in place, and some of them also don't hold contemporaneous documentation to support their transfer pricing. Failure to do so, or even worse, false declarations, can trigger penalties or lead to readjustments.
On the domestic side, we still find issues relating to employees versus independent contractor qualifications in certain industries, namely in transportation. Potential exposure for misclassifying someone as an independent contractor includes payroll taxes along with interest and penalties for failing to deduct and remit. Because it could impact employees, payroll issues are usually something purchasers want to see resolved quickly.
Another issue worth mentioning are the pre-closing reorganization, whereby sellers seek to reduce their tax burden on the sale. While the risk usually stays at the shareholder level, some more aggressive plans could trigger tax at the targets level, so the purchaser would be exposed post-closing. Aggressive tax planning is something our tax authorities have been focusing on lately, and it's important to identify these situations from a buyer's perspective. Foreign purchasers are often unaware of what constitutes aggressive tax planning as opposed to standard planning, so it's important for us to advise them on that.
Finally, even if it's not an issue we uncover in the tax due diligence, we like to advise the client on loss of CCPC status since it could have some impacts following the transaction. It is important that the client is aware that loss of CCPC status will put an end or reduce some preferential treatments such as small business deduction and research and development tax credits. Purchasers often make cash projections based on information from prior years and don't take into consideration these changes in rates. So, it's important to inform them properly on the consequences of loss of CCPC status.
Danvir Roopra:
Thank you, Steve. Lots of issues to consider. Fred, what about on the indirect tax side? What are some common issues you see?
Fred Wong:
Thanks Danvir. While many businesses, prospective vendors and prospective purchasers generally have a functional grasp of high level income tax issues, we find that there's a bit of a disconnect between that and indirect tax. In Canada, we have a federal value added tax in the GST/HST regime, a separate provincial value added tax in the Quebec QST regime, and then three more provincial sales taxes in British Columbia, Saskatchewan, and Manitoba. These three last PSTs are more "US style" retail sales taxes and not VATs that function off exemption certificates and specific carve-ins for taxability with unique rules for out-of-province sellers that are simply lobbing goods or services into that jurisdiction.
As the economy has evolved and as the fundamental nature of transactions undertaken in the economy have evolved as well, sales tax legislation has been a bit slow to catch up. Over the last, say two to three years, the five sales tax regimes have been updated with new rules to capture certain types of transactions, with a large focus on the digital economy. Where businesses might have done some analysis in years past to determine their risk and exposure, the implementation of new rules and new regulations and new legislation might have quietly tossed some of that confidence, shall we say, out the window with new liabilities and new hidden issues and exposures to consider.
Outside of core sales tax though, our indirect tax practice also deals with a whole host of other non-income tax issues, including customs, duties, international trade, excise tax, and even property taxes on some occasions. In one instance, I had to wrap my head around Ontario's new environmental handling fees and an effective “recycling tax,” which was a pretty far cry from what I imagined when I initially signed up for this Indirect Tax role.
Danvir Roopra:
How does your analysis differ between a share sale and an asset sale?
Fred Wong:
That's a great question. In a share sale, a lot of the issues that I mentioned earlier come up. We're focused on sniffing out those risks and exposures and potentially unconsidered liabilities and quantifying those as to how they might impact the purchase price and the purchase decision overall. In an asset sale, though, the buyer gets a bit more latitude in asset selection and can narrow down the scope of the deal quite a bit more. Here, a purchaser is generally not assuming the underlying tax obligations of the vendor. Most tax obligations, known or unknown, will generally not transfer to the purchaser if they're purchasing assets.
This renders the earlier discussion on multi-jurisdictional sales and VATs and PSTs, generally prospective operational discussion for future contemplation and not necessarily a key driver to the purchase decision itself. However, the question then turns to whether or not the purchase of the assets of the business are themselves taxable for GST/HST or for PST or for QST.
In short, spoilers here, yes, they're generally taxable. And tax between anywhere of 5% to 15% of the fair market value of those purchased assets could end up being pretty sizeable, so planning needs to be done to accommodate.
The timing of the transaction and the registration statuses of the purchaser and the vendor need to be carefully considered to ensure that the purchaser is entitled to its input VAT or input tax credit claim. If tax is payable and paid on that purchase, in certain instances, an election might be available to jointly avoid the application of GST/HST to the transaction itself, but again, eligibility for this election is very specific and would need to be reviewed to ensure compliance.
GST/HST and Canadian sales tax in general are a bureaucratic and very specific regime driven by transaction timing and a keen eye to documentation standards. A typo or an error in notation could result in pretty significant and material adjustments in subsequent tax authority reviews. So, it's important for professional advisors like BDO to get involved early and assist in the structuring of the transaction and eliminate unnecessary risk.
Danvir Roopra:
Thank you, Steve and Fred. Although this podcast focused on buy-side tax due diligence, business owners are more frequently choosing to perform sell-side tax due diligence in advance of selling their business. Sell-side tax due diligence helps avoid surprises and streamlines the buy-side tax due diligence process. It can reveal potentially deal-breaking issues before a prospective buyer finds them. It is essentially a health check from a tax perspective and it helps the seller maintain control over the sale process, potentially leading to a higher sale price. By detecting possible issues early, sell-side tax due diligence provides the seller an opportunity to correct or quantify these issues before going to market.
The decision to purchase a company should not be made lightly. It is important not to lose sight of risks associated with the transaction. Undertaking tax due diligence is a critical way buyers can be sure they are making the right decision without exposing themselves to excessive risk.
That's all we have for today. Tune into our next episode and don't forget to subscribe to our Cross-Border Tax Podcast Series. Thank you.