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This article was first published in the January 2009 edition of Accounting and Business magazine.
Due diligence can be a legal obligation, but the term will more commonly apply to voluntary investigations. A common example of due diligence in various industries is the process through which a potential acquirer evaluates a target company for acquisition.
Originally the term was limited to public offerings of equity investments, but over time it has come to be associated with investigations of private mergers and acquisitions.
Due care (duty of care) and due diligence are easily confused but are completely different terms. Duty of care may be very wide, far reaching, and is also subject to argument.
Fundamentally, a duty of care is a moral duty to care. When legal acknowledgment is extended to this moral obligation, then this duty becomes a legal requirement. For example, directors owe their shareholders a duty of care in running the company. In general terms, care is the passive mode; diligence is the active mode. When due diligence is called for, then there will be a set of demands to be complied with, depending on the context.
The due diligence procedures can be viewed as a consulting service, with certain standards established by different accountancy bodies. In normal cases, the due diligence consulting engagement gives the accountant and client the flexibility to design procedures that will meet the client's needs, such as acquiring or investing in an operating company. However, in the more common audit, review, and compilation engagements, the accountant designs the procedures to meet goals contained in professional standards, and issues a report based on them.
Due diligence is a vital part of the acquisition process. It helps clients analyse the quality of a company's historic earnings and the likelihood that forecasted operations can be met. However, it is frequently underappreciated, often leading to failed transactions.
Tax due diligence
The due diligence process varies for different types of companies. The relevant areas of concern may include the financial, legal, labour, tax, IT, environment and market/commercial situation of the company. The crucial, but often overlooked, parts of due diligence are the tax consequences of the proposed transaction.
Tax due diligence normally comprises an analysis of:
- tax compliance
- tax contingencies and aggressive positions
- identification of risk areas
- transfer pricing, and
- tax planning and opportunities.
In the worst cases, due diligence has uncovered aggressive tax planning, different degrees of tax avoidance and/or evasion, complicated group structure and financing structures, incomplete statutory and management books and records and personal tax and profits tax compliance weakness.
There are three major aspects of tax due diligence issues for consideration. These are scope of profits tax charge; profits tax adjustments; and tax administration. The question example below focuses on the tax administration issues. The other two aspects will be discussed in subsequent articles to be published in 2009.
You have been advised that Acquirer Ltd intends to purchase the shares in Target Ltd. Both companies close their accounts by 31 December each year. Target is a Hong Kong trading company incorporated 10 years ago. Its filing position is up to date (2007/08 return filed) but the last return agreed with the Inland Revenue Department (IRD) was one filed three years ago (2004/05 return). Acquirer is now conducting a tax due diligence exercise on Target.