This article was first published in the January 2009 edition of Accounting and Business magazine.

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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.

Sample question

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.

Further information

  1. In the profits tax return for 2005/06, Target claimed a profit on disposal of a property was non-taxable on the basis that the profit was of a capital nature. The Commissioner did not agree this, an additional assessment was raised on the profit made, objection was lodged and the tax assessed was held over. The case has not yet been finalised.
  2. Target's 2007/08 profits tax return was filed three months late due to missing records. This led to a qualified auditor's report for the year ending 31 December 2007 being issued.
  3. In its profits tax return for each year since 2006/07, Target made an offshore claim that profit arising from the sale of goods in Macau should be treated as non-taxable. This was on the grounds that it had appointed a salesman in Macau. However, the salesman has recently left the company and since then, the Hong Kong sales team has handled Macau sales orders.

From a tax perspective, what are the issues for the purchaser in negotiating the terms of the tax indemnity deed to be included as part of the sale and purchase agreement?

Sample solution

Answers should cover the following points:


Section 71(2) of the IRO (Inland Revenue Ordinance) says that the Commissioner has the discretion to allow the tax in dispute to be held over in one of the following ways:

(a) by an unconditional holdover
(b) by a holdover on condition that a Tax Reserve Certificate (TRC) is purchased for the amount of tax in dispute, or
(c) by a holdover on condition that a bank guarantee for the tax in dispute plus any interest is issued.

If the holdover was unconditional and the tax in dispute was subsequently found to be payable, Target would have to pay the tax in dispute plus interest at the Chief Justice's rate, counting from the later of the original due date or the date of the holdover notice to the date that the objection is settled or determined.

If it was a holdover with TRC and the tax in dispute was subsequently found to be payable, Target would only be required to present the TRC for settlement but no interest would be calculated on the TRC. Target would not be required to pay any additional interest accrued during the objection process.

However, if the tax in dispute was ultimately found not to be due, Target could either cash the TRC with interest or request a replacement TRC for other tax payment purposes.

Where the holdover was granted with the bank guarantee, in the case where the tax becomes payable, the consequences would be similar to the unconditional holdover, ie tax payment plus interest.

In view of the above, unless a TRC is purchased, the failure of the objection gives rise to an immediate tax payment plus interest. Upon share purchase transaction, this becomes a potential additional liability to be borne by Target. It is therefore advisable for the directors of Acquirer to ensure adequate provision is made in the accounts of Target or alternatively, an adjustment should be made to the share purchase price.


The late filing of the 2007/08 profits tax return may lead to the following:

(a) Under section 80(2), it is a potential offence to file, without reasonable excuse, the appropriate return under section 51(1) within a specified period. Therefore, if a return is filed later than the specified period, a penalty may be imposed.
(b) The maximum penalty, if prosecuted, is a fine at level three, ie HK$10,000 plus three times the undercharged tax.
(c) The penalty may be lowered, at the Commissioner's discretion.
(d) Alternatively, the Commissioner may invoke section 82A to impose an additional tax at a maximum of treble the amount of undercharged tax.

A company may try to negotiate with the assessor for a lower penalty on the grounds that the current management was not involved in the business for the captioned year. But this depends on the circumstances of the case, and negotiations are at the discretion of the Commissioner or the Deputy Commissioner.

Even if no penalty action has ever been taken by the Commissioner, it is still advisable for Acquirer to seek indemnity from Target with respect to the potential penalty or additional tax involved.

Record keeping

Under section 51C, any person carrying on a trade, profession or business in Hong Kong is required to keep sufficient records in English or Chinese of his income and expenditure for seven years after transactions are completed.

Records include books of account, receipts and payments, income and expenditure together with vouchers, bank statements, invoices, receipts and other documents necessary to verify the entries in the accounts. They also include records of assets and liabilities, goods purchased and sold, details of sellers and buyers, records of stocktaking, and records of services provided.

Although it is not clear what records are missing, Acquirer should request a tax warranty from Target that the records required by law have been sufficiently and properly maintained for not less than seven years.

Additional assessment

Depending on factors such as the place of negotiation and conclusion of the contracts for purchase and sale and decision-making, the IRD may refuse to allow the offshore claim on the basis that the operation is run in Hong Kong. The implication is obviously an increase in assessable profits (or reduction in allowable losses) since 2006/07. This should be taken into account in negotiating the tax indemnity.

The Commissioner is also empowered under section 60(1) to raise any assessment within six years after the end of the year of assessment in which a transaction or event occurs. In the case of fraud or wilful evasion, the time limit is extended to 10 years.

For the purpose of the share purchase, it is recommended that a tax indemnity be requested from the seller to shelter any further tax liabilities.

For all the potential additional assessments mentioned above, there is a risk that Target will be subject to a penalty for filing incorrect tax returns or information. Any tax indemnity should also cover all other possible additional tax liabilities arising out of the pre-acquisition period, and should remain valid for a period of at least six years after the acquisition.

This is in line with the statutory time limit within which the IRD has the right to issue any additional assessment. Any tax indemnity should also cover any additional costs arising from these events such as penalties, surcharges, additional taxes and probable legal costs.

Mike Li is principal of the Accountancy Training Company (ATC), Hong Kong