Common themes from a tax due diligence review

In a previous article we took a brief look at some of the common tax pitfalls in M&A transactions.

In this article, we will delve a little deeper into four of the most common themes arising from our experience of conducting tax due diligence reviews.

VAT reconciliations

One of the themes we find most often is that no VAT reconciliations are prepared by the target in question. A VAT reconciliation essentially is a control mechanism which allows management to ensure that the correct declarations have been made to SARS in any given period. This reconciliation compares, inter alia, what was declared to SARS via a VAT 201 return versus the final figures as compiled in a set of financial statements.

Theoretically, these figures should agree to one another, however legitimate differences often arise due to the time of supply, tax invoices not yet received at year-end, etc. Any differences found in completing a reconciliation should be easily explained. Performing a VAT reconciliation assists in identifying potential over or under declarations to SARS so that any risks can be corrected timeously. Any uncorrected issues may lead to SARS imposing penalties and interest in a period where VAT output has potentially been under declared or where VAT input has been overclaimed. 

Related party transactions

SARS requires the application of the arm's length principle in the pricing of related party transactions, essentially to ensure that the appropriate amount of profit arising from related party transactions is taxed in South Africa.

Companies may seek to reduce their South African profits in various ways, for example by claiming excessive intergroup expenses or excessive interest deductions, or by inadequately bringing related party income to book. A theme noted during tax due diligence reviews is that intergroup transactions are not being recorded properly and there is a general lack of supporting documentation, for example outstanding or deficient loan agreements or lack of intercompany service level agreements. These documents are essential in proving to SARS that such transactions truly exist and are at an arm’s length.

Payroll taxes

Tax law by its very nature is intricate, no more so than in the area of payroll tax. A common area of uncertainty and complexity is the treatment of independent contractors.

In general terms, an independent contractor is paid to render a particular result; he/she is not subject to the control or direction of the target company. In essence, the independent contractor is doing the work as part of his or her own business. However, oftentimes the “independent” contractor is not truly independent and, based on the nature and substance of their role, is more akin to an employee.

In situations where no or very loose employment contracts exist, these lines can easily be blurred, especially where individuals may be working across multiple companies in a group.

Income tax adjustments

Although corporate income tax may be viewed as a “stock-standard” part of any tax due diligence process, there are nevertheless a number of areas where we see common errors being made in target tax computations. These include:

• Income received in advance and the corresponding section 24C allowance for future expenditure;
• ‘Variable’ remuneration such as leave pay/bonus/overtime/commission provisions (section 7B of the Income Tax Act);
• Prepayments (section 23H of the Income Tax Act); and
• Provision for obsolete stock, in particular where ‘blanket’ provisions are applied.

While all of these items may simply represent timing differences between periods, SARS are not shy to impose penalties on these errors, even where a loss arises in the relevant year of assessment.

Conclusion

A tax due diligence review is key in flushing out potential tax risks that may scupper an acquisition transaction. Understanding the common potential tax pitfalls will hopefully enhance your decision-making process and allow contractual safeguards to be put in place where appropriate.

Authors:

Michelle Nyamupingidza, Manager & Marilize de Kock, Senior Manager