Tax concerns over an equity merger and acquisition may have a profound impact on key issues like the transaction plan and related costs. Ignoring the tax risks associated with the deal and not taking proper legal precautions to prevent and control such issues may result in these being passed to the acquirer, thereby causing significant loss. To ensure safety and efficiency of an equity M&A, it is important that the acquirer carries out thorough tax due diligence on the target to be well informed about the target’s related risks and take appropriate legal measures either to prevent or to control them.
Failure of target to pay taxes duly in ordinary course of business. Since the transition from business tax to value added tax, implemented across China in May 2016, there are five categories made up of 17 types of taxes in the country. Of these, VAT, corporate income tax and personal income tax are the most closely related to daily operations of enterprises. According to legislation, all enterprises have to pay taxes honestly. There are, however, enterprises that evade taxes through malpractices, including holding accounts in various names, concealing income, presenting imaginary costs or expenses, fraudulent profit-and-loss accounting treatments, or submitting false tax returns. While increasing liabilities on its balance sheet, these malpractices may expose the target to risks of being ordered to pay a tax-make-whole amount, late fees or a fine or being subjected to other administrative punishments.
Lying about nature of enterprise to be eligible for tax incentives. Both the central and local governments have introduced many tax incentive policies to encourage and support the development of small and medium-sized enterprises and high-tech companies. For example, eligible high-technology enterprises are entitled to a reduced corporate income tax rate of 15%, which is generally applied at 25%. Besides, between 1 January 2017 and 31 December 2019, small low-profit enterprises, with annual taxable incomes of less than RMB500,000, are eligible to assess income tax, at a rate of 20%, on only 50% of their actual taxable incomes. To receive tax rebates or deductions, some fraudulently claim to be micro and small or high-tech enterprises through some illegal means to qualify for the relevant tax incentives. These acts carry the risk of the refunded or deducted tax amounts being confiscated or the enterprises involved being subject to relevant administrative punishment.
Improper management of tax payment proof and documentation. Paying insufficient attention, many enterprises manage invoices poorly in the ordinary course of business. The most common actions may involve fake invoices, informal receipts or invoices with contents inconsistent with transactions that surely cannot be used as proof for accounting treatments or tax credits. There are also enterprises that become ineligible for deductions during the operating period for failing to obtain special VAT invoices and have them certified as required, or entities that enter into transactions randomly with the aim of increasing false costs so as to lower taxable profits on their balance sheets. Material tax risks may arise if the relevant tax authorities find unacceptable these or any other similar practices.
Conducting tax due diligence on target. M&A lawyers need to analyse the target’s nature, shareholder background and corporate governance, as well as other issues, including how it has been trading and fulfilling tax payment obligations, to evaluate the level of tax risks. The lawyers also have to ascertain if it has been subjected to any administrative punishments of tax authorities. In addition, they should get informed about tax burdens and risks of the target through a review of its tax proof and documentation. Besides, M&A lawyers may also need to pay a visit to the target’s competent tax authorities and ask tax officers how the target has been fulfilling its tax obligations. These steps can be helpful for a well-informed evaluation of the target’s tax risks.
Structuring and optimizing equity M&A plan from perspective of tax plan. To address properly the target’s tax risks, M&A lawyers may opt for an optimal tax structure and transaction approach to the deal. They need to take into account the actual circumstances of the target, what the acquirer intends to achieve through the deal and any other special requirements of the latter. For example, proper prior planning may lead to special tax benefits over some issues, resulting in a substantial saving in cash outflow costs. Likewise, cost savings may be achieved for both parties in the deal through the use of an offshore structure, if appropriate, to make it an indirect equity transfer rather than a direct one that may carry higher tax burdens.
Making tax implications important for negotiations in equity M&A. Business negotiations are necessary before terms and conditions of an equity M&A can be finalized. If the acquirer is well informed about the tax profile of the target, it may include tax-related matters and relevant potential risks as issues to be discussed in the negotiations. Upon a review of the target’s tax risks, which enables calculation of the tax make-whole amount, late fee or fine that it may be ordered to pay or any other potential tax loss, the acquirer may request that these sums be deducted from the consideration for the equity transfer or be otherwise compensated, thus lowering its acquisition cost or tax loss.
Designing terms and conditions reasonably to keep tax risks in check. The acquirer should ensure the terms and conditions of the equity M&A agreement expressly reflect the target’s identified tax risks, the pertinent tax planning and the negotiation results of these issues. For any unidentified tax risks to which the target may be exposed, the acquirer may prevent and control them with the addition of clauses that allow instalment payments and the acquirer’s retaining the deposit, or require the target to provide a guarantee or assume liability for breach of the deal. These clauses provide maximized protection for the acquirer’s business interests, enabling the acquirer to recover its losses through legal means if such unidentified risks occur.