In M&A transactions, especially in equity deals, tax-related issues directly affect the transaction costs for the acquiring party, as well as the taxation risks after the acquiring party takes over the target company. This article will analyze tax compliance issues and recommend how to mitigate taxation risks from the perspective of the acquiring party.
During the process of enterprise equity mergers, the acquirer and the target company will sign a letter of intent or a framework agreement with limited legal effects; the acquirer will then conduct legal and financial due diligence on the target company. Apart from the usual due diligence on the financial statements of the seller, due diligence on the tax compliance of the selling company will also be conducted.
Tax compliance due diligence mainly involves scrutinizing and discovering the types of applicable corporate tax and the corresponding tax rates involved for the target company, and whether there are any taxes owing, tax penalties, pending tax investigations or proceedings, and also whether any tax benefits could be enjoyed. For any tax issues or potential tax risks found in the due diligence process, usually there would be an agreement made in the share transfer document. For example, the acquiring party will require the seller in the terms of the contract to make appropriate tax representations and warranties on tax issues involved in the target company to ensure the evasion of taxation risks of the target company before the closing of the transaction date.
Sharing tax costs
In the process of equity transfer, the major tax issue should be for the seller to take liability for individual or corporate tax arising from the transaction. Income from the equity transfer less costs would be the income for the equity transaction.
The above-mentioned individual and corporate income tax are based on the Enterprise Income Tax Law, Individual Income Tax Law, Circular of the State Administration of Taxation on Strengthening the Administration of Enterprise Income Tax on Incomes from Equity Transfers of Non-Resident Enterprise, and Announcement of the State Administration of Taxation on Several Issues Concerning the Enterprise Income Tax on the Indirect Transfers of Properties by Non-Resident Enterprises.
When to declare
For enterprise equity mergers, if the selling party is a domestic individual, they should declare their individual income tax to the relevant tax authorities before the registration of equity transfer changes. If the seller is a domestic enterprise, the income from the enterprise equity transfer and the realized income should be confirmed when the transaction agreement becomes effective and the handover procedure is completed. When the enterprise calculates the income from the equity transfer, it cannot deduct undistributed profits of the invested company and other shareholders’ retained earnings likely to be distributed according to the equity ownership.
If the selling party and the acquiring party are both foreign and the target company is domestic, the domestic company would be the business income tax withholding entity, and the selling party would be the main subject for enterprise income tax. It should be noted that, regarding the declaration of income tax and the required documentation and processing for tax payment, tax authorities in various regions may have different requirements.
When the seller is a foreign citizen selling share ownership in a domestic business, some tax authorities could start tax investigations and require tax payments after obtaining the approval documents and the above-mentioned share ownership transfer documents from the Ministry of Commerce (MOFCOM); some tax authorities will only start processing the tax declaration after the share transfer documents and approval are obtained from MOFCOM, and the change of business registration is completed.
In addition, on the matter of determining taxable income, various tax authorities adopt the principle that “equity transfer income refers to equity transfer revenue minus the cost generated to acquire the equity”. However, on confirming the taxable income from the equity transfer, tax authorities may not use the agreed transaction price to calculate the income from equity transfer to avoid any unfairness in the agreed equity transfer prices, and may also consider the taxable income from the valuation reports of accounting assessment agencies.
Prevention of tax risks
To minimize the tax risks that arise from an enterprise equity transaction, the acquiring party must conduct financial due diligence on the target company before the transaction and require the selling party in the transaction documents to correspond with tax representations and warranties based on the results of the due diligence. However, due diligence may not necessarily find all the tax risks in the target company, and the seller’s tax representations and warranties can only avoid the risks and may not be able to solve the real tax issues that are found after the transaction date.
For example, if the seller is a foreign entity and the acquiring party is a domestic private enterprise, the target company will become a domestic private enterprise after the transaction is completed. After that, annual income tax of the domestic enterprise is settled and the tax authorities in tax inspection/audit process may discover various tax issues of the target company prior to the closing of the transaction. At this time, if the transaction price has been fully paid, and the parties on both sides are in different jurisdictions, the tax risks before the transaction may be transferred to the target company after the transaction.
Therefore, the acquiring party should try its very best when negotiating to further mitigate tax risks through lengthening the payment period, settling payments by instalments, demanding other forms of warranties from the seller, or monitoring account payments.