VAT issues before and after a share transaction

By Richard Cornelisse
Objective of a due diligence

Where acquisitions take the form of share transactions, expertise is called in at the due diligence stage in order to assist clients in negotiating a share purchase agreement (SPA). The VAT objective is to provide the buyer with insight into the VAT risks during this review and to provide a summary of additional VAT-related (acquisition) costs. As these risks must often be identified within a short period of time, the VAT consultant will look primarily at the risks from a technical perspective.

Risk profile

Businesses operating in a specific industry or conducting specific transactions may have an increased risk profile. Some examples are:

1. Companies with decentralized responsibility for indirect tax risk management;
2. Companies conducting high-volume cross-border goods transactions, especially within the European Community;
3. Companies using several ERP systems (for example because of earlier acquisitions);
4. Situations in which an ERP implementation procedure has begun at the acquired company, or the ERP package is being upgraded;
5. Businesses operating in the financial or real estate sector;
6. Businesses providing outsourcing services.

The process

In order to perform an effective audit, a VAT specialist will need a variety of documents in order to identify the VAT risks. In this context, particular consideration is given to situations where an incorrect VAT treatment is applied, VAT is wrongly deducted or the statutory conditions for certain facilities are not fulfilled. Obviously, it is essential to obtain insight into any risks that are acquired together with the shares. This may enable the buyer to demand a reduction of the selling price before signing the SPA, or secure indemnification to the extent of the identified risk (and ideally covering the entire VAT position).

The negotiating position will also depend on market factors. If various parties have shown an interest in a take-over object , it is more likely that risks will be accepted. In that case, the VAT consultant must be solution-oriented especially with regard to the risks detected, and formulate action points ensuring that these risks, which may relate to the past or the future, are kept to a minimum in the post-transaction phase.

New risks – future business

Although the emphasis is usually on acquired VAT risks, people often forget that the acquisition itself may generate considerable VAT risks too. Examples include a mistaken perception of the right to deduct the VAT on acquisition costs by a company which only holds shares and is not entitled to deduction. The funding of the acquisition is another case in point. The way in which this funding is structured in the organization may influence the VAT position.

Such matters may again result in a restriction of the right to deduction, although solutions may be found provided that action is taken in time. Before the transaction takes place, it is essential to identify the risks entailed by the acquisition (risk mapping) and to assess where there is (enough) flexibility to optimise the VAT position. Any action points and possible solutions will obviously depend on the actual situation, but the moment when this must be examined will always be the same: before or immediately after the transaction.

A second point is whether staff redundancies are expected after or as a result of the acquisition. In this context, it is relevant to know whether – for example – staff with historical VAT knowledge will be leaving the organization.

The due diligence may involve an assessment as to whether VAT processes, procedures and verification methods have been sufficiently documented. Staff turnover may result in problems such as the unavailability/ inaccessibility of historical VAT return data and unfamiliarity on the part of the acquiring company with the method used in preparing the returns (including any manual adjustments). This could mean that when a VAT audit concerning the period before the acquisition is performed after the event, staff members may have to work extremely hard in order to obtain more insight into the original processes, collect documents and reconstruct VAT returns in retrospect.

I recommend that an assessment be made as to whether the current VAT processes, including all manual adjustments, workarounds and internal processes, have been sufficiently documented (quality check).

Another issue is whether these VAT processes depend on input from local VAT expertise and/or the presence of technology (tax engines, VAT decision tree software, ERP systems, etc.). If so, it must be investigated whether this VAT expertise and/or technology will remain available/accessible or whether it will be replaced after the acquisition.

In addition, future VAT risks may arise as well if the business model of the acquired company is changed through integration with the acquiring company. The following changes may be relevant:

1. from buy-sell to broker or agent (random order)
2. central purchasing of goods
3. changes in goods flows and goods storage locations
4. integration of administrative duties in a shared service centre
5. etc.

The focus in the above change processes may be on the extent to which VAT functionality is automated at present in the ERP systems (such as SAP, Oracle, JD Edwards, Peoplesoft, etc.). An automated indirect tax set up often concerns outgoing invoices. Depending on the set-up and the ERP system, the system itself may be able to determine the VAT treatment and invoice requirements and generate the VAT reports automatically.

If the above automation of the indirect tax set up is not possible or desirable, risk management requires that uniform operating instructions/training programs and a verification system must be present where duties are delegated and have to be processed manually by staff members with a limited knowledge of VAT. This method must be implemented within the organizations in a uniform manner in order to ensure straightforward verification. The question is, of course, what changes the integration will entail for earlier operating instructions.

In addition, the integration may give rise to new (goods) transactions or cause goods to be stored at a different location. It must be examined what changes are implemented and what will be the VAT consequences of these changes, for instance whether the company will have to be registered for VAT purposes in other countries. In addition, it must be examined how exactly the changes will affect the ERP system and/or, in the case of manual VAT processes, what VAT operating instructions should be issued to the staff members who are to assess and manually process these transactions for VAT purposes.

Where the internal division of tasks is concerned, it is important to know whether there will be any changes with regard to the ultimate responsibility. This is essential, because VAT operations must be managed at decentralized level in the organizations (delegation through clear and uniform operating instructions) and retrospective verification must be possible (quality checks through uniform internal audits). The objective may be to establish a single (cross-border) VAT team with efficient and effective communication lines, to allocate tasks internally, or to delegate and verify duties under the ultimate responsibility of one VAT manager (integration).

On the other hand, a decision may be taken not to integrate and instead to structure the VAT return process via different applications, rather than set up an integrated ERP system. Each of the companies will then operate at decentralized level. A certain degree of integration may offer advantages also in this context in that it will accelerate the implementation of changes in the organization and save costs in the event of staff turnover. Here, too, it may be beneficial to set up efficient and effective communication lines for sharing knowledge and to realise a uniform VAT methodology despite the decentralization. The main rule, in many cases, is this: the more decentralized the level of implementation, the greater the need for uniformity in methodology (in order to prevent the development of uncontrolled, ad hoc solutions).

When acquiring a new business it is important to consider the indirect tax consequences of the deal itself and the subsequent integration of that new business into your current business. There are two main routes to acquire a new company: 1) through a share deal and 2) through an asset deal. In practice the most save way to purchase a (part of a) company is through an asset deal as in principle the inherent tax risks remain with the seller. From an indirect tax perspective the indirect tax qualification of the asset deal itself should be determined in the various countries involved (subject to VAT or whether local reliefs can be applied). In addition, as part of the overall tax strategy often new company’s are set-up to facilitate the acquisition. These new local entities need an indirect tax registration prior to the actual conversion in order to ensure application of local reliefs on asset deals, ensure that the new companies can continue the business and avoid penalties for late registration to go live. Timing is important as such a registration process can take more than 3 months in some countries.

One of the challenges is to gain understanding of the acquired business’ exact supply chain to ensure correct treatment of invoices. Any errors could potentially lead to:

1. Incorrect indirect tax reclaim;
2. Incorrect application of indirect tax treatment on sales invoices and rates; and,
3. The risk for administrative penalties and interest imposed by local tax authorities.
4. Invoices issued in the wrong name (both AP and AR) leading to non-recoverable VAT or commercial issues with clients

Albeit this may sound like the main challenge the blind spot usually is also the purchase itself as this can result in future risks.

Although often a transitional agreement is made to utilize the sellers ERP package, it is key that these changes are known and implemented timeline the purchaser's ERP system and tested prior to go live. Why is that important? In practice we have seen lack of central ownership and lack of awareness on the material impact of indirect tax at the right level of the project team leading to the following adverse consequences:

1. Logistical problems (getting goods into a country) and delays and hold off of shipments, resulting in disruption of daily business;
2. Incorrect set up of tax codes and tax determination logic leading to incorrect tax treatment on transactions
3. invoicing errors, resulting in commercial invoice production runs requiring to be re-done (increase days sales outstanding leading to a negative cash flow impact);
4. Difficulties in VAT compliance, resulting in over-/underpayment of VAT and over-/under reporting as well as an increase in manual effort to get returns filed;
5. Mismatch between factual situation and what was reflected in the contracts.

Based on the above complexity, right timing is again extremely important and central indirect tax management perspective is necessary to complete the design phase prior to the transfer date to avoid tax and commercial risks, non compliance and reputation damage.

Conclusion

The conclusion is that the acquisition may give rise to VAT risks that need to be identified in time, following which proactive steps may be taken to limit these risks and optimise the company’s VAT position. Creating VAT awareness and highlighting the risks in time will be the first action point when carrying out during a buyer’s due diligence

Examples of additional questions that may be addressed during a due diligence review with a view to the post-completion situation:

What will be the future internal tasks and responsibilities? Do we expect duplicate functions to result in redundancies? What will be the impact of this on the VAT process?

Is there sufficient insight into the current VAT processes, including all manual adjustments, workarounds and internal quality assurance processes? Have these processes been documented? Is all the historical data as regards the preparation of the returns still available/accessible and is the method of preparing the returns, including the manual adjustments, known and documented?

Have the current VAT processes been documented sufficiently to enable the handing over of duties, for instance when staff members leave the company?

Are these processes currently dependent on VAT expertise and technology of the acquired company? Will this VAT expertise or technology remain available, or will it be replaced after the acquisition?

Who currently bears the ultimate responsibility for the VAT return process? Who bears/will bear this responsibility after the acquisition?

Will there be an integrated ERP system, or will the VAT return process be structured via different applications? The latter option is more likely to involve manual adjustments (e.g. for consolidation purposes), which, from a VAT perspective, will increase the chance of risks (greater margin of error). In practice, for example, we see that staff members with a limited knowledge of VAT are able to manipulate data (e.g. via Excel or even directly in the ERP system), either in preparing the return or otherwise. This obviously raises the issue of data integrity.

To what extent will the set-up and the functionality of the acquired company’s ERP system continue to support the completion of VAT-relevant processes? Or will this system be abandoned?

To what extent will the acquiring company use the acquired company’s VAT-relevant processes to support its own processes (e.g. electronic invoicing/tax engines/tax reports, etc.)?

Will there be sufficient insight into the acquired company’s VAT adjustment and recalculation records?