1. Modern Key Tendencies Toward Development of a Standard Due Diligence Procedure and Its Tax Component – Tax Due Diligence
“Due Diligence,” as it is commonly considered, represents complex diagnostics of a given business or its part as an object of purchase and sale where parties gather and analyze information about the object of the transaction for the purpose of revealing any potential risks and factors that may result in any kind of legal consequences. It is important to remember that in most situations results of preliminary exercised due diligence are crucial for a buyer (an investor) to make its final decision regarding the purchase of that business and to determine its price, regardless of whether a subject matter of a transaction is interests in the charter capital, shares, any assets, a company as a property complex, etc.
In this regard, depending onbuyer’s (investor’s) objectives, it is appropriate to recommend the exercise of a complex or standard due diligence procedure, or any of its types, in particular, tax due diligence.
Traditionally, it is considered that one of the purposes of due diligence is to reveal and prevent any potential risks for the buyer (investor), however, in fact, in our opinion, it is more appropriate to mention not only risks but also any other consequences pertaining to the conclusion of the transaction, both positive and negative, and in case of existence of any negative consequences, it Is important to timely elaborate mechanisms for their eliminations or optimization.
Modern principles and methodology of exercising due diligence have evolved over the yearspredominantly in Western countries where they, while being a natural element of an M&A transaction, are specified in strict standards and rules. In this regard, we may mention theSarbanes-Oxley Act adopted in the United States in 2002 or the Swiss Bank's Due Diligence Agreementin Switzerland. At the same time, the history of M&A transactions and due diligence in the CIS countries started only about two decades ago that explains much the lack of uniform standards and views among professional participants of this market as well as among the legal society. Moreover, neither Russia nor Uzbekistan has such standards, which are undoubtedly required to be elaborated and promptly implemented. Also, most importantly, unfortunately, there is no strict compliance in practice.
In addition, the existing national standards of accounting in each of the CIS countries do not, unfortunately, regulate the procedure for exercising tax due diligence.
Not focusing on all differences in a standard distinction between audit and tax due diligence, Jim Wood, a prominent Western financier, once said that audit is an expression of an opinion regarding financial statements in accordance with certain standards (accounting rules) and not merely a process of finding key risks which may be of seller’s and buyer’s (the parties to the sale and purchase of the company) interest, where such a process is inherent to tax due diligence.
Taking into account the aforesaid, we may conclude that tax due diligence is an important component of a complex or standard due diligence procedure, which aims at providing a buyer with reliable information on fulfillment of its tax obligations by the target company in the past and present as well as a projected size of tax burden in the future.
While exercising tax due diligence, the following is to be completed:
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examination regarding compliance of company’s financial activities with the existing tax legislation;
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evaluation of main taxes to be paid by the company;
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evaluation of tax consequences under the concluded transactions (contracts);
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evaluation of already used as well as potential schemes of tax optimization;
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examination regarding availability of any tax violations committed by the company and registration of probable results of the existing and future tax disputes, as well as detection of any consequences regarding claims by tax authorities.
Typically, the following methods to acquire the existing business are distinguished, which a buyer (an investor) may use:
a) acquiring shares (interests) in the company’s charter capital;
b) acquiring underlying assets of the company;
c) purchasing the company as a property complex;
d) re-organizing the legal entity in the form of merger or acquisition.
Each of those methods, naturally, has its pros and cons and, therefore, any of such methods needs to be considered in terms of its feasibility and applicability to each specific situation.
2. Structure of Tax Due Diligence in Uzbekistan
The Tax Code of the Republic of Uzbekistan, that became effective on 1 January 2008, was originally designed as a code of direct action. However, it is generally recognized that the tax due diligence procedure, as well as any other varieties of a complex or standard due diligence procedure, is not sufficiently regulated in the legislation of the CIS countries, including Uzbekistan, and rather exercised according to certain agreements between (i) the buyer, the final owner of the assets to be acquired, (ii) the target company (or an owner of certain assets), and (iii) consultant who exercises due diligence. In some cases, this list may include investment intermediaries.
In Uzbekistan, “mergers and acquisitions” in their classical sense are carried out mostly in compliance with the general rules of re-organization of legal entities.
Upon merger and acquisition of legal entities, rights and obligations of each of them are transferred to a newly established legal entity or to a legal entity that has acquired another entity, where the bases and the scope of such rights and obligations are set out in a certificate of transfer.
With regard to taxation matters, here the key issue is the scope of succession tax. Fulfillment of tax obligations regarding payment of taxes and other mandatory payments of the re-organized legal entity is imposed on its successor regardless of whether before the finalization of re-organization the successor was or was not aware of any facts and/or circumstances of failure to fulfill or improper fulfillment of tax obligations by the re-organized legal entity.
It is important to mention that in Uzbekistan registering agencies usually consent to a merger or acquisition only after receiving from companies to be acquired a statement issued by the tax authority confirming that there is no debt to the budget at the time of the re-organization.
Often times, in practice, there is a question regarding seller’s responsibility for tax claims that may arise as a result of an unscheduled tax audit, cameral control, etc. In general, tax obligations of a legal entity are to be terminated upon its re-organization by acquisition (with respect to a target company), merger, separation, and transformation. Hence, in such cases, the seller’s responsibility shall be discharged upon such re-organization. Primarily it refers to administrative and criminal responsibility, however, at the same time, what should the successor company or the buyer do if while selling its business the seller represented and warranted that there were no any mandatory payments due? Should the seller bear any civil responsibility? In our opinion, this matter should be reflected in the terms and conditions of relevant contracts entered into by the parties to the transaction.
In addition, it is important to note that the State tax authorities may impose or revise the amount of taxes and other mandatory payments charged over a five-year period following the tax period. Within the same time frame, a taxpayer has the right to claim set-off or refund of overpaid taxes and other mandatory payments.
In Uzbekistan, one of the factors that may affect tax conditions of the acquired company is a territorial (regional) and industrial aspect of its activities. One of the examples of such effect is when the acquired company is located in a free economic zone existing in Uzbekistan or its establishment and operation in certain labor surplus regions.
An industrial aspect (types of company’s activity) is also significant. For instance, if the company carries on activities that are subject to licensing or enjoys special benefits and preferences, then in case of acquisition of this company and its subsequent re-organization, all preferences and benefits earlier granted to the target company under special acts of legislation become invalid, thus, the successor company will not be able to enjoy those tax benefits. In this regard, in order to preserve existing tax benefits and licenses of the company, one of our recommendations is to acquire a company in Uzbekistan by purchasing its stock or interests in the charter capital.
3. Peculiarities of Object Selection
In considering the issue of analysis and projection of tax consequences (risks) associated with company’s acquisition in Uzbekistan, one should pay attention to the likelihood of re-audit by tax authorities, including in respect of tax periods, which has previously been the subject of scheduled and unscheduled audits.
One of the possible solutions to this problem is to complete an M&A transaction by acquiring underlying (main) assets of the company.
The particularities of object selection while exercising tax due diligence include the analysis of existence of any tax potential (identification of overpayments, opportunities for tax optimization), where any of such particularities are to be determined individually for each company by:
- identifying unused benefits provided by the Tax Code of Uzbekistan or by special sub-legislative normative acts;
- identifying a possibility to transfer to a simplified taxation system;
- entering into special State investment programs that provide tax conditions which differ from the standard ones.
4. Scope of Due Diligence
The scope of issues to be analyzed while exercising tax due diligence is of practical importance. The most risky tax positions should be examined by verifying the accuracy of the following:
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identification of the taxable base and objects of taxation based on primary documents;
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application of benefits, tax rates, and compliance with the conditions under which the benefits are applied.
Due to the difficulty in determining a taxable base and the availability of different requirements that has to be met for the lawful application of benefits, such most risky positions usually include:
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income tax;
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VAT;
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property tax.
Besides, the above category may also include taxation of export and import operations where it is required to take into consideration an international legal component of tax treatment regulated by interstate and intergovernmental agreements.
Uzbekistan adopted a number of normative acts that significantly impede activities of so-called “one-day firms” whose objective is, as in other countries, partial or full tax evasion which has nothing to do with tax optimization.
For example, once the money is transferred to the company’s account as a result of trade transactions, whereas such company has the license necessary to carry on wholesale trade activities, a tax agent incontestably writes off the amount of sales tax therefrom.
Also, generally transactions, where one of the parties is an offshore company, are immediately subject to scrutiny and control by the law enforcement bodies.
5. Allocation of Tax Risks
Companies are taxed according to the legislation of Uzbekistan that is effective at the time tax obligations arise.
Acts of the tax legislation are not retroactive and apply to those relationships that have arisen after such acts came into force, unless otherwise provided by the Tax Code of Uzbekistan. At the same time, provisions of the tax legislation that eliminate or mitigate liability for violation of the tax legislation are retroactive.
It should be specifically emphasized that after the new Tax Code of Uzbekistan became effective, direct risks associated with inaccurate interpretation of its provisions have been considerably reduced. However, in practice, sometimes one has to face with situations where the tax authorities incorrectly construe certain norms of the tax legislation.
In such a situation it is important to remember that compliance by a taxpayer with written clarifications regarding the matters of application of the tax legislation, where such clarifications are issued by authorized bodies or their officials within the scope of their authority,is deemed circumstances that eliminate the guilt of a person in the commission of a tax offense.
Finally, it is necessary to point out that almost every M&A transaction, in a varying degree, is preceded by a complex or standard due diligence procedure. And tax due diligence as an essential part thereof is aimed at identifying tax risks or consequences and must take into account the totality of particularities of a legal and tax jurisdiction of the target company along with all other nuances.
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