M E M O R A N D U M
January 11, 2008
TO: Distribution
FROM: John Staples, Roger Cardinal, Cyrus Daftary
RE: Due Diligence Needed for All M&A
Background. Recent experience shows that financial institutions (“FIs") and multi-national corporations (“MNCs") who acquire companies do not adequately review the tax withholding and information reporting activities of the acquiree as part of their due diligence. Their due diligence often lacks sufficient understanding of the rules and risks in this area; acquirors may accept attestations at face value or make assumptions relying unduly on indemnification agreements to protect them. This is very risky in view of the enormous potential liabilities withholding and reporting failures raise.
Comment. Recent IRS enforcement activities have revealed significant compliance failures in the tax withholding and information return filing activities of FIs and MNCs. These failures may expose an acquiror to liability for taxes not withheld or not properly remitted to the IRS, as well as for large related penalties and interest. Penalty exposure may also arise out of failures to report properly either to the IRS or to customers, or both. The combination of these exposures can easily exceed the purchase price of the target company, and may be greater than the equity of the acquiring company.
Although taxes that must be withheld are not the tax of the withholding agent but of the customer, a withholding agent's failure to withhold makes the agent primarily liable to the IRS for these amounts. Specific failures may include failure to: 1) properly withhold taxes due to flawed documentation; 2) withhold the correct amount of tax due to misunderstanding the character or source of income; 3) remit withheld taxes on a timely basis; and 4) report properly, or at all, to the IRS, the customer/vendor, or both.
While these errors may be inadvertent - due to lack of understanding of the rules, carelessness, or systemic process failures - they are real and visible upon even cursory scrutiny, and the IRS is likely to find them during an IRS audit, especially given dramatically increased IRS enforcement in this area.
Recommendation. FIs or MNCs making acquisitions must determine whether the tax withholding and information reporting procedures of the target were sufficiently thorough. They must review all the target's income collection, tax withholding, and tax reporting systems and procedures before closing. Customer documentation (Forms W-8, W-9, etc) must be thoroughly reviewed to assure that they were current and valid at the time they were relied upon for reduction of withholding. The rates at which tax was withheld must be confirmed to be accurate, based on the character and source of the income being credited. Accurate determination must be made, particularly for US "institutional investors" as to whether or not those investors are exempt from the withholding and reporting rules.
A careful scrutiny of tax target's documentation for non-US persons is essential. If the target's accounts payable or treasury functions have been making payments to non-US vendors or to related parties outside of the US, a careful review of the character and source of such payments should be conducted, and a determination made regarding the status of the withholding and/or reporting activities related to these payments. In particular, failures related to intercompany transactions might be considered to be "FIN 48" issues under current accounting standards requiring financial statement disclosure.
In short, prior to making an acquisition, the acquirer should conduct thorough due diligence on: 1) the target's tax withholding and information return reporting, to include examining existing account files of customers/vendors; 2) the customer/vendor tax profile details and documentation; 3) account opening procedures; 4) characterization of income and corresponding withholding rates; 5) the information return reporting process; 6) all procedure manuals relating to tax withholding and information return reporting process; and 7) recent 1099 and 1042 audit results and/or any recent voluntary disclosures.