Tax due diligence is a crucial aspect of any significant business transaction, ensuring that all tax-related risks and obligations are identified, assessed, and properly managed. In Nigeria, a country with complex and evolving tax regulations, conducting thorough tax due diligence is especially important. Whether you are considering a merger, acquisition, investment, or any other transaction, understanding and managing tax implications can greatly impact the success of the deal. In this article, we will provide a comprehensive guide to performing tax due diligence in Nigeria.
Understanding the Importance of Tax Due Diligence
Tax due diligence involves a systematic examination of a company’s tax records, practices, and potential assets/ liabilities. In Nigeria, where tax laws can be intricate and subject to frequent changes, conducting comprehensive tax due diligence helps mitigate the risks associated with non-compliance, unexpected tax liabilities and possible deal breakers. It also helps in discovering inherent tax assets or incentives that may be benefitted from a business deal / transaction. Failing to properly assess these factors can lead to financial losses, legal disputes, and damage to the reputation of both parties involved in a transaction.
Tax due diligence should be conducted during the pre-transaction phase of any business deal or transaction that involves financial implications. It is a crucial step that should be taken before finalizing any merger, acquisition, investment, joint venture, or other significant business transaction. Performing tax due diligence early in the process helps identify potential tax-related risks and obligations, allowing you to make informed decisions and mitigate any negative impacts on the transaction.
Here are some specific situations when tax due diligence should be performed:
- Mergers and Acquisitions (M&A): When considering the acquisition or merger of a company, conducting tax due diligence helps the acquiring party understand the target company’s tax positions, liabilities, and potential risks. This information is crucial for accurate valuation and negotiating deal terms.
- Investments: Before investing in a company, whether through equity or debt, investors should assess the target company’s tax compliance, positions, and any outstanding tax liabilities. This evaluation ensures that the investor is aware of potential risks and can make an informed investment decision.
- Joint Ventures and Partnerships: When forming joint ventures or entering into partnerships, it is important to review the tax implications for all parties involved. This includes understanding how the business structure and profits will be treated from a tax perspective.
- Real Estate Transactions: Property transactions, such as buying, selling, or leasing real estate, often have significant tax implications. Conducting tax due diligence helps parties involved understand property-related taxes, exemptions, and other relevant obligations.
- Business Restructuring: Any significant changes to a company’s structure, such as spin-offs, divestitures, or reorganizations, can have tax consequences. Tax due diligence ensures that the restructuring is executed with a clear understanding of the tax implications.
- Initial Public Offerings (IPOs): Companies planning to go public should conduct tax due diligence to identify and address any potential tax issues that could arise during the IPO process.
- Cross-Border Transactions: Transactions involving parties in different countries often have complex tax considerations. Conducting tax due diligence helps manage risks related to international tax laws, transfer pricing, and double taxation agreements.
- Change of Ownership or Management: Even if there is no formal acquisition or merger, changes in ownership or management can trigger tax implications. Tax due diligence can help ensure a smooth transition and compliance with tax obligations.
Key Steps in Performing Tax Due Diligence in Nigeria
1. Understand the target Company/ Industry, the Transaction Triggering the Due Diligence and the Objective/ Brief of the Exercise:
To successfully perform a tax due diligence, one needs to have broad understanding and knowledge of the target company, the industry in which it operates, and the tax laws, practice and regulations that apply or may shape the industry imminently. Also keep in mind the many changes in tax laws that have been effected and those that are being envisaged in the country’s frequently changing tax laws. Further, a thorough understanding or awareness of the transaction giving rise to the due diligence exercise and the objective(s)/ brief of the exercise (e.g. identification of deal breakers, quantification of tax exposure or even determination of goodwill for business combinations purposes) will help shape and streamline the work approach for the tax due diligence.
2. Gather Relevant Information:
Start by collecting all relevant financial and tax-related documents. This includes income tax returns, value-added tax (VAT) returns, transfer pricing documentation, payroll tax records, any correspondence with tax authorities, etc. Understanding the company’s organizational structure and business operations is also essential.
3. Review the Composition and Quality of the Company’s Tax Function:
Review and evaluate the structure/ composition of the tax function in terms of size, skill, expertise, capacity, staff turnover, work arrangement, file/ document storage facilities, tools/ technology infrastructure, frequency and effectiveness of training programmes, external tax advisors, auditors, management oversight and then general employee culture of the company. These would form part of the initial indicators of the company’s tax culture and pointers towards the nature of tax risks or assets that may exist within company.
4. Review Tax Compliance:
Assess the company’s compliance with Nigerian tax laws/ practice/ regulations, and how responsive the company has been towards Nigeria’s changing tax laws. Verify whether the company has consistently filed tax returns, paid taxes on time, and complied with reporting requirement. Identify any outstanding tax liabilities or penalties.
5. Analyze Tax Positions:
Examine the company’s tax positions, such as tax deductions, exemptions, credits claimed. Ensure that these positions are well-supported by proper documentation and in accordance with Nigerian tax laws and regulations.
6. Identify Potential Risks:
Determine any potential tax risks associated with the company’s operations. This may include risks related to tax technology, lack of adequate tax knowledge by the tax function particularly in the face of changing tax laws and practice, transfer pricing risks (where a related party structure exists), income tax, withholding tax, VAT compliance and employee tax compliance risks. Assess the likelihood and potential financial impact of these risks.
7. Evaluate Income Tax:
Income taxes consist in current and deferred taxes. Evaluate the correctness of the company’s income taxes (current and deferred tax) computations and recognitions, particularly on the backdrop of changing tax laws and practice (e.g. income tax computations and filing on TaxProMax).
8. Review Tone of Correspondences Between the Company and the Tax Authorities:
Review tax correspondences between the tax authorities and the company. These will provide some indication or lead about the quality of relationship that exists between the tax authority and the company. The tone and nature of the correspondences will also provide indication about the company’s tax compliance levels/ culture and the disposition of the tax authorities towards the company.
9. Review Past, Existing and Impending Tax Audits/ Checks:
Review all tax audit files/ correspondences to determine tax issues peculiar to the company, areas of exposure/ weakness and contingent tax liabilities or assets.
10. Review Potential Risks or Benefits Associated with the Company’s Tax Technology Infrastructure:
Understand holistically the company’s tax technology infrastructure and evaluate the risks or benefits they hold towards the proposed deal/ transaction. Whether the company adopts custom made technology platform or third party/ already-made technology products, they are an integral part of the company’s tax function which will directly impact the proposed transaction.
11. Review Supply Chain and Tax Impacts:
Review the company’s supply chains – for both procurement and sales. This will reveal levels and ramifications of supply related taxes (value added tax, withholding tax, stamp duty) that may apply to the company.
12. Check Existence of Digital Assets and their Tax Treatments / Implications:
Recently, Nigeria has focused attention to taxing digital assets and incorporeal properties (e.g. shares). Check for existence of these assets and evaluate their tax impacts, particularly as it relates to the proposed transaction.
13. Assess the Company’s Tax Accounting and Disclosure Practice and its Compliance with Applicable Accounting Standards:
Assess the correctness and effectiveness of the company’s tax accounting function. Check whether accounting systems are properly setup for correct tax accounting and reporting. Check that tax recognition and disclosures in the financial statements are in line with applicable accounting standards, that effective tax rates (ETR) are properly reconciled and tells a consistent story with the tax disclosures throughout the financial statements.
14. For Business Combinations, Quantify Identifiable Tax Assets/ Liabilities for Goodwill Determination:
For business combinations purposes under International Financial Reporting Standards (IFRS) 3, quantify the identifiable tax assets and liabilities for the purpose of goodwill calculation.
15. Examine Transfer Pricing and Inter-company Transactions:
Nigeria has transfer pricing regulations to prevent profit shifting among related entities. Review transfer pricing documentation and inter-company transactions to ensure they are at arm’s length and comply with Nigeria’s Transfer Pricing Regulations.
16. Understand VAT and Withholding Tax:
VAT and withholding tax are significant components of Nigerian tax law. Review VAT calculations and returns (on TaxProMax) and ensure proper calculation. Also check for proper calculations and remittance of withholding taxes on payments made to suppliers, contractors, and employees.
17. Assess Employee-related Taxes:
Examine payroll records to ensure correct deductions and remittances of employee-related taxes and social security contributions, such as personal income tax, Employee Compensation Act (ECA) levy, Industrial Training Fund (ITF) and National Housing Fund (NHF) contributions, where applicable.
18. Review Contracts and Agreements:
Analyze existing contracts and agreements to identify any clauses related to tax indemnities, warranties, or other tax-related provisions that could impact the transaction.
19. Check for Existence of Double Tax Treaties:
Multinational transactions would often trigger international taxes. Check for existence of double tax treaty between Nigeria and the foreign transacting country to evaluate the cross border tax implications of the proposed transaction.
20. Understand Tax Incentives:
Nigeria offers various tax incentives in specific sectors to encourage investment. Determine if the company has taken advantage of any tax incentives and verify compliance with the associated requirements.
21. Engage Professional Advisors:
Due to the complexity of Nigerian tax laws, it is recommended to involve experienced tax advisors, legal experts, and accountants. Their insights can help you navigate the nuances of the tax landscape and make informed decisions.
Conclusion
It is important to note that tax due diligence is not a one-size-fits-all process. The extent and depth of due diligence may vary based on the specific transaction, the industry, and the level of risk involved. Engaging experienced tax advisors is essential to tailor the due diligence process to the unique circumstances of the transaction.
In summary, tax due diligence should be performed as early as possible in the transaction process, ideally during the planning and negotiation stages. This allows for the identification of potential tax risks and opportunities, enabling informed decision-making and effective risk management.
Conducting tax due diligence is a critical step in ensuring the success and sustainability of any significant business transaction. By diligently examining tax records, compliance, risks, and opportunities, you can identify potential pitfalls and take proactive steps to mitigate them. Engaging professional advisors and staying updated with changes in tax laws, regulations and practice, will contribute to a smooth and legally compliant transaction process. Remember, the effort invested in thorough tax due diligence can lead to significant long-term benefits for all parties involved.