Introduction

The level of mergers and acquisitions taking place has risen significantly since the recovery in the Irish economy. This presents an opportunity to revisit the tax issues and challenges which may arise from the due diligence (‘DD’) performed on a target company. This article will highlight the main direct tax issues that arise during DDs, with a focus on payroll taxes as this is the area most at risk of non-compliance.

Practical Issues

Before delving into the specific issues that may arise from a tax DD, it may be worth noting some practical issues that should be considered. The purpose of a tax DD is to review the recent tax compliance history of a target company and to report on any non-compliance uncovered. This may involve establishing non-compliance across a number of entities and tax years in order to quantify the total underpayment of tax in respect of a particular issue. Depending on the size of the transaction, a small amount of underpaid tax is unlikely to make or break a deal. Therefore, it is always advisable to build in a level of materiality into a DD report, as potential purchasers may not be concerned with smaller non-compliance issues. When reviewing the below issues as part of a tax DD, it is always important to consider their materiality in terms of the size of the transaction.

How a material underpaid tax liability is to be rectified or accounted for will need to be considered, such as whether it will be adjusted for in the sales price, or whether the company will make a voluntary disclosure to Revenue before the transaction takes place. Where there is doubt over whether or not the potential tax liability would in fact arise, this may have to be reflected in the share purchase agreement, including whether a specific tax warranty is required or whether the tax deed may be relied upon.

Pay Related Social Insurance (‘PRSI’) Class of Directors

In many owner-managed companies, the shareholders will also be directors of the company. Working directors who own or control 50 percent or more of the shares in the company in which they work are treated as self-employed for PRSI purposes. Class S applies to such directors, which does not attract Employer PRSI. Where a working director does not have the required shareholding, Class A should apply unless a determination has been received from the Scope section of the Department of Employment Affairs and Social Protection that Class S should apply.

However, there are instances where this is not as clear cut. For example, where a director has less than 50 percent of the shareholding of the company but may have 50 percent control of all board decisions as part of a shareholder agreement. It would appear that PRSI Class A should be applied, and if Class S had historically been applied to the directors’ remuneration, an underpayment of Employer PRSI may have arisen. However, the case may be argued that Class S is the appropriate PRSI class to apply given that the director would effectively control 50 percent of the company.

There are other cases in which Class S may apply even where the required shareholding has not been met for example where an individual is working for a company owned by a spouse or family member, if that individual is not an employee but participates in the running of the company or if the individual holds a directorship/shareholding position and has control over its operations, the individual may be treated as a self-employed contributor. An example of this would be where a spouse of an owner-manager did not hold 50 percent of the shares but carried out duties as a director without a contract of employment with the company.

In many cases, determinations may not have been received from the Scope section of the Department of Employment Affairs and Social Protection given how difficult it has proven to obtain such determinations in practice. Therefore, when considering whether an underpayment of Employer PRSI has arisen, one may have to use his/her own judgement when determining whether the strict rules governing the application of Class S should have been observed or whether it can be accepted that Class S would apply in principle.

Payments to Family Members

Another issue often arising in owner-managed companies is the payment of remuneration to a spouse or other family member who may not work a sufficient amount of time in the business to justify such remuneration. A spouse is often paid a salary to take advantage of the increased standard rate band where a married couple are both earning. For example, in 2018, an owner-manager may have €25,550 of his/her salary paid to a spouse so that it is taxed at the 20 percent rate rather than at 40 percent. The employment of a spouse may also be used for pension planning purposes, whereby pension contributions are made to a spouse’s pension fund when further contributions cannot be made tax efficiently into an owner-manager’s own pension fund. Owner-managers may also pay their children salaries as a method of providing them with money without eating into the capital acquisitions tax threshold. For example, a child could earn a salary of €16,500 without suffering any tax, which is well above the small gifts exemption.

Although Pay As You Earn (‘PAYE’) may have been correctly applied to such remuneration, if any part of the remuneration is deemed to be excessive, it should not have been allowed as a deduction for corporation tax purposes. Therefore, the exact role of family members and the number of hours they work in the business should be established as part of the DD work in order to determine whether their remuneration is commensurate with the duties of employment actually performed.

Personal Expenses

The payment of personal expenses on behalf of shareholders or directors is another issue which often arises in smaller owner-managed companies. Usually where expenses are paid on behalf of employees, these would be treated as benefits-in-kind (‘BIKs’) and liable to PAYE, unless the employee repaid the expenses to the company. However, personal expenses may be treated as distributions in the case of shareholders. This would apply where the company in question is a close company. Expenses that are treated as distributions will clearly not be allowed as deductions for corporation tax purposes. Although remuneration is generally allowed as a tax deduction, expenses which are not incurred wholly and exclusively for the purpose of the trade are not deductible. Therefore, a deduction should not be available for personal expenses.

Contractors

It can often be challenging to determine whether an individual providing services to a company is a bona fide contactor or whether the individual should be considered a de facto employee of the company. There are a number of factors that would need to be considered when determining the correct relationship, including whether the individual can determine his/her own working hours, whether he/she can subcontract his/her work, whether he/she is entitled to expenses, holidays and sick leave, and whether he/she provides services to other companies. However, it is possible to be an employee of more than one company and so this last point may not be a determining factor.

Where the contractor is a company, this becomes less of an issue as a company cannot be considered an employee. Individuals will often use a company to bill for the services they provide to reduce the risk that PAYE would be applied to any payments they receive. However, the use of a service company by a single individual is currently being reviewed by Revenue. There is a perceived loss of Employer PRSI contributions (at a rate of 10.85 percent) by Revenue because the individual is regarded as a proprietary director in their own service company and so Employer PRSI does not apply. Consequently, it is possible that the current basis might change going forward but only for single individual companies.

Permanent Establishment (‘PE’)

Another potential issue with workers who are based abroad is the possibility of a PE arising in the country in which they work. Whether or not a PE arises may depend on the activities being performed by the workers. In addition, whether an employee working from their home in a foreign country could give rise to an “office” in that country for PE purposes would need to be considered as this may not have been immediately obvious to a company. Although the concept of PE is common among most countries, foreign tax advice may be required to determine whether a PE exists based on the facts of the case.

Professional Subscriptions

Updated guidance on the treatment of professional subscriptions was issued by Revenue in January 2018. Previously, professional subscriptions paid by a company on behalf of an employee or director would not be treated as a BIK where membership of the professional body was seen as a condition of employment. However, under the updated guidance, professional subscriptions can only be paid tax-free where there is a statutory requirement for the employee or director to be a member of the professional body. Given that this guidance was issued relatively recently, many companies may still be paying professional subscriptions tax-free when they should be treated as BIKs under the updated guidance. In addition, it is possible that Revenue may look to apply this guidance retrospectively. Therefore, the underpayment of PAYE on professional subscriptions may be a common issue arising as part of tax DDs. However, in most companies, professional subscriptions may only be paid on behalf of members of the finance team, of which there may not be more than a handful depending on the size of the company. Therefore, the incorrect treatment of such subscriptions may not be considered a material item for the purpose of a DD report.

Travel Expenses

New civil service motor travel rates came into effect from the 1 April 2017. There are now four bands used whereas previously there had been only two. The previous rates had been in place for the preceding eight years and so many companies may not have updated their travel expenses policies to reflect the new rates. This can lead to an overclaim of expenses and so an underpayment of PAYE may have arisen. However, given how the bands are now structured, an overclaim of expenses by virtue of using the old rates is likely to arise only where an individual has a relatively low level of travel (i.e. less than 2,400 km) or a very high level of travel (i.e. over 72,000 km) in a year. It would be more common for employees/directors to have lower level of travel and so any discrepancies at this level are likely to be immaterial, unless there are a significant amount of employees/directors claiming at this lower level of mileage.

Accrued Bonuses

Unpaid remuneration which has been taken as a corporation tax deduction is deemed to have been paid, for PAYE purposes, on the last day of the accounting period in which the deduction was taken. This does not apply where the accrued remuneration has been paid within six months of the end of the accounting period. This issue generally arises in relation to bonuses declared at the end of an accounting period. Such accrued bonuses would be reflected in a company’s accounts and a corporation tax deduction would generally be taken. If such bonuses were not paid within six months, a liability should have arisen in respect of the PAYE return for the last month of the accounting period. In addition, interest should arise on the late payment of the PAYE liability.

Where significant PAYE liabilities and interest charges arise, a company does have the option to disallow the accrued bonuses from its corporation tax returns, provided it is not out of time to make any necessary amendments. This would mitigate the underpaid PAYE and potential interest charge but should lead to a higher corporation tax liability. Therefore, a company would have to compare the potential liabilities and interest under both tax heads before determining the best course of action.

PAYE Modernisation

PAYE Modernisation is being introduced from the 1 January 2019 and so would not have been relevant for previous DDs but which will now become important given the focus on Real Time Reporting (‘RTR’) and the potential penalties that may arise as a result of non-compliance. One area in particular that may be impacted by the introduction of PAYE Modernisation is the BIK treatment of company cars. Often, an estimate of the business mileage of an employee/director may be used throughout the year and a “true-up” would be done at the end of the year based on the actual business mileage for the year. However, any such true-ups may no longer be accepted by Revenue with the advent of RTR. Compliance with PAYE Modernisation will be monitored closely by Revenue and so this will become an important area for future DDs.

Conclusion

The above are some of the more common payroll tax issues to look out for while performing a DD. However, there will be other issues specific to each case that will need to be considered. Once all issues have been identified, the potential underpaid tax will need to be calculated. If these amounts are deemed to be material, any interest and penalties that could arise will also need to be calculated and details of such calculations will need to be reflected in the DD report. It will then need to be agreed between the vendor and purchaser how such potential underpaid tax liabilities will affect the sales price, how they will be reflected in the tax warranties and tax deed, and whether a settlement should be made with Revenue in advance of the closing of the transaction.

Cian O’ Sullivan, Senior Manager, BDO

Email: cosullivan@bdo.ie