Remembering Customs in your due diligence

The financial crisis has brought forth a compelling reason and season for mergers and acquisitions (M&A) worldwide. In the Philippines, weaker export markets, lower earnings forecasts and prospects of marginal economic growth have constrained companies to take a more introspective and tactical stance on how to grow or preserve their business. Profitable companies that have managed to keep their heads above the water are sending feelers in the marketplace to seek out and procure other entities that may not be doing as well but may have functions that complement their corporate strategies. Those faced with more challenging financial conditions are similarly in the market, looking for potential buyers or investors to give their companies a needed shot in the arm. At the end of the day, their objective is to find the appropriate synergies, technologies and market presence that would raise a company’s value and profitability.

Just like anxious traders in the equities market these days, many companies have begun to take stock of their current financial standing, looking into the prospect of selling high and buying low to preserve value and gain leverage on the opportunities at hand. Companies are now lending more open ears to objective third party advice before taking on strategic decisions. A greater part of the challenge posed by the financial crisis, therefore, is for companies to obtain the most appropriate, comprehensive, and complete advice on how to strategically position their business for sustainable growth with minimal risk.

For financial advisors, M&A season translates to a season for due diligence exercises. A due diligence, simply put, is an objective third party analysis on the overall standing and value of a company or business operation being put up for sale. The process should be as thorough as it should be worthwhile, taking into consideration the substantial amount of savings and underlying earnings that can be uncovered on the part of both buyer and seller. These due diligence exercises are usually conducted to examine the financial aspect (financial due diligence) of the company and its tax position (tax due diligence). Under a financial due diligence, the company’s financial health and value is assessed and its potential synergies with potential buyers are explored. A tax due diligence, on the other hand, is usually commissioned in tandem with a financial due diligence and looks into the company’s overall compliance with tax regulations. In fine, these prudent exercises uncover potential issues that may be of financial, operational and reputational risk to the buying company in the future.

One must consider, however, that not all due diligence exercises are alike. Because of the complexity of interlocking issues that would impact a company’s assets, income and cash flow, it is relatively easy to overlook certain aspects in a due diligence engagement. One striking area that is frequently left out, particularly for companies engaged in the cross border trade of goods, is the area of customs compliance.

Customs is generally considered a less significant subset of tax compliance and usually relegated to an obscure corner of tax due diligence reports. Discussions on customs would oftentimes only appear in a due diligence report if the company under review was being subjected to a customs audit at that time, if penalties had already been assessed, or if it is already under litigation. This leaves out the more proactive and forward looking aspects of customs compliance which, if not checked, could lead to the buying company encountering unanticipated and unbudgeted liabilities it would have to assume.

Among these frequently overlooked items are: the company’s historical and systemic compliance with customs regulations, the management of third party providers (i.e. customs brokers), and its internal controls for the management and resolution of customs related issues.

Customs issues may reside in various areas of a company’s operations, and it would require an inquisitive search through contracts, board resolutions, special purchase terms, customs declarations and electronic correspondences to recognize them. A single debit note, for example, to adjust the purchase price for imported products to evenly distribute a multinational’s profits across its regional operations can redound to cumulatively significant back duties and penalties that the purchasing company may have to assume. In another case, the absence of a contract for customs brokers and a considerable devolvement of customs functions to brokers could place a US based company at a high risk of violating the US Foreign Corrupt Practices Act (FCPA).

Import documents that are improperly or incompletely kept can also leave the company exposed to penalties. The absence of clear reporting standards as to who or which department is ultimately responsible for the valuation and classification of imported inventory, likewise leaves the buying company at risk of assuming possible penalties and pursuing unexpected litigation activities. On last example is the possible presence of electronic correspondences between suppliers on price negotiations that indicate sales below the cost of the imported goods which could trigger tedious and costly customs investigations further down the road.

In the end, the key message to buyers and sellers in the M&A market is for them to look closely into every imaginable aspect of the entity being sold, particularly small potentially inconspicuous details, such as customs risk, that could spell a large difference. Retaining trusted advisors with a multidisciplinary outlook, industry specific savvy, and a keen eye for compliance would be a good start.

(Raphael B. Madarang is a Manager for Business and Financial Advisory Services of Manabat Sanagustin & Co., CPAs, a member firm of KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative.

The views and opinions expressed herein are those of Raphael B. Madarang and do not necessarily represent the views and opinions of KPMG in the Philippines. For comments or inquiries, please email [email protected] or [email protected]).