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Navigating Different Types of Due Diligence in India

Written by: India Briefing, Dezan Shira & Associates
Posted: 7th December 2020 09:56

When due diligence is conducted, several aspects of the company are taken into consideration. The different categories of due diligence help evaluate every aspect of a business, in turn helping foreign companies make an informed decision about their business dealings in foreign jurisdictions.

The major types of due diligence are – legal, tax, HR, and financial; however, depending on the company’s sector and the proposed business deal, due diligence on intellectual property, environment, real estate, valuation, forensic accounting, and vendors can also be conducted.

Financial due diligence

Financial due diligence provides with the previous and current financial position of the business. Through this process, foreign companies get an idea about how the company’s finance will hold in the future. It also provides complete understanding of the company from the buying and selling point of view.

Financial due diligence includes reviewing the company’s debts at domestic and international levels, financial statements and audit reports, accounting policies, quality and sustainability of earnings and cash flow, condition and value of assets, potential liabilities, tax implications of deal structures, examination of information systems to establish the reliability of financial information, and internal control systems.

Usually for financial due diligence, the following information is reviewed and recorded by the due diligence team.

  • Audited financial statements (cash flow, balance sheet, income statement, footnotes) for the last three years, including the auditor’s report as well as the quarterly and annual statements;

  • Auditor’s correspondence to the management after finishing the audit report (This will help identify the strengths and weaknesses of the company);

  • Auditor’s correspondence for the past five years (these are letters sent to management that outline areas to improve profits and efficiency);

  • Company credit report;

  • Schedule of accounts receivable and payable;

  • A list of outstanding debt;

  • Check if any investors or shareholders have loaned money to the company;

  • List of unrecorded liabilities;

  • List of collateral for debt;

  • Analysis of gross margins;

  • Analysis of fixed and variable expenses;

  • List of the company’s internal control procedures;

  • List of assets and liabilities;

  • Schedule of inventory;

  • Projections, capital budgets, and strategic plans (this includes analysis of projected expenditure and depreciation and risks in the market in the future);

  • General ledger;

  • Breakdown of sales and gross profits;

  • Planned projection vs. actual sales chart;

  • List of all the shareholders with detailed information;

  • List of non-operational expenses; and

  • Public filings.

Legal due diligence

Legal due diligence covers all the legal aspects of a business transaction, liabilities of the company, potential legal pitfalls, and other related issues. Legal due diligence also covers intra/inter corporate transactions. Apart from verifying the documents, it includes preparation of regulatory compliance checklists, meeting with personnel, and independent check with regulatory authorities.

This due diligence process often covers various legalities, including corporate laws, loans and borrowings, real estate, intellectual property, secretarial due diligence, contracts and licenses, and competition law, among others.
In short, through legal due diligence a foreign company can determine if the company has any regulatory issues, verify the documents to check if it has any restrictions to undergo this particular business deal, check its corporate and environmental compliances as well as compliance with employment and industrial laws, licenses and regulatory approvals, and understanding existing and/or potential litigation against the business.

Usually, the following documents are reviewed while conducting legal due diligence for any business or company in India:

  • Copy of Memorandum and Articles of Association;

  • Minutes of board meetings for the last three years;

  • Minutes of all the meetings of shareholders for the last three years;

  • Copy of share certificate issued to key management personnel;

  • Copy of all guarantees to which the company is a party;

  • All corporate commercial contracts such as joint venture or partnership agreements, vendor agreements, license and franchise agreements; and

  • Copy of loan agreements, bank financing agreements, and lines of credit details (please note that this list is not exhaustive, and that the due diligence team can ask for other documents or more information).

Tax due diligence

Apart from verification of information, tax due diligence also helps in identifying any tax upside to the business dealing and assists in developing a suitable acquisition structure for the potential business deal.

Tax due diligence in India mostly comprises an analysis of tax compliance, tax contingencies transfer pricing, identification of risk areas, and tax planning and opportunities. This process reduces the risk of doing business with a company that has tax liabilities to risk exposures associated with the business transaction.

During this process, documents related to tax liability, company taxes, tax-related pending or ongoing cases, and tax audits of the company are reviewed and also verified with the tax authorities.

The following documents are reviewed and verified while conducting tax due diligence in India. This is a basic list, and more documents or information might be needed by the due diligence team.

  • All tax returns including income tax, sales tax, and goods and services tax (GST) for the last three years;

  • Tax audit reports of the company;

  • Any tax settlement documents for the last three years;

  • Tax registration certificates;

  • Tax payment receipts;

  • Balance sheets and profit and loss statements; and

  • Financial statements as they disclose tax disputes, demands against the company, and contingent liabilities.

If the company has foreign investment, then compliance with annual return on foreign liabilities and assets (FLA Return) and its annual performance report should be checked to determine further liabilities of the company.

Human resources due diligence

HR due diligence is used to evaluate HR procedures, processes, and human capital of the company. This process helps in understanding the company’s employment contract, compliance with labor laws and regulatory policies, work culture, and industry standards

Apart from these HR processes, it is important that the due diligence team checks if the company has been adhering with the new wage code, including the provisions for minimum wage. The Code on Wages Act, 2019 prohibits employers from paying workers less than the stipulated minimum wage. The Code on Wages Act, 2019 has replaced four labor regulations – Minimum Wages Act, 1948; Payment of Wages Act 1948; Payment of Bonus Act, 1965; and Equal Remuneration Act, 1976.

Trade unions form an important part of an organization as it safeguards the rights of the workers. According to the law, if there are seven or more blue collar workers in an organization, they are entitled to form a union. Hence it is important to check on how the relationship is between the organization and the trade union – if such a relationship exists.

All unions in India are tracked by the Ministry of Labor, and are regulated under the Trade Union Act, 1926.

This article was first published by India Briefing, which is produced by Dezan Shira & Associates. The firm assists foreign investors throughout Asia from offices across the world, including in in ChinaHong KongVietnam, Singapore, India, and Russia. Readers may write for more support.  

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