This article are provided for information purposes only, and are not intended as legal advice.

What happens when you do not do due diligence properly?

March 23rd, 2010

Ever thought why waste your money on due diligence when you are in the process of buying a company and the old owner provided you what you thought was everything?  If you received a letter on closing stating that the old owner did not for example do something, is that good enough?  Can you rely on that?  If that statement was false, now what consequences will result and how much will your good faith cost you trying to fight something that you did not realize existed?


A company acquired a business which was owned by a company.  The company was a bare trustee meaning that the assets were registered in that company’s name but owned by another entity.  This type of set up is typically done in real estate deals but is not restricted just to real estate.  The purchaser of the company received in due diligence the tax returns of the company and the financial statements which stated that there were no assets in the company.  The balance sheet consisted of cash of $1 and common shares totalling $1. 


In Canada, companies may have a sales tax called GST and they file GST returns.  Even though the company showed no assets, the company filed GST returns showing active sales in the company.  The sales really belonged to another entity however they were filed using the GST number of this bare trustee nominee company.  There was a liability in the company on the date that the new owner purchase bought the company due to unpaid GST taxes.  Who is liable?   Tthe new owner unfortunately is now responsible for the GST and potential tax liability.  Canada Revenue Agency sometimes compares the sales per the GST return to the sales on the tax return and sees if they are the same.  In this case, the corporate tax returns say no sales but the GST return shows sales.  Canada Revenue Agency (“CRA”) could reassess the company and state that they have unreported sales and now owe income taxes.  This should have been caught in due diligence however the investor did not do the due diligence properly, they relied on indemnifications of the old owner.


Now the new owner has to make representations to CRA to try to get them to change the prior filings and allocate them to the proper owner.  This is easier said than done and will cost the investor time and money to accomplish this.  Why did this arise in the first place – because someone did not do their due diligence properly and did not want to pay an accountant to do that for them.  They thought because the company looked like it had no assets in it, there was no point in investigating further. 


In summary, even if there does not look like there is a problem, do your due diligence properly because looks can be deceiving.  In theory there should not have been an issue in my example above but theory and reality can be different as proved in this example which is a true story.

Filed under: Due diligence — Gary Landa @ 8:28 am

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