How to do a ‘Tax Review’ of the Agreements

An entity enters into several agreements during its lifetime. As a very normal course, before any transaction is executed / entered into, a draft agreement is prepared which captures the general understanding of the two (or more) contracting parties and after a typical phase of negotiation(s), it gets finalized. More and more organizations today are realizing that before a draft agreement is finalized, all the different departments and stake holders must review the same (not only the legal and operations department) and include their points therein. Whether it is a commercial, NGO, charitable or a Government concern, it is becoming imperative to get its draft agreements comprehensively reviewed from all before finalization.

Hence, emerges the need to get all such agreement(s) reviewed from the Tax person in an(y) organization. But as a Tax reviewer, how should a review of an agreement be done? Lets see how.

Let us first keep in perspective the general role / responsibilities of a Tax Person. The basic duty is to see that all the tax laws /requirements involved in any transaction gets complied with; this coupled with the endeavor to achieve cost savings for the entity. In a synopsis form, the Tax review would involve (i) understanding the nature of the document under review; (ii) understanding the tax implications that would be involved in the transaction, both in present and future; and (iii) a sanctity check. Thereafter, one could incorporate the tax clauses in such agreement(s); and finalize it in consonance with legal & business teams.  

It would be important to understand the nature of the document / draft agreement in hand, first. Chances would be that it could be a Master Agreement or could be a subsidiary document which would be governed by a Master Agreement; or even a term sheet which would be culminated into an agreement later on. The Tax clauses might vary on the basis of the nature of document under review. For example, if it is a subsidiary agreement governed by a Master Agreement and the Master Agreement captures all tax clauses properly, there may not be a need to include any tax clause in such subsidiary agreement. Similarly, it may be agreed to insert the tax clauses only in Side Letters and not main agreement. Hence, it is very important to understand the nature of the document under review.

Now, the tax implications. To understand the tax implications involved, the reviewer must obtain a clear understanding of the transaction contemplated by the entity. In typical situations, the transaction would involve a payment, a receipt or barter or might sometimes have no monetary terms. After the basic understanding of the transaction(s), one can draw a caricature of the typical tax laws / implications that would be involved in such transaction(s) and then could proceed further.

The Reviewer must be able to clearly understand what tax implications are involved in such agreement and know the responsibilities of each of contracting parties arising therefrom. The Reviewer must ensure that the contracting parties remain responsible for taxes and compliance of their respective parts on their own; and appropriate clauses must be built accordingly in the agreement.

One would also like to understand the status of the contracting parties involved – whether such are company, non-company, LLP, university), its nationality (Indian, foreign), whether legal entity (branch or head office etc), since the tax implications would vary accordingly. As an example, if the contracting entity is a non-company and thereby, not eligible to claim benefit under the respective Double Tax Avoidance Agreement, it might cause certain concerns and the tax clauses would accordingly change.

The reviewer must incorporate the clause(s) to ensure compliance with all the tax implications. For example, to comply with the tax withholding obligations at the time of payments, a clause must be there in the draft to clearly state that the payments will be subject to tax withholding (under the Indian Income-tax or Work Contract Tax ‘WCT’ under the respective state VAT laws). If taxes have to be grossed up, clauses for the same. Also, for providing / getting Form 16A or tax withholding certificates.

One must also understand if the transaction would have bearing of indirect taxes such as Excise, Service tax, VAT, Central Sales tax (in case of inter-state sale and subject to availability of C forms) or Customs. Whether such taxes would be included in the price agreed in the agreement, or would it be charged extra. The relevant clauses must be incorporated accordingly. In case of foreign party agreement(s), one must understand what taxes would the foreign party charge in its own country and whether the agreement prices are inclusive or exclusive of such foreign taxes.

If certain documents (PAN, valid invoices with all necessary details, tax withholding certificates, waybills in case of interstate movement of goods; in case of foreign parties, no-PE and Tax Residency Certificate (TRC)) are required from the other contracting party, and the duration of submission of such documents (no-PE and TRC every year, invoices every month etc.), the relevant clauses must be incorporated. In case of purchases or foreign imports, it must be clearly defined when the title of goods would be transferred to the purchaser (VAT implications could vary basis the place of transfer); also, the delivery terms (FOB, CIF etc.) and the roles of the respective parties (as to who would be responsible for custom clearance etc.).  

If the agreement is between unrelated parties, a clause must be incorporated in the agreement that the status of parties would remain as independent parties and one should not be deemed as agent or representative of the other. Similarly, a clause could be there stating that both parties will remain responsible for their own tax liabilities and compliance, on their own. However, if the agreement is between related parties, it must take into consideration the transfer pricing implications (domestic and / or foreign).

The reviewer must also look at the confidentiality/non-disclosure clause, it should not restrict the entity from sharing such agreement with tax / regulatory authority if required under assessment or other such proceeding. Tax indemnity must be clearly provided. It must clearly state the items against which tax indemnity is provided / availed and the beneficiaries of such tax indemnity.

The Tax Reviewer must also keep in perspective, the present tax obligations and the future ones as well; and build the tax clauses accordingly. For instance, if there is a change in tax rates expected or a new type of tax (such as GST in India) envisaged, the Reviewer must understand who will bear such higher / lower taxes and put clauses accordingly. Similarly, if the other contracting party does not charge taxes properly on its invoice or does not deposit the taxes, adequate safeguards must be built in the agreement, so that no liability / implications could arise therefrom.

In the Sanctity check of the draft, the Reviewer must ensure that the transaction, the terms around it and consideration are clearly defined, without any ambiguity. There must be consistency in agreement. For instance, rates quoted in main agreement (tax inclusive or exclusive) and in annexures are same. The contract for Supplies is not termed as Service or Works Contract. The Agreement, invoice to/from, payment to / from remain with same party and has same terms. Also, ensure that the agreement is as per the entity’s policies and not against it. The tax clauses appearing in the annexures of the draft should be considered as agreement / part of the agreement only. Wherever any complicated tax position is incorporated in an agreement by way of an example, one could use examples to explain it clearly and mitigate ambiguity therein. One must put accurate referencing of the clause numbers in agreement.

The Tax Reviewer must follow the basic rule of ensuring entity’s compliance with tax laws (not to have any excessive responsibilities by virtue of the agreement), achieving cost savings and accordingly put clauses in the draft with a clear language. After having incorporated all tax clauses, the reviewer must obtain a buy-out of the same from legal or commercial / business teams; chances are that the business teams would have agreed different terms with the other contracting parties and the clauses would thus have to be suitably amended in view of the business exigencies.

As discussed above, due to the vital stake which the Tax person would hold in the transaction(s) / agreement(s), more and more organizations must ensure an effective Tax Review of the agreements for better and efficient business.