Due Diligence Checklist for Japan M&A: Financial, Tax, Legal and HR

Due diligence (DD) is the process by which an M&A buyer examines the actual condition and risks of the target company. In acquisitions of Japanese companies, the review centres on four areas, financial, tax, legal and HR, and the issues identified are reflected in the price and contract terms. This article sets out the items to check in each area in the form of a checklist.

What is due diligence: purpose and timing

DD has three purposes: to understand the actual condition of the target, to verify the basis for the acquisition price, and to identify risks that need to be addressed in the contract.

It is generally carried out after the letter of intent (基本合意書) is signed and before the definitive agreement. The SME M&A Guidelines issued by the Small and Medium Enterprise Agency also describe a process in which the buyer carries out financial, tax, legal and other DD after the basic agreement. The overall acquisition process is explained in acquiring a Japanese company: the M&A process and due diligence.

1. Give the seller a document request list and receive documents through a data room or similar
2. Review the documents and go through rounds of questions and answers (Q&A)
3. Interview management and visit business sites
4. Specialists compile their reports and the buyer makes its decision

The scope of the review is set according to the size of the deal, the industry, the budget and the schedule. Not everything needs to be examined to the same depth. Focus on the areas where risks are high for the industry concerned.

Points to note when the buyer is a foreign company

Most documents are in Japanese, and account headings and contract drafting follow Japanese practice. Build the scope and time needed for translation into your schedule. It is common to limit the channels for questions and the means of exchanging documents so that the seller’s employees do not learn of the deal. Differences from your home-country accounting standards (revenue recognition, provisions, etc.) should also be identified early.

Who covers each area and what they check

Depending on the deal, DD of IT systems, environmental matters and real estate may also be carried out.

Financial due diligence checklist

Financial DD checks whether the figures in the financial statements reflect reality. The financial statements of SMEs are often prepared mainly for tax filing purposes and may need adjustment.

• Are financial statements, trial balances and account detail schedules available for the last several years?
• Do receivables and inventory exist, and can they be collected or sold?
• What are the “normalised earnings” after excluding owner-related expenses and one-off gains and losses?
• Are all liabilities, such as borrowings, leases, guarantee obligations and retirement benefits, fully identified?
• Seasonal fluctuations in working capital and its level at closing
• Degree of dependence on key customers and suppliers
• Transactions, loans and borrowings with the owner and related companies

Typical off-balance-sheet liabilities

• Unpaid overtime and social insurance premiums owed because of missed enrolments
• Obligations to pay retirement allowances under retirement benefit rules
• Guarantees of third-party borrowings
• Damages claims in pending disputes
• Obligations to restore offices or shops to their original condition

The adjusted figures for normalised earnings and net assets feed directly into the valuation of the business. The approaches to valuation are explained in company valuation methods.

Tax due diligence checklist

In a share transfer, the target’s past tax risks pass to the buyer’s side along with the company. Corporation tax may be reassessed, in principle, up to five years back from the statutory filing deadline, or up to seven years where there has been deception or other wrongful conduct.

• Returns and payment records for corporation tax, consumption tax, withholding income tax and local taxes
• Issues raised in past tax audits and the action taken since
• Treatment of items that are often disallowed, such as directors’ remuneration, entertainment expenses and donations
• The amount of tax losses carried forward and when they expire
• Prices of transactions with overseas affiliates (transfer pricing)
• Status of blue-form return approval and the various consumption tax elections

Tax losses carried forward may not be usable after the acquisition

For a corporation filing blue-form returns (青色申告), losses arising in business years beginning on or after 1 April 2018 can be carried forward for ten years. However, this is conditional on final tax returns having been filed continuously from the year in which the loss arose.

In addition, there are rules under which losses cannot be used if certain events, such as discontinuing the former business and starting a new one, occur after a controlling relationship arises through an acquisition. If you are factoring the tax benefit of losses into the price, check with a certified tax accountant in advance.

Legal due diligence checklist

• Articles of incorporation, certificate of registered matters, shareholder register, and minutes of shareholders’ and board meetings
• Whether shares have been issued and transferred lawfully (including whether there are nominee shares)
• Change-of-control clauses in material contracts (such as clauses allowing the counterparty to terminate if the shareholders change)
• Licences and permits needed for the business, and whether notifications are required when shareholders or officers change
• Whether there are pending lawsuits, complaints or administrative guidance
• Ownership of intellectual property such as trademarks and software
• Handling of personal data and the status of transfers abroad

Transfers of shares in unlisted companies usually require the company’s approval. The approval and name-transfer procedures can be checked in share transfer procedures. Where the buyer is a foreign investor, check alongside the legal DD whether prior notification under the Foreign Exchange and Foreign Trade Act (外為法, FEFTA) is required.

Check whether licences and permits can be carried over

In a share transfer, licences and permits in principle remain with the company. However, some require a notification when shareholders or officers change, and some involve a review of whether officers fall under disqualification grounds. If you plan to replace officers after the acquisition, also check that the new officers meet the requirements.

HR due diligence checklist

HR is an area where problems are frequently found in SME M&A. Unpaid overtime in particular can amount to large sums.

• Records of working hours and how overtime pay is calculated (including the design of fixed overtime pay)
• Conclusion and filing of an Article 36 agreement (36協定)
• Work rules, wage rules and retirement benefit rules
• Missed enrolments in social insurance and labour insurance
• The actual position of employees treated as managers and supervisors
• Whether foreign employees’ status of residence matches the work they actually do
• Labour unions, labour disputes and harassment complaints

The limitation period for wage claims is five years for wages falling due on or after 1 April 2020, and three years for the time being. If there are unpaid wages, the company may face claims for the past three years.

If missed social insurance enrolments are found, the company may also be required to pay premiums retroactively. Identify the employees and periods concerned and estimate the cost.

If employees are doing work not permitted by their status of residence, the company may be charged with the offence of facilitating illegal employment. Cross-check residence cards, employment contracts and actual duties.

Reflecting DD findings in price and contract

Because risks remain with the company in a share transfer, switching to a business transfer may be considered where the risks are large. What you learn in DD is also used in planning post-merger integration (PMI).

How TIMOA can help

DD is a single process in which financial, tax, legal and HR specialists divide the review between them and the results are reflected in the price and contract. The scope of the review is set according to the size and risks of the deal.

Together with partner certified tax accountants (税理士), attorneys (弁護士) and labor and social security attorneys (社会保険労務士), TIMOA supports you in Chinese and Japanese with preparing document request lists, interpreting Japanese-language materials, and organising DD findings and reflecting them in the contract. For details, see our M&A, Succession & Exit page.