Tax on shareholders income
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This article has been written by Aman Gupta, pursuing the Diploma Programme in M&A, Institutional Finance, and Investment Laws (PE and VC transactions) from LawSikho

Introduction

Merger & Acquisition (M&A) is a corporate restructuring tool. Generally, it deals with the transfer of the business undertaking or their units or division by way of sale. The structuring of M&A transactions may be done in different ways, one of them being slump sales. Slump sale is defined under Section 2(42C) of the Income Tax Act 1961 (ITA) as “the transfer of one or more undertakings, by any means, for a lump sum consideration without values being assigned to the individual assets and liabilities in such sales.” The term “undertaking” has an inclusive definition and its meaning is assigned under Explanation 1 to Section 2(19AA) of the ITA. It “includes any part of an undertaking, or a unit or division of an undertaking or a business activity taken as a whole, but does not include individual assets or liabilities or any combination thereof not constituting a business activity.” 

Recently, vide Notification No. 68/2021 dated 24.05.2021, the Central Board of Direct Taxes (CBDT) has inserted Rule 11UAE into the Income Tax Rules 1962 (“ITR”), which prescribes the method to compute Fair Market Value (FMV) of a capital asset for the purposes of Section 50B of the ITA i.e. provision for computation of capital gains in case of slump sale. This write-up analyses the pre-amendment scenario and the post amendment scenario with special attention to its probable effect upon the M&A transactions.

Computation mechanism (pre-amendment) 

Prior to this amendment, the capital gains in case of slump sale were calculated as per the mechanism provided under Section 50B of the ITA. It stated that the difference between the “sale consideration” and the “net worth” of the undertaking shall be the capital gains. Any expenses related to the transfer shall be reduced to arrive at the “sale consideration” during any M&A transaction structured via slump sale. To arrive at the “net worth”, Explanation 1 of this section specifies that the aggregate value of the total assets of the undertaking is reduced by the value of liabilities. Further, such considered value shall be appearing on the books of the parties involved in the transaction i.e. the book value. Also, while calculating the net worth or the cost of acquisition, the aggregate value of total assets for: 

  • depreciable assets, shall be the written down value of the block of the assets, 
  • capital assets, if deduction under Section 35AD of the ITA is allowed then the value shall be taken as nil, and 
  • for the rest of the assets, it would be the book value. The question of short-term or long-term capital gains depends upon the holding period of the assets by the parties and the threshold for which is 36 months.

The whole mechanism does not provide to compute the capital gains via assigning the values to the individual assets rather stick to the concept of aggregate values of the asset, which is in consonance with the concept of slump sale as provided under the definition clause. This aspect differentiates slump sales from other structures of M&A transaction i.e. asset sale or itemized sale where an individual assignment of values to and cherry-picking of the assets respectively are allowed to execute the transaction.  

Computation mechanism (post-amendment)

The Income Tax (16th Amendment) Rules 2021 has inserted Rule 11 UAE in the ITR to change the established procedure for the computation of the value of the assets in case of slump sale in order to arrive at the capital gains. This Rule is synonymous to the standard method of calculation of the FMV, as prescribed in Rule 11UA for shares and securities, in situations where the valuation of the individual capital assets or property has to be undertaken.

Rules 11UAE prescribes for two FMV i.e. FMV1 and FMV 2 and the value of which amongst them is higher shall be considered for the computation of capital gains, which is again a matter of concern because the higher the FMV, the higher would be the net consideration and taxability of any deal. 

FMV 1 is the FMV of the capital assets transferred by way of slump sale and is calculated by the formula of (A+B+C+D – L). The abbreviation from “A” to “D” represents the individual value of the specific capital assets such as jewellery, artistic works, shares, securities, and immovable property, which are valued based on FMV computed as per Rule 11UA and all other assets are to be valued as per the book value. “L” represents the liabilities as appearing in the books of accounts of the parties to the transaction with certain exceptions that are reduced from the value of total assets to arrive at FMV 1. This method of computation explicitly provides for the assignment of individual values of the assets, which is in contradiction with the very basis on which the definition of slump sale under Section 2(42C) is based. In such a scenario, it would be difficult to differentiate between the slump sale and asset sale, which would also lead to hassles in structuring future M&A transactions. This would give birth to future disputes.   

FMV 2 is the FMV of the consideration received as a result of the transfer by way of slump sale. It is calculated by the formula of (E+F+G+H). The abbreviation from “E” to “H” represents the value of monetary consideration received during transfer; FMV of non-monetary consideration received as a result of transfer represented by the property referred to in Rule 11UA(1); the price which the property other than the immovable property could fetch in the open market; and the value assessed by the government for the purpose of payment of stamp duty in case of immovable property; respectively. This method of computation also considers non-monetary considerations for slump sales. The Finance Act 2021 amended the definition of slump sale to substitute the word “as a result of the sale” with “by any means” and also clarified that “transfer” would include any means of transfer as mentioned under Section 2(47) of the ITA along with “sale”. Following the amendment, the judgment passed by Hon’ble Madras High Court in Areva T&D Ltd. v. CIT. and Hon’ble Bombay High Court in CIT v. Bharat Bijlee Ltd., was overruled since they ruled that Section 50B applies only in case of “sale” for monetary consideration rather than “exchange” for non-monetary. Therefore, the amendment in the definition of slump sale was done in order to facilitate the inclusion of non-monetary consideration in Section 50B of the ITA.

Analysis     

The concerned amendments might plug the loopholes that aid tax leakage, however, that would tweak to hurt concluded, ongoing, and upcoming M&A deals. The Finance Act 2021 amended Section 50B to insert that fair market value shall be deemed to be the full value of consideration of the capital asset. To calculate such FMV, Rule 11UAE was inserted. It is concerning that earlier Book value was considered for arriving at the net consideration and post amendment the FMV shall be deemed to be the full value of the consideration received even if the transaction price would have been somewhat lower. This, in case, would raise the taxability and affix higher liability in the hands of the seller, which would further lower the confidence of the parties to pursue slump sales as a structured way of doing M&A deals and other group restructuring transactions. 

The amendment will take effect from 1 April 2020, and shall accordingly apply to the assessment year 2021-22 and subsequent assessment years. Therefore, it would be an upheaval for all those parties who have already concluded or they are on the verge of concluding their deals during the period of 1 April 2020 – 28 March 2021. The parties in due process of their deals, in lieu of complying with the amendment would have to restructure their transactions again, which would compromise their resources such as time and money. The deals already concluded on the book value would witness higher liability by the tax authorities if the FMV is greater than the book value on the basis of which such a deal is concluded.   

Conclusion

Amidst the COVID-19 pandemic, corporate debt restructuring and M&A transactions are perceived as an avenue to avoid falling into the pit of insolvency. However, the concerned amendments, at this stage, are a blow to this alternative. The amendments bring into scanner any deals since April 2020 (inception of the lockdown period) and would affect those deals where the struggling companies aimed or aim to sell off their undertakings in one go in order to avoid the cumbersome process of valuation of individual assets and liabilities. On one hand, the government provided for moratoriums and on the other hand, via this amendment, they are aiming to charge higher taxes, which is a setback to governments’ own policies and a prejudiced approach towards corporates. 


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