This article is written by Madhav Gawri, pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from LawSikho.
A cross-border merger is an event where two organizations originating from two different countries join together to form one entity. A cross-border merger or an acquisition would result in the transfer of control and authority of the organization either into a newly formed organization or to the acquiring organization. India has made great stride in reforming and making cross-border mergers and acquisitions possible under the guidance of the Government of India and other governmental organizations as applicable. The Companies Act, 2013 under section 234 permits the merger and amalgamations of an Indian company with a foreign company and vice-versa. Moreover, Rule 25A in the Companies (Compromises, Arrangements and Amalgamation) Rules, 2014, per the Reverse Bank of India.
Taxations depending upon the type of cross-merger
In India, cross-border mergers mean any merger or amalgamation between an Indian Company and a Foreign Company under the Companies Act 2013 and Companies (Compromises, Arrangements, and Amalgamations) Rules 2016. The Regulatory Framework of cross-border mergers includes (i) SEBI (Substantial Acquisition of Shares and Takeovers) Regulations 2011; (ii) Competition Act 2002; (iii) Insolvency and Bankruptcy Code 2016; (iv) Income Tax Act 1961; (v) The Department of Industrial Policy and Promotion (DIPP); (vi) Transfer of Property Act 1882; (vii) Indian Stamp Act 1899 (viii) Foreign Exchange Management Act 1999 (FEMA) and other allied laws that may be applicable on the transaction. The Taxation of such transactions is very difficult to judge and the same is a complicated matter. To understand the taxation procedure and norms of a merger or an acquisition, we have to first understand what Outbound, Overseas and Inbound mergers are.
Outbound mergers: It means a merger where a resultant company is a foreign company. Meaning the takeover of assets and liability of the company is by a foreign company. Therefore, the resultant company becomes a Foreign Company under Indian Laws. There is no tax-neutrality in the execution of outbound mergers. The transfer of capital assets under the current would surely attract capital gains tax in the hands of the Foreign Companies and the shareholders as under:
- In the hand of the Indian Companies: The Indian company being a transferor entity could be liable to capital gains tax on the transfer of its assets in case of a merger. But in the case of an amalgamation of two companies, the Indian Company may not receive any consideration against the same, therefore then there would not be capital gains tax.
- In the hands of the Shareholder: Shareholders experiencing capital gains either in the situation of a merger or in the case of amalgamation should be taxable either as long-term or short-term capital gains tax as per the provisions of the Income Tax, Act 1961.
Moreover, after the transfer of employees, all assets and liabilities and licenses to the foreign company then the company would be operating in India as a permanent establishment under the head of the branch office.
- Stamp Duty, it would be applicable and payable on the conveyance relating to the amalgamation of Companies and is levied as per the respective state Stamp Act.
Overseas mergers: It is a situation where a company buys and takes control of a company in another country. But there might some effected parties in the domestic country. For example, an amalgamation between organizations, one registered in the UK and another registered in the USA, but Indian hold shares and the same person is situated in India. In this kind of merger, the company doesn’t have any assets situated in India, but there are some shareholders situated in India. The per merger or amalgamation or the acquisition doesn’t have any effect in India per se, therefore it doesn’t call for any tax implications in India. Even for the shareholders, there would be no capital gains implications on the transfer of shares of the merging foreign company in India, unless the shareholders of the company are Indian tax resident according to the Income Tax Act, 1961, or these shares may derive their value substantially from the assets present or originated from India. In case of a transaction involving an Indian tax resident, the transfer of shares or in case of a capital gain, the tax liability would be calculated per the fair value of the shares of the merged company received as consideration or involved in the transaction.
Inbound mergers: It is a situation where a merger or an acquisition or takeover results into an Indian Company, being a resident of India. The acquisition of the business of an Indian Company can be performed by the method of an asset purchase or share purchase. Asset purchase can be done in the form of a going-concern basis or either on the form of individual asset purchase. Accordingly, the capital gain tax would be calculated and the stamp duty for the execution of the agreement between the parties. For equity purchase, the valuation of shares is done by a certified valuer who calculates the fair value of the equity being purchased. Capital gain tax is given on that according to the Income Tax Act, 1961.
Currently, the ITA provides for tax-neutral treatment of inbound mergers only. The merger of two foreign companies involving the transfer of shares of an Indian company is tax-exempt provided that the merger satisfies the criteria for an amalgamation set out in Part 1 above, i.e. (i) at least 25% of the shareholders of the amalgamating foreign company remain shareholders in the amalgamated foreign company, and (ii) such transfer does not attract capital gains tax in the country in which the amalgamating foreign company is incorporated. While the operational provisions to outbound merger seek to enable Indian companies to restructure their shareholdings and obtain access to foreign markets, absence of corresponding tax neutrality provisions under the ITA places outbound mergers in a disadvantageous position vis-à-vis inbound mergers. Further, risks about the constitution of the permanent establishment of the resultant foreign company may also arise in case of outbound mergers.
Moreover, section 234 of the Companies Act, 2013 allows cross-border mergers without any mention of cross-border demergers. The Income Tax Act, 1961 provides for the tax-neutrality for transfer of shares for a consideration of an Indian Company in the transaction of demergers between two foreign companies.
Managing tax risks in cross-border merger and acquisition
The government has taken many steps to better the measures and process of cross-border mergers and acquisition in India and to create a tax-friendly environment for investors and companies. But in case of these transactions, tax risks continue to remain a big hurdle. In India the following tax risk exists:
- Withholding tax obligation on the buyer while paying the sales consideration to a non-resident seller, if the gains are held to be taxable in India.
- The buyer can be treated as an agent of a non-resident seller under section 163 of the Act, which would lead to an assessment on the buyer in a representative capacity for the income arising to the non-resident seller.
- Assets transferred by a seller on whom there are outstanding tax demands / pending proceedings can be held void under section 281 of the Income-tax Act (Act) in certain circumstances.
To mitigate these risks and possible liabilities, the parties indemnify each other depending upon the agreement from the above risk accordingly.
The taxation predicament about the inbound and overseas merger is clear from the start. The process, the obligations to be completed and the tax liability which is created in a transaction of an inbound merger or an oversea merger is very clear and simple to understand. But, in a transaction of the outbound merger, there is the absence of many exemptions. An outbound merger leads to the shifting of value and future profits of an Indian company to another country. Therefore, a chance to make an outbound merger tax-neutral is not in the foresight of Indian laws, without building relevant contingencies in the Indian tax laws. An outbound merger needs to be approved by the RBI and the same should be following the Foreign Exchange Management (Transfer or Issue of Foreign Security) Regulations, the liberalized Remittance Scheme etc. The due diligence process and numerous certifications required for an outbound merger make the process very gruesome. The Indian tax laws pertain more towards inbound merger as compared to outbound mergers. Therefore, the government should re-define the process and provisions on outbound mergers.
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