This article is written by Nikunj Arora, pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from Lawsikho.com.
The United States (“US”) has the highest US statutory corporate income tax among various developed nations and with this highest corporate tax, US is the only developed country with both a high statutory corporate income tax rate and a worldwide system. These herein mentioned features have a slight disadvantage over the US companies in the global market for cross-border Mergers and Acquisition (“M&A”). This disadvantage has caused a higher tax on repatriated income than any other developed nation. On the other hand, in Greece, LAW 2578/1998 had been enacted concerning cross-border M&A, which implemented the European Union (“EU”) Merger Tax Directive. Now, the recent Law 4172/2013 (new income tax code) incorporated the provision of the EU Merger Directive, thereby, providing a common system for the taxation. However, in India, the three major laws governing cross-border M&A are the Income Tax Act, 1961, Companies Act, 2013 and the Foreign Exchange Management Act (FEMA) Regulations. In 2017, Ministry of Corporate Affairs (“MCA”) enacted various provisions for corporate law which affects cross-border mergers. Under the Companies Act, 2013, Section 234 allows the merger/amalgamation of an Indian company with a foreign company.
The MCA again introduced Rule 25A in the Companies (Compromises, Arrangements and Amalgamations) Rules, 2014, with approval of the Reserve Bank of India (“RBI”). The important factors for cross-border M&A in India have been expanded globalization, the high-speed development of arising economies like India combined with decay in industrial competitiveness in the developed nations. In practically every M&A arrangements, while tax cuts are not the essential explanation behind directing a consolidation or procurement, tax assumes a critical part in deciding an arrangement s achievement or disappointment.
Thinking about the size and extent of these exchanges, which have an enormous income sway, it is fundamental for the arrangement structure to appropriately address tax assessment issues so that there is no foundational impact because of issues, for example, tax avoidance, income spillage or legitimate difficulties which can affect a particularly powerful M&A climate. Cross-border mergers can be either Inbound or Outbound.
Under this research, the researcher has aimed to put an overview of cross-border M&A from the view of tax considerations with the help of case studies given by Mr Binoy Parikh, CA, L.L.B. (see here) so that the apart from theoretical aspects, practical aspects shall be understood to gain a piece of in-depth knowledge.
Inbound, outbound mergers & demergers
- INBOUND MERGER:
Inbound mergers are those mergers where the foreign company is merging into an Indian company and it could involve foreign shareholders or Indian shareholders or combination of the two. The resultant company of such arrangement shall be an Indian company. The tax implications of an inbound merger are explained by the following case study.
- There is a group of shareholders owning an Indian company (“IC”).
- IC owns a foreign company (“FC”).
- FC doesn’t have any operations and only has cash.
- The motive of FC is to repatriate the cash back into the Indian Company.
Now, FC has two options, i.e., either to payout dividend to IC or to merge with the same. If FC pays out a dividend to IC, then provision of Section 115BBD of the Income Tax Act, 1961 (“ITA”) shall be attracted. Section 115BBD of ITA provides a concessional rate of tax in respect of a dividend received by an Indian company by a foreign company in which the Indian company holds 26% or more in nominal value of share capital. According to Section 115BBD, dividends received by an Indian company from a foreign company in which the Indian company holds 26% or more in nominal value of the equity share capital is charged to tax at a flat rate of 15% (plus surcharge and cess as applicable). Thus, the gross amount of dividend (without deducting expenditure/allowance) shall be taxed at the rate of 15% (note: Dividend Distribution Tax (“DDT”) is scrapped).
The other consideration is that FC merges into IC. The result of this arrangement will be that entire cash for surplus profits which were forming a part of FC’s balance sheet would now be vested in the books of IC. In this case, IC is the parent company holding 100% shares in FC, and the latter being the subsidiary of IC; hence, there shall be the issuance of shares. The following provisions shall be attracted:
- Section 56(2)(x) of ITA (deemed gift provision): IC being a parent company of FC, will not pay any consideration to FC as the former is itself a shareholder in the latter. The definition of amalgamation under Section 2(1B) of the ITA prescribes that all the properties and liabilities of the amalgamating company shall become the properties and liabilities of the amalgamated company, i.e., all the properties and liabilities of FC shall become properties and liabilities of IC as a result of amalgamation; hence, it shall be considered as a tax neutral amalgamation. As a result of which if it is a transaction referred to Section 47 (vi) of the ITA which is effectively capital gains taxation for FC into IC, then it is specifically exempted under Section 56 (2)(x). Thus, there will be no deemed gift provision under IC.
- Section 2(22)(a) of the ITA (deemed dividend): Section 2(22)(a) of the ITA prescribes that any distribution of assets by a company to its shareholders shall be considered as a deemed dividend at the hands of the shareholders. In this case, since FC is merging with IC, the accumulated profits are embedded in the assets of the FC, it should not be considered as a deemed dividend, specifically.
- Section 2(24)(iv) of the ITA (deemed income): Section 2(24)(iv) of the ITA prescribes that any value or any benefit which is derived by the shareholders of a company which is considered as income is taxable in the hands of the receiving shareholder. In this case, IC is receiving shares of FC without any consideration; hence, this shall not be considered as deemed income because this amalgamation is specifically exempted under Section 47, 56(2)(x) and various other provisions of the ITA.
Therefore, an inbound merger enjoys the benefit of tax-neutrality.
- OUTBOUND MERGER:
In an Outbound merger, an Indian company merges with a foreign company, as a result of which a foreign company is formed. The tax implications of an outbound merger are explained by the following case study.
- There is a group of Indian shareholders owning a manufacturing company (“MC”) in India.
- A group of foreign shareholders owning a foreign company (“FC”) outside India.
- MC will merge with a foreign company.
- As a result of the arrangement, FC will issue shares to the Indian shareholders owning MC.
Now, outbound mergers provide that if an Indian company merges into a foreign company, then the residual office which continues to be in India shall be treated as a branch office (as per Regulation 5(3) of Cross-Border Merger Regulations, 2018), thus, there shall be compliance of provisions of FEMA. However, FEMA regulations do not allow a Foreign Company Branch Office to perform any manufacturing activities in India. For these reasons, it is unlikely that the Foreign Company will choose to assemble its arms/production units in India.
The tax implications in an outbound merger are the following:
- First, this merger shall be subject to tax in the hands of the two entities, i.e., one is a manufacturing company and the other its shareholders. MC is transferring capital assets to FC and there could be a tax implication in the hands of FC as Successor Company of MC.
- The shareholders of FC could also be taxed. In Commissioner of Income-Tax v. Mrs Grace Collis (2001) 48 ITR 323 (SC), a three-member bench of judges of the Supreme Court held that any extinguishment of shares is considered as a transfer under the definition of Section 2(47) of the ITA and therefore, any shares which are received are considered for such extinguishment and shall be subject to tax as capital gains. Hence, there could be a tax liability in the hands of FC and as a successor company; there could be a tax liability in the hands of the shareholders as well.
- There is no specific provision providing for tax neutrality for outbound mergers.
- There shall be going forward implications for Indian operations. The Indian operations of MC will be considered as a permanent establishment in India and FC shall be subjected to the much higher tax rate in India for profits derived from such permanent establishment as opposed to an Indian manufacturing company.
A demerger is an arrangement whereby some part/undertaking of a company is transferred to another company which operates completely separate from the original company.
- Indian company (“IC”) which is a listed company.
- IC holds 100% of a foreign company (“FC”).
- FC holds 100% of another foreign company (“FC2”).
- There was a demerger of an undertaking directly from FC2 to IC.
In 2019, Ahmedabad National Company Law Tribunal (“NCLT”) in the case of Sun pharmaceutical Industries Ltd. no.38/nclt/ahm/2019, held that the provisions of Section 230-232 of the Companies Act, 2013 shall be construed when interpreting Section 234 of the Act. It means that the terms mergers and amalgamations if constructively interpreted then it shall include demergers also, thus, permitting demerger directly from a foreign company to an Indian company.
The tax implications are the following:
- This demerger arrangement from FC2 to IC shall be considered as a tax neutral demerger under Section 2(19AA) of the ITA, which defines demerger, whereby properties and liabilities about that undertaking become the properties and liabilities of an Indian company (IC) and 75% value of shareholders of FC2 becomes the shareholders of the resulting company. Here, demerging company is FC2 and the resulting company is IC.
- Under Section 47(vi)(b) of the ITA, any transfer of capital assets to IC shall be considered as capital gains exempt in any case be the course of Section 2(19AA) of the ITA exemption or not. There is no reason for the exemption of capital gains because there is no Indian asset or Indian income which is accruing in the hands of FC2 at the time of demerger.
- Section 56(2)(x) of the ITA prescribes that if a person or a company receives any consideration or receives any property but there is no issuance of shares and there is an inadequate consideration, then it shall be considered as deemed gift in the hands of IC (in this case). If this arrangement is a tax neutral demerger then there is a specific exemption under Section 56(2)(x) of the ITA in the hands of IC that such receipt of the property will not be considered as a deemed gift even if there is inadequate consideration, as in this case. If such arrangement is non-tax neutral, then also it shall not fall within the provision of Sec. 56(2)(x) because undertaking has been transferred and undertaking shall not be considered as a property for Sec. 56(2)(x) of the ITA.
- Now that the Dividend Distribution Tax (DDT) has been abolished, if this arrangement is considered as deemed dividend under Section 2(22)(a) of the ITA, then it shall be taxable in the hands of IC.
- The risk of provisions of Section 2(22)(a) and 2(22)(iv) of the ITA will continue to operate even if this demerger is considered to be tax neutral.
Other taxation issues
The issue of General Anti Avoidance Rule (“GAAR”) is considered as an anti-tax avoidance law in India to curb the issues of tax evasion and avoid tax leaks. The main purpose of GAAR is to check aggressive tax planning especially when an arrangement of M&A or cross-border M&A, or any other such similar nature arrangements are entered into with sole objective to avoid tax.
GAAR under Chapter X-A Section 95 of the ITA can declare any such arrangement to be an impermissible avoidance arrangement (“IAA”) under this provision. Now, the following will be tax implications for invoking GAAR, as per Section 98 ITA:
- There shall be a denial of tax benefit to such arrangement, or
- Disregarding, combining, or re-characterising entire or part of an arrangement,
- Treating the arrangement as if it had not been entered into,
- Disregarding the accommodating party or treating such party and any other party as the same person,
- Re-allocation of income, expenses, relief, etc.,
- Re-characterisation of equity-debt, income, expenses, etc.,
- Disregarding corporate structure,
- Re-assignment of the place of residence, or site of assets or transaction.
Countries with a GAAR include the UK, France, Germany, The Netherlands, Belgium, Canada, China, Singapore, Italy, South Africa, Kenya and Australia. Therefore, any arrangement of cross-border M&A shall be entered while keeping the main focus on the provisions of GAAR.
- TAXABILITY OF INDIRECT SHARES TRANSFER:
Where a foreign company transfer shares to another organization and the estimation of the shares is gotten considerably from assets arranged in India, at that point capital gains determined on the exchange are dependent upon Income Tax in India. Further, payment for such shares is dependent upon Indian withholding tax (WHT). Shares of a foreign organization are considered to get their worth considerably from resources in India on the off chance that the estimation of such Indian assets is at any rate INR100 million and represents at any rate 50% of the estimation of the relative multitude of assets possessed by such foreign company.
- THIN CAPITALIZATION:
India introduced thin capitalization provisions with effect from 1 April 2017. Under these rules, the total interest deduction for Indian companies and permanent establishments (PE) of foreign companies is capped at 30 per cent of earnings before interest, taxes, depreciation and amortization (EBITDA). The rules also apply to debt issued or guaranteed (including implicit guarantee) by a non-resident associated enterprise. The interest disallowed is eligible to be carried forward for 8 years and is deductible in later years, subject to a cap of 30 per cent.
Under Section 195 of the ITA, a person who is responsible for making payment to a non-resident that is chargeable to tax shall be obligated to withhold tax at the applicable rates. Numerous courts have given their view on the applicability of Section 195 of the ITA.
- In Transmission Corpn. Of A.P. Ltd. v. CIT (1999) 239 ITR 587 (SC), the Supreme Court held that the main consideration on the applicability of Section 195 of the ITA would be whether or not the sum paid to a non-resident is chargeable to tax under such provisions. The tax treaties are entered into under the provisions of the tax act, which provide that between a tax treaty and the Tax Act, a taxpayer can choose for whichever is beneficial to him.
- In CIT v. Samsung Electronics Co. 320 ITR 209, the Karnataka High Court held that Section 195 not being a charging provision, the tax office could not embark on an exercise to determine actual nature of the income or the tax liability of the non-resident assessee. They concluded that the resident payer’s liability to withhold tax springs into action the moment there is a payment to be made to a non-resident if such payment is per se income in the hands of the recipient.
The question of whether an inbound merger shall be re-classified as a deemed dividend provision under Section 2(22)(a) of the ITA has been answered in the following cases also:
- In the ruling of Shashibala Navnitlal V. CIT (1964) 054 ITR 0478, it was held that if accumulated profits are capitalised and redeemable preference shares are issued as a bonus to equity shareholders, then on the redemption of such bonus preference shares there would be the release of assets in favour of the shareholders, such pay off of bonus share would be taxable as a dividend.
- In another ruling of CIT V. Central India Industries Ltd. 82 ITR 555 (SC), it was held that where assets are distributed as a dividend, the amount of dividend is taken to be the market values of the property on the date on which the shareholders are entitled to receive the dividend.
The famous Vodafone case is another case which holds an important impact in this situation.
- The Bombay High Court in its order upheld the tax department’s jurisdiction to proceed against Vodafone on its USD 11.1 billion acquisition of Hutchison’s Indian telecom operations.
- The Vodafone International Holdings BV, Netherlands entered into a purchase agreement with Hutchison Telecommunications International Limited, Cayman Islands, for acquiring Cayman-based CGP investments.
- The court held that the taxpayer did not invite ‘moral dilemma’ and thus is under no obligation as long as the transactions are designed for the bona fide purpose, even if the results of such transaction lead to legal mitigation of tax incidence. The court accepted that the income earned by a non-resident from a cross-border transaction cannot be taxed in India unless the assets have sufficient territorial nexus with India.
Other relevant case laws:
- In Union of India v. Azadi Bachao Andolan 263 ITR 706 (SC), the Supreme Court held that the capital gains tax benefit would only be applicable under the Indian-Mauritius Tax Treaty when such Mauritius Company has obtained a tax residency certificate from Mauritius Tax Authorities.
There is a liquidity crunch due to on-going COVID-19 pandemic, due to which corporate are facing tough strategic choices in a cross-border deal. Cross-border transactions have been severely impacted due to the lockdown and closure of international borders. If the COVID-19 crisis and the lockdown conditions were to continue, parties could consider flexible alternative interim structures to give effect to commercial understanding. In terms of this crisis, parties shall continue to place reliance on e-execution and e-signing of the various agreements and documents, however, the taxation and the stamping and registration of the agreements shall remain a concern during these tough times.
The process, the commitments to be finished and the assessment risk which is made in an exchange of an inbound merger or an oversea merger is clear and easy to comprehend. However, in an exchange of the outbound consolidation, there is the nonattendance of numerous exclusions. Thus, an opportunity to make an outbound merger tax-neutral isn’t in the foreknowledge of Indian laws, without building significant possibilities in the Indian assessment laws.
Although all potential tax issues arising from cross-border mergers may be difficult to envisage at this stage, it would be interesting to see how the income-tax provisions are amended to provide for the taxation of both inbound and outbound mergers.
- International Tax Learning Platform by Pratik Vora.
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