This article is written by Nibha Yadav pursuing Diploma in M&A, Institutional Finance, and Investment Laws (PE and VC transactions) from LawSikho.com.
Tax is one of the crucial factors governing the type of structure and reorganizations that businesses want to undergo since tax implications vary depending on the type of business structure that is chosen. Mergers or amalgamations are one such method to acquire business undertakings. Section 234 of the Companies Act, 2013 permits the merger and amalgamation of an Indian company with a foreign company and vice-versa. Furthermore, Rule 25A in the Companies (Compromises, Arrangements and Amalgamations) Rules, 2016, as per the Reverse Bank of India regulates cross-border mergers and amalgamations.
In addition to the Companies Act, 2013 and Rule 25A of the Companies (Compromises, Arrangements and Amalgamation) Rules, 2016 by Reserve Bank of India, the regulatory framework of cross-border mergers and amalgamations will include;
- SEBI (Substantial Acquisition of Shares and Takeovers) Regulations 2011,
- Transfer of Property Act 1882,
- Indian Stamp Act 1899,
- Foreign Exchange Management Act 1999 (FEMA),
- Competition Act 2002,
- Insolvency and Bankruptcy Code 2016,
- Income Tax Act 1961,
- The Department of Industrial Policy and Promotion (DIPP) and other allied laws that are applicable to the transaction.
Indian Companies Act, 2013 under Section 230 to 232 allows the merger of companies through a scheme of arrangement provided the approval of the National Company Law Tribunal is necessary for such arrangement. Interestingly, the Indian Income Tax Act (ITA), 2016 does not use the term ‘merger’ but defines ‘amalgamation’ under Section 2(1B) of the act as the merger of one or more companies with another company or the merger of two or more companies to form a new entity. Thus, the merging company is known as an ‘amalgamating company’ and the company that is formed as a result of this amalgamation is known as an ‘amalgamated company’. The amalgamating company ceases to exist from the date the amalgamation is made effective and the ‘amalgamated company’ is the surviving entity. For the purpose of ITA, for a merger to be regarded as an amalgamation, certain conditions as discussed below have to be fulfilled.
By virtue of the amalgamation;
- All the properties and the liabilities of the amalgamating company should immediately become the properties and the liabilities of the amalgamated company
- Shareholders holding at least 3/4th value in shares in the amalgamating company excluding the nominee or the subsidiaries of the amalgamated company become shareholders of the amalgamated company
In certain circumstances amalgamations subject to certain additional conditions, may be regarded as tax neutral and exempt from capital gains tax in the hands of the amalgamating company and in the hands of its shareholders. This will certainly impact the type of business structure that is sought in order to avail of the exemptions. As discussed above the tax implications and the subsequent tax issues will depend on the business consolidation and reorganization that is undertaken and thus, the understanding of the term ‘amalgamation’ as given in the Income-tax Act becomes important in both the international and the domestic context. Further in this article, we will discuss the different types of structures that can be chosen for mergers and acquisitions with a primary focus on the relevant tax issues that arise in cross-border mergers and amalgamations.
Different methods of transferring business undertakings
Business undertakings can be transferred primarily in two ways by acquiring shares of such a company or by acquiring the assets for a lump sum consideration on a going concern basis or through itemized sale i.e. by cherry-picking the assets and individually paying for them and not for the entire business. The tax accounted in each transaction will be different which is discussed below
Acquiring businesses by way of share acquisition is one of the most commonly used methods which involves acquiring shares of the target company. In share acquisitions, major tax implication arises from the liability to tax on capital gains and the liability that arises under Section 56(2)(x) of the ITA. The taxation of gains depends on whether the shares are held as capital assets or stock in trade.
Further, in respect of income arising from the sale of listed shares and securities which can be treated as business income or capital gains, for one time, if held for more than 12 months while in case of income arising on sale of unlisted shares and securities will be treated as capital gains irrespective of the period of holding, thereby making a difference to the amount that will be taxed. The rate of tax will also depend on the fact whether the capital gains are long time capital gains or a short time capital gains. In case of cross-border acquisition, the Double Tax Avoidance Agreement (DTAA) will determine whether the capital gains will be taxable in India or foreign countries or both the countries involved in such acquisition.
Under ITA slump sale is defined as the sale of a business undertaking for a lump sum consideration on a going concern basis, without assigning values to individual assets or liabilities. However, a combination of individual assets would not mean a business activity in itself. In view of the gains arising from a slump sale it will be subjected to capital gains tax in the hands of the transferor in the year of transfer, if the transferor holds the undertaking for a period of 36 months or more it will be taxed as long term capital gains, otherwise as short term capital gains. There is no GST in the case of the sale of a business as a slump sale.
The asset sale is an itemized sale wherein the acquirer assigns individual values to the assets and pays for them separately. In an asset sale, the acquirer has the choice to cherry-pick the assets and liabilities and is not required to acquire the entire business. In the case of an asset sale, the taxability of capital gains is determined by drawing differentiation between depreciable and non-depreciable assets. Assets on which depreciation is not available under Section 32 of the ITA are considered as non-depreciable assets and capital gains are calculated as per Sections 45 and 48 of the ITA. Section 50 of the ITA provides computation of capital gains on depreciable assets. The method of computation of capital gains will depend on the ‘Block of assets’ given under Section 2(11) of the ITA, from which the asset is an asset sale is transferred provided if such asset exists or ceases to exist post-transfer. Stamp duty in case of a slump sale or an asset sale will depend on the relevant stamp acts of the respective states.
Inbound mergers v. Outbound mergers
Section 234 of the Companies Act, 2013 allows cross-border mergers and amalgamations wherein Indian companies can merge with foreign companies and vice – versa. An inbound merger is a cross-border merger where the resultant company is an Indian company i.e. the surviving entity post-merger is an Indian company. An outbound merger is a cross-border merger where the resultant company is a Foreign company i.e. the surviving entity post-merger is a foreign company. It is pertinent to note that depending on the type of merger whether inbound or outbound the liability to tax will vary. Inbound mergers are tax neutral by the virtue of the Indian income tax act i.e. the tax liability on capital gains both in the hands of the transferor and in the hands of the shareholders are exempted. Further in the case of overseas merger of two foreign companies involving the transfer of shares of an Indian company is tax neutral provided, if at least 25% shareholders of the amalgamating company remain shareholders of the amalgamated foreign company and such amalgamation does not attract capital gains tax in the country where the amalgamated company is incorporated. While there may be numerous reasons for an acquirer to undergo outbound mergers like access to foreign markets, for the purposes of the Income Tax Act, they are not taxed neutral like inbound mergers, and hence, outbound mergers are in a disadvantageous position.
Top 5 tax issues in cross-border mergers and amalgamations
Claiming tax benefits by virtue of treaties
Section 90(2) of the ITA permits a non – resident who is resident in a country that has a Double Tax Avoidance Agreement (DTAA) with India to claim tax benefits under the provisions of DTAA or ITA whichever is more beneficial to them. The underlying criteria in order to avail the benefits is that a non-resident in case of a person or a company has to be recognised as separate legal persons under the laws of the country of residence and additionally have to furnish the following details for claiming such relief like the status of a claimant whether a person or a company, nationality in case of a person and country of incorporation in case of a company, unique tax identification number like PAN (Permanent Account Number) provided by the Indian tax authorities. Thus, subject to the fulfillment of these criteria the relief is granted. The process may sound simple on paper but it is tedious and difficult to comprehend in reality.
Withholding tax obligations
Any person who pays a sum to a non-resident which is taxable in India, under Section 195 of the Indian Income-tax act read with DTAA, such person will be liable to withhold taxes on the sum paid at an appropriate rate. Such withholding of tax will be either applied at the time of payment or when the amount is credited to the non-resident, whichever is earlier. However, if such an amount is not taxable in India then the withholding of tax will not be applicable. A non-resident is obligated to withhold taxes if the remittances paid by such non-resident has an element of income and it is taxable under the Income Tax Act. For the purposes of ITA, withholding tax is levied on income like dividends, royalties, interest, etc. India initially used to levy Dividend Distribution Tax (DDT) which now stands abolished and the country has returned back to the classical model of taxation of dividends in the hands of shareholders with a corresponding appropriate rate of withholding taxes on the Indian paying company. The regular withholding tax on interest is 40% in case the recipient of such interest is a foreign company, however, the tax rate is subject to certain exceptions. Indian courts have time and again restricted benefits arising out of multilateral agreements like DTAA due to the abuse of such agreements and an attempt to evade taxes.
Generally, the tax liability on capital gains falls on the seller, however for the purposes of cross-border mergers and amalgamations the person responsible for making such payment can be treated as a representative taxpayer of the seller. This provision is duly recognised in Section 161(1) of the ITA. Nonetheless, this requirement is completely independent of the liability of the buyer to reduce tax at source (TDS) or the withholding tax obligations. Basically in case of a cross-border merger when Indian tax authorities find it difficult to retrieve tax from the non-resident involved in such a cross-border transaction then, they may proceed to recover the amount from the agent or the representative of such non-resident.
For a person to be considered as an agent or representative of the non-resident in the eyes of ITA, such person shall be employed by or on behalf of the non-resident, may have a business connection with the non-resident, shall be a trustee of the non-resident or from whom the non-resident receives income directly or indirectly. In Vodafone International Holdings, the Supreme Court of India held that the provisions of representative taxpayer will not be invoked in case there is no transfer of the capital asset, thereby emphasizing the fact that such provision will be only applicable when the amount is taxable in India.
Tax indemnities in cross-border mergers
By the nature of cross-border mergers and amalgamations and the risk involved, it becomes inevitable for the businesses undergoing such transactions to not consider tax indemnities, and thus, indemnity agreements become a crucial part of negotiating M&A deals. Generally, tax indemnity is sought for a period of 7 years subject to the limitations of ITA. It is advisable for the investors to do the due diligence and pre-empt any possible litigations or adverse tax orders by the tax authorities and thus, reach the Authority on Advance Rulings (AAR) at an earlier stage for relief. AAR is a quasi-judicial body and its rulings are binding on both the taxpayer and tax authorities.
As discussed above that Section 234 of the Companies Act, 2013 permits cross-border mergers and amalgamations, however, it does not talk about demergers explicitly, thus, leaving room for confusion whether cross-border demergers are allowed under Section 234 or not. However, this loophole was sought to be addressed in the case, of Sun Pharmaceuticals Industries Ltd wherein the National Company Law Tribunal (NCLT) Ahmedabad bench in 2019 held that the provisions of Section 230-232 of the Companies Act, 2013 shall be construed while interpreting Section 234 of the Act. It means that the terms mergers and demergers shall include demergers within its ambit. ITA provides for a tax neutral provision for demergers of two foreign companies resulting in the transfer of the shares of an Indian company.
If Company A and Company B which are two foreign companies demerge as a result of which the shares of an Indian Company C gets transferred to the resulting foreign company B then such transaction will be exempted from the tax liability provided the following conditions are fulfilled.
- the shareholders of the demerged foreign company holding not less than 3/4th of the total value of shares in such company continue to be the shareholders in the resultant foreign company.
Example: In the above case, the shareholders holding not less than 3/4th of the total shares in the demerged foreign company A shall continue to remain shareholders in the resultant foreign company B.
- such transfer shall not attract the capital gains tax in the country in which the demerged foreign company is incorporated.
Example: In the above case, the demerged foreign company A shall not accrue any capital gains tax in the country it is located.
Recent tax developments in India and their possible impact on the transfer of businesses
Recent tax changes announced in February 2021 will likely impact business transactions both domestic and international. Now, goodwill of the business will not fall under the depreciable asset and hence, tax depreciation will not be available and the amount paid for the goodwill of the business will be considered in the cost of acquisition. However, depreciation obtained in the past will be deducted from such cost of acquisition. Initially, transfer of business undertaking for lump sum consideration for ‘non-monetary consideration’ was considered non-taxable but now post the recent development it will fall within the scope of slump sale taxation. The benefits given under Double Tax Avoidance Agreements will now be extended to Foreign Institutional investors subject to certain conditional requirements. Dividend payments made by Special Purpose Vehicle (SPV’s) to Real Estate Investment Trust (REIT) and Infrastructure Investment Trust (InvIT) will be exempted from withholding taxes, this will certainly give some relaxation to the buyers on whom withholding taxes are levied. In addition to these developments changes in the tax regulatory framework is also evident as the time limit for tax assessment has been reduced to 3 years from 4-6 years.
With globalization and liberalization of the economy, the Indian Government over the years has accordingly liberalized the domestic laws and attempted to mitigate the possible adversaries in order to attract investments into the country. Like exempting inbound mergers and overseas mergers from the tax liabilities under the Income Tax Act is one such example. Though it is evident that the regulatory framework with respect to outbound mergers is pretty aggressive and such mergers do not enjoy any exemptions under ITA, it can effectively prove to be a hindrance in such transactions. Therefore, the laws pertaining to outbound mergers need to be more relaxed and lenient. Having said that the availability of multilateral agreements like Double Tax Avoidance Agreements (DTAA) can be abused to evade tax liabilities and thus, in turn, can hinder the conclusion of cross-border transactions.
There is a growing global concern regarding treaty abuse and the introduction of the Base Erosion and Profit Shifting (BEPS) Action Plan is an attempt to prevent such treaty abuse. Such concern is also reflected in the approach and the actions adopted by the Indian Government like actively participating in OECD’s BEPS project and introducing General AntiAvoidance Rules (GAAR) in the domestic law. Needless to say, investors and companies involved in cross-border mergers and acquisitions need to perform the due diligence on the target companies, pre-empt the litigations or pending tax obligations, if any, before making any investment.
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