Addressing the taxation issues from an Indian perspective
The boom in cross-border Mergers and Acquisitions (M&A) has given new urgency to understanding and managing the complex tax consequences of international expansion. There are very little globally accepted norms regarding tax law legislations. With India occupying an increasingly important place on the world stage, there is a need for India to mature in relation to administration of tax laws. This article explores the available tax laws that govern the cross border deals involving India. The debate over a couple of taxation issues has led to a few amendments by virtue of the Finance Act, 2008. This would have a major impact on deals with a country with which India does not have a Double Taxation Avoidance Agreement (DTAA). The major legal battles including the Vodafone dispute which would decide the fate of a large chunk of Foreign Direct Investments into India is much awaited and the challenge lies in balancing the interest of the investors and the revenue authorities.
Introduction
1. Mergers and Acquisitions (M&A) play a major role in the materialization of globalization. With increasing importance on globalization of businesses, cross-border transactions have become the quickest way of achieving the objective. Except for purely domestic legislation in some countries, there is little tax law at point, and no globally accepted norms. The market for these transactions, however, has expanded well beyond the regulatory reach of any single country. Tax law should better accommodate cross- border M&A. In an endeavour to geographically expand the utilization of their competitive advantages, M&A allow the firms to do so in a fast, effective and supposedly cheap manner.
Many countries have some tax rules that grant certain benefits to M&A transactions, usually allowing some deferral of the tax otherwise imposed on the owners of some of the participating parties upon the transaction. On the other hand, once M&A transactions cross borders, countries are much less enthusiastic to provide tax benefits to the involved parties, understanding that, in some cases, relief of current taxation practically means exemption since such countries may completely lose jurisdiction to tax the transaction.
Cross-border M&A, although presenting many of the same issues as domestic deals, are usually more complex and rife with surprises and other pitfalls, more so when the number of geographies involved in the transaction increases. The sheer range of concerns has expanded as the speed and volume of international deals have increased. Domestic M&A are, generally and on average, socially desirable transactions. In many countries, they enjoy tax (deferral) preferences, but only to the extent to which they use stock to compensate target corporations or their shareholders.
The boom in the cross-border M&A has given new urgency to understanding and managing the complex tax consequences of international expansion. The legal framework for business consolidations in India consists of numerous statutory provisions for tax concessions and tax neutrality for certain kinds of reorganizations and consolidations. With India rapidly globalising, and the economy growing and showing positive results, a sound tax policy is a must have. Tax is an important business cost to be considered while taking any business decision, particularly when competing with other global players. The new direct tax code that the Government is planning to introduce, to replace the current Income-tax Act, 1961 (‘the IT Act’), is expected to emphasise on transparency and taxpayer-friendliness.
Structuring the Transaction
2. A number of important issues arise in structuring a cross-border M&A deal to ensure that tax liabilities and cost will be minimized for the acquiring company. The first step is to explore leveraging local country operations for cash management and repatriation advantages. Moreover, the companies should be looking at the availability of asset-basis set up structures for tax purposes and keeping a keen eye on valuable tax attributes in M&A targets, including net operating losses, foreign tax credits and tax holidays.
As per the provisions of the IT Act, capital gains tax would be levied on such transactions when capital assets are transferred. From the definition of ‘transfer’, it is clear that if merger, amalga-mation, demerger or any sort of restructuring results in transfer of capital asset, it would lead to a taxable event.
2.1 Sale of Shares
(i) Capital gains and security transaction tax - The sale of shares is subject to capital gains tax in India. Additionally, Securities Transaction Tax (STT) may be payable if the sale transaction for equity shares is through a recognized stock exchange in India. The STT has to be paid by the purchaser/seller of securities. In case of shares held for a period of more than 12 months, the gains are characterized as long-term capital gains or otherwise as short-term capital gains (less than 12 months). If the transaction is not liable to STT, resident investors are entitled to the benefit of an inflation adjustment when calculating long-term capital gains; the inflation adjustment is derived from the inflation indices produced by the Government of India. Non-resident investors are entitled to benefit from currency fluctuation adjustments when calculating long-term capital gains on a sale of shares of an Indian company purchased in foreign currency. In case the transaction is liable to STT, long-term capital gains arising on transfer of equity shares are exempt from tax.
(ii) Transfer taxes - The transfer of shares (other than those in dematerialized form) is subject to transfer taxes, that is, stamp duty.
2.2 Sale of assets
(i) Slump sale - The sale of a business undertaking is on a slump-sale basis when the entire business is transferred as a going concern for a lump-sum consideration; cherry-picking assets are not possible. Consideration in excess of the net worth of the business is taxed as capital gains.
Transfer taxes - The transfer of assets by way of a slump-sale would attract stamp duty. Stamp duty implications differ from State to State. Depending on the nature of the assets transferred, appropriate structuring of the transfer mechanism may reduce the overall stamp duty cost.
(ii) Itemized sale - This happens when individual assets or liabilities of a business are transferred for separately stated consideration. The assets of the business can be classified into three categories :
(a) Capital assets - The tax implications for the transfer of capital assets (including net current assets other than stock-in-trade) would depend on whether they are eligible for depreciation under the Act or not. In the case of assets on which no depreciation is allowed, consideration in excess of the cost of acquisition and improvement is chargeable to tax as capital gains. In the case of assets on which depreciation has been allowed, the consideration is deducted from the tax written down value of the block of assets, resulting in a lower claim for tax depreciation subsequently. If the unamortized amount of the respective block of assets is less than the consideration received, or the block of assets ceases to exist (that is, there are no assets of that category), the difference is treated as short-term capital gains. If all the assets in a block of assets are transferred and the consideration is less than the unamortized amount of the block of assets, the difference is treated as a short-term capital loss and could be set off against capital gains arising in up to eight succeeding years. The question of whether depreciation on goodwill acquired can be claimed has yet to be tested in the courts, but the chances of such depreciation of goodwill being allowed appear remote.
(b) Stock-in-trade - Any gains or shortfalls on the transfer of stock-in-trade are considered as business income or loss. Business losses can be set off against income under any head of income arising in that year. If the current year’s income is not adequate, business losses can be carried forward to be set off against business profits for eight succeeding years.
(c) Intangibles (goodwill and brands, among others) - The tax treatment for intangible capital assets would be identical to that of tangible capital assets, as already discussed. The question of whether depreciation on goodwill acquired can be claimed has yet to be tested in the Courts, but the chances of such depreciation of goodwill being allowed appear remote.
Transfer taxes - The transfer taxes with respect to an itemized sale would be identical to those under a slump-sale.
2.3 Liabilities - Gains on transfers of liabilities are taxable as business income in the hands of the transferor.
2.4 Merger or amalgamation - For a merger to qualify as ‘amalgamation’ under the provisions of the IT Act, the definition highlights that the following conditions need to be satisfied :
u The merger should be pursuant to a scheme of amalgamation.
u All the assets and liabilities of the amalgamating company should be included in the scheme of amalgamation.
u No prescribed time limit exists within which the property of the amalga- mating company should be transferred to the amalgamated company.
u The requirement that the shareholders holding 75 per cent in value of the shares in the amalgamating company to be shareholders in the amalgamated company applies to both preference and equity shareholders. However, it does not prescribe any minimum holding in the amalgamated company, nor does it stipulate for how long they should continue being shareholders in the amalgamated company.
u The consideration to the shareholders of the amalgamating company can be a combination of cash and the shares in the amalgamated company.
It is possible to issue even redeemable preference shares as consideration to qualify as amalgamation.
(a) Capital gains tax implication for the amalga-mating (transferor) company - Section 47(vi) of the IT Act specifically exempts the transfer of a capital asset in a scheme of amalgamation by the amalgamating company to the amalgamated company, provided the amalgamated company is an Indian company. It is essential that the merger falls within the definition of ‘amalgamation’ as given under section 2(1B), if the exemption hereunder is to be availed of.
(b) Exemption from capital gains tax to a foreign amalgamating company for transfer of capital asset, being shares in an Indian company - In a cross-border scenario, when a foreign holding company transfers its shareholding in an Indian company to another foreign company as a result of a scheme of amalgamation, such a transfer of the capital asset, i.e., shares in the Indian company would also be exempt from capital gains tax in India for the foreign amalgamating company if it satisfies the following two conditions :
(i) At least 25 per cent of the shareholders of the amalgamating foreign company continue to be the shareholders of the amalgamated foreign company.
(ii) Such transfer does not attract capital gains tax in the country where the amalgamating company is incorporated.
(c) Capital gains tax liability on the shareholders of the amalgamating company - In the case of a merger, the shareholders of amalga-mating company would be allotted shares in amalgamated company as a result of the amalgamation. This process presupposes the relinquishment of shares in amalgamating company held by shareholders thereof. It is important to determine whether this constitutes a transfer under section 2(47), which would be liable to capital gains tax. According to judicial precedents in this regard, including decisions of the Supreme Court till recently, this transaction did not result in a ‘transfer’ as envisaged by section 2(47).
In the case of CIT v. Mrs. Grace Collis , the Supreme Court has held that “extinguishment of any rights in any capital asset” under the definition of ‘transfer’ would include the extinguishment of the right of a holder of shares in an amalgamating company, which would be distinct from and independent of the transfer of the capital asset itself. Hence, the rights of shareholder of the amalga- mating company in the capital asset, i.e., the shares stand extinguished upon the amalgamation of the amalgamating company with the amalgamated company and this constitutes a transfer under section 2(47).
However, a transfer by the shareholders of the amalgamating company is specifically exempt from capital gains tax liability, provided the following conditions are satisfied :
(i) The transfer is made in consideration of allotment to the shareholder of shares in the amalgamated company.
(ii) The amalgamated company is an Indian company.
The issue addressed by Mrs. Grace Collis’ case (supra) would arise in situations where the amalgamation does not satisfy all the conditions under section 47(vii) and section 2(1B) and is, therefore, not exempt from the capital gains tax. In view of this decision, the present position of law seems to be that such a merger would result in capital gains tax to the shareholders of the amalgamating company.
(d) Computation of capital gains tax on disposal of the shares of amalgamated company - This section contemplates a situation in which shareholders of the amalgamating company, having acquired the shares in the amalgamated company as a result of the amalgamation, now elect to sell off such amalgamated company’s shares. Accordingly, when these shareholders sell their shares in the amalgamated company, for computing the capital gains that would accrue to them as a result of the sale, the cost of acquisition would be the cost of their shares in the amalgamating company. Also the period of holding for determining long-term or short-term gains would begin from the date the shares were acquired by the shareholders in the amalgamating company.
(e) Availability for set-off of unabsorbed losses and other tax benefits - In case of amalgamation of a company owning an industrial undertaking, the amalgamated company would be able to get the benefit of carry forward of losses and depreciation to set off against its future profits, provided some conditions are fulfilled.
(f) Availability of carry-forward and set-off of losses by certain companies - Where there is a change in the shareholding of a company in which public are substantially interested, such a company would not be allowed the carry-forward or set-off of accumulated losses if shareholders carrying 51 per cent of voting power of the company on the last day of the year in which the loss is sought to be set off are not the same as the shareholders carrying 51 per cent of voting power on the last day of the year in which the loss was incurred.
2.5 Demerger - Under a demerger, all the assets and liabilities of the undertaking of the demerging company are transferred to the resulting company and, in consideration for this, the resulting company issues its shares to the shareholders of the demerging company.
The recognition for the need for reorganization and restructuring of businesses for growth and optimization of resource allocation has also resulted in the Government reducing the tax cost of such transactions. In furtherance of this purpose, the IT Act provides certain tax beneficial provisions in the case of a demerger. If the demerger fulfils the conditions listed in the definitions under section 2(19AA) and 2(19AAA), the transfer of assets by the demerged company to a resulting company has been exempted from capital gains tax. To qualify for the exemption, the resulting company should be an Indian company.
When a demerger of a foreign company occurs, whereby both the demerged and resulting companies are foreign but the assets demerged include or consist of shares in an Indian company, any transfer of these shares is exempt from capital gains tax in the hands of the demerged company. The following conditions need to be complied with for availing of this exemption:
(a) The shareholders holding at least three-fourths in value of the shares of the demerged foreign company continue to remain shareholders of the resulting foreign company; and
(b) Such transfer does not attract tax on capital gains in the country, in which the demerged foreign company is incorporated.
Since such a demerger would not be in India and, hence, the provisions of the Indian Companies Act would not be applicable in respect thereof, the proviso to this clause has waived the application of sections 391 to 394 of the Companies Act, 1956 to such a demerger.
India wants More Taxes From Cross Border M&A
3. Though mergers and acquisitions provide a substantial upside, yet shareholders will have to bear the brunt of the taxman. The revenue authorities are exploring the possibility of generating tax from cross-border M&A resulting in the transfer of beneficial interest of the Indian company. This is on the basis of the substance theory that the country has a right to claim tax on the profit generated from the business carried out in India, which itself is a debatable subject.
The current tax legislation does not provide for the concept of levy of tax on transfer of beneficial ownership in a cross-border transfer. The Hutch-Vodafone and a spate of other overseas deals involve taxability of transfer of shares of a holding company (having an Indian operating subsidiary company) outside India.
3.1 Present position of law - The current legislation provides for taxation of gains arising out of transfer of the legal ownership of the capital asset in the form of sale, exchange, relinquishment or extinguishment of any rights therein or compulsory acquisition under any law. Section 9 of the IT Act deems gains arising from transfer of a capital asset situated in India to accrue or arise in India. In a cross-border transfer involving transfer of shares, normally the situs of the capital asset provides the safe guide to decide as to which of the contracting states has the power to tax such income subject to the relevant tax treaty. The concept of levy of tax on the transfer of beneficial ownership in a cross-border transfer is not provided for in the current tax legislation, but the revenue authorities are of the view that in a cross-border transaction the valuation of the transaction includes valuation for the Indian entity as well and, accordingly, the overseas entity which has a business connection in India.
3.2 Changes in the Indian Law - The Finance Act, 2007 has brought amendment to section 9 with retrospective effect. This is with a clear view to increase tax revenues from cross-border M&A transactions. Further, amendments have been brought to sections 191 and 201 with retrospective effect by the Finance Act, 2008 to remedy the mischief and ensure that the tax due and payable is not evaded.
3.3 The legal battles - In line with this approach, the revenue authority recently issued notices to some 400 companies who were engaged in cross-border M&A deals in the recent past. Let us discuss some of the major deals.
(i) Hutch-Vodafone deal: Hutchison International, a non-resident seller and parent company based in Hong Kong sold its stake in the foreign investment company CGP Investments Holdings Ltd., registered in the Cayman Islands (which, in turn, held shares of Hutchison-Essar - Indian operating company, through another Mauritius entity) to Vodafone, a Dutch non-resident buyer. The deal consummated for a total value of $ 11.2 billion, which comprised a majority stake in Hutchison Essar India. In light of this, the revenue issued show-cause to Vodafone asking for an explanation as to why Vodafone Essar (which was formerly Hutchison Essar) should not be treated as an agent (representative assessee) of Hutchison International and asked Vodafone Essar to pay $ 1.7 billion as capital gains tax.
The whole controversy in the case of Vodafone is about the taxability of transfer of share capital of the Indian entity. Generally, the transfer of shares of a non-resident company to another non-resident is not subject to tax in India. But the revenue department is of the view that this transfer represents transfer of beneficial interest of the shares of the Indian company and, hence, it will be subject to tax.
On the contrary, Vodafone’s argument is that there is no sale of shares of the Indian company and what it had acquired is a company incorporated in Cayman Islands which, in turn, holds the Indian entity. Hence, the transaction is not subject to tax in India.
However, the revenue authorities are of the view that as the valuation for the transfer includes the valuation of the Indian entity also and as Vodafone has also approached the Foreign Investment Promotion Board (FIPB) for its approval for the deal, Vodafone has a business connection in India and, therefore, the transaction is subject to capital gains tax in India.
The much awaited Bombay High Court order in the case of Vodafone deal will be an eye opener for the taxation of cross-border deals in India, involving Indian entities.
(ii) The Genpact deal : Genpact originally was established in 1997 as a GE Capital International Services, a captive subsidiary of GE Capital. At the end of 2004, GE invested 60 per cent of the firm to US based private equity investors for $ 500 million dollars. GE did not pay any capital gains tax on such sale. Notices have been sent to the company following the deal. This matter is also pending before the Court.
Based on the above, the CBDT has reopened about 400 cases of large and mid sized transactions that took place during the past six to seven years.
Conclusion
4. Tax laws in many countries tend to be complex, but with India beginning to occupy an increasingly important place on the world stage, the benchmark for comparison has to be changed. There is a need for India to mature in relation to administration of tax laws. Two important dimensions are the need for laws that are clear and also for a mechanism to provide taxpayers with upfront clarity and dispute resolution.
Significantly, several multinational companies doing business in India, across a broad spectrum of industries, are saddled with ever-increasing number of tax audits and prolonged tax litigation in India on account of failure of our tax authorities to apply tax treaties or follow internationally-accepted standards in treaty interpretation and transfer pricing.
At present, the dispute resolution mechanism in India moves slowly. Assessment proceedings continue for more than two years from the date of filing of the tax return. Thereafter, the two appellate levels take approximately two to seven years to dispose of an appeal. If the dispute still continues, on a question of law, the matter gets referred to the High Court and the Supreme Court which takes very long. This is worrying corporates as it takes a lot of management time and effort.
There is a need to speed up the litigation procedure. There should be a limitation period on disposal of appeals too. Two years ago, the National Tax Tribunal (NTT) was set up to speed up the dispute mechanism. The NTT has, unfortunately, yet not been functional.
The new direct tax code that the Government is planning to introduce, to replace the current Income-tax Act, is expected to emphasise on transparency and taxpayer-friendliness.
The Indian tax authorities have been aggressively alleging that the Indian subsidiaries are economically dependent on the foreign parent company and, therefore, constitute a Permanent Establishment (PE) of the parent company. In claiming that the parent company has a PE in India, the Indian tax authorities ignore that the rule only applies if the transaction between the foreign company and the agent is not on arm’s length terms. The Indian tax authorities have also been aggressive when asserting PE, based on their own interpretation of the rules relating to place of business in India, provision of services in India, etc, rather than relying upon internationally-accepted rules.
Transfer pricing regulations require all international transactions amongst group entities to be priced on an ‘arm’s length’ basis, leading to the often-debated and vexed question of what the best manner of determining the arm’s length price is. Internationally, too, a majority of tax litigation is due to transfer pricing-related aspects.
In India, we find the litigation on transfer pricing increasing, so the corporates need to manage these risks. Introduction of Advance Pricing Agreements (APAs) and safe harbour provisions; further development of practice around Mutual Agreement Procedures (MAPs) are key steps required to take the Indian transfer pricing regime to the next level.
Amendments brought about by the Finance Act, 2008 would have a major impact on transfer of shares overseas, especially in a case where the seller of the shares is a tax resident of a country with which India does not have a Double Taxation Avoidance Agreement (DTAA). The amendment also brings the investors from countries like the US and UK within the tax net in India, since India’s DTAA with such countries provides for taxation of capital gains in accordance with the domestic tax laws of India.
Currently, a large chunk of Foreign Direct Investments into India is coming from favourable offshore jurisdictions. The tax laws shall face the challenge of balancing the interest of the investors and the revenue authorities.
