Tax and regulatory norms governing M&A in India, though numerous, are at times considered to be lacking the sophistication required for addressing the complexities in today's M&A environment, especially in cross border activity. This leads to subjective, context specific interpretations, which at times become an industry standard, or at times lead to time consuming litigation, which then has to be handled by rationalising the tax laws.

Having said this, the authorities have recognised the need for rationalising and updating the regulations concerning M&A in the Indian context, and a few important steps were taken in 2008. This year also saw a landmark litigation being pursued by the Indian Revenue authorities on transfer of Indian businesses through off shore transactions, which on its resolution, could significantly impact the manner in which overseas investment is structured into India.

Still a lot needs to be done on the regulations, and one can expect momentum on the open issues only after the new government is in place, which is expected by mid 2009.

Taxability of transfer of offshore holding companies

For a long time, transfer of Indian companies/ businesses effected through a sale of shares of an overseas holding company was considered to be a non taxable event in India. This was based on an interpretation that the Indian law seeks to tax only transfer of a capital asset situated in India, and the transfer of shares in a foreign holding company, as such, did not amount to a taxable event in India. Protection from such tax was also sought on the basis of specific tax treaties entered into by India.

The Revenue authorities now seem to have questioned this approach by pursuing litigation in a prominent acquisition of an Indian telecom services operator. In this case, the Indian operator was held through a holding company located off shore, the shares in which were transferred to a global telecom player in one of the most prominent M&A transactions in the Indian telecom sector. No taxes were paid or withheld on the transaction based on the understanding that a taxable event had not arisen in India.

However, the Revenue authorities took the view that, through the offshore transaction, it was the economic interest in an Indian business that was transferred and accordingly, the transaction should be considered taxable in India. Based on this view, the authorities proceeded against the overseas acquirer for not complying with regulations prescribing mandatory tax withholding on specified transactions which are taxable in India. Under Indian laws, if an entity, which is required to withhold Indian taxes, fails to do so, the Revenue authorities can seek to recover such taxes along with interest and penalty from it.

The overseas acquirer sought protection from Indian courts on the grounds that the tax withholding norms could not have been applicable to it, since Indian laws could not have an extra-territorial jurisdiction, and in any case, the transaction could not be considered taxable in India. The courts, without specifically concluding on taxability of the transaction, held that the Revenue authorities were well within their rights to initiate proceedings and investigate, and therefore the acquirer should cooperate (by furnishing the required information) with the Revenue authorities in concluding the proceedings.

While the issue of taxability of the transaction is yet to be concluded, the court ruling certainly emboldens the stance of the Revenue authorities on such transactions. Further, the applicability of tax withholding norms to off shore entities which are parties to transactions found taxable in India has been clearly established.

Though the ultimate impact of this litigation could be far reaching, its immediate consequences are already being felt. Overseas entities engaged in transactions which could be taxable in India now have to take a careful view on the ultimate taxability and their compliances. More importantly, until such time a clear view is taken, in transactions involving transfer of offshore holding companies, it would be important to demonstrate substance (ie interests/ business other than shareholding in the Indian entity) to make a defendable claim before the Revenue authorities.

Dividend tax rationalisation

Generally, dividends paid by Indian companies are tax free in the hands of the shareholder. However, the company is liable to pay a dividend tax at 16.995% on dividend payments made by it. This tax leads to considerable costs in multi tiered holding structures located in India due to cascading taxes on a single dividend stream.

In 2008, the government partially addressed this issue by allowing holding companies to off set the dividend received from their subsidiaries, while discharging tax obligations in relation to dividends proposed to be paid by them. However, the off set would be available only for one layer of holding, implying that in a structure involving multiple holding companies in India, the relief would only be partial.

The move brings much needed tax efficiency in holding company structures which are quite often employed in infrastructure and real estate sectors, where due to commercial and risk considerations, individual projects are housed in separate companies organised under a holding company which is the flagship. Now, strategic/ PE investments can be made at the holding company level also, without significant impact on taxation of dividend flows.

Foreign currency exchangeable bonds (FCEBs)

FCEBs were formally introduced in 2008 as a measure to enable holding companies to raise resources for their group companies by using stock of an underlying listed group company which they hold. Essentially, an FCEB is a bond denominated in foreign currency, which can be exchanged for share(s) of a listed Indian company held by (and in the group of) the issuer. Norms were introduced regarding the end use, tenure, interest caps, eligibility etc.

As far as taxation of such instruments is concerned, the interest payable on FCEBs is subject to tax at 10%. Further, a transfer of FCEBs between two non residents would not be considered a taxable transaction in India. Finally, the holder of an FCEB would not be liable to pay any tax on conversion of an FCEB to shares, making the instrument attractive from a tax perspective.

While the tax implications for the holders are very clear, the same is not true for an issuer. It is not certain as to whether the issuer company and/ or its group companies would be entitled to a tax deduction in respect of the interest payable on FCEBs. Further, basis on which the FCEB issuer would be taxed on conversion of FCEBs into shares is not clear.

These uncertainties, restrictions on end uses prescribed in India's exchange control norms, and most importantly, the economic scenario has perhaps restricted the use of FCEBs for raising resources in an Indian context. However, as the market conditions improve, it would be interesting to see how the tax and regulatory uncertainties are resolved.

Limited liability partnerships (LLPs)

Conceptually, an LLP is a hybrid corporate form entity combining features of the existing partnership firms and limited liability companies. LLP combines the benefits of limited liability for partners with flexibility to organise internal management based on mutual agreement among the partners. Internationally, an LLP is a popular and flexible format for organising small to mid size operations especially in the service sector without significant compliance requirements, and with tax advantages for the stakeholders.

In 2008, the government passed a legislation recognising the concept and permitting set up of an LLP. While the LLP will be a separate legal entity, liable to the full extent of its assets, the liability of the partners would be limited to their agreed contribution to the LLP. Further, no partner would be liable on account of independent or unauthorised actions of other partners, thus allowing individual partners to be shielded from joint liability created by another partner's wrongful business decisions or misconduct.

The legislation also permits foreign residents (whether individuals or body corporate) to become partners in LLPs in India. It allows foreign limited liability partnerships to establish a place of business in India, in accordance with rules which are to be separately framed and notified by the government.

However, the legislation does not contain detailed provisions regarding taxability of LLPs and hence at the moment, these would be governed under the existing tax laws. The government has, however, assured that the Indian LLPs will in no way be put to any disadvantage and will have a level playing field with other similar bodies outside the country.

Unlike other countries, India recognises a partnership firm as a separate taxable entity and not a transparent entity. Present income tax laws do not provide a conclusive tax framework for LLPs and hence the risk that distributions to partners may be liable to double taxation.

A recommendation report which had preceded the passage of legislation, had recommended tax transparency for LLPs in line with international practices. It is also prominent to note that many countries like the UK provide for tax transparency for LLPs. It is expected that the taxation of LLPs would be suitably incorporated in the income tax laws. Needless to mention, the tax regime would have an impact on the viability of LLPs in India. If pass through status is granted, LLPs will be a significant tool for organising certain activities including LBOs, investments in real estate and infrastructure sectors.

Key regulatory changes

Recently, the Indian government has issued clarifications on the method of calculating foreign investment in companies engaged in sectors in which foreign investment is subject to a cap (telecom, information and broadcasting, defense, etc). This subject had seen a lot of controversy of late, given that investments were routed through myriad holding companies and a range of financial instruments. The Indian regime also distinguished between foreign portfolio investment (FII) and strategic investment (FDI), and at times, it was argued that only FDI should be counted towards the foreign investment caps in regulated sectors.

The government has now clarified that foreign investment in a regulated Indian company would include all foreign inflows, and comprise a host of equity linked instruments (ie depository receipts, convertible bonds and preferred shares). Further, foreign investment through an intermediate Indian holding company would be counted towards the cap, only if the entity is owned and controlled by non residents (in such cases the entire holding by the intermediate holding company would be counted as foreign). While the government has laid down tests for determining ownership and control of intermediate holding companies, one can expect a lot of debate and scrutiny surrounding this issue.

Prima facie, the revised guidelines may enable effective foreign investment beyond regulatory caps through the holding company route – however, the issue is yet to be tested. Further, it is debatable whether foreign investment can now be structured through an intermediate holding company into sectors in which foreign investment was not permitted at all (eg multi brand retail, agriculture, etc).

The government has also clarified and relaxed norms governing approval requirements for down stream investments by Indian companies which have foreign investment. This matter had been subject to debate of late; however, it is still not clear as to whether the relaxations made now would benefit the cases, which were previously considered non compliant.

Overseas borrowings by Indian companies are restricted in terms of end use, eligible borrowers and lenders, all in cost ceilings, etc. The norms were considerably tightened in 2007 to manage excess liquidity coming into India through capital flows by restricting end use only for specified foreign currency expenditure, and imposing ceilings on the all in costs. However, the challenging economic environment in 2008 saw the government relaxing some of these restrictions (end use and all in cost ceilings) for identified sectors such as infrastructure, hotels, hospitals and software companies. However, despite these relaxations, using overseas borrowings for rupee expenditure and importantly, domestic M&A is still largely restricted.

Challenges

As mentioned above, Indian regulations require an over-haul to address the sophisticated M&A transactions of today. Also, the government needs to clarify its policy stance on certain key issues which have a bearing on the M&A environment. For market participants, important challenges are use of overseas leverage to fund acquisitions, and setting up structures for tax efficient cash repatriation typical in LBOs. Also, structuring of divestitures becomes important since there is considerable tax disparity with regard to exits effected on and off stock exchanges. Until a clear direction on these issues is established, a careful and risk cognisant view on tax planning would be essential.

Biography
		Rohit Berry BMR Advisors The Great Eastern Centre First Floor 70 Nehru Place New Delhi 110 019, India Tel: +91 11 3081 5030 Fax: +91 11 3081 5001 Email: rohit.berry@bmradvisors.com He has over 14 years of experience in tax, fiscal and regulatory matters working with multinational and domestic corporations across a range of industries. Berry has advised clients on a variety of complex transactions which involve varyingly, issues relating to the establishment, expansion, restructuring and divestment of businesses in India. Berry is actively involved in Japanese client initiatives and has served a host of Japanese companies engaged in a diverse range of businesses in matters relating to entry strategy, opportunity assessment, feasibility analyses, business realignments, and exit structures. Berry has a Bachelor's degree in Commerce from the Delhi University and, qualified both as a Chartered Accountant and Chartered Secretary (company law specialisation) in 1994. Berry finds is mentioned in International Tax Review's World Tax 2005, as an adviser on significant M&A transactions in India.