Financial year (FY) 2020-21 has been an unprecedented and challenging year for businesses owing to the COVID-19 pandemic. Many businesses including – but not limited to – start-ups and micro, small and medium enterprises (MSMEs) have been facing financial and other resource constraints, mainly due to minimal economic activity during the year gone by. Thus, the focus of the businesses during the year often shifted from growth to sustainability.
With the belief that India may be able to combat the wide spread of the pandemic through vaccination and other government drives in the times to come, companies with a positive financial outlook may target for growth through mergers and acquisitions (M&A).
- Cash rich companies may strategise their growth by leveraging on the acquisition of targets which may become available at a distressed valuation;
- Start-ups and MSMEs may look out for opportunities to merge with companies within its verticals; and
- Companies facing financial constraints may consider raising funds from financial institutions or may outright sell part of its undertaking or transfer its investment in securities.
The M&A ecosystem is likely to see a lot of traction in India, as well as globally, during the economy's recovery and growth phase. Tax and regulatory implications on such M&A transactions are inevitable. Key tax and regulatory implication with respect to certain key M&A transactions have been captured below.
Mergers and demergers
Capital gains, arising in the hands of the transferor being the amalgamating company or its shareholders, on account of a merger would be exempt, as per the provisions of the Income-tax Act, 1961 (Act), subject to the satisfaction of certain conditions. Mergers for this purpose include:
i) A merger of two domestic companies; or
ii) A foreign company merging with an Indian company; or
iii) A merger between two foreign companies, and the amalgamating foreign company transfers the shares of an Indian company on account of the merger (direct transfer); or
iv) Transfer of shares by the shareholders, being shares that derive its substantial value from assets located in India, on account of a merger between two foreign companies.
Similar to the above, capital gains arising on account of a demerger would be exempt from tax in the hands of a demerged company, as well as gains arising on shares transferred or acquired by the shareholder of the demerged company would be exempt from tax. A key consideration in the case of a demerger would be a capital asset being transferred, and this should qualify as an undertaking i.e. a capital asset being transferred should constitute as a business activity.
The period of holding and cost of acquisition of shares being transferred by the shareholders/amalgamating or demerged company on account of a merger or a demerger will be the same as that of its original purchase date or price.
As per the provisions of the Act, for any person receiving any property without a consideration or at a price lower than the fair market value (FMV), the difference between the acquisition price and FMV would be chargeable to tax in the hands of the acquirer.
However, such deeming provisions should not be applicable in the case of a merger or a demerger.
In the case of shares issued for consideration which exceed the face value of shares, and the aggregate consideration received for the shares exceeds its FMV, the difference between the issue price and the FMV of shares should be taxed in the hands of the issuing company. While there are arguments that these provisions ought not to be applied in the case of a merger or a demerger, this issue is not free from litigation.
Other key tax considerations
Carry forward and set off of accumulated loss and unabsorbed depreciation
Business losses and unabsorbed depreciation of an amalgamating company may be allowed to be carried forward and set off in the hands of the amalgamated company, subject to the satisfaction of certain conditions. Business losses may be carried forward for eight years pursuant to a merger, subject to certain conditions.
“The M&A ecosystem is likely to see a lot of traction in India, as well as globally, during the economy’s recovery and growth phase.”
In the case of a demerger, the accumulated losses and unabsorbed depreciation of the demerged company would be allowed to be carried forward and set off in the hands of a resulting company, subject to the satisfaction of certain conditions. Accumulated business losses are permitted to be carried forward for the unexpired period and depreciation can be carried forward indefinitely.
Any change in the beneficial shareholding of more than 51% would result into a lapse of losses. However, provisions of the Act under which losses are permitted to be carried forward, in case of a merger or a demerger (as discussed above), are non-obstante provisions (bearing words 'notwithstanding anything contained in any other provisions of this Act…'). Accordingly, a view may be taken that provisions of a lapse of losses on account of change in a beneficial shareholding in excess of 51%, ought not to apply in the case of a merger or a demerger.
Companies Act, 2013
Section 230 to 240 of the Companies Act, 2013 (Cos Act) covers the statutory provisions governing M&A including arrangements involving companies, their members and creditors. Furthermore, guidance on procedural aspects are covered in the Companies (Compromise, Arrangements and Amalgamations) Rules, 2016. A merger or a demerger needs to adhere to these statutory provisions as contained under the Cos Act.
Stamp duty implications may be attracted on the scheme for a merger or a demerger as per the relevant entries under the stamp duty laws of each state.
For example in the case of a merger, the applicable stamp duty per the state laws in Maharashtra would be 10% of market value of shares issued/allotted and the amount of consideration paid on account of the merger, provided such stamp duty does not exceed, higher of the following:
- 5% of the market value of immoveable property of the transferor located in Maharashtra; or
- 0.7% of market value of shares issued/allotted, and the amount of consideration paid on account of the merger.
Separately, stamp duty may also be attracted on the issue or transfer of shares/securities, as per the laws of the Indian Stamp Act, 1899, as amended from time to time.
Other key regulatory considerations
Other laws which need to be considered while undertaking a merger or a demerger may be:
- SEBI Regulations (in case a merger or a demerger involves listed entities or entities which are regulated by the SEBI);
- Competition Act, 2002;
- Foreign Exchange Management Act, 1999 (FEMA); and
- The Goods and Services Act, 2016.
As per the erstwhile company law regulations, only inbound mergers were permitted. Having said this, as a liberalisation measure, both inbound and outbound mergers are now permitted by the Ministry of Corporate Affairs. The relevant provisions were notified under the Cos Act. This is a welcome move and would assist the Indian economy to take a step closer towards globalisation.
Tax implications with respect to an inbound merger (i.e. in cases where the amalgamated company is an Indian company) has been discussed in length above. All provisions, as applicable in the case of a domestic merger, ought to apply in the case of inbound merger. However, since the income of foreign companies are not chargeable to tax in India, accumulated losses incurred or unabsorbed depreciation may not be permitted to be carried forward and set off under the Indian tax laws.
Accordingly, accumulated losses and unabsorbed depreciation of foreign amalgamating companies may not be permitted to be carried forward and set-off by the Indian amalgamated companies pursuant to an inbound merger.
However, the only exception to this may be in the case of a foreign amalgamating company which has a place of effective management (POEM) in India prior to a merger. A view may be taken that losses and unabsorbed depreciation of such a foreign amalgamating company having POEM in India may be permitted to be carried forward and set-off by the Indian amalgamated company.
There are neither any specific provisions under the Act, which provide for exemption from capital gains arising on the transfer of a capital asset by an Indian amalgamating company to a foreign amalgamated company, nor are there any provisions which provide for any exemption to the shareholders, in the case of an outbound merger.
Accordingly, as per the existing provisions of the Act, an outbound merger may attract tax in the hands of an Indian amalgamating company and its shareholders.
Income from other sources/deeming provisions
As per the provisions of the Act, for any person receiving any property without a consideration or at a price lower than the FMV, such a difference between the acquisition price and the FMV would be chargeable to tax in the hands of the acquirer.
Accordingly, where shareholders of an Indian amalgamating company receives shares of a foreign amalgamated company on the account of a merger (which derives its value directly or indirect from Indian assets) and such shares are acquired at a price lower than the FMV, the difference between the FMV and acquisition price may be taxable in India (subject to certain exceptions/conditions).
Other key tax considerations
As outbound merger transactions could potentially lead to the shifting of tax bases from one jurisdiction to another, one needs to be wary of the recommendations and provisions under the base erosion and profit sharing initiatives and the general anti-avoidance rule (GAAR) in this respect.
Furthermore, the foreign amalgamated company pursuant to the outbound merger may continue to have decision-making based out of India. This may trigger POEM-related implications and such a foreign company may be considered as a resident of India for tax purposes.
Companies Act, 2013
Certain key compliances i.e. including – but not limited to – obtaining the reserve bank's approval, needs to be adhered from the Cos Act.
Provisions of the Cos Act only deal with amalgamations and mergers. It does not uses the word 'demerger' or have any other similar arrangement specifically. Accordingly, ambiguity arises as to whether an outbound demerger may be permitted under company law. It may be pertinent to note here, that the National Company Law Tribunal vide, order dated December 19 2019,(CP (CAA) No. 79 of 2019 in CA (CAA) No. 38/NCLT/AHM/2019), had rejected the application of Sun Pharmaceutical Industries Limited with respect to an outbound demerger, on the ground that it is not specifically permitted as per the Cos Act, as well as FEMA regulations.
Foreign Exchange Management Act, 1999
The FEMA regulations suggest that inbound and outbound mergers are permitted under an automatic route without prior approval of the Reserve Bank of India (RBI), provided that certain conditions are satisfied. Some of the key conditions have been tabulated in Table 1.
|Issues for consideration||Inbound merger||Outbound merger|
|Issue of securities on account of merger||Foreign investment conditions i.e. pricing guidelines, sectorial capping, other attendant conditions, may be required to be adhered to. |
Outbound investment regulations to be complied in following cases:
• Transferor foreign company is a joint venture (JV)/wholly owned subsidiary (WOS) of the Indian company; or
• Where a merger results into the acquisition of a step-down subsidiary of JV/WOS outside India.
|Compliance with FEMA outbound investments needs to be complied with.|
Shareholders of the transferor Indian company needs to follow the resident individual limits as prescribed under the Liberalised Remittance Scheme.
|Regulations with respect to branches or offices in India and abroad||A branch or a representative office of a foreign amalgamating company would become the office of a resulting Indian company. Accordingly, the relevant FEMA regulations need to be complied with.||A branch or offices of the Indian amalgamating company may become the branch or office of the foreign company. Accordingly, the relevant FEMA regulations need to be complied with.|
Inbound mergers and outbound mergers may attract stamp duty in India.
Gains arising on the transfer of an undertaking for a lump sum consideration, without assigning consideration toward any of the assets individually, would be chargeable to tax as per the special provisions as contained under the Act. Capital gains for the purposes of a slump sale are computed as the difference between the sales consideration (less expenditure incurred in relation to the transfer) and the net worth of the undertaking.
Having said the above, for the only slump sale covered within the ambit of taxation under the special provisions, the view was taken that gains arising on the slump exchange (i.e. shares exchanged in lieu of shares), not being a slump sale, was outside the purview and hence not chargeable to tax. However, pursuant to amendment vide the Finance Act, 2021 (Finance Act), it has been clarified that even a slump exchange is covered within the ambit of taxation. Furthermore, the sales consideration was not linked to the FMV.
Pursuant to an amendment vide the Finance Act, the sales consideration has now been linked to the FMV of capital assets, as on the date of transfer, and where such sales consideration is lower than the FMV, such that the FMV would be considered as the full value of consideration for the purpose of computing capital gains. However, the mechanism and methodology for computing the FMV is yet to be prescribed by the Central Board of Direct Taxes.
It may be pertinent to note that the amendment made vide the Finance Act, is partially retrospective i.e. it is effective from FY 2020-21. Accordingly, slump exchange deals which have been concluded during the FY 2020-21, taking a view that slump exchange may not trigger any taxes, may be required to be reconsidered (pursuant to method of the FMV being prescribed).
Insolvency and Bankruptcy Code, 2016
The Insolvency and Bankruptcy Code, 2016 (IBC) played a pivotal role in bringing back economic balance prior to the pandemic. The IBC assisted in resolving the problems of increasing stressed assets, by offering such stressed assets to the interested bidders at a competitive price. With the hope that there is success in combating COVID-19, the next task in hand would be to bring the economy back into place. Accordingly, the IBC might come to the rescue for achieving economic balance.
The IBC enables an interested bidder to present a resolution plan to the committee of creditors. Generally, a resolution plan involves a proposal which includes a partial debt waiver, an interest waiver, and a conversion of loans into equity, among other matters. The resolution plan assists in the revival of a corporate debtor which is under the IBC proceedings.
While implementing the resolution plan, the key tax considerations listed in Table 2 should be considered.
Relaxation has been provided by the government for the carry forward of losses in the case of companies under the IBC i.e. where the insolvency resolution plan involves changes in the beneficial owners of shares beyond 51%, the tax losses may still be available pursuant to the approval of the resolution plan under the IBC.
Additional relaxation with respect to the above tax issues may contribute towards the smooth functioning of the IBC process and would promote more IBC participation, thereby giving a boost to acquisition plans.
|IBC participants||Tax considerations|
|In the hands of corporate debtor||Write-back:|
• Debt write-back may be considered as taxable where deduction for the same has been claimed, while computing profits chargeable to tax under the head business and profession.
• In cases where no deduction has been claimed with respect to the write-back, it may be considered as a business perquisite in the year of the write-back and may be chargeable to tax in the hands of the corporate debtor.
• Having said this, there is a favourable ruling of the Apex Court in the case of Mahindra and Mahindra, which states that write-backs may not be treated as a business perquisite and where no deduction for the same has been claimed while computing taxable profits there ought not to be any tax incidence.
Minimum alternative tax (MAT):
• Write-backs may result into an increase in MAT in cases where corporate debtors are taxable under the MAT and corporate debtors are not availing concessional tax regimes.
• Where shares by the bidder are acquired at premium (as bidder may want to infuse monies at premium) and such a premium is in excess of the FMV of shares of the corporate debtor (which generally would be the case, as net worth of the corporate debtor under the IBC would be eroded), difference between the FMV and the acquisition price would be taxable in the hands of the corporate debtor.
|In the hands of promoters||Where shares held by the promoters are transferred at a price lower than the FMV, the FMV would be considered as full value for the purposes of taxation. However practically, the FMV of shares of the company under the IBC is less than the transaction price. Accordingly, there ought not to be any tax impact.|
|In the hands of the bidder||Where the shares acquired by the bidder are at a price lower than the FMV, the difference between the FMV and the acquisition price would be chargeable to tax in the hands of the bidder.|
International financial services centre
Given the tax incentives granted by the government (i.e. deduction of 100% business profit for 10 out of 15 years, concessional MAT rate etc.) for the units set-up in international financial services centres (IFSC), offshore financial service providers are keen on having a presence in them.
One of the possible options for having a presence in an IFSC, could be by the way of relocating an existing overseas fund to an IFSC. The tax exemption has been extended to the overseas fund and its unitholder/shareholder upon relocation, vide the Finance Act.
Furthermore, financial service entities set up in India may consider leveraging on the concessional rate of taxes offered in an IFSC. It may consider merging with entities set-up in the IFSC. Through such mergers, companies may attain synergies of resources and leverage on tax benefits.
Entities set-up in an IFSC are considered as entities set-up overseas for the limited purposes under FEMA. Accordingly, all the provisions with respect to domestic mergers, as contained under the Act, may apply in the case of mergers between Indian entity and entities set-up in an IFSC. However, this may be subject to approval from the regulators (i.e. special economic zone and IFSC authorities).
Special purpose acquisition company
A special purpose acquisition company (SPAC) is a company formed for the sole purpose of raising capital through an initial public offering (IPO) to fund a future target. At the time of set-up of a SPAC, the target entity is not known. The SPAC raises funds from global financial sponsors, private equity houses and general public investors with creditability. Pursuant to raising funds, a SPAC is listed on a stock exchange.
In order to fund the target, a SPAC may consider a reverse merger or a swap of shares. Through such a merger, a target can raise capital without having to go through a long drawn IPO process. A SPAC is a concept recognised in western countries, particularly in the US, and such structures currently face certain regulatory challenges in India.
Accordingly, in order to fund an Indian target, a reverse merger of Indian targets with a SPAC formed overseas may be required. This may attract tax and regulatory considerations, as discussed under the paragraph with regard to outbound mergers.
Other key considerations
A no objection certificate may be required to be obtained from an income tax officer under section 281 of the Act (subject to certain exceptions and conditions), by the transferor.
In case of transfer of assets/business pursuant to mergers or acquisition, the transferor may consider, obtaining lower/nil withholding certificate (if applicable and as the case may be) and furnish the same to the acquirer, in order to avoid fund flow issues.
Tax deducted at source and tax collected at source may be required to be deducted/collected on account of transfer/issue of shares and securities, pursuant to a merger or a demerger.
Challenging times come with hidden growth opportunities. Given that targets may be available at lucrative discounted values, it is time for companies seeking expansion and growth to start evaluating potential targets, plan their financial resources, and deploy it in acquiring targets which have potential at the right time.
Evolving tax, regulatory and legal framework, provide essential support to businesses for undertaking mergers, acquisition and restructuring activity, in a structured and effective manner.
Given the above, it is to be believed that M&A will be the growth mantra in the years to come.
T: +91 982 005 8327
Uday Ved is the lead partner in the global tax practice group at KNAV, and is based out of the firm's Mumbai office.
Uday has over 30 years of experience on tax matters, and has worked extensively on M&A, inbound and outbound tax structuring, cross-border transactions, and global reorganisations. His clients have been both Indian and international firms in sectors including infrastructure, manufacturing and technology. He has interacted extensively with the Central Board of Direct Taxes and regulatory bodies in India by making representations to them on international and domestic tax and regulatory issues. He is frequently invited by various news portals to participate in debates and express his views on various tax issues.
Uday is a chartered accountant and has a bachelor's degree in commerce from the University of Mumbai. Prior to joining KNAV, he held key positions at a Big Four firm, including as the national head of tax. He has co-authored a book, 'General Anti-Avoidance Rule (GAAR) – Establishing substance over form' (2017).
T: +91 983 375 7804
Deep Kothari is the manager of the India tax practice at KNAV, and is based out of the firm's Mumbai office. He has over 7 years of post-qualification experience in tax and regulatory advisory services with a specialisation in transaction structuring and financial service space.
Deep has assisted a leading asset and wealth management company in India, in having a first presence in the IFSC. He has been an active member in various funding deals which involves debt financing and structuring. He has been extensively involved in debt listing process, due diligence of the borrowing entities and providing incidental transaction advisory services. He has experience in advising clients on matters relating to domestic and international taxation, including on exchange control regulations, SEBI regulations and corporate law. He also has expertise in providing fund set-up services, which includes but not limited to Category II AIF, Category III AIF, and offshore funds.
Deep is a chartered accountant and holds a bachelor's degree in commerce, as well as law, from the University of Mumbai. Prior to joining KNAV, he has worked for large Indian tax firms and a Big Four firm.
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