How taxmen can help ease stress of distressed asset investors
Mayur Gala and Bhavin Shah of PwC India.

The Indian stressed asset segment has attracted active interest from several quarters within India as well as abroad. The government and regulators have done well to provide the much-needed liberalised framework for investors in the segment. Certain amendments in the Income-tax Act (IT Act) also form part of this reform exercise.

However, given the dynamic nature of stressed asset investment opportunities and the varied interests of the investors, there have been a few challenges that have emerged on the taxation front. Here are some key concerns of investors in stressed asset space.

Valuation: Deemed income for acquirer

Valuation below the net asset value is expected in most deals in stressed assets given the high risks involved. Under the Income Tax Rules (IT Rules), in case of acquisition of any property below its fair value, the difference between the acquisition price and the fair value is considered as taxable income in the hands of the investor.

Under the IT Rules, the fair valuation is driven partly by the book value of the assets of the investee company and partly by ready reckoner value / open market value of the said assets. The investors focusing on turnaround of the company may not find either of the values to be relevant for pricing purposes. However, there is no flexibility in this regard under the IT Rules. Given that these provisions directly impact the valuations, it is generally seen as becoming a potential deal-breaker in some cases.

MAT: More distress

Another common concern faced in the distressed asset space is minimum alternate tax (MAT) on borrower entities that agree on one-time settlement with lenders with certain haircuts. The amount written back by the borrowers as a result of the settlement typically forms part of the book profit of the borrower company and MAT is computed taking this book profit as the base.

While the borrower entities generally have brought forward losses and depreciation, provisions under the IT Act permit deduction for only one of them, actually the lower of the amount of book losses and depreciation.

The Finance Act, 2018 did give some relief to companies undergoing insolvency proceedings by permitting them to take deduction for both the brought-forward book losses as well as depreciation. However, the same benefit is not available to companies having stressed loans but not yet under the Insolvency and Bankruptcy Code (IBC) process. 

Foreign portfolio investors: More confusion

Several FPIs are actively considering investment in Security Receipts (SR) of asset reconstruction companies’ trusts. The IT Act provides for a pass-through treatment for income from ARC trusts in the hands of SR investors, which is generally in the nature of business income.

In the context of FPIs, the IT Act provides that the securities held by FPIs would be considered as capital assets. These provisions may result in a peculiar situation – while the SRs are considered as capital assets in the hands of the FPI, income flowing from the ARC trust to them may have the characterization of business income and not capital gains. There is significant confusion around applicability of IT Act provisions specific to ARC trusts versus FPIs – both lead to different tax conclusions.

Thin cap rules: No tax shelter

Interest paid to related non-resident investors may be disallowed as deduction in hands of the borrower where total interest expenditure exceeds 30% of EBITDA of the borrower.

Outstanding tax dues: Impact after resolution

In respect of resolution plans submitted under the IBC, there have been different views emerging regarding continued liability with respect to outstanding tax dues. Resolution plans have proposed writing off of outstanding tax dues as IBC puts the government dues below those of unsecured creditors in the order of priority. While the IBC expressly overrides other laws in force, it remains to be seen whether the resolution plans approved under the IBC also carry the same overriding powers.

Withholding tax

Withholding tax provisions require tax withholding on interest at the time of accrual in books of the borrower entity. Considering that the borrower entities would have had history of loan defaults, a situation can arise where the borrower accrues interest but is unable to pay interest to the investor. In such cases, the borrower would still be required to withhold taxes on the amount of interest accrued. The investor would unlikely offer interest income following real income theory. It would be difficult practically to claim refund of such taxes withheld.

Silver lining

It would be unfair to overlook the various positive amendments that have been introduced in the IT Act: the pass-through status to the ARC trust and relief to companies under the IBC process, to name the important ones. One must also take cognizance of the path-breaking amendments undertaken in other laws and regulations impacting the distressed asset space to get an idea of the complete picture.

The above complexities can at best be described as teething issues and part of the evolution process within the larger scheme of reforms that the Indian government and the regulators have undertaken. Looking at the responsiveness of the government and regulators, resolution of the above challenges should just be a matter of time.

(With inputs from Jigar Mehta, PwC India.)

Bhavin Shah and Mayur Gala are partners in the financial services tax team of PwC India.

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