Tax payers across the world are struggling with tax litigation and the situation in India is no different.  While tax payers are trying their best to stay clear of existing tax controversies, new issues keep emerging every year and 2013 was no different.  In this article, we have highlighted a few of the dominant tax debates affecting M&A transactions.

Cash repatriation 

Over the past few years, buyback of shares has been one of the favoured routes for cash repatriation by Indian subsidiaries of multinational companies (MNCs) or as a means to provide exit to investors.  Buyback of shares enabled cash repatriation without triggering dividend distribution tax (DDT), which is a big saving.  Moreover, where the shareholder offering the shares for buyback was a resident of a country with which India had a favourable tax treaty (like Mauritius), capital gains on such buybacks also enjoyed tax exemption in India.  Thus, cash was repatriated without triggering any tax liability in India.

The Finance Act, 2013, however, changed this position by introducing a buyback distribution tax (BDT) of 20%++ on closely held Indian companies implementing buybacks.  BDT applies on the difference between the buyback consideration and consideration received by the company on issue of the shares being repurchased.   This made cash repatriation through the buyback route liable to tax in India regardless of whether the shareholder offering the shares was a resident of a tax favorable jurisdiction, and at a rate higher than the rate for DDT.

With a view to repatriate cash without being subjected to BDT, buybacks are being implemented through court schemes and a tax position (although debatable) is adopted that such a buyback is not as specifically provided under the current Companies Act and hence, not liable to BDT.  Further, since buyback of shares is not akin to reduction of shares, such a transaction also does not trigger DDT.  The current Companies Act seems to permit buyback of shares pursuant to court approved schemes.  However, the new Companies Act, which is likely to come into effect from April 1, 2014, requires that buyback of shares, even if implemented pursuant to a court approved scheme, is restricted by specific buyback provisions.  Accordingly, once the new Companies Act comes into effect, it will be difficult to adopt the above tax position, and therefore this is a limited-life opportunity. 

Demerger of a business sought to be taxed

Transfer of business from one company to another pursuant to a court approved scheme of demerger has been adopted in a number of transactions.  Such transfers accord tax exemption both for the demerging company as well as its shareholders where the transfer is of an undertaking (akin to business on a going concern basis) and where at least 75% shareholders (excluding shares held by the resulting company) in the demerging company become shareholders in the resulting company.

Recently, revenue authorities have questioned tax exemption to such a transaction on the basis that one of the conditions prescribed for tax exemption is not fulfilled.  In this case, a wholly owned subsidiary company demerged one of its businesses to its parent (also engaged in the same line of business) pursuant to a court scheme.  Since, the business was demerged to the parent itself, which held all of the shares in the demerging company, the resulting company neither issued any shares nor did it pay any other consideration.  Both the companies claimed that the transfer of the business was pursuant to a court approved demerger scheme and hence, tax exempt.  The revenue authorities however, denied tax exemption on the basis that one of the conditions – allotment of shares - was not fulfilled.  They argued that the demerging company transferred its business to its parent and hence, was liable to capital gains as per the provisions of taxation of capital gains on slump sale.  Further, the parent was held to be taxable in respect of the value of the business received as a perquisite since, it did not discharge any consideration.

The income tax law itself recognizes a situation where shares are held in the demerged company by the resulting company pre-demerger; coupled with the bar under the Companies Act which prohibits issuance of shares in such a situation, it appears that the above decision is questionable.

Income on transfer of business pursuant to sale of shares sought to be taxed as business income

Transfer of businesses routinely get implemented by way of transfer of shares followed by transfer of control over the company whose shares are transferred.  In such situations, the seller generally offers income from sale of shares as capital gain.  

Recently, revenue authorities treated such a transfer to be a transfer of ‘business’ and hence, brought income on such transfer to tax as ‘business income’ instead of ‘capital gain’.  While it could be contested that gain on transfer of business is also liable to capital gain tax and hence, transfer of business by way of transfer of shares should also be taxed as capital gains; a high court has taken a different view.

Given this, the taxpayers will need to be more careful in structuring share sale agreements on a going forward basis to avoid litigation on this front. 

As can be seen, the challenges for taxpayers to keep litigation at bay are increasing.  Considering the aggressive nature of the revenue authorities, one should recognize that risk thresholds are now lower and it is imperative that tax structures are designed to satisfy all prescribed conditions, howsoever technical these maybe.  Also, utmost care must be taken at the time of negotiating and drafting the transactions documents to avoid unwarranted litigation at a later stage.

(Kalpesh Desai is Partner, BMR Advisors.)

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