INTRODUCTION:
Union budget 2022-23 has finally been introduced. Various aspects of taxation laws are demanding reforms and corporations and other entities were looking forward to the new Finance Bill, 2022. However, unfortunately some voids were left unfilled Therefore there is a need to relook at some key issues governing corporate tax regime demanding reforms. One of which is the application of tax neutral provisions on outbound mergers under relevant legislations. In India, outbound mergers i.e. mergers where the merged entity is a foreign entity do not enjoy the principle of tax neutrality. However the same is not the case for inbound mergers or the mergers where the merged entity is an Indian entity or domestic mergers where 2 or more Indian entities merge into one. Indian corporations have been demanding reforms whether it is the issue of interpretation of demergers U/s 234 of the Companies Act, 2013[1] or the tax reforms to allow an exemption to outbound mergers. While the former is specifically related to company law, the latter is an important concern from a tax perspective.
Before delving into the aspect of unequal treatment of outbound mergers, it is important to understand the concept of an “amalgamation”. The Income Tax Act, 1961 (“ITA”) has defined “Amalgamation” as a merger of one or more entities into one or in case more than two entities forming into one.[2] The legislative intent behind defining the term “amalgamation” is to extend the tax neutrality principle or capital gain tax exemption to the transfer of assets in inbound and domestic mergers. Tax neutrality means a neutral tax system that allows corporations to function efficiently without modifying their revenue model which accordingly makes it an ideal tax system.[3] However, there are conditions that shall be fulfilled for a merger to qualify as amalgamation under ITA. For example, the shareholders of the amalgamated entity shall hold at least 75% of shares in the amalgamating entity or “3/4th of value in shares”.[4]
Transfer of assets is subject to tax liabilities under ITA. In CIT v. Grace Collis (SC)[5], the Hon’ble Supreme court stated that once an amalgamated entity merges with the amalgamating entity then the rights of the former extinguishes. Thus, such an amalgamation is dealt with as a “transfer” U/s 2(47) of ITA. However, In terms of amalgamations of 1 or more entities, Section 47 of ITA talks about amalgamations where transactions shall not be dealt with as transfer of assets. This, however, excludes outbound mergers. Therefore the contention is based on the exclusion of an outbound amalgamation from the tax exemption accrued upon the capital gains transactions under section 47 of ITA. Technically, any capital gain by an amalgamating/merging company as a result of the amalgamation/merger must be taxable under the capital gains tax. However, the same is not applicable in the case of inbound and domestic mergers. Therefore, there is a need for an amendment which the Finance Bill unfortunately overlooked.
TREATMENT OF OUTBOUND MERGERS
While unequal tax treatment under existing legislations for outbound mergers is in general unsupportive towards the principle of neutrality, other implications to this void could be even more detrimental. It is to be noted that if a foreign entity takes over an Indian entity then the Indian entity or the amalgamated entity is dealt with as if the Indian entity had never existed. Thus, the laws would consider it as a foreign entity operating in India. This means that the application of domestic laws would be different if the Indian entity would cease to exist.[6] It would rather become a “branch” of the amalgamating foreign entity.[7] This view has been further supported by Foreign exchange management regulations governing branch offices of amalgamating entities after the outbound merger (“Branch Regulations”).[8]
Further, Companies (Compromises, Arrangement or Amalgamation) Rules (“CCAA”) deal with the jurisdictional obstruction to foreign entities. In other words, not all foreign entities can open their branch office or amalgamate with an Indian entity. Certain jurisdictions are better at regulating entities operating on their land. This means that strict regulation would prevent potential white-collar crimes. However, the other side of the coin is the unattractive obstruction that foreign entities would face in regulating business in India. Other obstructions to foreign entities in amalgamating with Indian entities will be the limitations towards to business undertaken by them. Foreign amalgamating entities can only operate in India through a branch office if the business undertaken by them falls into the categories which are listed in the Branch Regulations. Other activities would require prior approval of RBI.[9] The tale of rigid regulations does not end here, things become worse when the amalgamating foreign entity is deemed to have a permanent establishment in India.
FEAR OF PERMANENT ESTABLISHMENT
The concept of permanent establishment (“PE”) is dealt with U/s 92F (iiia) of the ITA. PE in the context of amalgamations means that after the merged entity is formed through an outbound merger, the establishment of the merged foreign entity in India through any branch office would be subject to a much higher tax rate. The reason behind this is that once a foreign entity merges with an Indian entity, the resulting merged entity would be a foreign entity and any operation by such resulting merged entity in India would be dealt with as a PE thereof. Generally, PE is of many types such as service PE, construction PE, fixed location PE, subsidiary PE, etc. Therefore, any outbound amalgamation in broader fields where the foreign entity operates its Indian subsidiary or any branch office in India[10] would be taxed at 40% with a surcharge.[11] However, the same is not fixed as the income that is taxed on such merged entity would depend on various factors.
In the case of Galileo International Inc vs. DCIT, the ITAT Delhi held that income taxable depends on the situation arising out of facts in each case depending upon various factors such as risks, functions, and assets. Therefore no express provision for such income leaves a void to be filled. This could lead to arbitrary conduct towards taxing profits of the amalgamated entity further burdening the judiciary to interpret taxable income according to each case. While burdening the judiciary is one aspect of litigations arising out of PEs, the other side of the coin includes litigation costs and a rigid legal regime for foreign entities to amalgamate with Indian entities.
Further, the amalgamated entity cannot set off assets or any property derived out of such PE if it does not qualify related regulations such as The Foreign Exchange Management (Acquisition and Transfer of Immovable Property outside India) Regulations, 2015 (“Immovable Property regulation”). If such assets need to be disposed of, then the same shall be disposed of within 2 years from the date of the approval of scheme by NCLT.[12] This further imposes a heavy burden over foreign entities amalgamating in India to sell assets in a shorter period not allowing them to modify and adjust to the changing commercial needs, thus, acting as an active barrier to outbound amalgamations.
OTHER TAX IMPLICATIONS
Taking into consideration the issues regarding transfer pricing in outbound amalgamations, the tax payable out of the transaction happening at a price less than the Fair Market Value (“FMV”) would also be taxable in India.[13] Further, the Indian tax regime being unsupportive towards outbound mergers could further lead to the base shifting by amalgamated entities in different jurisdictions. This would attract provisions related to anti-avoidance in International taxation or the General Anti-Avoidance Rules (“GAAR”). These rules allow tax authorities to arbitrarily exclude such entities from tax benefits arising out of treaties. Other implications also include the application of stamp duty on transfer of assets and transfer of minimum alternative tax credit (“MAT credit”) from the amalgamating entity to the amalgamated entity.
CONUNDRUM OF MAT CREDIT
The MAT credit allows entities to carry the excess MAT liability incurred by them in the process of an amalgamation or a demerger. When the MAT payable exceeds the otherwise normal tax liability arising out of a company’s income U/s 115JAA for a particular assessment year (“AY”), then the same is converted into the credit and can be transferred over in case of a merger. It is to be noted that the transfer of MAT credit, in general, extends to mergers whether inbound or outbound. However, this transfer is an interpretation of ITATs various orders and not a result of any express provision either U/s 115JAA or 115JB. MAT is specifically categorized U/s 115JB as when the tax payable is less than 15% of profits shown by the company in its “book profits”.
It is important to note that in the Guidance Note for accounting of credit available in respect of Minimum Alternative Tax under Income-tax Act, 1961 (“Guidance Note”) by the ICAI, the MAT credit has been categorized as an “asset” and U/s 2(1B) of ITA, all assets of the amalgamating entity are transferred to the amalgamated entity. Therefore, the merger/amalgamation of two or more entities should also include the transfer of MAT credit from the former to the latter. Moreover, this view is supported by logic and reason as since the amalgamated entity ceases to exist, there is no way for it to enjoy the MAT credit of the amalgamating entity. This position of law was upheld in various orders of ITAT as already mentioned.[14] One could consider the amended provision of section 72A of ITA to be a distant clarification. This provision explains loss determination and transfer of losses and “unabsorbed depreciation” in demergers. Though logical interpretation could help the case for taxpayers to sustain till the time tribunals remain cognizant, there is a genuine need for an express provision to not negate such treatment towards taxpayers. The presentment of the Union budget seemed to be an apt opportunity for this reform. However the same was yet again deferred
CROSS JURISDICTIONAL ANALYSIS:
Tax neutrality is a principle that every jurisdiction tries to accomplish more or less as it helps in the overall financial stability of a state and helps the economy to flourish. However, the same is affected by various factors such as political downfall, diplomacy failure, social factors, etc. An example of Switzerland could be taken to understand the uniformity needed in tax laws in India. Swiss cross-border mergers are regulated through the Swiss Private International Law Code (“SPIC”) which safeguards the interests of the creditors.[15] Further, express provisions are made to deal with mergers, demergers, and transfer of capital assets to such mergers.[16] Therefore, tax ambiguities are prevented.
Another example could be South Africa. Tax neutrality applies generally in acquisitions where a foreign entity is exposed to several options to structure the acquisitions. Further the Income Tax Act of South Africa (“ITASA”) also contains express provisions regarding amalgamation transactions and intra-group transactions aiming to achieve tax neutral regime. However, the VAT liability remains the same.[17] Further taking the example of Luxembourg, corporate reorganizations are tax neutral. An important example of this is in the case of a Merger or a Demerger of an entity based in the EU. Further, different jurisdictions have different considerations and methods to maintain a smooth merger/demerger regime. An example of this could be the French Commercial Code (“FCC”) which allows a “split-off” restructuring of assets. This allows the transfer of all assets into the merged entity and is akin to a merger by absorption.[18] The merger regime, therefore, is a pond, and tax implications can cause ripples of uncertainty to it.
SUGGESTIONS AND CONCLUSION:
The tax regime plays an important role in the overall development of an economy from a both domestic and international point of view. Ease of doing business and FDI are two of the most important pillars of the Indian economy. Tax ambiguities could be a shackle to the growth of both of them. Corporations and tax professionals were eyeing the Budget as it could have been proved to be an opportunity for resolving ambiguities, instilling uniformity, and easing the tax burden arising out of such problems. However, it’s never too late to introduce reforms. Therefore, a few suggestions could be taken into consideration to be introduced and gradually be proceeded to further ease off the barriers. Some of the suggestions are given below:
1. Firstly, the legislature shall eliminate ambiguities by introducing an express provision enabling tax-neutral outbound mergers, dealing with the transfer of MAT credit, resolving the contingent tax implications on deferred consideration by taxing capital gains (“CGT”) only when it occurs, etc.
2. Alternatively creating separate uniform legislation dealing with Mergers, Demergers and Acquisitions wherein express provisions in relation to tax neutrality shall be introduced could fill the void.
3. Establishing procedures to allow better employee negotiations between the employees of the entities merging or demerging to ensure a smooth process of mergers and demergers preventing unnecessary obstacles.
4. Adoption of corporate minimum global tax could also bring uniformity into the process of amalgamations. The US’s treasury secretary Janet Yellen supported this view stating that this move could result in a “stable tax system”. Recently Switzerland had agreed to adopt the global minimum tax rate on corporations which will also come into effect by 1st January 2024. India’s adoption of such tax will make an attractive proposition as the tax on foreign entities would be uniform across jurisdictions resulting in the reduction of ambiguities.
In view of the above-stated suggestions, there remains hope for its implementation which could have been initiated through the new Finance Bill and the Budget. Restrictions and excessive regulatory oversight can cause detrimental effects to an otherwise beneficial restructuring process. Mergers and Acquisitions have proved to be an important strategy in the pandemic debacle. With the wave of start-ups and growing entrepreneurs in India, corporations have perceived mergers to be a way of revival.[19] With the current merger taxation regime in India, an outbound amalgamation process will not be considered as a good option to restructure. Not to mention, foreign entities not only contribute to FDI but further lead to more employment. Tax neutrality in this regard could prevent unnecessary procedural complications and would further ease the burden of other stakeholders involved. Therefore, irregularities and ambiguities shall be resolved. Acting on such issues is the need of the hour and would be a welcome step.
Note:
[1] Sun Pharmaceuticals industries ltd. No.38/NCLT/AHM/2019.
[2] Income Tax Act, 1961, § 2(1B), No. 43, Acts of Parliament,1961(India).
[3] David Hasen, Tax Neutrality and Tax Amenities, 12 FLA. TAX REV. 57, 78 (2012), https://scholar.law.colorado.edu/cgi/viewcontent.cgi?article=1128&context=articles.
[4] Income Tax Act, 1961, § 2(1B) (iii), No. 43, Acts of Parliament,1961(India).
[5] [2001] 248 ITR 323.
[6] Rakshitha Nayak et al., Transcending International Boundaries: Cross Border Mergers in the Light of Fema Regulations, 2 JCLG 102, 110 (2019).
[7] Shruthi Shenoy, Cross Border Merger- Key Regulatory Aspects to consider, MONDAQ (Jan 30, 2022, 7:01), http://www.mondaq.com/india/x/695282/M+A+Private+equity/Cross+Border+Mergers+Key+Regulatory+Asp ects+To+Consider.
[8] Foreign Exchange Management (Establishment in India of a branch office or a liaison office or a project office or any other place of business) Regulations, 2016.
[9] Foreign Exchange Management (Establishment in India of a branch office or a liaison office or a project office or any other place of business) Regulations 2016, § Regulation 4(b)
[10] Income Tax Act, 1961, § 5(2), No. 43, Acts of Parliament,1961(India).
[11] Atul Pandey et al., FEMA Cross Border Regulations Issued by RBI, MONDAQ (Jan 31, 2022, 2:10PM), http://www.mondaq.com/india/x/689316/Corporate+Commercial+Law/FEMA+Cross+Border+Merger+Regulations+Issued+By+RBI.
[12] Foreign Exchange Management (Cross-Border Merger) Regulations, 2018, Regulation 5(6).
[13] Uday Ved et al., Mergers and Acquisitions A new mantra for growth during challenging times in India, INT’L TAX REV. (Jan 31, 2022, 2:23 PM), https://www.internationaltaxreview.com/article/b1rw3h0sw2xdhh/mergers-and-acquisitions-a-new-mantra-for-growth-during-challenging-times-in-india.
[14] Ambuja Cements Ltd. v. Deputy Commission of Income-tax, ITA no.3643/Mum./2018 (ITAT Mumbai),
M/S Caplin Point Laboratories Ltd. v. Assistant Commissioner of Income-tax, ITA No.667/Mds/2013 (ITAT Chennai);
[15] Swiss Code of Private International Law, 1987, § 163a, The Federal Assembly of Swiss Confederation, 1987 (Switz.).
[16] Swiss Code of Private International Law, 1987, §§ 163b-163d, The Federal Assembly of Swiss Confederation, 1987 (Switz.).
[17] Taxation of Cross-Border Mergers and Acquisitions, KPMG 13 (2018), https://assets.kpmg/content/dam/kpmg/xx/pdf/2018/04/taxation-of-cross-border-m-and-a.pdf.
[18] Supra note 5, at 117.
[19] See, Rorry Singleton, Mergers as the Next COVID-19 Solution, KORN FERRY (Jan. 31, 2022, 5:00PM), https://www.kornferry.com/insights/this-week-in-leadership/merger-revival-coronavirus.
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