prpri Insolvency and the tax conundrum Insolvency and the tax conundrum

In recent times, India Inc. has witnessed a paradigm shift in the conduct of business. With the Insolvency and Bankruptcy regime (IBC) kicking in, companies are becoming exceedingly wary of any defaults in repaying creditors and banks, fearing that creditors/ lender banks may drag them to the NCLT for resolution.

The IBC is a welcome move, as it provides for faster and definitive resolution in comparison to the now repealed Sick Industrial Companies Act, 1985 (SICA) and insolvency related provisions of the erstwhile Companies Act, 1956 – a move that has boosted India’s ranking in the “ease of doing business.”

Under the IBC, apart from operational aspects, the resolution plan provides for several aspects, such as quantum of debt sought to be waived, moratorium, interest cuts, repayment schedules, proposed structure of transaction, etc. While the IBC provides for various aspects, it does not address the potential tax issues that could arise as a result of the resolution plan.

One of the key fall outs of any resolution plan will be the haircut that the lenders would take on their outstanding loans. As loans are the origin of the whole proceedings, this haircut will be the cornerstone of any resolution plan. The tax issues that could arise for an already beleaguered company and its acquirer is not something which was bargained for. The taxability of waiver of loans has always been a highly litigious issue, the focus slowly but surely shifting from the fact that loans are on capital account and cannot be taxed as revenue receipts, to their use determining the tax treatment of their waiver; several courts have held the waiver to be taxable if the loan was used for general working capital purposes (as against acquiring capital assets). While, on first principles, one may still argue that the write back of any loan is on capital account and cannot be treated as a revenue receipt or any kind of benefit to the company, the spectre of Minimum Alternate Tax (MAT) on the write-back remains, irrespective of the usage of loans.

Hitherto, MAT provisions were clearly not applicable on the profits of a company from the year in which it was declared sick under the SICA provisions until the year in which it achieved a positive net worth. As a result, the write back of the waived portion of the loans to the Profit & Loss account was not subject to MAT.

However, the MAT provisions have not yet been amended to extend the exclusion to a company declared insolvent under the IBC provisions – accordingly, until such time as an amendment to this effect is introduced, stressed companies may be subject to MAT at nearly 20% of any book profits, including the quantum of haircut on the loan, and the resultant write back to the Profit & Loss account.

Taxing financially stressed companies on the “notional” profit arising on loan waiver would only serve to create further problems for companies already stressed for liquidity. Such a huge and immediate tax outflow may end up negating the positive effects of a revival plan, possibly making it imperative for acquirers to build the tax impact into their resolution plan – in fact, banks may need to take further haircuts to make up for this tax outflow. This is probably the single largest concern of acquirers today, when looking at taking over stressed companies. As per reports, ASSOCHAM has already written to the Central Board of Direct Taxes (CBDT) for insertion of a suitable amendment in the Income-tax Act to not only exempt the write back of loans from tax and MAT, but also exempt the write back of interest accrued thereon. In fact, ASSOCHAM has also sought to extend the MAT exemption previously available to sick companies falling under SICA to companies whose resolution plan is approved and effected under the IBC.

Any stressed company is likely to have significant tax losses. Depending on the transaction structure, such losses may lapse and not be available in future. For example, if the company is a privately held company, any change in its voting power beyond 49% would result in lapse of the losses.[1] Alternately, if the resolution plan provides for a merger of the stressed company with the acquirer, even if one were to assume the fulfillment of the basic condition of being an industrial undertaking, the availability of losses would be bound by other strict riders,[2] such as achieving and maintaining utilization of at least 50% of the installed capacity, holding onto at least 75% of the assets taken over for 5 years, etc. This would put an additional strain and burden on the acquirer, who would then practically be starting the company afresh, with a higher tax burden, deepening the stressed company’s liquidity crisis. On the other hand, if the transaction is structured as a business sale, while the acquirer may potentially be ring fenced from several of the stressed company’s past liabilities, it would also mean the latter’s losses would not be available to the acquirer –clearly, a cost benefit analysis would need to be carried out.

Although MAT on waiver of loans and lapse of tax losses would impact cash flows going forward, a more immediate red flag from the acquirer’s perspective are the provisions of section 56(2)(x) of the Income-tax Act – a draconian provision indeed, which provides that when shares are acquired at a value lower than the fair value of such shares, computed as per a prescribed method, the shortfall between the price paid by the acquirer and such fair value would be taxable in the acquirer’s hands. Interestingly, until FY17, these provisions did not apply in case of acquisition of shares of a listed company. However, from 1 April, 2017 on wards, acquisition of listed shares for a discount to the ruling market price would attract tax implications for the acquirer.

As of now, most stressed companies are listed companies, all of whom are trading on the markets; their market price is largely a function of market dynamics. However, the acquisition price would be a function of several factors – the resolution plan, business fundamentals, haircut available, etc. Thus, the acquisition price could well enough be at not only a significant discount to the market price, but actually be negligible/ nominal, given that the companies’ equity may have no value at all. This will bring in an immediate tax burden on the acquirer, which also they would need to factor in while framing the resolution plan.

Tax being an outcome of doing business, clearly, for any acquirer, business considerations would outweigh tax considerations. However, to knowingly step into something that could have tax consequences for them even before they have reaped any benefits from it, and with the knowledge that it will be a long time before they do, is sure to be a dampener of sorts for acquirers. The acquirers would likely seek to recover some part of this tax outflow from the lenders in the form of an enhanced haircut. Rather than this circuitous route, the CBDT would do well to look into the provisions and provide relief, with suitable riders to prevent misuse, to potential acquirers (or dare we say, the white knights) and the beleaguered companies.

Rekha Bagry, Partner, M&A Tax, PwC India and Neelu Jalan, Director, M&A Tax, PwC India

Authors: Rekha Bagry, Partner, M&A Tax, PwC India and Neelu Jalan, Director, M&A Tax, PwC India

(Views expressed are personal and the article contains inputs from Ria Ajmera, Associate, M&A Tax, PwC India.)

[1] Section 79 of the Income-tax Act, 1961

[2] Section 72A of the Income-tax Act, 1961 read with Rule 9C of the Income-tax Rules, 1962

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July 2021