An insight into the most taxing M&A issues in India

Growth is the underlying philosophy for most businesses, many of which have transformed from a bricks-and-mortar-based model to a virtual/online one by altering their basic tenets of doing business.

These changing paradigms of business operations – including funding, profit repatriations, expansions, entry and exit strategies, testing overseas waters, and generating cross-border trade – are now the cornerstones of boardroom discussions. Every M&A transaction among multinationals has created avenues for businesses to thrive and compete in local and international markets. This has led to the adoption of aggressive strategies that have artificially shifted profits to jurisdictions with low or no tax.

Consequently, tax administrators have struggled to collect their fair share of taxes, and sought to introduce modifications, amendments, and new legislation to counter such strategies.

Typically, most Indian companies start out as promoter-held companies incorporated in India and set up a subsidiary company in the US or Singapore, pursuant to business exigencies. However, in several instances, overseas investors prefer to invest in a US holding company or a Singapore holding company rather than investing directly in the Indian company. This results in the need to ‘flip’ the holding structure of the Indian company from being a holding company to becoming a subsidiary company, and the erstwhile subsidiary company in the US/Singapore being converted into a holding company.

The need to flip the holding structure predominantly arises out of commercial/funding requirements and not from a tax-saving motivation, and the discussion on a general anti-avoidance rule (GAAR) elsewhere in this article should be considered; failing which, any restructuring activity that results in a potential loss of taxes to the Indian revenue authorities could be investigated for being a tax avoidance transaction.

The holding structure could be flipped using various options, with the key mechanics of one approach described below. Along with tax considerations, the extant exchange control regulations prescribed by the Reserve Bank of India (the Central Bank) are also to be considered, to ensure that a structure is in compliance from a regulatory perspective.

Consider an Indian holding company (India Hold Co) with a US subsidiary company (US Sub Co).

US Sub Co sets up a new step-down subsidiary in India (New India Sub). The setting up of a step-down subsidiary in India is now permitted by the Central Bank and is not considered a round-tripping transaction/structure.

India Hold Co transfers its business to New India Sub under a business transfer agreement (BTA), which would be treated as a ‘slump sale’ for tax purposes. This may involve minimal taxes, considering the transfer of assets at book value (except in the case of immovable properties), and potential stamp duties to be paid based on the situs of assets.

India Hold Co could thereafter be wound up or merged with New India Sub, resulting in US Sub Co now being the ultimate holding company, with New India Sub as its subsidiary.

The place of effective management (PoEM) of US Sub Co should be outside India; otherwise, US Sub Co could be considered a tax resident of India (please refer to the discussion on PoEM in the subsequent paragraphs).

Early-stage start-ups should typically not be covered under the PoEM provisions, considering that the provisions are applicable only in the event of turnover or gross receipts exceeding INR 500 million (around $6 million).

As an alternative to a BTA, the following steps could be explored:

• Merge India Hold Co with New India Sub;

• India Hold Co would cease to exist, and New India Sub would be directly held by US Sub Co, which becomes the parent/holding company;

• This would be a tax-neutral merger, but the GAAR provisions may be involved to a greater extent under this option compared with that of transferring assets under a BTA.

While one of the options to flip the holding structure has been discussed above, there are other methods, such as a swap of shares or a cross-border merger, with other tax and regulatory implications. For instance, the promoters could have incorporated an Indian company with no further overseas operations providing alternative options to restructure the group holding.

While there are nuances in the interpretation of the PoEM provisions for a foreign company, there are key aspects in determining the PoEM, which are discussed below.

A company is said to have active business outside India (ABOI) if:

• Its passive income does not exceed 50% of its total income;

• Its Indian assets are less than 50% of its total assets;

• Its Indian employees comprise less than 50% of the total number of employees; and

• The payroll expense of Indian employees is less than 50% of the total payroll expense.

If the board is standing aside and Indian residents actually exercise power, the PoEM would be considered as being in India.

The person(s) making the key management and commercial decisions for the company's business as a whole should be identified. The place where the decisions are being taken should also be determined.

The PoEM provisions above are relevant not just in the case of flip structures but in the case of any foreign company which has Indian promoters in its management and for most tech companies that have expanded overseas from India.

Valuation is a key concept in any M&A activity, especially considering that the requirement to carry out a valuation is born out of tax and regulatory legislation.

The Union Budget of India 2023 extended the applicability of valuation guidelines to overseas angel investors.

Essentially, the provision is one of anti-abuse and seeks to tax the share premium received, which is in surplus of the fair market value (FMV) of the shares of the Indian company.

The FMV of shares has been defined to mean the higher of:

• The FMV on the basis of the net book value of assets determined as per the prescribed formula; or

• The value of the shares settled on by a merchant banker as per a discounted cash flow basis.

During M&A activity involving the transfer of shares of a foreign company deriving its value substantially (i.e., more than 50% and with a value exceeding INR 100 million) from assets located in India, the transfer of shares of the foreign company shall trigger capital gains tax to the extent attributable to India (as a proportion of the FMV of the Indian assets vis-à-vis the total assets of the foreign company).

A valuation exercise is to be carried out, especially having regard to purchase price allocation if the deal has been created at the holding company level overseas to ensure no capital gains tax is triggered in India.

The valuation is to be performed by a merchant banker or by an accountant (including a foreign accountant who satisfies prescribed conditions) by adhering to internationally accepted valuation methodology.

Internal restructuring activities typically involve changing an organisational set-up or a business model. This requires compensation and/or triggers exit tax. Such implications must be assessed early in the process to avoid further complexities.

Additionally, in the case of overseas companies, the Central Bank requires the transaction to adhere to floor price or threshold guidelines to ensure excess capital flowing out of the country and to regulate the money entering the country. This impacts the price at which securities are issued to overseas investors and the value at which securities are transferred between Indian residents and non-residents.

In all the above cases, valuation plays a key role, as the ultimate tax outflow depends, to a large extent, on the valuation exercise carried out and compliance with the tax and regulatory requirements in India.

Transfer pricing (TP)-related diligence plays a key role in successfully closing an M&A deal. The risky TP policies, untimely compliances, and weak litigation history with tax authorities are some of the potential threats to an M&A deal, which require expert analysis. The buyers' vigilance to identify hidden TP-related lapses of the seller may result in the shrinking of the valuations and may also result in the M&A deal being ‘called off’. Furthermore, it may also result in a severe financial impact in the future, including facing pressure from the tax authorities.

In order to avoid challenges in the future, TP-related checks of the seller are suggested as below:

• One of the important checks is to scrutinise the cross-border transaction with the existing formal TP contract and compare it with the actual functions undertaken, assets held, and risk assumed (FAR) by the seller with its related parties. Reg flags result if the TP policies do not marry up with the FAR.

• In the digital era, where an intangible asset plays a key role, it is worthwhile to identify which entity within the seller group undertakes the development, enhancement, maintenance, protection, and exploitation (DEMPE) functions. It is also pertinent to examine that the DEMPE functions are carried on by the key managerial personnel with the requisite skill sets to fulfil the substance test.

In a situation where TP lapses are identified, the alignment of the TP experts from the buyer and the seller is required to agree on the positions taken, which will help to save the deal and avoid unnecessary escalation of the indemnity amount from the seller.

Today, the focus of legislators is clearly anti-avoidance and economic substance. In many instances, courts have primarily held that the legal form of a transaction has to be respected (cases such as Vodafone International Holdings B.V. v Union of India (2012), and CIT v High Entergy Batteries (India) Ltd. (2012)) to achieve tax efficiency, whereas, in certain transactions, courts have applied GAAR principles to disregard the transaction or to deny tax benefits (cases such as Mc Dowell & Co. Ltd. v CTO (1985), and Ajanta Pharma Mumbai, NCLT (2018)).

Developing, as well as developed, countries have come up with specific and general rules to address aggressive tax planning strategies; for example, Australia, South Africa, Canada, and New Zealand. In addition, the BEPS actions generally deal with tax avoidance measures in cross-border transactions/arrangements.

To address matters relating to tax avoidance, India has introduced a GAAR in addition to other anti-avoidance provisions under the Income-tax act. The concept of a GAAR was initially introduced in India as a part of the Direct Tax Code 2009. However, the introduction of GAAR provisions was deferred and only became effective from financial year 2017–18.

In earlier years, many taxpayers reorganised their internal businesses and entities, and restructured them for tax planning purposes within the judicial framework. Under the GAAR regime, tax planning under such arrangements may be challenged and have to pass a test of their commercial substance.

M&A transactions are generally driven by commercial considerations and not by the motive to obtain a tax benefit. And while such transactions should remain largely unaffected by the implementation of a GAAR in the country, there are issues that need to be carefully considered and included in the transaction structuring and documentation processes, some of which are illustrated below.

The arrangement should be looked at in a holistic manner and not in a dissecting manner, and the presence of corporate structures in tax-neutral countries should not lead to the conclusion that these are meant to avoid taxes. Business entities may arrange the activities of their business so as to reduce their tax liability in the absence of any statutory laws eliminating the same.

Multinational companies often institute corporate structures, and all these structures should be established for business and commercial purposes only.

The corporate veil may be lifted if facts and circumstances reveal that the arrangement or corporate structure is a sham intended to evade taxes.

The GAAR should be made applicable to arrangements where the main purpose (and not one of the main purposes) is to obtain a tax benefit and one or more elements of the four tainted elements test exist.

Although the Central Board of Direct Taxes – through its Circular No. 7/2017, dated January 27 2017 – has stated that the GAAR will not interfere with the right of a taxpayer in choosing the mode of implementation of any arrangements, the fact that the tax department could question the arrangement under the GAAR, to ascertain whether a mode of undertaking an arrangement could be construed to be an artificial device and an unnecessary non-commercial step to evade tax out, cannot be ruled out.

The GAAR may be invoked if the arrangement sanctioned by an authority such as a court or the National Company Law Tribunal (NCLT) does not explicitly and adequately consider the tax implication.

The period for which the arrangement exists, the payment of taxes, and the arrangement providing the exit route are relevant but not sufficient factors to be considered while forming a holistic assessment to determine whether an arrangement lacks commercial substance.

The conduct of the parties to an arrangement is paramount to the legal form of the documents or agreements, and it should satisfy the bona fide test.

While the government has expressly clarified that the GAAR will be separate from the right of a taxpayer to choose the means of implementing a transaction, it has also been explicated that just the fact that a court or the NCLT has sanctioned a transaction or an arrangement will not protect it from the application of the GAAR, lest such court or the NCLT has "expressly and adequately" assessed the tax implications while sanctioning such arrangement.

The NCLT orders clarify that a sanction to a scheme of arrangement shall not operate as a bar from the Income Tax Department exercising its rights under, and in accordance with, the applicable tax law. Despite this, the tax authorities have repeatedly objected to schemes of arrangement before the NCLT on the ground that they are merely devices for tax avoidance or that they are amenable to the GAAR.

There are a few unanswered questions in the minds of businesses and investors, such as the following.

India's tax treaties with other countries are an indication of the government's commitment to the international community. Whether such commitments can be overruled by way of a unilateral amendment made by the government of India to the domestic tax laws is a question of great concern. This is especially relevant in the case of investments made by foreign investors in India through tax-friendly jurisdictions such as Mauritius, Singapore, the UAE, and Cyprus.

In accordance with a recent protocol to the tax treaty between India and Mauritius, all the investments made by Mauritian residents in India before April 1 2017 have been grandfathered and would continue to enjoy a capital gains tax exemption under the India–Mauritius treaty, and any investments made thereafter would be taxed in India subject to a limitation of benefits (LOB) clause. If GAAR provisions are invoked to override tax treaties, the capital gains exemption and the LOB clause under the India–Mauritius treaty would be futile. There is much concern about this issue, and clarification is needed to remove any ambiguity and uncertainty.

Many transactions involve the payment of additional consideration to sellers in M&A transactions which is linked to future earn-out targets being met by the acquired business (for example, the achievement of commercially agreed turnover or EBITDA). However, the timing of the taxability of such amounts received is not safe from litigation even today, and no settled position has been firmed up in this regard.

Hence, the issue is sometimes addressed by organisations putting in place innovative tax planning structures for deferring such taxes and achieving certainty on the timing of tax liability. Structuring such transactions under the GAAR regime would further complicate the uncertainty surrounding the taxability of such transactions. In this scenario, even organisations' approach to due diligence, transaction-related documentation, and the negotiation of deals is almost certain to change.

Moreover, transactions (beginning with term sheets and concluding with definitive agreements) will have to be carefully documented and executed. The scope and extent of tax representations, and warranties and indemnities will also need to be redefined.

BEPS Action 12 contains recommendations regarding the design of mandatory disclosure rules for aggressive tax planning schemes, taking into consideration the administrative and compliance costs for tax administrations and business, and drawing in the experiences of countries that have implemented such rules. It is not a mandatory standard to be implemented by each country under the BEPS proposals.

With the trend of M&A activities booming in a conducive environment where deals are surpassing all records, it is essential for the buyer and the seller to look at the business synergies and the estimated tax cost impact considering the options discussed above. The tax authorities minutely scrutinise M&A events, and hence it is advisable to structure an M&A deal diligently and promptly.