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Taxation v/s Cross Border Mergers

With the intent of attracting foreign investors, the Indian government has always responded by liberalising domestic regulations and attempting to mitigate potential conflicts in the phase of making economy more globalised and liberalised. In reality, on the other hand, it can be seen that several recent tax reforms are going to have an impact on both domestic and international corporate transactions.

Such as:
  • The 'business goodwill' being no more a depreciable asset, tax depreciation will not be available, and the cost of acquisition will be inclsuive of an amount paid towards such business goodwill.
  • Transfer of business undertaking for 'non-monetary consideration' will fall under the purview of taxation for slump sale, unlike as earlier considered as non-taxable.
  • FII will now be eligible for advantages under the Double Tax Avoidance Agreements (DTAA), subject to specific conditions.
  • Dividend payments made by SPVs to REITs and InvITs will be exempted from withholding taxes.

As a result, the tax implications of the entity's sale and purchase will have a significant impact on its thrift, resulting in a reduction in the number of cross-border transactions. Hence, it is not incorrect to assert that "Taxation" is inversely proportional to "Cross Border Mergers" in the current situation.

The Income Tax Act, 1961 ("IT Act") does not define "merger", but instead defines "amalgamation" under Section 2 (1B) of the IT Act, with certain conditions to be met, such as:
  • All of the assets and liabilities of the merging entity, prior to the amaglamation, should be transferred to the amalgamated entity immediately;
  • Shareholders who own at least 3/4 of the value of the amalgamating entity's shares, excluding the nominee and the amalgamated entity's subsidiaries, become shareholders of the merged entity.

If certain additional conditions are met, amalgamations may be regarded as tax-neutral and exempt from the Capital Gains Tax (CGT) in the hands of the merging entity and its shareholders. This will likely influence the type of corporate structure adopted to benefit from the tax exemptions, as well as the consolidation and reorganisation of the entity.
  • Tax Implications "Inbound Merger" v. "Outbound Merger"
    An Indian entity can merge or amalgamate with a foreign entity under Section 234 of the Companies Act, 2013 ("CA-2013") read with Rule 25A of the Companies (Compromises, Arrangements, and Amalgamations) Rules, 2016 ("CAA Rules-2016").

    "Inbound Merger" is a merger in which a foreign entity merges with an Indian entity and the foreign entity ceases to exist. The resultant entity is an Indian entity, according to Section 2(v) of the Foreign Exchange Management (Cross Bound Merger) Regulations, 2018 ("FEMA-CBM Regulations-2018").

    "Outbound Merger" is a merger in which an Indian entity merges with a foreign entity and the Indian entity ceases to exist. The resultant entity is a foreign entity, according to Section 2(viii) of the FEMA-CBM Regulations-2018.

    It is necessary to mention here that the tax liability will vary depending on whether the merger is 'inbound' or 'outbound'.

    By virtue of the IT Act, inbound mergers are tax neutral, meaning that the tax liability on CGT is exempt in the hands of both the transferor entity and its shareholders. Furthermore, if at least 25% of the shareholders of the amalgamating entity remain shareholders of the amalgamated foreign entity and the merger does not trigger CGT in the country where the amalgamated entity is incorporated, a tax-neutral cross-border merger of two foreign entities involving the transfer of shares of an Indian entity is possible.

    The foreign entity would be taxed on the transfer of assets in an inbound merger under Section 45 of the IT Act. Such a transfer of assets will be taxed in India to the extent that the assets are located in India. If a foreign entity does not have any assets in India, there are no tax implications for the foreign entity in India.

    The cost of acquisition of a capital asset acquired by an Indian entity as a result of merger shall be the cost of acquisition (including the cost of improvements) incurred by a foreign entity. The period of holding capital assets begins on the date such assets are acquired by a foreign entity.

    While there are various reasons for corporations to undertake outbound mergers, such as access to overseas markets, they are not tax neutral for the purposes of the IT Act, and hence outbound mergers are in a negative position. There is no tax neutrality in the operation of outbound mergers, and the transfer of capital assets under the current framework would almost certainly result in CGT.

    Furthermore, if a Permanent Establishment ("PE") is formed as a result of an outbound merger, resultant foreign entity in India would be liable to a significantly higher tax rate of 40% plus a surcharge. If the resultant foreign entity does not qualify for associated restrictions such as the Foreign Exchange Management (Acquisition and Transfer of Immovable Property Outside India) Regulations, 2015, it will be unable to put off assets or property obtained from the PE. If such assets need to be sold, they must be sold within two years of the NCLT's approval of the scheme, which puts a burden on foreign entities to sell assets in a shorter time frame without allowing them to modify and adjust to their changing commercial needs, thus acting as an active barrier to outbound mergers.

    Excess MAT liabilities incurred during a merger can be carried forward using the MAT credit, and it generally applies to cross-border mergers as well. However, rather than being based on any express provision of the IT Act, such MAT credit transfers are based on the ITAT's jurisprudence. However, such a logical interpretation may benefit taxpayer corporations only before ITATs, and an express provision that does not invalidate such tax treatment of taxpayer corporations before the assessing authorities is a legitimate necessity.

    Another important concern is the availability of the transferor entity's cumulative tax losses and unabsorbed depreciation to the resultant entity as a result of a cross-border merger under Section 72A of the IT Act. It is important to note that if the resulting entity is a foreign entity, its tax benefits are unlikely to qualify as 'accumulated loss' and 'unabsorbed depreciation', as provided under Section 72A of the IT Act, because the foreign amalgamating entity would not have been entitled to carry forward and set off its accumulated loss and unabsorbed depreciation under the provisions of the IT Act if the amalgamation had not occurred. As a result of the merger, the new foreign entity will not be able to carry forward and set off such cumulative loss and unabsorbed depreciation under Section 72A of the IT Act. To promote cross-border mergers, this issue should also be reviewed by the government.
  • Present Status and Tax Implications of Cross Boarder - Demerger:
    "Demerger" is defined under Section 2(19AA) of the IT Act, with certain conditions to be met, such as:
    • All of the assets and liabilities of the demerging entity, prior to the demerger, should be transferred to the resulting entity immediately at book value and on a going concern basis.
    • The resulting entity issues shares to the shareholders of the demerged entity on a proportionate basis, except where the resulting entity is a shareholder of the demerged entity.
    • Shareholders holding a minimum of 75% of the value of shares become shareholders of the resulting entity (other than shares held therein immediately before the demerger by, or by a nominee for, the resulting entity or its subsidiary).
    As previously stated, Section 234 of the CA-2013 enables cross-border mergers and amalgamations; however, it does not specifically mention demergers, allowing opportunity for confusion as to whether or not cross-border demergers are permitted under Section 234 of the CA-2013.

    In the case of Sun Pharmaceuticals Industries Ltd., the National Company Law Tribunal ("NCLT") bench at Ahmedabad concluded in 2018 that the provisions of Sections 230-232 of the CA-2013 should be construed while reading Section 234 of the CA-2013. Section 232(1)(b) of the CA-2013 allows for the transfer of all or part of a transferor entity's undertaking, and any other applicable merger or amalgamation provisions of the CA-2013 can be applied to a demerger.

    Surprisingly, in a case involving Sun Pharmaceuticals Industries Ltd., NCLT Bench at Ahmedabad concluded in 2019 that cross-border demergers are not authorised in India, although taking a completely different interpretation than the aforementioned order. As a result, this gate is currently blocked to corporates, and no cross-border demergers are permitted.

    Cross-border demerger occurs when one or more undertakings of an entity are transferred to another entity overseas as a going concern, either to form a new entity or to merge with the existing entity, subject to the conditions of Section 72A (4) of the IT Act being met.

    The benefit of Section 47 of the IT Act would be accessible in the case of an inbound demerger, i.e. where the resulting entity is an Indian entity, and the transferor entity and its shareholders would have no CGT liability.

    However, the benefit of Section 47 of the IT Act would disappear in the situation of an outbound demerger, where the resulting entity is a foreign entity, because the conditions that the resulting entity be an Indian company are not met. As a result, an outbound demerger would expose the demerging entity, its shareholders, and the demerged entity to CGT liability. This may make the option of an outbound demerger less appealing to corporations wishing to invest abroad.
  • International Tax Reforms and Synchronization:
    Despite the fact that the legal structure for outbound mergers is fairly tight and that such mergers are not exempt from the IT Act, it can effectively act as a bottleneck in such deals. As a result, outbound merger policies must be looser and more flexible. However, multilateral agreements such as DTAA can be used to avoid tax responsibilities, which can prevent cross-border mergers from being completed.

    Treaty infringement is a growing global concern, and the Base Erosion and Profit Shifting (BEPS) Action Plan aims to prevent it. The Indian government's approach and actions reflect this concern, including actively participating in the OECD's BEPS programme and enacting General Anti-Avoidance Rules ("GAAR") in domestic law.

    The challenges associated with BEPS have been highlighted as being exacerbated in the Indian context due to India's reliance on corporate revenues, particularly those from multinational corporations subject to international tax standards. Among the various elements addressed by BEPS, India has identified issues created by the digital economy, artificial avoidance of PE status, treaty misuse, and transfer pricing as being particularly important in the Indian context.

    As part of an initiative under BEPS Action Plan, Indian government has been experimenting with and modifying its domestic tax regime in order to align it with BEPS norms. In recent years, however, there has been no discernible, regular, or continuous advancement of the Indian tax regime that benefits cross-border mergers.

    While the operational provisions for outbound mergers are intended to assist Indian corporations in reorganising/ externalising their shareholdings and gaining access to global markets, the lack of comparable tax neutrality regulations puts outbound mergers in a precarious position when compared to inbound mergers.

    In addition, the need of the hour is to support cross-border demerger transactions for a corporate restructuring exercise required to meet the constantly changing needs of industry, take advantage of new technology to help each of the segments operate more smoothly, cost-effectively, and tax-friendly during these difficult economic times, and the current legal framework prohibiting cross-border "demergers" needs to be reconsidered.

    As a result, "cross-border mergers" under the CA-2013 and the establishment of FEMA-CBM Regulations-2018 necessitate appropriate IT Act revisions to provide a favourable legal environment for cross-border mergers in India, especially at a time when the economy is struggling. The Indian government has been liberalising the regulatory framework for cross-border transactions, but some details still need to be worked out in order to make the system more work effective, smooth and attractive for foreign investors.
  • Betterment of Tax:
    A few proposals could be considered for introduction and gradual implementation to further reduce obstacles in the cross-border merger / demerger tax implications, by:
    • resolving ambiguities with express provision permitting tax-neutral cross boarder mergers / demergers, dealing with the transfer of "MAT" credit, resolving the contingent tax consequences on deferred consideration by taxing "CGT" only when it arises, and such other taxation issues in cross boarder merger / demerger enacting separate uniform law for Mergers and Demergers.
    • adopting a corporate minimum global tax would offer consistency to the cross-border merger / demerger process, making it more appealing because the tax on foreign entities would be uniform across jurisdictions, reducing ambiguity.

With the influx of start-ups and emerging entrepreneurs in India, corporations have seen mergers as a method to resurrect their businesses. Restrictions and excessive regulatory scrutiny could ruin an otherwise beneficial reorganisation process. Although it may be difficult to anticipate all potential tax concerns arising from cross-border mergers, it will be fascinating to observe how the income-tax laws are updated to account for the taxation of both incoming and outbound mergers.

Furthermore, foreign corporations not only contribute to FDI but also create new jobs. Hence, in this context, tax neutrality could help to avoid unnecessary procedural complexities while also easing the burden on other players. As a result, irregularities and ambiguities in the current tax regime must be addressed urgently.

"The information provided in this article is for general informational purposes only. While an author tries to keep the information up-to-date and correct, there are no representations or warranties, express or implied, about the completeness, accuracy, reliability, suitability, or availability of the information. Any views or interpretations described in this article are the author's personal thoughts and do not constitute legal or other professional advice. You may discover there are other views or interpretations to accomplish the same end result."

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