Will Budget 2016 address tax issues for M&A?
Saumil Shah February 27, 2016The industry expects the Union Budget to add a new shade to the Merger and Acquisition (M&A) activities in India. The country witnessed one of the most vibrant seasons of M&A in 2015. Though the steps taken by the government have helped improve investor perception towards India as well as the ease of doing business in the country to some extent, there exist certain bottlenecks which need urgent attention.
In an era of globalisation, cross-border M&A activities are common. While a merger/demerger between two foreign companies which have Indian investment is exempt from tax subject to certain conditions, there is no such exemption available with respect to merger/demerger between two foreign companies in which an Indian entity is a shareholder. With several companies going global and actively participating in M&A activities, having specific provisions exempting such foreign restructuring in the hands of Indian shareholders shall help the India industry reduce tax cost of undertaking such activities outside India.
'Earn-out' structures are very common in M&A. Investors today are ready to share an upside with promoters who continue to create wealth for all. This upside is typically referred to as an 'earn-out'. Earn-out linked payments are common in deals with promoters and are essentially compensation models where a buyer agrees to pay part of the deal consideration depending on the future performance of the business. There exists ambiguity around taxation of such earn-outs. As per the prevailing tax regime in India, sellers could potentially pay tax on the entire consideration, including an earn-out linked compensation received in future. This results in cash outflow of tax which is not in proportion to the cash received by the sellers. Further, there is no mechanism for recoupment of tax in the event of any reduction in the overall consideration in the future, say on account of under-performance of business. The Indian tax regime has special provisions for taxing deferred compensation on a receipt basis, in case of compulsory acquisition of land by the government. A similar concept could also be introduced to provide a conducive tax regime for earn-outs as well. Earn-out linked business models are prevalent internationally, and hence the Indian tax regime should also recognise such commercial requirements and provide for appropriate tax treatment for earn-outs.
Non-compete payments are usually one of the key parameters in the deal. While these payments are taxable in the hands of the recipient, there are divergent judicial precedences as to whether the taxpayer could get a tax break on such payments. Receiving clarity in this regard, could help the buyer estimate the effective tax cost on its Internal Rate of Return (IRR), taking into consideration potential tax savings.
Contribution of the Indian services sector towards the Indian economy has been increasing. While the manufacturing sector is entitled to carry forward tax losses in the event of a merger, such a benefit is not available for the services sector. Considering the amount of M&A activities in this sector, the Finance Minister may consider extending this benefit here as well.
There exists a disparity with respect to the period of holding criteria for shares which are offered for sale in an Initial Public Offering (IPO) vis-à-vis listed shares. As per the prevailing tax regime, when shares are offered for sale in an IPO, such sale of shares qualify as a long-term capital asset only if the holding period exceeds 36 months. Whereas, for listed shares, the criteria is 12 months. Since the Securities Transaction Tax (STT) is made applicable even in case of shares offered for sale in an IPO, this disparity may be streamlined.
Another challenge faced by the M&A industry is the requirement of obtaining a Tax Clearance Certificate from Indian tax authorities prior to transfer of certain assets. As per the requirement, such a certificate is required prior to transferring specified assets and in the absence of such a certificate the transfer could be regarded as void by the tax authorities. Obtaining such a certificate could be time consuming and at times, affect the deal timelines. The Finance Minister could consider introducing the Safe Harbour Rules in relation to this requirement.
We hope that this Budget gives due consideration to all the above mentioned taxation hurdles in the M&A domain, providing the necessary impetus to the growth of the Indian economy.
(The author is Partner, Tax, KPMG in India. Nitesh Mehta, Director, Tax, KPMG in India contributed to the article. Views expressed are personal.)