What measures should be taken to best prepare for a corporate reorganisation?
For intra-group reorganisations, parties should:
- conduct a high-level legal diligence to identify:
- the regulatory approvals that will be required before the reorganisation can be sanctioned by the NCLT; and
- the post-sanction approvals and notifications required to be made under applicable law;
- conduct a tax analysis of the reorganisation to determine the capital gains (if any) and stamp duty payable; and
- engage a valuation expert to conduct a valuation of the securities, undertaking and business of the company (as the case may be) to determine the fair market value of the transaction. The determination of fair market value is critical from a tax perspective, to avoid the applicability of the General Anti-Avoidance Rules.
What are the main issues relating to employees and employment contracts to consider in a corporate reorganisation?
Conditions for the transfer of employees
In the event that ‘workmen’ are being transferred from one legal entity to another as a result of the corporate reorganisation, it must be ensured that such transfer complies with the following conditions:
- there is no interruption in the service of the workmen;
- the terms and conditions offered to the workmen after the transfer are not in any way less favourable to the terms offered before the transfer; and
- the legal entity to which the workmen are transferred is legally liable for paying retrenchment compensation payable to the workmen as if they have been in continuous service without any interruption due to the transfer.
In the event the conditions set out above are not met, the workmen would have to be provided notice and compensation for retrenchment, in accordance with the provisions set out in the Industrial Disputes Act 1947.
Mechanism for the transfer of employees
The transfer of employees may be carried out by way of:
- a tripartite agreement between each employee, the transferor entity and the transferee entity; or
- a resign and rehire mechanism, where each employee resigns from the transferor entity and enters into a fresh employment agreement with the transferee entity.
Confidentiality and data protection
The transferor and transferee entities should contractually agree with each employee that any sensitive or personal data concerning such employee will be transferred from the possession of the transferor entity to the transferee entity.
Closure of industrial establishments
Any proposed reorganisation that envisages the closure of an industrial establishment employing, on average, at least 100 workmen (or another number as notified by individual states), would require the prior written consent of the appropriate government. The application for obtaining such consent must be made at least 90 days before the date on which the intended closure becomes effective.
What are the main issues relating to pensions and other benefits to consider in a corporate reorganisation?
Under Indian law, employers have to contribute a fixed percentage of their employees’ remuneration towards a provident fund and pension fund. In the absence of any agreement to the contrary, the transferee entity would be liable for paying the employer’s contribution towards the provident fund and pension fund, if the employees are being transferred from the transferor to the transferee entity without any interruption in service.
The transaction documentation should clearly set out the obligations of the transferor and transferee entities, with regard to the payment of the employer’s contribution before and after the date of transfer of the employees. Typically, the transferor entity assumes the obligation to pay for all amounts payable before the date on which the employees are transferred to the transferee entity, and provides an indemnity to this effect.Financial assistance
Is financial assistance prohibited or restricted in your jurisdiction?
Under the Companies Act, public companies are prohibited from directly or indirectly providing any financial assistance to any person for the purpose of, or in connection with, the purchase or subscription of shares in the company or its holding company. The term ‘financial assistance’ includes giving assistance by way of a loan, guarantee, the provision of security or otherwise.
However, this restriction is not applicable to:
- financial assistance provided by private companies for the acquisition of their own shares or the shares of their holding companies;
- the provision of money by a company for the purchase or subscription of its shares or the shares of its holding company by:
- a trust, for the benefit of the company’s employees; or
- the employees directly; and
- the giving of loans by a company to persons in its employment (other than directors and key managerial personnel) for the purchase by such employees of shares of the company or its holding company. The loan amount given to an employee cannot be greater than the wages earned by the employee over six months.
What are the most commonly overlooked issues or frequently asked questions in a corporate reorganisation?
A few critical issues that are typically faced by parties seeking to undertake a corporate reorganisation are as follows:
- whether the reorganisation would result in the continuation of tax benefits and incentives or the carry-forward of tax losses and unabsorbed depreciation;
- the characterisation of the reserves of the transferor company, and the manner in which they may be transferred to the transferee entity;
- the nature of rights and remedies available to third-party contractual counterparties, who are not agreeable to the terms of the proposed reorganisation;
- the manner in which shareholders and creditors are classified into separate classes for the purposes of voting under the Companies Act;
- the grounds on which the NCLT may reject a proposed reorganisation even after it has been approved by the requisite majority of shareholders and creditors. Although it is settled law that the NCLT does not act as an appellate court in reviewing reorganisations and should not substitute its view over the commercial wisdom of the parties, it may refuse to sanction a reorganisation if it finds that the reorganisation contravenes any provision of law, is ‘unconscionable’, is against ‘public policy’, or is not ‘fair, just and reasonable’ to any class of members or creditors as a whole. For instance, in a recent decision, the NCLT rejected a proposed reorganisation on the ground that the share exchange ratio was not fair, and that the reorganisation unfairly benefited the promoters.
Accounting and taxAccounting and valuation
How will the corporate reorganisation be treated from an accounting perspective? How are target assets and businesses valued?
The rules on accounting standards in India vary significantly depending on multiple factors, such as whether a company is listed on a stock exchange, whether it is banking or financial entity, and whether any sector-specific regulations are applicable to it. Broadly speaking, the new accounting rules (the Indian Accounting Standards or ‘Ind AS’) are applicable to companies that: (i) have debt or equity securities listed on a stock exchange, or are in the process of having such securities listed; or (ii) as of 31 March 2014 have a net worth of more than 2.5 billion rupees. If Ind AS is applicable to a company, it is also automatically applicable to any holding, subsidiary, or associate company, and any joint venture, of such company.
Under the Ind AS rules, for ‘business combination’ where the businesses or entities are under common control, Ind AS requires companies to adopt the ‘pooling of interests’ method. Under this method, the assets, liabilities and reserves of the transferor are recorded at their existing carrying amounts and, in the same form, in the accounts of the transferee entity. No adjustments are made to reflect the fair value or recognise any new assets or liabilities other than to harmonise accounting policies between businesses or entities.
Under the provisions of the Companies Act, the parties to a reorganisation under a court approval must procure a valuation report from a valuation expert. However, there are no specific valuation parameters that the valuation report must adhere to.
In the event that the reorganisation involves an issuance of securities to non-resident entities, the issuance must be in accordance with the order of the NCLT. The NCLT is unlikely to approve any issuance of securities to non-residents which is in violation of the pricing guidelines issued under the Foreign Exchange Management Act 1999.
Further, if the reorganisation involves an issuance of shares by a listed entity on a preferential basis, any preferential allotment must comply with the pricing guidelines set out in Chapter VII of the SEBI (Issue of Capital and Disclosure Requirements) Regulations 2009.Tax issues
What tax issues need to be considered? What are the tax implications of carrying out a corporate reorganisation?
One of the major tax issues in corporate reorganisations pertains to capital gains tax. Under the Income Tax Act 1961, mergers and demergers receive tax-neutral treatment if they meet certain criteria. Once these criteria (which are briefly set out below) are met, no capital gains would be payable on the transfer of the undertaking from the transferor company to the transferee company, or the issue of shares to the shareholders of the transferor company.
A merger is eligible to receive tax-neutral treatment if it meets the following conditions:
- all the property and liabilities of the transferor company become the property and liabilities of the transferee company as a result of the merger; and
- the shareholders holding 75 per cent or more in value of shares (other than the shares beneficially held by the transferee company or its subsidiaries) in the transferor company become shareholders of the transferee company as a result of the merger.
A demerger is eligible to receive tax-neutral treatment if it meets the following conditions:
- all the property of the undertaking being transferred, and all liabilities related to such undertaking, become the property and liabilities of the transferee company as a result of the demerger;
- the property and liabilities of the undertaking being transferred are transferred at values appearing in the books of account of the transferor company;
- in consideration of the demerger, the transferee company issues its shares to the shareholders of the transferor company proportionately (except where the transferee company itself is a shareholder of the transferor company);
- shareholders holding 75 per cent or more in value of the shares (other than the shares beneficially held by the transferee company or its subsidiaries) in the transferor company become shareholders of the transferee company as a result of the demerger; and
- the transfer of the undertaking is as going concern.
Separately, any reorganisation involving a transfer of capital assets by a company to its wholly owned subsidiary, or vice versa, would also be exempt from capital gains tax under Indian tax law provided the shares of the wholly owned subsidiary have been held by the parent company for a period of eight years.
Carrying forward tax losses and unabsorbed depreciation
In reorganisations in the nature of mergers that qualify for tax-neutral treatment as set out above, the accumulated losses and unabsorbed depreciation of the transferor company may be utilised by the transferee company for reducing its tax burden.
Similarly, in demergers that qualify for tax-neutral treatment as set out above, accumulated losses and unabsorbed depreciation of the transferor company that are directly relatable to the undertakings being transferred may be utilised by the transferee company for reducing its tax burden. If accumulated losses and unabsorbed depreciation are not directly relatable to the undertakings being transferred, they may be apportioned between the transferor and transferee companies in the same proportion in which the assets of the undertakings have been retained by the transferor company, and transferred to the transferee company.
Tax losses are allowed to be carried forward and set off for a period of eight financial years while unabsorbed depreciation can be carried for an indefinite period.
Treatment of accumulated profits
In the past, companies have undertaken amalgamations to reduce the dividend distribution tax payable on dividends paid by a subsidiary company to its parent company. However, with effect from 1 April 2019, the accumulated profits of the amalgamated company will include the accumulated profits of the amalgamating company for the purposes of dividend taxation, thus effectively nullifying the reduction in dividend tax payable as a result of the amalgamation.
Expenses of reorganisation
The expenses incurred by a company, wholly and exclusively for the purposes of a merger or demerger qualifying for tax-neutral treatment as set out above, may be deducted from its income over the course of five years, beginning in the year in which the merger or demerger takes place. The amount of deduction that may be claimed in any particular year is capped at one-fifth of the total expenses incurred for the merger or demerger.
In light of the above, where possible, parties should structure their reorganisations such that they are eligible to qualify for tax-neutral status, as set out above. However, readers must note that the benefits set out above are subject to detailed criteria, which cannot be specified here. Parties should engage tax specialists to fully understand the tax implications of their reorganisations.