Acquisitions (from the buyer’s perspective)Tax treatment of different acquisitions
What are the differences in tax treatment between an acquisition of stock in a company and the acquisition of business assets and liabilities?
The key differences between an acquisition of stock in a company and the acquisition of business assets and liabilities are as follows:
- In the case of acquisition of stock, the consideration paid by the buyer becomes the cost of acquisition of the stock for the purpose of calculation of capital gains on transfer of stock in future. However, there is no step-up in the cost basis of the assets of the company whose stock is being acquired. However, subject to certain conditions, in the case of an acquisition of business assets and liabilities, the buyer can achieve a step-up in the cost basis of the assets, thereby enhancing the amortisation base of assets, including for goodwill and intangibles.
- Most tax holidays available to an Indian company would continue to be available despite an acquisition of stock (partial or complete) in such a company. In the case of an acquisition of specific business assets and liabilities, the benefit of the tax holiday for the unexpired period is not available to the buyer. In cases where the business is acquired as a whole, while there is a possibility of the tax holiday being available to the buyer, the position is less secure compared to an acquisition of stock.
- In the case of acquisition of stock in a private company whose shares are not traded on the stock exchange, the tax losses of the company (other than unabsorbed depreciation) would not be permitted to be carried forward and set off if the acquisition is of shares in a company carrying more than 49 per cent voting power. This limit does not apply to a company whose shares are traded on the stock exchange and in certain other scenarios, such as a change in shareholding of an Indian company as a result of amalgamation or demerger of its foreign parent company, provided that 51 per cent of the shareholders of the amalgamating or demerged foreign company continue as shareholders of the resulting company. An amendment to the Income Tax Act in 2017 provided an exception to eligible start-ups for carry-forward and set-off of losses, wherein all shareholders having shares with voting power continue to hold such shares in the year of set-off and such loss should have been incurred during a period of seven years from the incorporation of the company. A further amendment to the Income Tax Act in 2018 provided that in cases of companies covered under a resolution plan of the Insolvency and Bankruptcy Code 2016, restrictions pertaining to a change in shareholding do not apply for the carry-forward and set-off losses. In the case of an acquisition of business assets and liabilities, tax losses are not available to the buyer unless the acquisition is approved by the court and satisfies prescribed conditions.
- In the case of acquisition of stock in a company, prepaid taxes and other tax credits (such as indirect tax credits, including goods and services tax (GST)) would continue to be available. Such prepaid taxes and tax credits do not normally transfer to the buyer upon an acquisition of business assets and liabilities. Further, the buyer would need to withhold taxes prior to making payment to the seller for the acquisition of the stock if the seller is a non-resident and if protection under a tax treaty is not available to the seller for such income. This requirement does not arise in the case of an acquisition of stock or acquisition of the business assets and liabilities if the seller is an Indian resident. However, this requirement would apply where the business assets and liabilities are sold by the Indian branch or liaison office of a non-resident seller.
- Capital gains on the sale of stock are treated as long-term if the stock (shares) is listed and held for more than 12 months prior to the sale. For unlisted stock, however, the gains on transfer will be considered as long-term if the same has been held for more than 24 months prior to the sale. In the case of a sale of business (assets and liabilities), the capital gains will be treated as long-term only if the business has been carried on for more than 36 months. Similarly, in the case of sale of stock, the consideration is received directly by the shareholders, whereas in a sale of business assets and liabilities, the consideration is first received by the company and then, if distributed to the shareholders, results in two levels of tax. These are capital gains tax in the hands of the seller company and subsequently dividend distribution tax (DDT) in the hands of shareholders at the time of profit or dividend distribution. Although these are seller issues, they could affect the pricing of the deal from a buyer’s perspective.
- Acquisition of business assets and liabilities may require a no-objection certificate from the revenue authorities to ensure that the transfer is not treated as void because of any tax demand arising from pending proceedings against the seller as on the date of transfer. A transfer is not treated as void where it is for adequate consideration. No-objection certificates could also be required for the sale of stock and are now increasingly being insisted upon by the buyer to avoid withholding tax obligations, particularly where the stock is of an offshore company with underlying Indian assets. Guidelines have been issued for streamlining the procedure for the issue of no-objection certificates by the revenue authorities, laying specific timelines to respond to the applicant. If the no-objection certificate is either not issued by the revenue authorities or cannot be obtained owing to lack of time, the buyer could seek an indemnity from the seller pertaining to potential losses that may arise (to the buyer) for the transaction being treated as void (which is typically agreed between the parties to be an amount equal to the sale consideration paid by the buyer), or the buyer may negotiate with the seller to seek tax insurance for the above.
- In the case of acquisition of shares at a price less than the fair market value of such shares, the difference between the fair market value (FMV) and the consideration paid will be taxable in the hands of the recipient of the shares as ordinary income. The law was amended in 2017 to cover all categories of taxpayers (companies under the extant law) for the transfer of shares of unlisted companies at a value other than FMV. FMV for this purpose is defined as the net asset value of the company whose shares are being transferred, to be determined on the basis of book values of its assets and liabilities. However, certain tax-neutral transfers fall outside the purview of the above provisions. The sale consideration on the sale of unquoted shares is deemed to be at FMV in the hands of the seller for the purposes of computing capital gains tax. Accordingly, in cases of unlisted shares, the difference between FMV and the actual sale consideration will be taxable in the hands of both the buyer and the seller. This will not be applicable in cases of acquisition of business assets and liabilities by a company.
In what circumstances does a purchaser get a step-up in basis in the business assets of the target company? Can goodwill and other intangibles be depreciated for tax purposes in the event of the purchase of those assets, and the purchase of stock in a company owning those assets?
A step-up in the cost basis of the business assets is only possible in the case of acquisition of the business assets of the target company on a going-concern basis. The step-up would have to be justified by an independent valuation report. There are specific anti-abuse provisions under which the step-up could be denied if the only purpose of the acquisition is to achieve a tax advantage.
The excess of the consideration over the fair value of the assets is recognised as goodwill or intangibles in the books of the buyer. Intangibles (such as trademarks, patents, brand names, etc) are clearly specified to be depreciable assets under the law. The question of depreciation on goodwill has been a subject matter of litigation in India and there have been some rulings where depreciation has been allowed if the amount representing goodwill was actually on account of acquisition of certain intangibles, such as customer lists, business rights, etc. The Indian Supreme Court has subsequently ruled that even goodwill simpliciter (ie, goodwill arising in cases of an amalgamation as the difference between the amount paid and the cost of the net assets) is eligible for tax depreciation. The Supreme Court held that goodwill is a capital right that increases the market worth of the transferee and, therefore, satisfies the test of being an intangible asset, thereby being entitled to tax depreciation. However, even following this Supreme Court ruling, litigation cannot be ruled out in certain circumstances.
In the case of acquisition of specific business assets, the consideration paid by the buyer for each asset becomes the cost of acquisition for the respective asset.
In the case of acquisition of stock, the consideration paid becomes the cost of acquisition of the stock for the buyer. Accordingly, there is no step-up in the cost basis of the assets of the target company.Domicile of acquisition company
Is it preferable for an acquisition to be executed by an acquisition company established in or out of your jurisdiction?
An acquisition of business assets and liabilities in India would have to be undertaken by a company incorporated in India, since a foreign company cannot directly own assets and carry on a business in India, except through a branch office, a project office, liaison office or a wholly owned subsidiary in certain cases, subject to prescribed restrictions.
Where stock in a company is being acquired, it may be preferable for the acquisition company to be established outside India for the following reasons.
An Indian company is subject to corporate tax at the rate of 30 per cent (plus applicable surcharge and cess). In addition, the distribution of dividends is subject to DDT at the rate of 17.65 per cent (plus applicable surcharge and cess) in the hands of the company. Also, dividends paid and the DDT thereon is not tax-deductible. The gains arising from the sale of shares in an Indian company trigger capital gains tax implications in India. Further, India does not permit the consolidation of profits or losses for tax purposes for group companies.
Thus, in the case of an Indian acquisition company, repatriation of profits from the target company by way of distribution of dividends could be subject to two levels of DDT (first, when the target company distributes dividends to the Indian acquisition company, and second, when the Indian acquisition company distributes dividends to its foreign parent). This dual impact is, however, relaxed in cases where the Indian acquisition company holds more than 50 per cent of the equity share capital of the target company. In such a case, the dividends distributed by the target company on which the target company has paid DDT are allowed as a deduction in the hands of the Indian acquisition company, while computing its DDT liability in the same financial year. Upon the sale of stock of the target company by an Indian acquisition company, there would be two levels of tax: first, capital gains tax on the sale of shares, and second, DDT on the distribution of such gains as dividends. In addition, the distribution of dividends is subject to Indian corporate laws, which permit dividends to be paid only out of profits.
On the other hand, if the acquirer company is outside India, there would be one level of tax in India, in the case of distribution of profits by the target company in the form of dividends. Further, in the case of the sale of the shares in the target company, one level of capital gains tax would be triggered in India. The capital gains tax incidence could be mitigated if the acquisition was made from jurisdictions such as Cyprus, Mauritius, the Netherlands, Singapore, etc, by relying on the favourable tax treaties that India has with these countries, subject to the satisfaction of Limitation of Benefit (LOB) test and GAAR Regulations (discussed later). The substance test will vary from treaty to treaty and further upon terms of the covered tax agreements (CTAs) under multilateral instruments (MLIs). There has been significant debate in India on whether the benefits granted under the tax treaties are being abused by offshore companies resorting to treaty shopping, and the government has been engaging in a renegotiation of tax treaties with some countries. Tax treaties with Singapore, Cyprus and Mauritius have been negotiated and revised, as discussed later. The tax treaty with the Netherlands is under negotiation. While having a tax residency certificate (TRC) (disclosing prescribed particulars either in the TRC itself or in a separate prescribed form) from the revenue authorities of the home country is the basic and most essential requirement for claiming tax treaty benefits, the revenue authorities are also laying increased emphasis on the substance in the offshore holding companies set up in jurisdictions with favourable tax treaties. The substance test will vary from treaty to treaty and, in future, upon the terms of CTAs under MLIs.
The India-Mauritius tax treaty was amended in May 2016 to introduce a source-based taxation of the capital gains earned by a Mauritian resident on the transfer of shares in an Indian company. Pursuant to this amendment, capital gains arising from the sale of shares of Indian companies that are acquired and transferred between the period 1 April 2017 and 31 March 2019 are to be taxed at 50 per cent of the domestic tax rate (subject to satisfaction of certain LOB conditions), while capital gains arising on transfer of shares of Indian companies acquired after 1 April 2017 and sold after 31 March 2019 will be taxable at the full domestic tax rate. All investments made in shares of Indian companies before 1 April 2017 are grandfathered and will continue to enjoy exemption under the India-Mauritius tax treaty. The above-mentioned amendment does not apply to any asset other than shares in an Indian company (ie, gains arising from the transfer of any other securities issued by Indian companies will continue to be exempt from capital gains tax under the India-Mauritius tax treaty).
Aside from the above, the Financial Services Commission, Mauritius, has also notified requirements to be complied with by a Mauritius Global Business Licence Company - Category 1 (GBL-1) (which is the kind of company primarily used for Indian acquisitions) to be eligible for obtaining a TRC. These requirements essentially necessitate GBL-1 companies to have economic substance in Mauritius, such as having office premises in Mauritius, employing a full-time Mauritian resident at a technical or administrative level or have arbitration in Mauritius, etc.
Similar to the revision in the India-Mauritius tax treaty, the tax treaty with Singapore has undergone its third revision since its inception on 24 January 1994, wherein a protocol has been inserted providing for taxing the capital gains arising out of the sale of shares of an Indian resident company that were acquired on or after 1 April 2017 in India. However, shares acquired before 1 April 2017 shall be outside the scope of taxation in India and shall continue to enjoy the capital gains tax benefit in accordance with the erstwhile tax treaty provisions, subject to the fulfilment of revised LOB provisions. The erstwhile India-Singapore tax treaty provided for capital gains tax exemption in India in cases of transfer of shares of an Indian company, subject to the satisfaction of the LOB condition (ie, shares of the Singapore transferor company should be listed on a recognised stock exchange in Singapore or total annual expenditure on operations in Singapore should be equal to or more than S$200,000 in the immediately preceding period of 24 months from the date the gains arise).
Transitional provisions have also been notified wherein a relaxation of up to 50 per cent of capital gains tax has been provided to capital gains arising on the transfer of shares acquired after 1 April 2017 but before 31 March 2019 (the transition period), subject to revised LOB provisions. Under the revised LOB provisions, the expenditure threshold shall be applied during the period of 12 months immediately preceding the date of gain for cases falling within the transitional period.
The government classified Cyprus as a notified (uncooperative) jurisdiction in 2013. However, subsequent to the revision of the bilateral tax treaty on 18 November 2017, the government rescinded its notification. The amended India-Cyprus tax treaty provides for source-based taxation of capital gains arising from the sale of shares in the source country. Grandfathering provisions have been introduced pertaining to gains on the sale of share investments made prior to 1 April 2017, in respect of which capital gains will continue to be taxed in the country of residence of the taxpayer. No LOB clause has been notified in the revised tax treaty.General Anti-Avoidance Rule (GAAR)
The Finance Act 2012 introduced the GAAR, which came into effect on 1 April 2018. GAAR provisions could apply if an arrangement is declared an ‘impermissible avoidance arrangement’; in other words, an arrangement for which the main purpose is to obtain a tax benefit, and that satisfies certain other tests. The GAAR provisions effectively empower the revenue authorities to deny the tax benefit that was being derived by virtue of an arrangement that has been termed ‘impermissible’.
Further, the GAAR provisions lay down certain scenarios in which an arrangement or transaction would be deemed to lack commercial substance, such as if the situs of an asset or a transaction, or one of the parties to the transaction, is located in a particular jurisdiction only for tax benefits. Thus, interposing special-purpose vehicles in a tax-friendly jurisdiction, devoid of any commercial substance or rationale, would be one practice that the revenue authorities would seek to challenge through the GAAR. As per the recent Central Board of Direct Taxes (CBDT) Circular No. 7 issued on 27 January 2017, where anti-avoidance rules (LOB) exist in a tax treaty, GAAR provisions should not be invoked in cases where such LOB provisions sufficiently address the tax-avoidance strategy of the taxpayer.
Recently, India has signed MLIs in support of the OECD’s BEPS Action Plan 15. India has opted for Simplified LOB (SLOB) and the Principle Purpose Test (PPT) for all its CTAs. The PPT is broader than Indian GAAR, since under the Indian GAAR provisions, one of the main purposes of an arrangement is tax benefits. In the PPT, ‘one of the main purposes’ of entering into an arrangement is to obtain treaty benefits, which is the decisive factor for identifying treaty abuse. Further, the PPT has a carve-out wherein a treaty benefit is granted to a transaction if such a benefit is in accordance with the object and purpose of the relevant tax treaty.
A notification has been issued by the government laying down certain exclusions from the scope of applicability of the GAAR provisions. The revenue authorities will not be empowered to invoke GAAR in cases of income arising to a person from the transfer of investments made before 1 April 2017. Further, the revenue authorities will not be empowered to invoke GAAR in cases where the tax benefit in a year arising to all parties to the arrangement (in aggregate) does not exceed 30 million rupees. GAAR will also not apply to:
- foreign institutional investors (subject to certain conditions) who have invested in listed or unlisted Indian securities and have not obtained any treaty benefits;
- non-residents, in respect of their investments in offshore derivative instruments; and
- investments made prior to 1 April 2017.
The Finance Act 2012 introduced a retrospective provision for Indian taxation on any gains from the transfer of shares (or interest) of an offshore company or entity that derives value substantially from assets located in India (indirect transfer provisions). The CBDT issued a clarification in May 2012 directing no reopening of cases on account of indirect transfer transaction where the tax assessment stands completed and no reassessment notice was issued before 1 April 2012. Further, on 28 August 2014, a committee was formed comprising senior officers of the CBDT, namely joint secretary (FT&TR-I), joint secretary (TPL-I) and commissioner of income tax (ITA), with the director (FT&TR-I) being the secretary of the committee. The tax officers need to seek a prior approval of the committee before initiating any action on the taxability of indirect transfers prior to April 2012. The Finance Act 2015 introduced further clarifications regarding the applicability of the indirect transfer provisions. Dual conditions are required to be fulfilled for the applicability of these provisions:
- the FMV of Indian assets exceeds 100 million rupees on the date on which the accounting period of the offshore entity (indirectly holding such assets) ends preceding the date of transfer; and
- the FMV of Indian assets represents at least 50 per cent of all the assets owned by the offshore entity.
In addition, to provide relief to minority shareholders, it has been provided that a transaction of an indirect transfer will not be subject to Indian tax if the transferor (along with its associated enterprises) does not hold, directly or indirectly, the right of control or management and voting rights, share capital or interest exceeding 5 per cent in the foreign entity at any time in the 12 months preceding the date of transfer. The indirect transfer of shares of an Indian company pursuant to amalgamation or demerger of foreign companies has also been exempted from Indian tax, subject to the fulfilment of specified conditions.
The CBDT has issued valuation rules with respect to the indirect transfer provisions. The rules prescribe:
- a methodology to calculate the FMV of the Indian assets based on the nature of the asset;
- a methodology to calculate the FMV of the total assets of the offshore entity whose shares are being transferred;
- a methodology to determine the income attributable to Indian assets that will be taxable in India; and
- compliances to be undertaken by the transferor to disclose the basis of arriving at the income attributable to Indian assets.
Are company mergers or share exchanges common forms of acquisition?
Mergers and demergers are the preferred forms of acquisition in India. This is primarily due to a specific provision in the tax law that treats mergers and demergers as tax-neutral, both for the target company and for its shareholders, subject to the satisfaction of the prescribed conditions.
Other reasons mergers and demergers are preferred include:
- the unabsorbed business losses and depreciation of the transferor company can be carried forward, subject to certain conditions. In the event of a merger, all the losses of the target company are transferred to the buyer, while in a demerger only the losses pertaining to the undertaking being sold are transferred. An undertaking is broadly understood to mean an independent business activity operating as a separate division on a going-concern basis, comprising its independent assets, liabilities, employees and contracts. In a merger, the period of carry-forward of the unabsorbed losses is renewed for a period of eight years from the date of the merger, while in a demerger, the unabsorbed losses can only be set off and carried forward for the unexpired period;
- generally, tax holidays and other incentives would continue to be available to the acquiring company. However, there are specific tax holidays that may cease to be available in the event of a merger or demerger; and
- the transfer of prepaid taxes and other tax credits from the target company to the acquiring company is permitted in certain cases.
However, the ability to achieve a step-up in the cost basis of the assets is difficult in both mergers and demergers. Further, these involve a court or National Company Law Tribunal (NCLT) approval process and, therefore, are at present time-consuming.
The government of India, under the Companies Act 2013 (the Act), replaced the Companies Act 1956 with effect from 29 August 2013. The NCLT was constituted with effect from 1 June 2016, subsuming the functions of four corporate regulatory bodies; namely, the Company Law Board, the High Court, the Board of Industrial & Financial Reconstruction and the Appellate Authority for Industrial and Financial Reconstruction. The NCLT deals with all business reorganisations and acts as a single window approving authority for all business reorganisation schemes. Further, the Act specifically provides for simplified and faster processes for mergers and demergers for specified small private companies and between holding and wholly owned subsidiary companies, whereby the central government’s approval is sought and the requirement to approach the NCLT for approval is absolved, subject to the fulfilment of prescribed conditions.Tax benefits in issuing stock
Is there a tax benefit to the acquirer in issuing stock as consideration rather than cash?
In mergers and demergers, issuing stock as a consideration instead of cash ensures the tax-neutrality of such mergers and demergers, subject to the fulfilment of prescribed conditions. Apart from the above, there is no tax benefit to the acquirer in issuing stock as a consideration instead of cash.
There could be tax implications if shares are issued at a price higher or lower than the FMV.
In the case of shares issued at a premium to Indian residents (and not to non-residents), the issuer company could be made liable to tax for the amount of the premium received in excess of the FMV of the shares. The FMV for this purpose is a value that is the higher of the book value of the assets and liabilities of the issuer company, determined as per the prescribed manner, or the FMV of the stock, determined by a merchant banker or an accountant as per the discounted cashflow method. This tax does not apply to venture capital undertakings issuing shares to a venture capital fund registered with the regulatory authorities in India.
In the case of shares being issued at a price less than their FMV, such FMV or the difference between the FMV of the shares received and the asset given up could be brought to tax in the hands of the recipient of the shares as ordinary income. FMV for this purpose is defined as the net asset value of the company issuing the shares, to be determined on the basis of book values of its assets and liabilities.Transaction taxes
Are documentary taxes payable on the acquisition of stock or business assets and, if so, what are the rates and who is accountable? Are any other transaction taxes payable?
All forms of business acquisitions involve transaction taxes in some form, though the nature, incidence and quantification of the taxes vary. Typically, these include stamp duty, GST, etc. The Indian government introduced GST with effect from 1 July 2017. Stamp duty is payable on the execution of a conveyance or a deed. GST is an indirect tax that subsumes an array of indirect taxes, including excise duty, service tax and value added tax (excluding stamp duty), and is payable on the supply of goods and services. Who bears the stamp duty is negotiated between the buyer and the seller, although it is common for the buyer to bear it. GST, being an indirect tax, is normally collected from the seller and paid or borne by the buyer. Depending on the facts, the buyer may be able to offset the GST paid against its output GST liability, if any.
The impact of transaction taxes and applicable rates for different forms of acquisition are given below.Acquisition of stock
Transfers of shares in a company are liable to stamp duty at the rate of 0.005 per cent of the value of the shares. No stamp duty is levied where the stock is held in an electronic form with a depository (and not in a physical form). Securities transaction tax (STT) is applicable on the purchase of shares listed on a stock exchange. In 2019, the law was amended to levy STT on the difference between the strike price and market price, which was earlier levied twice on the aforementioned prices individually. There is no GST on the sale of shares, since the definition of ‘goods’ and ‘services’ under GST regulations excludes securities.Acquisition of business assets
The acquisition of business assets as part of an acquisition of an entire business does not attract GST. GST does not apply on the sale of a business as a whole as an undertaking on a going-concern basis. Stamp duty applies on specified movable property such as ‘towers’ and immovable property if the transfer is undertaken by way of a conveyance. Stamp duty is a state levy and the rate of stamp duty differs depending on the nature of the assets transferred and their location. Generally, however, stamp duty is payable only on the immovable property transferred on the basis that movable property is transferred by way of physical delivery.
In the event of an acquisition of specific business assets, GST is applicable on the transfer of movable assets. The rate of GST depends on the nature of the assets and varies within a range of 12 to 28 per cent. However, input tax credits for the same may be available to the payer, depending on the nature of the asset. The stamp duty implications are the same as discussed above.Mergers and demergers
In most states, mergers and demergers attract stamp duty. Stamp duty is normally based on the value of shares issued as a result of the merger or demerger and the value of the immovable property transferred.Net operating losses, other tax attributes and insolvency proceedings
Are net operating losses, tax credits or other types of deferred tax asset subject to any limitations after a change of control of the target or in any other circumstances? If not, are there techniques for preserving them? Are acquisitions or reorganisations of bankrupt or insolvent companies subject to any special rules or tax regimes?
Unabsorbed business losses are allowed to be carried forward and set off for a period of eight years from the year in which they were incurred, while there is no time limit for carry-forward and set-off of unabsorbed depreciation.
A change in shareholding of a closely held company (ie, a private company whose shares are not listed on a stock exchange) by more than 49 per cent of shares carrying voting power in any year would result in such unabsorbed business losses not eligible for carry-forward or set-off in the future. However, this does not affect carry-forward and set-off of unabsorbed depreciation, if any. Also, there is no impact in certain other scenarios, such as a change in shareholding as a result of amalgamation or the demerger of a foreign parent, provided that 51 per cent of the shareholders of the amalgamating or demerged foreign company continue as shareholders of the resulting company. Tax credits (such as a minimum alternate tax) or deferred tax assets are not affected by a change in control of the target or upon its insolvency.
An exception has been made for eligible start-ups for carry-forward and set-off of losses, subject to the condition that shareholders having shares with voting power continue to hold such shares in the year of set-off and such losses should have been incurred within seven years of the incorporation of the company. Further, for companies covered by a resolution plan under the Insolvency and Bankruptcy Code 2016, restrictions pertaining to a change in shareholding do not apply for such carry-forward and set-off losses.Interest relief
Does an acquisition company get interest relief for borrowings to acquire the target? Are there restrictions on deductibility generally or where the lender is foreign, a related party, or both? In particular, are there capitalisation rules that prevent the pushdown of excessive debt?Deductibility of interestAcquisition of stock
The deductibility of interest on acquisition finance used by the acquisition company to acquire stock in a target company depends on the characterisation of income received from the target company; in other words, ordinary income versus investment income. Further, as a general rule under the domestic tax law, where any expense is incurred for earning tax-exempt income, no deduction is allowed for such expenditure. The apex court in the case of Maxopp Investment Ltd v CIT (Civil Appeal Nos. 104-109 of 2015) ruled that if a taxpayer acquires shares of a company to gain a controlling interest over the company and earns exempt income, the portion of the expenditure attributable to such exempt income should be disallowed. However, if the taxpayer holds the shares as stock-in-trade, then income earned shall be business income. Accordingly, expenditure incurred in relation to such income shall be deductible as a business expenditure.Acquisition of business
In the event of an acquisition of business assets, whether in the form of a business as a whole or specific assets, the interest on borrowings, which is relatable to a capital asset, should be capitalised as the cost of the asset, while the interest payable on an ongoing basis should be allowed as a deduction, as such expenses would be incurred for the purposes of the business of the acquisition company.Withholding taxes on interest payments
Payment of interest by an Indian company to a foreign party that is a related party would be subject to Indian transfer pricing regulations. Under exchange control regulations, foreign loans are subject to maximum interest-rate ceilings on repayment schedules and end-use restrictions, such as the proceeds not being used for on-lending, investment in a capital market, acquiring a company or a part thereof, repayment of an existing rupee loan and real estate (excluding development of an integrated township as defined in the regulations). In the case of foreign-related party loans, arm’s-length interest is allowed as a deduction. With effect from 1 April 2017, taxable deduction of interest expenditure claimed by an Indian company is capped at 30 per cent of earnings before interest, tax, depreciation and amortisation (EBITDA) of the Indian company, and the excess balance, if any, can be carried forward for up to eight years to be allowable as a deduction against future taxable income.
The strict source-based rule is applied for taxation of interest in India. Generally, the interest payable by a resident is taxable in India. However, in certain cases, interest payable by a non-resident is also taxed in India if it is payable in respect of any debt incurred for the business or profession carried on in India by such a person.
Thus, the interest payments made from India would be liable to tax in the hands of the recipient and would, therefore, be subject to withholding tax implications. The rate of withholding tax depends on whether the borrowing is in a foreign currency or in Indian currency. In the case of monies borrowed in a foreign currency before 1 July 2020, the rate of withholding tax is 5 per cent (plus applicable surcharges and cess) of the gross amount. The withholding tax rate is more beneficial as compared to the treaty rate (at 7.5 to 15 per cent under various treaties). Interest payments on monies borrowed in Indian currency are subject to withholding tax at the rate of 10 per cent (plus applicable surcharges and cess) on a gross basis.Debt pushdown
Debt pushdown for offshore financing for acquiring Indian company or business assets is not feasible owing to exchange control restrictions and thin capitalisation rules. However, debt pushdown by way of local financing (through a banking institution) procured by an Indian company for acquiring either stock or a business asset is not common owing to restrictive banking and corporate regulations. Accordingly, careful planning and structuring is required for achieving tax-optimised debt pushdown.Protections for acquisitions
What forms of protection are generally sought for stock and business asset acquisitions? How are they documented? How are any payments made following a claim under a warranty or indemnity treated from a tax perspective? Are they subject to withholding taxes or taxable in the hands of the recipient? Is tax indemnity insurance common in your jurisdiction?
In the case of a stock acquisition, the seller normally warrants that the target has been compliant with all tax matters and that all disputed matters are either provided for or otherwise disclosed. An indemnity is provided in case there are any tax dues that arise over what is disclosed; the seller shall indemnify the buyer for such claims. Since tax dues can arise several years later, indemnities are provided for a seven- to 10-year period, often without any monetary cap unless they are quantifiable. To implement the indemnity, part of the consideration could also be placed in an escrow account, particularly if a claim of tax administration is imminent. These aspects are documented in the share purchase agreement entered into by the parties. The buyer could also insist that the seller obtains a nil tax withholding order from the revenue authorities for tax withholding on consideration for the sale, particularly in cases where the seller is claiming capital gains tax exemption under a favourable tax treaty or where tax on offshore acquisition of shares with underlying assets are exempted due to the threshold.
In the case of an acquisition of assets and liabilities, the warranties and indemnities are less stringent, since the buyer does not acquire control over the selling company itself, and any tax dues would fall upon the selling company. The sale agreement should contain a general indemnity clause for indemnifying the buyer against representations and undertakings made by the seller. In addition, a specific indemnity clause can also be placed indemnifying the buyer against any action that the revenue authorities may take on the buyer or assets acquired by the buyer (or both). It is also common for the buyer to insist that the seller obtain a no-objection certificate from the revenue authorities for the sale of the assets.
Payments made pursuant to a claim under a warranty or an indemnity are not liable to tax (for the recipient) if they are treated as capital receipts and, hence, are not subject to withholding taxes. However, if the indemnity relates to a profit-earning activity, it may be taxable in the hands of the recipient and subject to withholding taxes. The payer of the claims is unlikely to be able to claim the amount paid as a deduction against its income on the sale of the stock or assets and liabilities.