Key tax aspects to consider when contemplating M&A

In these testing times, when organic growth is getting difficult, companies are resorting to inorganic business growth including through acquisitions. This has resulted in an upsurge in structuring and restructuring of the companies by way of merger, demerger, takeovers, etc. For a smooth inorganic expansion and value creation, companies will need to be aware of certain tax issues.

Statutory conditions

The term “merger” is not defined in the Companies Act, 1956, or the Income Tax Act, 1961 (ITA). The term amalgamation, which is akin to the term merger, is defined in section 2(1B) of the ITA. Amalgamation refers to the merger of companies under sections 391 to 394 of the Companies Act which satisfies the following conditions, thereby making it tax neutral: (a) all property and liabilities of the amalgamating company becomes the property and liabilities of the amalgamated company; (b) shareholders holding not less than three-fourths in value of the shares in the amalgamating company become shareholders of the amalgamated company by virtue of the amalgamation.

As the shareholders of the amalgamating company must become shareholders of the amalgamated company by virtue of the amalgamation, consideration should be by way of issue of shares by the amalgamated company. This condition would not be satisfied if the shareholders are already shareholders of the amalgamated company and no fresh shares are issued. Payment by other modes, such as debt instruments, may not satisfy this condition. If the conditions prescribed for amalgamation are not satisfied, then the fair value of the shares issued by the amalgamated company will be treated as consideration for the purpose of computing capital gains in the hands of the shareholders.

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Methods used

Where the amalgamated company does not intend to change the pre-amalgamation shareholding of the company, the amalgamated company sometimes issues a different class of shares or preference shares to the shareholders of the amalgamating company with a view to meeting the above statutory conditions.

Further, shareholders of the amalgamating company are statutorily not required to continue to be shareholders of the amalgamated company for a specific period, post the amalgamation. Thus, it can be contended that the new shareholders of the amalgamated company can transfer their shares immediately after the amalgamation. For the purpose of computing gains on transfer of the amalgamated company’s shares, the period of holding will be considered from the date of acquisition of the amalgamating company’s shares.

Availability of benefits

As one of the objectives of a merger is mitigating tax liability, it is essential to ascertain if the benefits enjoyed by the amalgamating company prior to amalgamation are available to the amalgamated company after the amalgamation, e.g. setting off the losses of the amalgamating company. As per section 72A of the ITA, if there is amalgamation of a company which owns an industrial undertaking, banking company or one or more public sector companies engaged in the business of operation of aircraft, then such losses can be set off by the amalgamated company, subject to the prescribed conditions.

For some companies – e.g. those engaged in IT enabled services or the manufacture of software – the key challenge is to ascertain whether the company owns an industrial undertaking. Further, for companies other than public companies, section 79 of the ITA provides that the loss will not be available for set-off if the shareholding of the company pursuant to amalgamation changes by more than 51%. If the shareholding changes beyond 51%, it is unclear whether the amalgamated company will be allowed to take the benefit of setting off losses under section 72A of the ITA or whether the amalgamated company will be restricted to setting off losses as per section 79 of the ITA.

Akin to the issue of availability of brought forward losses for set-off, compliance issues such as claiming the credit of tax deduction at source by the amalgamated company post amalgamation that pertains to the amalgamating company need to be evaluated. Whether tax deducted for transactions between the two amalgamating companies will be treated as advance tax paid by the amalgamated company will also need to be analysed.

Outlined above are some of the key tax considerations which could impact the commercial decision to proceed with a merger. If the benefits that are discussed above are not available to the amalgamated company then part of the commercial basis for the merger may not be achieved and the exercise of amalgamation could be in vain. Many other areas – depreciation allowance, cost step-up for different assets, continuity of tax holiday, recognition and valuation of intangibles, etc. – also play an important role in decision making from a group restructuring perspective. Detailed evaluation of all the issues is imperative before proceeding with the restructuring of companies.

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Pranay Bhatia is a partner and Janhavi Sharma is an associate at Economic Laws Practice. This article is intended for informational purposes and does not constitute a legal opinion or advice.