Corporate restructuring strategies – Tax and legal impediments

The Union Budget 2021 is slated to be presented on 1st February. This year, the Finance Ministry has decided to go completely paperless, which would happen for the first time since Independence, due to the coronavirus disease (COVID-19) pandemic.

COVID-19 has had a material impact on mergers and acquisition transactions globally. A slowdown has been witnessed with the investors putting their acquisition and growth plans on hold and shifting focus towards cash conservation.

Growth is the driving factor for all organisations – old or new. Business owners have always strived to achieve business growth through organic and inorganic means. Business reorganisation is imperative for inorganic business growth and for achieving various commercial benefits such as operational synergies, maximisation of stakeholder's value, cost optimisation, focusing on core competencies etc.

With a view to enable economic and business growth, the legislature has, over the years made various modifications in the tax laws to provide flexibility for commercially driven business restructurings.

The Indian tax regime has undergone significant changes in the recent years, which on one hand has aimed at restricting aggressive tax planning strategies and preventing abuse of tax laws with the introduction of buy back tax, deemed income-tax provisions under section 56, equalisation levy, modification of residency rules etc. and on the other hand has enabled business growth by reduction in the corporate tax rates and by exempting conversion of convertible securities into equity, exempting conversion of companies into Limited Liability Partnership (LLPs), etc.

However, certain further clarifications in the Tax laws are imperative. For instance, an outbound merger (i.e. merger of an Indian company into a foreign company) is currently not treated at par with inbound and domestic mergers under the Indian Income tax provisions.

The Ministry of Corporate Affairs (MCA) notified the relevant provisions of the Companies Act, permitting the outbound merger of an Indian company with a foreign company in 2017. Similarly, the Reserve Bank of India (RBI) also issued the Cross-Border Merger Regulations in 2018, permitting the outbound mergers and according deemed RBI approval for such mergers subject to certain prescribed conditions.

While the aforesaid regulatory reforms and amendments were certainly aimed at providing greater flexibility to cross border business reorganisations, outbound mergers are still an unattractive proposition from an Indian tax perspective.

Unlike domestic or inbound mergers, there is no specific tax exemption for the Company and its shareholders from capital gains tax for outbound mergers. Accordingly, such a treatment is likely to result in  two-fold tax implications in India. One, since the Indian company would cease to exist pursuant to merger with the foreign company, the Indian tax authorities would seek to tax capital gains in the hands of the successor entity i.e. the Foreign company with respect to transfer of the capital assets of the Indian Company to the Foreign Company. Secondly, consideration received by the shareholders of the Indian company pursuant to the outbound merger would also be subjected to capital gains tax in India. 

In addition to the above, as a result of acquisition of ownership and control of fixed assets or business operations in India pursuant to merger, the Foreign entity is also likely to face permanent establishment issues in India. Income from such permanent establishment shall be subject to tax in the hands of the foreign company at the rate of 40% plus applicable surcharge and cess.

Another issue which is likely to be faced by the Foreign company post- merger is the historical tax liabilities, if any, of the Indian company. Enforcement of tax claims against the successor foreign company would be a challenging task for the Indian tax authorities and hence, they would always have their reservations against any outbound merger application filed before the National Company Law Tribunal (NCLT).

Considering Indian business are increasingly going global, it is imperative that appropriate tax amendments and clarifications are introduced in relation to outbound merger which would facilitate ease of doing business for the Indian companies investing abroad and also restructuring of their overseas operations.

Similarly, there is lack of clarity in the tax laws on certain aspects of domestic restructuring transactions, such as tax implications on corporate reorganizations involving an LLP.

LLP was introduced in India in 2008 as an entity form which provides the benefits of a company viz. limited liability and separate legal identity and simultaneously retaining the flexibility of a partnership i.e. management and control.

Small entrepreneurs generally prefer LLP as it is easy to start with a minimum capital, customized agreements and lesser compliances. However, as the business grows, the requirement of capital arises for growth and expansion and there may be an emergent need for conversion of LLP into a company form for raising capital through equity funds.

Currently, both the Companies Act, 2013 and the LLP Act, 2008 have enabling provisions for conversion of a Company into LLP. The Income tax  laws  also  provides  for  a  tax  neutral  conversion  of  an  Indian company into an LLP subject to certain prescribed conditions.

However, there is no similar enabling provision under the LLP Act which enables conversion of an LLP into a Company. The MCA, however, addressed this anomaly in 2016 through a notification and allowed conversion of LLP into a Company under the Corporate law provisions. The Income tax laws also provides exemption from the capital gains implications on conversion of a firm (LLP) into a company subject to certain prescribed conditions, however similar exemption has not been provided to the partners of the firm on swap of partnership interest with the shares of a company.

Further, while the LLP Act permits merger of two or more LLPs through the NCLT approval process, there is no specific provision for tax neutrality of such mergers under the Income tax Act, 1961.

The current tax regime has specific provisions providing for the tax neutrality of amalgamation and demerger of companies subject to fulfilment of specified conditions. However, there is no similar exemption provision for merger of LLPs. Accordingly, there is no clarity on tax implications in the hands of the Transferor and the Transferee LLP and their partners respectively. Introduction of similar provisions for LLPs is required in order to give LLPs a level playing field along with companies. It is anticipated that this gap will be bridged through introduction of enabling provisions for tax neutral conversion of existing firms into LLP, tax neutral merger of two or more LLPs and carry forward of losses in case of amalgamation of LLPs.

Another consideration is the merger of an LLP into a Company. Provisions of the erstwhile Companies Act, 1956, permitted merger of 'body corporate' into a Company. However, the Companies Act, 2013, does not contain any specific provision permitting merger of any other body corporate like LLP etc. into a Company.

It is however, interesting to note that the provisions of Companies Act, 2013 governing cross border mergers define a 'foreign company' as inclusive of a body corporate incorporated outside India, which may include a foreign LLP. Considering the intention of the legislature is to permit merger of a foreign LLP into an Indian Company, it would not be correct to believe that the Act prohibits amalgamation of an Indian LLP with  an  Indian  Company.  Recently,  the  Chennai  NCLT  has  also approved the amalgamation of an LLP into a Company on similar grounds. Nevertheless, in absence of a specific provision, the tax implications cannot be evaluated with clarity.

In a nutshell, the Indian corporate law as well as tax regime consist of comprehensive set of provisions for mergers and acquisition, however the same require further clarity with respect to certain aspects of corporate restructuring transactions.

In view of the ever-increasing significance of the Indian economy on the global platform, there is a dire need for the Indian corporate law and tax regime to offer requisite flexibility and clarity in relation to corporate reorganizations thereby, providing impetus to global investments in India. While there are many more such clarifications expected from the Budget, one would hope that some of the aspects discussed above find a mention in fine print of 'Budget 2021'.

This article was originally published on Taxmann.