‘The Interconnect’ : Business Combinations - A Tryst with Taxation
Ketan Dalal (Managing Partner, Katalyst Advisors LLP)
It has been said that change is the only constant – and with changes comes the paradigm shift in how we perceive the same things. In this context, a transaction would definitely be perceived differently owing to the new accounting standards i.e. Indian Accounting Standards (“Ind-AS”) kicking in, inter alia, for all listed companies from FY17-18. As in any other situation (such as taxation matters), Ind-AS also focuses on the substance of the transaction rather than merely the form or nomenclature of the transaction.
One of the key impact areas is “Business Combinations” which are dealt with under Ind-AS 103. Conceptually, Ind-AS 103 not only deals with amalgamations (which were dealt with under the erstwhile Accounting Standard-14) but also all such transactions which result in acquisition of control over a business or an entity (by way of demergers, slump sale, share purchase, capital reduction, buy-back etc.). The fallouts of ushering in of Ind-AS 103 are inextricably intertwined with income-tax and this article attempts to examine some typical facets which would be impacted by Ind-AS 103.
1. Third-party Demergers
One of the basic tenets of Ind-AS 103 is “acquisition accounting” in case of an acquisition of business or entity from an unrelated seller (who is not ultimately controlled by the same persons controlling the acquirer) (“Third-party Acquisitions”). This method of accounting is basically a fair value accounting in case of a Third-party Acquisition which is effected either by way of whether by way of a merger or demerger.
Therefore, in case of a demerger between two unrelated or third-parties, the acquirer would record the assets/ liabilities at their respective “fair values” in its books. In contrast, the Act provides that in order for a demerger to be tax-neutral, the assets and liabilities pursuant to a demerger have to be transferred at their respective “book values”.
Therefore, whether this disparate treatment under Ind-AS 103 and the Act could lead to adverse tax consequences? Essentially, a “demerger” under the Act is looked at from the perspective of the transferor or the demerged company i.e. in order for a demerger to be tax-neutral, the “transfer” of assets and liabilities of the demerged company have to be at their respective “book values”. On the other hand, Ind-AS 103 proposes accounting in the books of the “acquirer” i.e. the resulting company wherein it prescribes fair value accounting.
As a consequence, it seems that there is no embargo in the Act on the manner of recording assets/ liabilities in the books of the Acquirer; hence, it should not affect the tax neutrality in the hands of the demerged company (or its shareholders) u/s 2(19AA) read with section 47 of the Act. Incidentally, the rationale of recording the assets so transferred at book value itself seems to have not rationale, since the resulting company would anyway be eligible to claim depreciation only on the written down value of the block of assets in the hands of the demerged company. However, given the importance of the issue, the CBDT should expressly clarify the same.
2. Depreciation on Goodwill
Under Ind-AS 103, in case of Third-party Acquisitions, the Acquirer has to record “goodwill” in its books on the difference between the consideration paid (either in the form of cash, shares or liabilities assumed) and the fair value of the assets/liabilities. Further, under Ind-AS 103, goodwill is merely a residual figure and not an intangible asset; therefore, goodwill, per se, is not subject to amortization in the books of the Acquirer (as was previously possible under the erstwhile IGAAP).
Therefore, for example, in case of acquisition of business by way of a slump sale, it may so happen that after the purchase price allocation i.e. after allocating the consideration in accordance with the fair values of the assets and liabilities, the residual amount would be recorded as goodwill. Such goodwill would not be amortised in the books; however, depreciation on such goodwill should, nonetheless, be permissible as deduction u/s 32 of the Act, owing to the fact that the acquirer has actually paid consideration to acquire such goodwill and especially, in light of the Supreme Court decision in the case of CIT v. Smifs Securities Limited wherein it was held by the Supreme Court that goodwill is eligible for depreciation u/s 32 of the Act.
3. Reverse Acquisitions
The thrust of Ind-AS 103 is acquisition of control by the acquirer. Usually, the acquirer is the entity which discharges consideration in the form of cash or assumption of liability, subject to certain conditions. The nebulous area is where the acquirer discharges the consideration in the form of equity. Therefore, there could be a case where the actual acquirer is different from the legal acquirer i.e. the entity issuing its equity.
For example, Company A with substantial business merges with Company B, a relatively smaller company; as consideration for which Company B issues its own equity shares to the shareholders of Company A. Post-merger, the shareholders of Company A have greater voting rights and control over the management decisions as compared to the shareholders of Company B. Therefore, effectively, it is the shareholders of Company A who have acquirer control over the merged entity and not the other way, although, legally, Company B is the legal acquirer.
Such transactions are termed as “reverse acquisitions” where the legal acquirer is, in substance, the acquiree or the transferor entity whereas the legal acquiree is the actual acquirer or the transferee entity. As discussed earlier, under Ind-AS 103, the assets and liabilities of the actual acquiree (i.e. legal acquirer in case of reverse acquisitions) are to be recorded at their respective fair values.
Consider a case where the holding company first acquires the shares of an operating company and later the holding company merges with the operating company itself; as consideration for which the operating company would issue its equity to the shareholders of the holding company. In this case, the operating company is, legally, the acquirer; however, in substance, the holding company is the acquire. Therefore, upon merger, the assets and liabilities of the operating company, being the actual acquiree would have to be recorded at fair values. This would, more often than not, include recognition of certain intangible assets at fair values. The question would then be whether depreciation on such intangibles would be allowable as deduction u/s 32 of the Act. The dichotomy between the Act, where the law would still recognize the operating company as the acquirer, and Ind-AS 103, which recognizes the operating company as the acquiree is prominently surfaced here. In substance, now, where the Act itself recognizes the concept of substance over form (by introduction of GAAR), the Revenue Authorities should pay heed and recognize this dichotomy.
4. Contingent Consideration
Lately, in order to mitigate acquisition risk, acquirers have begun to incorporate various “earnout clauses” which, basically, determine the final consideration payable on the basis of certain contingent events (such as level of revenues, EBITDA, net-profits, etc.) and the liability to discharge such consideration is deferred to a future date when such contingent event when such milestones are met.
Under Ind-AS 103, such contingent consideration (including the initial upfront consideration) is accounted upfront in the books of the acquirer at fair value on the basis of the assumptions either as equity or a liability (depending on the nature of consideration to be discharged in future). If such contingent consideration is accounting for as a liability, any changes in the fair value of such liability at the time of discharge would be charged off to or be recorded as income in the statement of profit or loss, depending on the ultimate quantum of the liability; whereas, fair value changes for contingent consideration recorded as equity is directly adjusted in equity.
Taxability of contingent consideration has always been a bone of contention between the taxpayer and the Revenue Authorities, wherein the latter has always sought to tax the same upfront in the year of transfer of capital asset although the final consideration is contingent upon certain event.
However, now, with the fair value adjustment in the P&L account for contingent consideration recorded as liability, whether this could lead to taxability could be a matter of concern. While computing income under normal provisions, if the excess liability recorded earlier is written back (by way of fair value adjustment), this should not lead to taxability u/s 41(1) of the Act since this would not be a liability for which any “deduction in respect of loss or expenditure” would have been claimed while computing business income. Further, notwithstanding that a write-back of liability would lead to increase in book profits, such write back should not lead to taxation u/s 115JB of the Act since the original amount recorded as liability was as such not chargeable to tax. This view (albeit in a different context) has recently been confirmed by the Mumbai ITAT in the case of JSW Steel Limited.
5. Business Acquisition versus Asset Acquisition
Ind-AS 103 is only applicable in case where there is an acquisition of a business or an entity engaged in a business. Therefore, in absence of there being an acquisition of “business”, as defined in Ind-AS 103, such an acquisition would be classified as an “asset” acquisition. Business, under Ind-AS 103, consists of inputs and processes that have the ability to create outputs. Therefore, where a group of assets are being acquired which lack certain inputs or processes (which put together are capable of generating output), such an acquisition would not be classified as a business combination. Further, Ind-AS 103 details various parameters of what could constitute a business keeping in mind various inputs and processes.
Drawing a parallel, Explanation 1 to section 2(19AA) of the Income-tax Act, 1961 (“Act”) explains the concept of undertaking to mean that individual assets/ liabilities, not constituting a business activity, would not be classified as an “undertaking”. However, what constitutes a business activity is not further explained under the Act.
Therefore, if, in certain cases, a group of assets fail to satisfy the definition of “business” under Ind-AS 103, that could be taken as a basis by the Assessing Officer (“AO”) to deny the benefit of tax neutrality in case of a demerger. For example, an established real estate company (“Acquirer”) seeks to acquire certain land parcels from another company (“Transferor”) by way of a tax-neutral demerger. The Transferor is also a company engaged in the business of developing real estate and therefore, certain preliminary work has been undertaken by the Transferor on the land parcels; however, such group of land parcels do not meet the definition of a business under Ind-AS 103 and is accounted for as “asset” acquisition in the books of the Acquirer, although the same may be approved by the National Company Law Tribunal as an “undertaking” u/s 2(19AA) of the Act.
Owing to such divergences in the definition of “business” under Ind-AS 103 and “undertaking” under section 2(19AA) of the Act, the AO may deny the benefit of tax neutrality in the hands of the Transferor Company. Therefore, one would have to be cognizant of the definition of “business” under Ind-AS 103 to mitigate tax-risks arising on a demerger which is otherwise tax neutral.
Ind-AS 103 – Wearing different-colored lenses!
As can be deduced from the above discussion, under Ind-AS 103, a transaction could very well be looked at differently than what has been the situation till now; therefore, the consequences of such different treatment could create issues, and cause unintended consequences – both from an accounting perspective as well as income-tax perspective. Therefore, before undertaking any transaction, one needs to be extremely wary of the fallouts, since the traditional concepts of business reorganization are now fundamentally challenged under Ind-AS 103. Of course, a timely resolution by the Revenue Authorities streamlining the cracks and crevices between Ind-AS 103 and the Act would be a welcome move.
* This article has been co-authered by Binoy Parikh.