‘The Interconnect’: Cross Border Mergers – The Inbound Stitch

Over the last decade, Indian companies have set up or acquired companies overseas, largely to access the overseas potential customer base, capitalise on favourable market conditions, leverage the liberal regulatory climate and of course, gain significant synergies. Domestic companies primarily engaged in the Information Technology, Pharmaceuticals, Automobile and Oil and Gas sector have been more active in achieving their international footprint gradually. Notable acquisitions by Indian companies in the last decade are Tata Steel - Corus, Hindalco - Novelis, Lupin – Gavin and Tata Motors - Jaguar Land Rover. 

Indian companies have used a combination of organic and inorganic growth structures abroad. Some overseas structures are plain vanilla in nature, while others are two-tiered or a complex multi-layered structure; (of course, in the context of an acquisition one would simply inherit a structure which may or may not be ideal from the acquiror’s point of view). Further, some Indian companies have also chosen to set up an offshore foreign-domiciled Holding Company which inter-alia facilitate tax beneficial intermediary entities in a foreign jurisdiction and access relatively cheap funding options available.

Regulatory framework for Cross Border Merger (For this, please refer to Annexure)

Considering the complexity of issues under the cross-border merger framework, this article primarily focusses to examine key issues arising on account of Inbound Merger i.e. a cross border merger where the resultant company is an Indian Company. The issues arising on account of Outbound merger will follow as Part II in a separate article.

Offshore structures of Indian companies:

Typically, existing outbound structures of an Indian Company could be organic (i.e. undertaken either by way of greenfield investments such as JV / WOS) or inorganic (i.e. by way of previous acquisitions. The Indian company may want to revisit the same on account of the commercial reasons or tax and regulatory developments in the recent past. Some key issues pertain to such intended restructuring are dealt under Section I of this article. As opposed to this situation, foreign third-party acquisitions by an Indian company will have its own unique challenges in terms of commercial or regulatory issues which are separately dealt under Section II of this article.

Tax and regulatory developments:

As mentioned above, an Indian company may have set up or inherited a structure that may need a relook. This may be for a variety of reasons such as commercial, tax or regulatory driven, often a combination of factors. This may be even more so for a Holding company structure. Some of the circumstances needing such a relook are as under:

• Place of Effective Management (“POEM”) – From a tax perspective, if a foreign company has a place of effective management in India, it is considered to be a resident and will be taxed @ 40% on its global income. While the CBDT[2] has carved out companies having active business outside India (subject to conditionalities), however, the overseas Indian Holding Companies or subsidiaries mainly deriving passive incomes (i.e. passive companies) may be exposed to the domestic tax net due to POEM.

• Round tripping - From a regulatory perspective, under FEMA, certain structures, either intentionally or unintentionally, may result in direct / indirect FDI through the overseas entities established under Outbound Regulations which may pose challenges under RBI’s view of round tripping of funds. 

• Restriction on the number of subsidiaries - To add another dimension, MCA vide its notification[3] has restricted Indian companies (other than exempted companies) to have more than two layers of subsidiaries. While the grandfathering provisions are available to the existing group structures, an Indian company may want to review the same in order to space out the multiple layers within its group.

Accordingly, an Indian company may choose to revaluate its existing group structures to mitigate the aforesaid exposures.

Section I: Issues surrounding Inbound Merger of existing group companies:

Typically, WOS / JV of an Indian company could be an operating entity engaged in business of trading, service or manufacturing sector or a Holding Companies which may not have significant operations but would derive passive income. While section 47(vi) of the Income tax Act, 1961 (“the Act”) treats inbound mergers as tax-neutral (subject to conditions), the key issues related to inbound merger are outlined as under:

1. Merger of a foreign domiciled Holding Company:

• Loans obtained prior to merger – As mentioned in point (c) of the Regulations, RBI has permitted an Indian company to take over the guarantees and outstanding borrowings of the Foreign company which should conform to the ECB norms within the transition period. In such a case, if the Holding Company has obtained loans from a local vendor / non-recognised financial body not falling within the definition of “Recognised Lender” (as per the extant ECB guidelines) or alternatively, the Indian company does not fall within the definition of “Recognised Borrower”, prima facie such borrowings may be permissible to be grandfathered in the hands of the Indian entity; however, the same has to be repaid within the transition period of two years out of the foreign exchange earnings.

Secondly, if the “Eligible Borrower” and “Recognised Lender” conditions are satisfied, but, the minimum maturity period or the end use criteria are not in alignment with the ECB guidelines, in such a scenario, the Indian party may have to renegotiate the maturity period prior to merger or repay the ECB within two years.

• Migration of foreign accumulated losses – Section 72A of the IT Act provides for carry forward and set off of accumulated loss in certain cases of amalgamation for companies which fall within the ambit of \'Industrial undertaking\'. Currently, there is no mechanism under the IT Act to subsume the foreign tax losses (computed outside the purview of Income tax laws) post-merger with the resulting Indian company. In such circumstances, it may not be possible for the Indian company to prima facie migrate such accumulated business losses into the Holding Companies and carry forward the same in the tax computation.

Another issue related to tax liability under Minimum Alternate Tax (“MAT”) provisions; the Indian company will have to incorporate the profit and loss account of the foreign amalgamating company into itself to determine the tax liability under MAT provisions.

2. Merger of operating overseas WOS / JV:

While the aforesaid issues pertaining to treatment of foreign liabilities and foreign accumulated losses would be even more relevant in the merger of an operational WOS / JVs, the additional key considerations in such scenarios may be entailed as under:

• Merger of overseas Manufacturing entities – As mentioned in point (b) of the Regulations, on amalgamation, the “office” of the foreign company outside India shall be deemed to be the branch / office of the Indian Company. Accordingly, if an overseas manufacturing company having factories / warehouses is proposed to be merged with an Indian company, such factories / warehouses would deem to become its branch or office outside India. Assuming that post-merger, the manufacturing activities are intended to continue, this will lead to establishing a place of business outside India which could have Permanent Establishment implications in the foreign country. Further, such branch may have ongoing commercial liabilities, employee’s contracts, vendor and customer contracts etc. which would continue to prevail post amalgamation. Merging a manufacturing entity into an Indian Holding Company would directly expose the Indian Holding Company to such a commercial reality. Given these consequences, it is unlikely that Indian companies will choose to amalgamate its WOS / JV engaged in manufacturing activities with its Indian Holding Company.
• Merger of Trading and Service sector entities - The Indian company may propose to either cease the operations of the WOS/JV and then merge or continue the same even post-merger. While in the former case, if the Indian company intends to cease its operations completely, the overseas JV / WOS may first shut its existing operations, turn into a non-operating company and then merge into the Indian entity. However, in the latter case, if the trading and service operations are intended to be continued even post-merger, the following issues may arise:
• Transfer of foreign employees to Indian company - The foreign employees of the WOS/ JV will also shift on to the payrolls of the amalgamating Indian company and accordingly, the salary pay-outs, allowances, provident fund contributions and social security aspects will have to be dealt with appropriately. Since the business operations are to be continued post-merger, the employees and the overseas branch will form a place of business outside Indian and will constitute a Permanent Establishment. Further, in case the foreign employees have participated in Employees stock option scheme (“ESOPs”) of the Indian Holding Company (which is likely to be in a case where Indian Holding company is listed), they will continue to hold the same post-merger.
• Determination of ODI threshold step down subsidiaries - While evaluating the inbound merger, in case the JVs / WOS have downstream investments in SDS, the Indian company is required to revaluate the prescribed threshold of 400% of the net worth, as such entities will become the direct subsidiary of the Indian Company. However, the Outbound regulations do not mention whether the thresholds are required to determined basis the net worth appearing in the pre or post-merger balance sheet of the Indian company. One may assume that the threshold criteria will be grandfathered for the SDS becoming WOS of the Indian company post-merger; however, for fresh investments, the prescribed threshold would apply.
• Discharge of consideration to JV partner under share swap - In a scenario where the overseas JV merges with the Indian company, the JV partner would receive shares of the Indian company on account of such merger. To that extent this would be regarded as a share swap transaction under the FDI regulations and would fall under the automatic route, subject to conditions. This may be more likely in the case of overseas JV engaged in the service sector vis-à-vis trading sector (e.g. Software companies may have overseas JVs which may collapse with the Indian company).

Section II: Issues surrounding Foreign acquisitions under cross-border merger:

In the context of an acquisition, an Indian company may propose to acquire a foreign unrelated company which may be engaged in trading, service or manufacturing business. The key challenge in this regard, would be in discharging the considerations to the foreign shareholders. As the unrelated foreign companies are not a direct WOS of the Indian company, it may first acquire the shares of the unrelated foreign company and thereafter proceed to merge the overseas business.

Incidentally, the Cross-Border regulations provide for discharge of consideration by the resultant Indian Company, to a person resident outside India on deemed approval basis. However, in case where the shareholding structure of the foreign company consists of combination of Indian and foreign shareholders, for example, an overseas company (XYZ Inc) has ABC (UK) and PQR (Indian) as its existing shareholders and proposes to merge with another Indian Company (ICo), in such a case, ICo will have to issue its shares to ABC and PQR in the same proportion. In this regard, it seems that the ICo will have to obtain a prior RBI approval for issue of its shares to PQR (Indian shareholders), considering issue of shares to a person resident in India is not expressly covered within the Inbound merger regulations.

There may also be instances wherein the parties may agree that the consideration to be paid to the foreign promoters / shareholders of the overseas amalgamating company would be in the form of shares of the Indian company, as opposed to a cash consideration. Resultantly, the foreign promoters / shareholders will hold stake in the Indian company by way of a share swap transaction. The FDI regulations under Schedule I Para 1(4) has permitted an Indian company to issue capital instruments to a person resident outside India, if it is engaged in an automatic route sector and subject to valuation[4] criteria mentioned therein. Such transactions may be akin to an inbound merger, but generally, they may not classically fall within the inbound merger regime. Since this article focusses primarily on the inbound mergers, we have not dealt with the issues surrounding such transactions in detail.

Other issues

Listed Indian companies and Companies having net worth of INR 250 crores or more will also have to follow the Accounting treatment under Indian Accounting Standard[5] (Ind AS) 103 if undertaking a Business Combinations as defined. Accordingly, a large proportion of the Indian corporates, and certainly Indian entities proposing to undertake foreign third-party acquisitions, are more likely to fall within the scope of IND AS compliances. In such a situation, whether such companies have a historical structure or are proposing to enter into a third-party acquisition, review of Accounting treatment under IND AS 103 will be important. Issues pertaining to same have been broadly discussed in a previous article - ‘The Interconnect’: Business Combinations - A Tryst with Taxation. To access the same, Click here.

Concluding Remarks:

As would be seen from the above, before undertaking an Inbound merger, the Indian companies may have to analyse a host of issues arising not only under FEMA, but also under the Income tax laws and IND AS. One may have to further wait for RBI and CBDT to issue FAQs or clarificatory notifications to address the issues in this regard. However, the introduction of the cross-border merger Regulations is an important stepping stone in the regulatory journey, enabling Indian companies to review the possibility of an Inbound merger in a structured framework.

The above article is from the Inbound merger perspective. The framework and the issues specifically pertaining to the Outbound merger will be dealt under Part II separately.

This article has been co-authored by Ms. Neha Lal.

[1] Introduced vide Union Budget 2015

[2] CBDT Circular No. 06 of 2017 dated 24 January 2017

[3] vide notification dated 20 September 2017 in Companies (Restriction on number of layers) Rules, 2017

[4] As per FEMA 20(R) - In case of swap of capital instruments, subject to the condition that irrespective of the amount, valuation involved in the swap arrangement will have to be made by a Merchant Banker registered with Securities and Exchange Board of India or an Investment Banker outside India registered with the appropriate regulatory authority in the host country.

[5] Under Phase III, IND AS is also applicable to Companies which are in process of Listing in India or outside India with a Net Worth of Rs. 250 Crores or more and Holding, Subsidiary, Joint Venture or Associate Companies of such Companies having net worth of INR 250 crores.