Will CFC regime pose threat to M&A deals?

The recent merger and acquisition (M&A) tracking report by Dealogic, estimated that the global M&A deal volume reached $1.5 trillion in the first half of 2011 itself, registering a 22 per cent increase from last year levels. Global M&A deals were mainly targeted at America followed by Europe, West Asia and Africa and the Asia Pacific region, including India and China. According to the report, India has the second highest cross region inbound M&A volume in Asia Pacific with $ 22.3 billion in the period under review, up a whopping 144 per cent from last year. The global M&A climate is expected to remain positive for the rest of the year as well. Companies are looking to expand in new geographies and acquisition route could be the preferred route for a majority of companies.

TAX IMPLICATIONS

In any M&A deal, the tax implications and their effect play a key role in considering the viability of the deal. It may very well be said that while tax never makes a deal but it can often break one. While structuring a M&A deal, especially where intermediary jurisdictions for commercial and tax consideration are involved, presence of Controlled Foreign Company (CFC) regime in the home country assumes importance and it is worthwhile to examine its impact on the tax outflow.

Given the recent initiatives of the G-20 nations against the use of tax havens and the quantum of outbound investments witnessed in the past, it is not surprising that India has sought to introduce CFC regime as part of its tax system at this juncture, by including it in the proposed Direct Taxes Code.

It is interesting to note that whereas the revised discussion paper on the Code mentions about introduction of safe harbour rules in relation to General Anti Avoidance Rules and for determination of arm length price; it is silent on the safeguards in respect of implementation of CFC provisions.

Safe Harbour Rules

The safe harbour provisions are intended to mitigate undue hardship and avoidance of compliance burden on tax payers, by providing certain threshold. Most countries provide one or more of the following safe harbours in respect of CFC regulations:

(i) Exemption for CFC that distributes certain percentage of income in a year

(ii) Exemption for CFC engaged in genuine business activities

(iii) Exemption for CFC which is not established for the purpose of avoiding domestic tax –”motive test”

(iv) Exemption for CFC whose shares are listed on recognised stock exchanges

(v) A de-minimis exemption where the total income of the CFC does not exceed a particular threshold amount

Interestingly, the UK allows exemptions in all situations listed above, whereas the US provides for exemption only in respect of situation (iii) and (iv).

For determination of the foreign subsidiary or affiliate of the Indian parent company, which may fall within the ambit of CFC rules, the definition of the term “territory with a lower rate of taxation” has been defined to mean a country or a territory outside India in which the amount of tax paid under the law of that country or territory in respect of profits of a company that accrue in any accounting period, is less than one half of the corresponding tax payable on those profits computed under this Code, as if the said company was a domestic company.

Similarly, the Code provides the parameters for the company which shall be deemed to be engaged in active trade or business.

A company which shall be deemed to be engaged in active trade or business if and only if- (i) it actively participates in industrial, commercial or financial undertakings through employees or other personnel in the economic life of the territory of which it is resident for tax purposes; and (ii) less than 50 per cent of income of the company during the accounting period is of the specified nature, for instance, dividend, interest, capital gains, etc.

The CFC provisions are meant to curb the practice of investors to establish intermediary and park income there.

Introduction of CFC rules would be a step towards prevention of potential tax avoidance or deferment. While, it would increase tax collection, certain sections of the tax payers may feel that undue tax costs and compliance requirements have been thrust upon them. Applicability of these rules to cross border M&As may cause concerns to the international lender and investors.

The international lenders and investors need to watch out if along with the CFC rules, related anti-avoidance measures such as thin capitalisation and group fiscal consolidation rules are also introduced.

While, no doubt the CFC regime will act as an impediment in M&A deals, for it reduces the room for flexibility in structuring the transactions, it is also an opportunity for Indian entrepreneurs to stretch the boundaries of human ingenuity and come up with innovative ideas to turn CFC provisions to their advantage in deal negotiations. It, therefore, remains to be seen if the government's intention of curbing the existence of “dividend-trap” or “money-box” companies would achieve its stated purpose.

(The author is Principal Associate, Vaish Associates, Advocates)

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