New tax code should iron out M&A issues

The Task Force (re)constituted to construct the new income tax code has an overwhelming job at hand, as it is expected to submit the report to the government by February 28.

One would anticipate the task force to focus on three key objectives: a) overwrite the labyrinthine flow of the extant legislation (1961 Act) to give the new law a more appealing, yet robust architecture; b) shun the incremental approach to legislating that has been the bane of tax laws in the recent two decades; and c) embrace, to the extent possible, the wisdom emanating from jurisprudence to develop a law that is much less litigious.

Besides, the endeavour must be to make the new legislation work effectively in tandem with realities of the new age businesses, and the emerging tax policy order globally.

Among key areas, the new tax code holds the promise of setting right several imperfections, particularly from the standpoint of tax provisions for mergers and acquisition transactions. Presently, chapter IV of the 1961 Act is fraught with ‘missing links’, thus being prone to controversial determinations on many occasions. Let us look at a few illustrations.

Chapter IV (re Section 47) lends tax neutrality to merger/demerger transactions in select instances of domestic and foreign business combinations. However, the condition as to continuity of minimum shareholding is near impossible to fulfil in the case of subsidiary merging into its parent shareholder.

Technical glitch

Whilst a similar anomaly impeding tax neutrality in mergers of two Indian companies has now been set right through Finance Act 2013, a literal interpretation continues to come in the way of carrying out tax-neutral mergers between foreign companies (having underlying shares in Indian companies). One would like to believe this technical glitch could be set right rather easily, for the underlying condition is impossible to perform.

Another example is that whilst the merger of two Indian companies can be achieved in a tax neutral way, not only with respect to merging entities but also with respect to shareholders thereof, such dispensation is not currently available in case of merger between two foreign entities. There will be a need to have a relook at this ‘missing link’ to bring tax parity between domestic and foreign mergers.

From an ‘indirect transfer’ tax legislation standpoint, certain provisions in the law still require rationalisation in the context of foreign mergers/reorganisations. Presently, tax neutrality in the case of foreign merger/demerger is limited to cases where such merger results in transfer of Indian asset being ‘shares’ of underlying Indian companies. With evolving forms of businesses, it is imperative to consider extending tax neutrality to cases where the underlying Indian assets are not ‘shares’, but interests in partnerships/LLPs, intangibles, or any other relevant forms of assets, such as branch offices.

There are other areas to ponder over. On the principle of carry forward of tax losses in case of change in beneficial shareholding, the present law (Section 79) frequently finds itself prone to interpretation hazards; partly because the concept of beneficial ownership is not adequately defined in law.

Recent jurisprudence has favoured non-applicability of Section 79 (meaning, losses not to be disregarded) in case of intra-group shareholding change not resulting into change of ultimate beneficial ownership, say between parent and subsidiary or amongst fellow subsidiaries, as such change ought not to be seen as change in beneficial shareholding.

It will help if the task force re-looked at the remit of Section 79 and if found wanting, re-write this piece of law to limit the tax loss carry forward only in cases of abusive transactions. This single changeover could significantly reduce the frequency of tax litigations in M&A transactions.

Taxability of earn-outs and tax depreciation on goodwill in business acquisitions are other distractions in most M&A deals. The absence of an unequivocal law on this aspect has caused protracted debates and often led to frivolous tax demands. The draft legislation could provide clarity on some of these nuanced tax issues, which will certainly promote the objective of achieving a simplified M&A tax regime.

With LLPs increasingly finding acceptance amongst investors, conversion into LLP should be allowed seamlessly even from tax implications standpoint.

There is no gainsaying that the proposal to redraft the tax law presents huge opportunity to relinquish an ageing legislation and usher in contemporary ideas to cater to innovative and futuristic business models.

The writer is Partner, Deloitte India.

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