What the FM has to Offer for M&A in Finance Bill 2010

M&A deals may see hidden tax agenda which may delay deal closure.

The year 2010 began with feverish activity on the M&A front with several domestic companies announcing deals. However, the Finance Bill 2010 has propositions that might adversely impact the M&A activity, the two key amendments are discussed as under:

Conversion to LLP: Restricted benefit?

Income Tax Act (“IT Act”) was amended to extend the definition of a ‘firm’ to include a Limited Liability Partnership (“LLP”). Thereafter, the LLP was eyed as a lucrative tax structuring option in view of the exemption from capital gains on conversion of firm into a company. However, the tax implications upon conversion of a company into an LLP were not specified.

Exemption was granted under Section 47(xiii), introduced w.e.f assessment year 1999-2000, where-under transfer of any asset (capital or intangible) by a firm to a company, shall not be regarded as a transfer and therefore not liable to tax, subject to the fulfillment of following conditions:
• all the assets and liabilities are transferred and all the partners become the shareholders;
• the partners do not receive any consideration other than by way of allotment of shares in the company; and
• the aggregate of shareholding of the erstwhile partners, in the new company, is not less than 50% of the total voting power in the company for a period of five years from such succession.

Finance Bill, 2010 has introduced a new Section 47(xiiib) w.e.f. April 1, 2011, vide which transfer of assets on conversion of an existing private / an unlisted public company into an LLP, shall not be regarded as transfer for the purpose of capital gains, upon satisfaction of prescribed conditions. The basic conditions prescribed in relation to conversion under erstwhile Section 47(xiii) have been retained. However, the two additional conditions that have been introduced are:
(i) Total sales, turnover or gross receipts in business of the company should not exceed INR 6,000,000 in any of the three preceding years; and
(ii) No amount is paid either directly or indirectly to any partner from the accumulated profit of the company for a period of 3 years from the date of conversion.

Effectively, the aforesaid conditions make the tax benefit available only to small companies in business, not profession, (having a turnover of less than Rs. 6 million), while keeping the big companies keen on such conversion at bay. Non-availability of the accumulated profits to the partners of the successor LLP for a period of three years seems too stringent a condition to encourage conversion of small companies into LLPs.

Further, while the LLP Act, 2008 envisages both merger and /or spin-off of division(s) of LLPs, the Finance Bill 2010 remains silent on tax implications thereon. Also, there is no clarity as regards the tax liability of a shareholder upon acquiring an interest in the LLP. It would also be important to examine the tax implications where the conditions are not fulfilled.

Taxation of Notional Income

The Finance Bill, 2010 has, by way of amendment to Section 56 of the IT Act, sought to levy tax on notional gain on receipt of shares by firms and closely held companies as under:

Taxable Event
Tax to be levied on
Shares received without consideration, (FMV exceeds INR 50,000)
Aggregate FMV of the shares
Shares received for consideration lower than the aggregate FMV in excess of INR 50,000,
FMV less Consideration paid for such shares

Though the valuation method in relation to such share transfers will be notified, yet the amendment is likely to have far-reaching implications. While the global as well as domestic amalgamation and demerger scenarios are specifically exempted from the application of these provisions, following unintended transactions may fall within the folds of the said amendment:
- Transfer of shares amongst two non-residents (which are not subject to any pricing restrictions under FEMA);
- Transfer of shares pursuant to family settlement;
- Transfer of shares amongst the holding and subsidiary company;
- Put or call option exercised based on agreed valuation methods in terms of an existing Shareholders Agreement;
- Global takeover which may have the effect of transferring shares of the Indian company
- Transfer of shares where the Indian promoter may default on the payment schedule of loans or some other transaction parameters like profitability, exit to investors, etc; and
- Distressed sale of shares.

Commercial transactions like above are likely to be adversely impacted by the said amendment. Accordingly, the transfer price is now required to be the FMV of the shares in line with the valuation guidelines that are yet to be notified. Further, since this is a taxation of income on notional basis as against an actual source of income, it would also be important to examine the taxability such income in the hands of non-resident under a tax treaty scenario.

In view of the above issues, M&A deals may see hidden tax agenda which may delay deal closure. It is therefore likely to slow down the otherwise fast-pacing M&A sector

PRANAY BHATIA & ANURADHA MOHANTY, ECONOMIC LAWS PRACTISE