The Interconnect

Schemes of Arrangement – Possibilities Galore!

Ketan Dalal (Managing Partner, Katalyst Advisors LLP)
Dec 6, 2017

The term “Arrangement” used in the context of a Scheme of Arrangement (“Scheme”) has an extensively wide import and can be explored to achieve various commercial objectives could principally be in the form of external arrangement or an internal arrangement. Any Scheme seeking to achieve such commercial objectives would have wider ramifications from a tax and regulatory perspective in the backdrop of evolving tax and regulatory landscape vis-à-vis different arrangements. A Scheme undertaken u/s 230-240 of the Companies Act, 2013 (corresponding to erstwhile sections 391-394 of the Companies Act, 1956) is a complete code in itself to achieve the objectives envisaged and requires approval of the National Company Law Tribunal (“NCLT”) and other regulatory authorities. 

External arrangement could, inter-alia, include acquisition of companies by way of amalgamation, acquisition or divestment of business either through a hive-off or slump sale (i.e. sale of business on a lock-stock and barrel basis for lump-sum monetary consideration), setting up of joint ventures in various manners such as share exchange at the promoter-level, push-down of businesses in jointly-controlled entities, etc. 

Internal arrangements are those arrangements mainly dealing with the intra-group structures and could include plethora of possibilities such as realignment of shareholding of promoters to achieve rationalization and simplification of group structure, migration to an ideal holding structure such as private trusts in order to facilitate succession planning, realignment of family wealth among various family members under a family arrangement/ settlement, pre-IPO/ private equity preparedness such as hiving-off of non-core assets or businesses in order to optimize valuation, balance-sheet right-sizing by way of capital reduction (for example, accumulated losses could be set-off against the credit balances of paid-up share capital, securities premium, other reserves, etc.), elimination of group cross-holdings by way of selective cancellation of shares, etc. 

Depending on the structure chosen, usually an amalgamation or demerger under a Scheme is tax-neutral from the perspective of companies and their shareholders provided certain conditions are satisfied such as issuance of only shares as consideration, transfer of “business undertaking”, vesting of all/ concerned assets/ liabilities, etc. In case of slump sale, ordinarily, the difference between the consideration and book value of the business is subject to capital gains tax. Capital reduction of shares of certain shareholders involving a payout is subject to either in the hands of the company (as dividend distributed) or in the hands of shareholders (as capital gains over and above the accumulated profits). Therefore, the mechanics of each arrangement would lead to different tax and regulatory consequences. This article seeks to deliberate upon some of the many possibilities that could be achieved by way of a Scheme and the tax and regulatory implications of the same. 

1. Folding up of Holding Companies 

Typically, in India, many promoters hold their shareholding in holding company which in turn acts as a pooled vehicle for holding shares in various listed and unlisted operating companies, interests in various others entities, etc. However, such shareholding in listed company through a holding company poses tax and regulatory challenges. For example, if the holding company does not have any other significant operating income, any divestment of stake in the listed company on the floor of the stock exchange by the holding company would be subject to Minimum Alternate Tax (“MAT”) u/s 115JB of the Income-tax Act, 1961 (“ITA”) since the long-term capital gains tax arising out of such sale would be exempt u/s 10(38) of the ITA. 

Further, any dividend distributed by a listed company to its holding company would be subject to Dividend Distribution Tax (“DDT”) u/s 115-O of the ITA when the holding company declares dividend to its shareholders i.e. promoters, if the year of distribution of dividend by the holding company is different from the year of receipt from the listed company. In this context, it may so happen that if the holding company holds less than 51% stake in the listed company, even if the listed company and such company declare back-to-back dividends in the same year, underlying credit for DDT paid by the listed company would not be available to such company since it holds less than 51%, thereby leading to double DDT at the holding company level.  Additionally, any surplus repatriation other than dividend i.e. either in the form of capital reduction or buy-back would also be subject to tax u/s 2(22)(d) of the ITA or u/s 115QA in the hands of the company. 

Further, any interest expenditure in the books of the holding company may be subject to disallowance u/s 14A of the ITA since the primary income of the holding company would be dividend income which is exempt u/s 10 of the ITA. 

From a succession planning perspective, any contribution of shares of listed company by the holding company to a family trust could be subject to deemed income taxation u/s 56(2)(x) of the ITA in the hands of the family trust, thereby leading to impediment in migration to a trust structure since the specific exemption provided u/s 56(2)(x) is for contribution by individuals to a trust with beneficiaries as relatives of such individuals. 

From a regulatory perspective, since the main asset in the holding company would be shares in various companies, it is exposed to the risk of being classified as a NBFC and further as a Core Investment Company, thereby, such holding company could potentially fall within the ambit of RBI-supervision. 

Owing to the above-mentioned inherent weaknesses in the holding company structure, promoters of various listed companies have undertaken amalgamation of holding companies into the listed companies itself by way of a Scheme as a result of which the shares held by the holding company in the listed company would be cancelled and shares of listed company would directly be issued to the promoters. This amalgamation would be tax-neutral from the perspective of the holding company as well as its promoters. 

Of course, the facts of each case would involve evaluation of merger of holding company with the listed company such as whether any other assets are held by the holding company, whether such assets need to be carved-out from the holding company prior to the merger, related transaction costs (such as stamp duty) on issuance of shares pursuant to amalgamation, etc. 

Some of the recent examples to explore this route include DCM, Apcotex, Ajanta Pharma, Igarashi Motors India and Kirloskar Pneumatic Company. 

2. Listing of business division through demerger 

Over the course of time, a listed company which had commenced its operations into one business segments grows to become a diversified conglomerate engaged in multifarious businesses. Since each of the businesses could be distinct from each other and could be at different stages of maturity with differing capital and operational requirements, the true economic value of each of the business may not be captured in the consolidated listed entity. Therefore, many conglomerates spin-off one or more of their businesses into new company/(-ies) by way of a demerger under a NCLT-approved Scheme in order to unlock the economic worth of the said business. 

Pursuant to SEBI Circular dated March 10, 2017 (corresponding to earlier SEBI Circulars dated November 30, 2015 which in turn superseded SEBI Circulars dated February 4, 2013 and May 21, 2013), it is possible to automatically list the shares issued to the shareholders of the listed entity from which the business is being carved out without having to tread the laborious route of a traditional IPO. 

The key advantages of this route over and above the obvious advantage of not undertaking an IPO process are that it ensures business continuity in the hands of the new listed company in the form of no adverse tax implications upon demerger, continuity of cost of acquisition and period of holding of assets held by the transferor listed company, continuity of business losses, if any, etc. Additionally, from a shareholders’ perspective, it ensures liquidity (in the form of shares of new listed company) in their hands in a tax-neutral and cash-neutral manner.

However, in order to ensure tax-neutrality in the hands of the company and its shareholders, two main conditions that need to be fulfilled, inter alia, are: 

a) Shareholders representing 75% in value of the listed company should be issued shares proportionately - If, for example, shareholders of the transferor listed company are issued debentures in addition to shares or are paid the consideration partly in cash, this would result in the demerger not being considered as tax-neutral from the shareholders’ perspective, thereby attracting capital gains tax in the hands of the shareholder. 

b) Transfer of business division should qualify as an “undertaking” under Explanation 1 to section 2(19AA) of the ITA i.e. the asset and liabilities being transferred should constitute a business activity as a whole and does not include individual assets or liabilities which do not constitute a business activity – Therefore, for example, if the business activity of a listed company is carried through its subsidiaries, the demerger of sole investment in that subsidiary may not constitute as an “undertaking” for the purposes of section 2(19AA) of the ITA, thereby resulting in non-tax-neutral demerger. Further, demerger of individual asset such as a land parcel may not constitute as a tax-neutral demerger due to lack of “business activity” element. 

Few recent examples of demerger of business division from listed company into a new company followed by listing of the new company include: 

a) Demerger manufacturing business of Tube Investments

b) Demerger of power generation and distribution, retail, and other businesses of CESC

c) Demerger of renewable energy business of Adani Enterprises

d) Demerger of API manufacturing businesses of Strides Shasun and Sequent Laboratories

e) Demerger of cotton textile business of DCM.

Schemes of Arrangement – Opening up of a Pandora’s Box?

In the light of the above, it could be seen that various objectives could be achieved by way of a Scheme. However, given the complex and inextricably linked tax and regulatory environment in India, proper evaluation of facts of each case and harmonizing them with such environment is of utmost importance. 

For example, with effect from 1 April 2017, General Anti-Avoidance Regulations (“GAAR”) have kicked-in which focus on taxing such arrangement/ tax-abusive structures which have been undertaken without any commercial rationale and focus on avoiding taxes. Therefore, if the heart of an arrangement is to derive tax benefit, it may very well be subject to GAAR. 

Further, with the advent of converged-IFRS regime in India in the form of IndAS, focus is on accounting for the substance of a transaction rather than merely the form. For example, in cases of reverse acquisitions, a legal acquirer may indeed be the entity being acquired and may have to be accounted differently under IndAS 103 i.e. accounting for business combinations. Further, redeemable preference shares issued upon amalgamation may be classified as debt under IndAS 109 dealing with accounting for financial instruments and may have consequent effects while computing the tax liability under MAT u/s 115JB of the Act from the company as well as shareholders’ perspective. 

In the context of various evolving regulations such as introduction of NCLT (thereby replacing High Courts) to oversee the Scheme-approval process, Real Estate Regulatory Authority (“RERA”), evolving securities’ and competition laws, etc. could result in changing the fundamental manner in which a transaction takes place. 

Therefore, any Scheme not only involves conceptualising commercial objectives but understanding, harmonizing and ensuring compliance with the nitty-gritties of extant and emerging tax and regulatory laws in India.

* This article has been co-authered by Binoy Parikh. 

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