Tag Archives: capital gains

Capital Gains Tax on Conversion of Compulsorily Convertible Preference Shares – The Current Scenario

The question of taxability on conversion of compulsorily convertible preference shares (CCPS) has come up for consideration quite a few times in the recent past. There seemed to be ambiguity regarding whether an event of conversion amounts to ‘transfer’ under Section 2(47) of the Income Tax Act, 1961 (the “Act”), thereby triggering capital gains tax under Section 45 of the Act.

As early as 12 May 1964, the Central Board of Direct Taxes (CBDT) in its Circular F. No. 12/1/64-IT(A) (the “Circular”) had stated that where one type of share is converted into another type of share, there is no ‘transfer’ of capital asset within the meaning of Section 2(47) of the Act. However, there have been many instances when assessments have still been framed adversely. The matter of Periar Trading Company Limited v Income Tax Officer[1] (the “Periar Case”) is one such instance where the conversion of preference shares was sought to be taxed and the above question again came up for consideration. The decision in this case pronounced by the Mumbai bench of the Income Tax Appellate Tribunal (ITAT) further consolidates the position that CCPS would not attract any capital gains tax upon conversion. In this post, we look into the facts of the Periar Case and the reasoning adopted by Hon’ble Justice Mahavir Singh for pronouncing the judgment.

Factual Matrix of the case:

  • Perirar Trading Company Pvt Ltd (the “Assessee”) was engaged in the business of investment activities.
  • During the financial year 2010-11 relevant to the assessment year 2011-12, the Assessee had made investment in 51,634 CCPS of Series A of Trent Ltd. on a rights issue basis. The entire issue price of the said CCPS was paid on application itself.
  • As per the terms of the scheme for issue of CCPS, one CCPS of Series A would compulsorily and automatically get converted into one fully paid up equity share. Accordingly, on 10 September 2011, the Assessee was allotted one equity share of Trent Ltd. for every preference share held in Trent Ltd., i.e. 51,634 CCPS. The conversion was compulsory and automatic.
  • The Assessing Officer (the “AO”) noted from the schedule of non-current investment forming part of the balance sheet of the Assessee for the previous year 2011-12 that the Assessee company had its 51,634 CCPS Series A of Trent Ltd into equity shares and thus, during the assessment year 2012-13, sought to tax the Assessee, treating the conversion of CCPS into equity shares as a ‘Transfer’ within the meaning of the definition provided in section 2(47)(i) of the Act.
  • The Assessee brought the matter before the Commissioner of Income Tax (Appeals) [the “CIT(A)”], which accepted the AO’s arguments and relied on rulings in Re: The Nizam’s Second Supplementary Family Trust[2] and CIT v Santosh L Chowgule[3] to reject the Assessee’s appeal holding that the conversion of the CCPS amounted to a ‘transfer’ by way of exchange.
  • Aggrieved by the same the Assesee preferred appeal to the Mumbai bench of the ITAT.

Main Issue before the ITAT:

The ITAT was primarily faced with the question of, “Whether the action of CIT in confirming the action of AO to treat the conversion of Cumulative Compulsory Convertible Preference Shares (CCPS) into equity shares as transfer within the meaning of section 2(47) of the Act on the said conversion, was proper in law?” In dealing with the issue the decision also touches upon the following points:

  • Modality of calculating period of holding in the case of conversion and subsequent sale/transfer of the converted CCPS? and
  • The distinction between exchange and conversion of shares.

Arguments of the Assessing Officer (AO):

It was contended by the AO that the difference of,

  • (i) the market value of converted number of equity shares of Trent Ltd. and
  • (ii) the cost of the acquisition of equal number of CCPS Series A of Trent Ltd

is taxable as capital gains on account of transfer of shares by way of exchange of ‘assets’. The AO also relied on the definition of ‘exchange’ as per the Black’s Law Dictionary in support of his reasoning.

Reasoning adopted by the CIT(A):

Before the CIT (A), the AO relied on the case of Re: The Nizam’s Second Supplementary Family Trust[4], in which Hon’ble Andhra Pradesh High Court categorically held that conversion of preference shares into equity shares is nothing but a barter, which constitute transfer by way of exchange within the meaning of Section 45 of the Act. The CIT-A therefore held that the ratio of the above case should be applicable to the case of the Assessee and that the Assessee must pay the amount as long term taxable capital gain.

Arguments of the Assessee before the ITAT:

The Assessee contended that the legislative scheme emanating from the provisions of the Act also did not require such transaction to be taxable. The Assessee relied on section 55(2)(b)(v)(e) of the Income Tax Act which states that where the newly converted share is transferred at a later date, then, the cost of acquisition of such share for the purpose of computing the capital gain tax shall be calculated with reference to the cost of acquisition of the original share from which it is derived. Thus, the legislative intent seems to be clear that conversion ought to be regarded as tax neutral.

Rulings of the ITAT:

The ITAT held that the CBDT vide the Circular has clarified the position that where one type of share is converted into another type of share, there is no transfer of capital asset within the meaning of Sec. 2(47) of the Act. It also noted that the provisions of the circular have also been adopted in the tribunal’s earlier judgment in ITO v Vijay M Merchant[5].

The ITAT further relied on the ruling in Gillanders Arbuthnot & Co[6] and Texspin Engineering and Manufacturing Works[7] to hold that the market value of the converted equity shares on the date of conversion shares resulting from the conversion cannot be treated as ‘full value of consideration’ of the CCPS, even if such conversion was treated as a transfer, for the purpose of determining capital gains under section 48 of the Income Tax Act, 1961. The Supreme Court in Gillanders[8] faced a similar case where the value of asset transferred in lieu of shares was sought to be the ‘full value of consideration’, the Apex Court had observed that ‘full value of consideration’ is inherently different from ‘fair market value of the capital asset transferred’. Further in Texspin[9], the Bombay High Court had held that one has to read the expression ‘full value of consideration’ under section 48 dehors section 45 and that the expression cannot be used to mean the market value of the capital asset on the date of the transfer.

The ITAT further observed that the present case was not a case where “one form of share has been exchanged, bartered, swapped for other form of share. In the present case, one type of share was converted into other type and the earlier type of share has ceased to exist. Thus, there is no exchange of any share as the pre-conversion security has ceased to exist. From the above, it is evident that mere conversion of one type of share to other type of share will not be a transfer of a capital asset within the meaning of Sec. 2(47) of the Act.” ITAT further pointed out that AO’s reliance on the ruling of the Hon’ble Supreme Court in the CIT v Motors & General Stores Pvt Ltd[10] was unfounded, as the Court therein had held the exchange of cinema house to preference shares is to be considered as a transfer for the purpose of taxability. The facts of the matters are, therefore, entirely different.

The ITAT accepted the interpretation of the Assessee, claiming this to be in furtherance to the legislative intention, that mere conversion of one type of share to other type of share will not be a transfer of a capital asset within the meaning of Sec. 2(47) of the Income Tax Act, 1961, which would also make the provision of capital gains work smoothly, in synchronization with other provisions, without any conflict with other provisions. If the view is adopted that capital gain tax liability arose upon conversion, then the same would be not only against the legislative intention but also would make the composition of capital gains unworkable and would bring conflict with other provisions of the Act. In fact, it would lead to instances of double taxation, as having taxed the capital gain upon such conversion, at the time of computing capital gain upon sale of such converted shares, the Assessee would be still taxed again, as the cost of acquisition would still be adopted as the issue price of the CCPS and not the consideration adopted while levying capital gain upon such conversion. The tribunal in this regard noted “by no stretch of imagination, such interpretation process is permissible”.

Key Takeaways:

Although now there is a specific provision in the form of Section 47(xb) (with effect from 1 April, 2018), the decision comes as a boon for matters where conversion took place even before the Finance Act, 2017 came into force. Further, to consolidate the mandate under Section 55(2)(b)(v)(e), the Finance Act, 2017 has also introduced new provisions in form of Sections 2(42A)(hf) and 49(2AE) that provide that holding period of equity shares resulting from conversion of preference shares start from the date of acquisition of original preference shares. The position of law with respect to taxability of conversion events now seems to be well settled therefore.

Authors: Mr. Avaneesh Satyang and Ms. Sohini Mandal

[1] ITA No. 1944/Mum/2018 decided on 09 November 2018

[2] (1976) 102 ITR 248 (Andhra Pradesh)

[3] (1998) 234 ITR 787 (Bombay), wherein the Bombay High Court held that preference shares and equity shares are different.

[4] Supra note 2

[5] (1986) 12 ITD 510 (Bombay)

[6] 66 ITR 622 (Supreme Court)

[7] 263 ITR 345 (Bombay)

[8] Supra note 6

[9] Supra note 7

[10] (1967) 66 ITR 692 (SC)

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M & A: Different structures and a comparative

Acquisition of an entity can be undertaken in a number of ways such as an asset transfer, stock purchase, share swap, etc. It is critical to have certainty on the mode or structure of acquisition from the initial stage itself since the definitive agreements and the implementation steps for effectuating the acquisition will largely depend on the mode of acquisition. An acquisition transaction can be structured in different ways depending on the objective of the acquiring entity or the buyer. In this article, we have attempted to provide a brief overview and comparative of some of the different structures of acquisition.

Asset Purchase

  • In an asset purchase transaction, the acquiring entity takes over, either all or certain identified assets of the target entity or the seller. The first step in an asset purchase transaction is to determine what the assets and liabilities being taken over would be. Similarly, the definitive agreements should clearly lay down the assets/ liabilities being taken over and those which are not.
  • One of the major advantages of an asset purchase transaction is that the buyer can pick and choose the assets and liabilities which are to be acquired. The buyer may also choose not to take over any liabilities but purchase only the assets.
  • Another important aspect which has to be taken into consideration is with respect to the employees. In an asset transfer transaction, consent of the employees has to be taken if they are part of the acquisition transaction. Compliance to various labour laws has to be met. If the employees are not part of the transaction, then retrenchment compensation under Industrial Disputes Act, 1947 has to be examined. Please see our previous post on Employee Rights in M&A to know more on this.
  • In an asset purchase transaction, tax is calculated basis depreciable assets and non-depreciable assets. Capital gains tax is applicable basis the difference between the cost of acquisition and sale consideration. Depending on the holding period of the asset, either long term capital gains tax or short-term capital gains tax is applicable. In case of depreciable assets, depreciation is allowed as deduction.
  • Stamp duty is levied, in an asset purchase transaction, on the individual assets being transferred. Stamp duty is usually a percentage of the market value of the assets.
  • Losses or any other tax credits cannot be carried forward in an asset purchase transaction, as the target entity itself is not being acquired in this case. After an asset transfer, the shell entity remains and it is often a commercial consideration of whether the promoters of the acquired entity need to compulsorily shut down the shell entity or if it can be used for other business purposes. If the target entity continues to exist, considerations of ongoing business, usage of any remaining intellectual property, etc. become major discussion points between the parties involved.
  • Slump Sale: Slump sale refers to the sale of the entire business of an entity as a going concern without values being assigned to individual assets. As per section 2(42) of the Income Tax Act, 1961, ‘slump sale’ means the transfer of one or more undertakings as a result of the sale for a lump sum consideration without values being assigned to the individual assets and liabilities in such sales. In case of a slump sale, the seller is liable to pay tax on the profits derived on the transfer at rates based on the period for which the undertaking is held. If the undertaking is held for more than 36 months, the capital gains will be taxed as long-term capital gains and if the undertaking is held for less than 36 months, capital gains will be taxed as short-term capital gains.

Share Purchase

  • Share purchase is a type of acquisition in which the buyer takes over the target entity by purchasing all the shares of such target entity. The entire liability of the seller is taken over by the buyer in such an acquisition.
  • An advantage of structuring an acquisition as a share purchase, is that there would not be any major disturbances caused to the business of the seller since there is no requirement of entering into fresh contracts, licenses, etc. Losses and other tax credits could also be carried forward.
  • If the shares being sold are held for more than 24 months, capital gains will be taxed as long-term capital gain tax. If the shares being sold are held for less than 24 months, the capital gains will be taxed as short-term capital gains tax. Indexation benefits will be as applicable.
  • In the event of transfer or issue of shares to a non-resident, the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017 and the pricing guidelines have to be complied with.
  • Determination of fair market value pricing is important in such case, due to the applicability of pricing guidelines (in case of non-resident involvement) and also as per Section 50CA and Section 56(2)(x)(c) of the Income Tax Act, 1961, that provide for deeming provisions and taxation (in the hands of both transferor and transferee) basis full value consideration, in case of transaction price being less than FMV/full consideration.
  • Deferred Consideration: Since in a complete share purchase acquisition, the buyer also takes over the liabilities of the target entity, it is common to have deferred consideration models, in order to set off any future liabilities from the total consideration package. However, in case of such share purchase acquisition coming under the ambit of the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, the Reserve Bank of India, vide Notification No. FEMA 3682016-RB, has mandated that not more than 25% of the total consideration can be paid by the buyer on a deferred basis within a period not exceeding 18 months from the date of the transfer agreement. As mentioned in the said Notification, for this purpose, if so agreed between the buyer and the seller, an escrow arrangement may be made between the buyer and the seller for an amount not more than 25% of the total consideration for a period not exceeding 18 months from the date of the transfer agreement, or, if the total consideration is paid by the buyer to the seller, the seller may furnish an indemnity for an amount not more than 25% per cent of the total consideration for a period not exceeding 18 months from the date of the payment of the full consideration.

However, this brings in difficulties in transactions where for commercial reasons, the buyer and the seller may mutually agree to tranche based or deferred consideration, which as per the mentioned Notification, can only done within certain specified parameters.

Share-Swap

  • Another method of structuring an acquisition deal is through a share swap arrangement. In a share swap arrangement, if one entity wants to acquire another entity, instead of cash consideration, the shares of the buyer entity may be exchanged for the shares of the seller entity. An acquisition can be structured such that the entire consideration is through share swap or it can also be partly through share swap and partly through cash consideration.
  • If a foreign entity is involved in a share swap deal, the FDI and ODI Regulations become applicable. One of the most important consideration to be mindful of, is that the FDI regulations states that the price of shares offered should not be less than the fair market value of shares valued by SEBI registered Merchant Banker. Please refer to our previous post on M&A through Share Swap/Stock Swap Arrangements for more details in this regard.
  • The taxation in a share swap transaction works such that the shareholders swapping the shares are subject to taxation, basis the difference between the value of the shares being swapped. The concern here is that the shareholders will have to pay taxes when they have not received any actual cash consideration, but only shares of another entity by exchanging the existing shares they held.

Acqui-hire

  • In an acqui-hire transaction, typically, a relatively bigger entity, acquires the talent pool of a relatively smaller entity and this has gained significant prominence in the early stage ecosystem in India over the last couple of years. An acqui-hire may also be combined with an asset purchase transaction. The consideration in an acqui-hire is usually based on the talent of the employees, seniority, etc.
  • One of the main advantages of an acqui-hire transaction, from the perspective of the buyer, is that the employees already have experience, the buyer need not spend time, effort and energy in training them.
  • Another advantage of an acqui-hire is that the employees are usually subject to non-compete clauses with their employer and therefore, lateral hiring of employees may not be always possible especially when the acquirer is in a competing business as that of the target company. In an acqui-hire, the non-compete clauses would typically get waived.
  • Shares held by the existing investors of the target company and the way it is dealt varies on a case to case basis and it is mostly a function of discussion between the promoters, the existing investors and the potential buyer, given the economic condition and sustainability of the target company, if the acquisition does not go through.
  • Since the main objective of an acqui-hire is to acquire the employees, the employment agreement entered into with the acquired employees becomes very important. Adequate precaution needs to be taken to ensure that all important clauses such as earn out, non-compete, stock options granted to employees, etc. are included in the employment agreement.
  • Some of the consideration points of an acqui-hire deal would be conducting interviews of the employees selected to be acquired, and assess suitability. Also, there is always the possibility of the acquired employees leaving upon the expiry of the earn-out period, which then needs to be structured in a very balanced manner. This requires a very evaluated cost benefit analysis of the earn out versus the minimum time period for which an employee would be required to continue in the purchasing entity.

Cross-Border Merger

  • Cross-border mergers are one of the ways adopted by entities to expand their operations to a foreign country and entering into new markets. A cross-border acquisition means acquisition of one entity by a foreign entity.
  • Cross border mergers in India are mainly dealt with under the Companies Act, 2013 and the Foreign Exchange Management (Cross Border Merger) Regulations, 2018 (“Merger Regulations”). As per the Merger Regulations, the separate approval of RBI is no longer required as long as the cross-border merger is undertaken in accordance with the Merger Regulations.
  • Cross-border merger may be either ‘inbound merger’ or ‘outbound merger’. Inbound merger means a cross-border merger, where the resultant company is an Indian company. An outbound merger means a cross-border merger where the resultant company is a foreign company. A resultant company means an Indian company or a foreign company which takes over the assets and liabilities of the companies involved in the cross-border merger. There are separate set of compliances required for inbound merger and outbound merger under the Merger Regulations. For example, in case of an inbound merger, the compliances with respect to pricing guidelines, sectoral caps, reporting requirements, etc. under the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017 ought to be adhered to. Also, subject to the foreign exchange management regulations, the Indian entity is allowed to hold assets in the foreign country. Also, the Merger Regulations give both the Indian entities and foreign entities a time period of 2 years to comply with the foreign exchange management compliances. Please refer to our previous post on Cross-Border Mergers-Key Regulatory Aspects to Consider for further details regarding the regulatory aspects to be considered in case of cross border mergers.
  • One of the major concerns regarding cross-border mergers is with respect to taxation. While an inbound merger, where the resulting entity is an Indian company, is exempt from capital gains tax as per Section 47 (vi) of the Income Tax Act, 1961, there is no such exemption given in case of outbound mergers. Also, in case of outbound mergers, the branch office in India may be considered as a branch office of the foreign entity. In such a scenario, the branch office in India may be considered as a permanent establishment of the foreign entity in India and global income of the foreign entity may become be subject to tax in India.

Disclaimer: Structuring an M&A transaction is complex and requires a case to case evaluation of objectives, consideration, taxation at each stakeholder level, etc. The purpose of this article is to disseminate information only and readers are requested to seek profession advice shall for any individual requirement.

 We do not practice in tax matters. Any reference to tax matters herein is indicative and for reference purpose only.