Tag Archives: M & A

Income Tax clearance: M &A or secondary transactions

Obtaining a no objection certificate or prior permission under section 281 of Income Tax Act, 1961 (Section 281 Certificate) is a mandatory ‘conditions precedent’ in a merger, acquisition or a secondary transaction. A general disdain is the time it takes to obtain the permission. Without the permission, the transaction could risk being voided by the tax department.

This article analyses the significance of the Section 281 Certificate, when should it be procured and implications if not procured.

tax certificate

Breaking down Section 281

As per Section 281 of the Income Tax Act (“Act”), in the event an assessee creates a charge or parts with the possession (by way of sale, mortgage, gift, exchange or any other mode of transfer whatsoever) of, any of his assets in favour of any other person, during the pendency of any proceeding under the Act or after the completion thereof, but before the service of notice under Rule 2 of the Second Schedule of the Act, such charge or transfer shall be void as against any claim in respect of any tax or any other sum payable by the assessee as a result of the completion of the said proceeding or otherwise. As per the explanation to the section, ‘asset’ includes shares and securities as well.

The section has the following exceptions in which case, such charge or transfer is not void:

  • if it is made for adequate consideration and without notice of the pendency of such proceeding or, as the case may be, without notice of such tax or other sum payable by the assessee; or
  • if it is made with the previous permission of the assessing officer.

It may also be noted that this section applies to cases where the amount of tax or other sum payable or likely to be payable exceeds Rs.5000 and the assets charged or transferred exceed Rs.10,000 in value.

In a nutshell, section 281 of the IT Act requires an assessee to obtain the permission of the assessing officer before creating a charge on certain assets or transfer of certain assets in the event there are ongoing tax proceedings or pending claims/demands against such assessee. The main objective of section 281 is to safeguard the interests of the revenue against assessees who may fraudulently part with their assets to avoid payment of taxes.

Process for obtaining Section 281 Certificate

The Central Board of Direct Taxes through its Circular No. 4/2011 [F. NO. 402/69/2010-ITCC], dated 19-7-2011 (“Section 281 Circular”), has issued certain guidelines for obtaining the Section 281 Certificate. The format of the application (which also mentions the documents and other information to be provided) is also provided in the said Circular. The assessing officer may, at his discretion, ask for additional documents. The application is to be filed at least 30 (Thirty) days prior to the proposed transaction. The Section 281 Circular also contains the circumstances under which Section 281 Certificate could be granted by the assessing officer, the timelines within which the assessing officer has to grant/refuse the permission under section 281 and the validity of the certificate granted. It is interesting to note that the Circular provides for an approval timeline of 10-15 days.

It may also be noted that the assessing officer would require the approval from the Range Head for granting permission if the value of assets being transferred or on which charge is being created, or the amount of charge being created is Rupees Ten crores (Rupees Hundred Million) or more.

Analysis of Section 281

Going by the strict interpretation of section 281, the Certificate is required only when an assessee creates a charge or parts with possession of any asset, under the following circumstances:

  • If the transfer is made during the pendency of any proceeding under the Act, or
  • After the completion of any proceeding under the Act but before the service of notice under rule 2 of the Second Schedule of the Act.

It appears that strict interpretation seems narrow.

In most cases, in a M & A or in a secondary sale of securities, the purchaser insists on Section 281 Certificate to de-risk a possibility of a tax claim which in turn would impact the purchase consideration. As an extension to that, the purchaser also wants to apriori know of the possibility of tax claims, before releasing the purchase consideration. Hence, Section 281 Certificate is almost always a Conditions Precedent to the transaction. In cases where it takes a long time to obtain the Section 281 Certificate, the purchaser reluctantly moves it as a “conditions subsequent” but with a personal guarantee or specific indemnities from the seller/s to de-risk the possibility of the transaction being considered void by the tax authority.

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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.

Employee Rights in Mergers and Acquisitions

An entity to entity merger/acquisition has manifold considerations, movement of employees and their rights being one of the most important aspects. A change in the ownership or management of a company may result in a significant change in the working conditions of employees. Transfer of employees between different locations of the new entity, change in work profiles and execution of fresh or revised employment agreement with the new entity are some of the changes that would arise as a result of a merger or an acquisition. In this post, we have tried to provide a bird’s eye view of the many points and challenges to be conscious of in the process.

Status of the Employee: Workforce in India can be categorised into 2 broad categories of ‘workman’ and ‘non-workman’. There are specific labour statutes which have to be mandatorily complied with in respect of a ‘workman’.

Section 2 (s) of the Industrial Disputes Act, 1947 (“ID Act”) defines ‘workman’ as any person who does any manual, unskilled, skilled, technical, operational, clerical or supervisory work for hire or reward and for the purposes of any proceedings in relation to an industrial dispute, includes any such person who has been dismissed, discharged or retrenched in connection with, or as a consequence of, that dispute, or whose dismissal, discharge or retrenchment has led to that dispute. The section also makes certain exceptions. For example, an employee in a managerial or administrative capacity or a supervisor drawing wages in excess of Rs. 10,000/- is exempt from the definition of workman.

However, as it appears from a plethora of judicial pronouncements in this regard, it is clear that the courts rarely go by a bare reading of Section 2 (s). The courts look into the facts and circumstances of each case while determining whether an employee is a workman or not. As observed by the Delhi High Court in Tata Sons Ltd. v. S. Bandopadhyay [111 (2004) DLT 489], in examining the question of whether an employee is a ‘workman’ or not, what is of importance is the nature of his duties, particularly his primary duties or his basic duties and the dominant purpose of his employment. Further, as held by the Supreme Court in T.P. Srivastava v. National Tobacco Co. of India Ltd. [1991 AIR 2294], duties which require the imaginative and creative mind could not be termed as either manual, skilled, unskilled or clerical in nature and therefore, such a person cannot be termed as a workman. In the case of Delta Jute & Industries Ltd. Staff Association and Ors. v. State of West Bengal and Ors. [2015 (145) FLR105], the High Court of Calcutta held that when a person is performing multifarious functions, the nature of the main function that the employee performs should be taken into account to determine whether the person will fall under the ambit of workman or not.

As a result of these judgements, the courts appear to be creating a distinction between unskilled, skilled and highly skilled employees without actually setting out clear parameters on how and when to classify them as such. Hence, it would be crucial to show that the work performed by an employee is imaginative, creative and highly specialized, in order to claim that such employee does not fall within the ambit of the definition of ‘workman’ under the Act. If an employee falls under the ambit of workman, the old employer as well as the new employer has to ensure that compliance under all applicable labour legislations, including but not limited to those under the Industrial Disputes Act, 1947, Industrial Employment (Standing Orders) Act, 1946, etc. have been met with regard to the employees.

Consent of Employee: As per Section 25FF of the ID Act, where the ownership or management of an undertaking is transferred, whether by agreement or by operation of law, from the employer in relation to that undertaking to a new employer, every workman who has been in continuous service for not less than one year in that undertaking immediately before such transfer shall be entitled to notice and compensation in accordance with the provisions of section 25F, as if the workman had been retrenched. There is a proviso to this section which states that a workman will not be entitled to any notice or compensation if the following conditions are fulfilled:

  • the service of the workman has not been interrupted by such transfer;
  • the terms and conditions of service applicable to the workman after such transfer are not in any way less favorable to the workman than those applicable to him immediately before the transfer; and
  • the new employer is under the terms of such transfer or otherwise, legally liable to pay to the workman, in the event of his retrenchment, compensation on the basis that his service has been continuous and has not been interrupted by the transfer.

However, the Supreme Court in the case of Sunil Kr. Ghosh v. K. Ram Chandran ((2011) 14 SCC 320) has held that, in the event employees are transferred to a new employer, it is mandatory for the old employer to take the consent of the workmen even if there is no change in the terms and conditions of their service and they are transferred on same or more favourable terms. In the event the workmen do not consent to such transfer, they will have to be given retrenchment compensation as per the provisions of the ID Act. This brought through a paradigm shift in the industrial jurisprudence with regard to rights of workman in case of their transfer to new employer. The reasoning given by the Supreme Court for the decision is that a workman cannot be forced to work for anyone against their wish.

Even though the employer-employee relationship for a non-workman is mainly governed by his or her employment agreement, some concepts of the ID Act are extended to non-workman as well. Therefore, even though ID Act is applicable only to workman, it is advisable that certain concepts such as taking consent of the employee in case of transfer to a new entity and other principles of natural justice are followed in case of non-workman as well in order to avoid scrutiny by courts.It has to be noted that the labour statutes and the courts in India are pro-employee and therefore, employers need to be extra cautious while dealing with the rights of the employees.

Notice of Change: As per Section 9A of the ID Act, if there is any change in the working conditions of workman as prescribed in Schedule IV of the ID Act, the workman needs to be given notice at least 21 days in advance of such change.

Continuity of Service: Another important aspect with regard to employees in case of a merger or acquisition if the employees are being transferred is that, they need to be given continuity of service. Their seniority should be taken into account by the new employer and the conditions of service shall not in any way be less favourable than those immediately prior to the transfer. This has to be mentioned clearly in the new employment agreement/ appointment letter entered into with the new entity.

Social Security Obligations: The Supreme Court in the case of McLeod Russel India Limited vs. Regional Provident Fund Commissioner, Jalpaiguri and Others [2014(8)Scale 272] has held that the transferee entity will be liable for any default on part of the transferor entity even if there is an agreement to the contrary stating that the transferor will be liable. This decision of the Supreme Court highlights the importance of a thorough due diligence which has to be conducted by the acquiring entity and clearly ascertain the liabilities of the transferor entity towards provident fund and various other labour laws and obtain indemnification and damages from the transferor companies prior to such acquisition, if required.

The transaction documents entered into between the two entities should clearly provide for transfer of employee benefits, such as provident fund, to the new employer. Please refer to our handbook for details on this aspect, in case of an NCLT driven merger/amalgamation: https://novojurislegal.files.wordpress.com/2018/06/blog_ncltmerger-final-04062018.pdf

Another important aspect in case of a merger or acquisition is with regard to the treatment of leave under statutes such as the various States’ Shops and Establishment Act. Every employee is entitled to certain number of days of leave depending on the length of service in a particular year which can be accumulated and also encashed depending on the state specific Shops and Establishments Act. For example, as per the Karnataka Shops and Establishment Act, 1961, if the employment of the employee is terminated by the employer before such employee has taken the privilege leave which he or she is entitled to or if the employee has applied for leave and have not been granted such leave, or quits his or her employment before he/she has taken the leave, the employer will be liable to pay the employee the wages for leave not taken. Thus, it becomes important for the transferee entity to give due regard to the leave balance of the employees who are being transferred and due regard must be given to the liability that may arise with regard to such leave encashment. Therefore, adequate adjustments may be made to the consideration amount paid to the transferor so that the transferee entity does not incur any additional burden in this regard.

Treatment of ESOPs: ESOPs usually have a vesting period and would be subject to exercise at a price before an acquisition or accelerated vesting in case of an acquisition. This becomes an especially significant point of consideration in case of stock swap structures.

The above-mentioned pointers are few of the many considerations during a merger/acquisition. Depending on the particular structure of a merger/acquisition, the steps for employee transfer/discontinuation needs to be evaluated.

Authors: Mr. Paul Albert and Ms. Sohini Mandal