Tax takeaways

While tweaks to the tax regime announced in the budget may not have grabbed headlines, they will have a discernible impact on mergers and acquisitions. Amit Singhania and Gouri Puri report

Treading on the side of fiscal prudence, India’s 2021-22 budget maintained the status quo as it steered clear of any big-bang tax announcements. Instead, the government opted for a detox of sorts, where its key focus has been to clean up tax administration.

On a general note, the budget has revamped the entire tax assessment procedure, and has considerably slashed the limitation period for re-opening tax assessments. The Settlement Commission and the Authority of Advance Rulings (AAR) have been abolished, and a new advance ruling board is proposed to be set up, this time with the right to appeal before the high courts.

For small taxpayers, a new dispute settlement committee is proposed, and the government has also announced its intent to make income tax appellate tribunal proceedings faceless. There was not much to cheer on the tax incentive front, although the government continues to offer to promote International Financial Services Centres (IFSCs). In addition, the existing tax holidays for startups and affordable housing projects have been extended by a year.

This article focuses specifically on the top five takeaways from the budget for M&A-related taxation in the country.

Tax depreciation on goodwill

Tax depreciation on goodwill has always been contentious under Indian tax jurisprudence. In the case of CIT v Smifs Securities Ltd, the Supreme Court held that goodwill would be subject to tax depreciation as an intangible asset. However, the ruling was also relied on by taxpayers in case of acquisitive mergers, where they would argue that the accounting goodwill arising on the merger would be subject to tax depreciation (even though the transaction was tax neutral).

The matter was litigated by the tax office, with divided rulings on this issue. The Finance Bill, 2021, seeks to retroactively clarify that goodwill per se (irrespective of the mode of acquisition) will not be tax depreciable. The policy rationale appears to be that goodwill is akin to land, and the value of goodwill, like land, should only appreciate. The tax proposals also provide that any payment made for the purchase of goodwill will be a part of the cost of acquisition (cost basis) of the asset.

The proposed amendments are likely to have an impact on pending tax litigation and claims relating to tax depreciation on goodwill. Acquisitions will also become more expensive as buyers can no longer rely on tax depreciation on premiums paid for acquiring businesses. There is, however, some ambiguity on how goodwill will be identified and removed from an existing block of intangible assets, where depreciation is currently being claimed.

Body for advance rulings revamped

The AAR was a novel mechanism for taxpayers to gain tax certainty upfront, with respect to contentious tax claims, and avoid a world of trouble with post-the-fact tax litigation. Especially in the context of withholding tax and treaty benefits, this was an approach that was often contemplated to gain advance certainty.

However, the AAR bench (which comprised retired judges) often remained vacant, resulting in a significant backlog of cases. Matters remained pending for three or four years, making it impracticable to get a ruling before the close of the transaction. There was also no statutory right to appeal against AAR decisions unless the high courts or the Supreme Court exercised their writ jurisdiction.

The government’s proposal to revamp the AAR has two key highlights. First, the Board of Advance Ruling will comprise high-ranking tax officers. Second, parties will have a right to appeal the board’s orders before a high court. Such changes should make the AAR mechanism more efficient and attractive to parties looking for certainty in the M&A tax space. It is hoped that, in spite of being made up of tax officers, the Board of Advance Rulings will render balanced decisions to make the process meaningful.

Penalizing tax evaders

The Finance Bill proposes to penalise non-filers of income tax returns through deduction/collection of higher tax deduction at source (TDS) and tax collection at source (TCS). TDS or TCS will be deducted or collected at twice the rates under the Income Tax Act (ITA), or at 5%, whichever is higher, in cases where the payments are made to, or sum is collected from, a specified person.

A specified person is defined as a person who has not filed income tax returns for the immediately preceding two years (and where the statutory time limit for filing the income tax return has expired), and the aggregate amount of TDS or TCS is more than ₹50,000 (US$680). Such provision will not apply if the TDS or TCS is to be collected from a non-resident (with no permanent establishment in India).

In several M&A deals, buyers are required to deduct TDS on purchase of shares and land, and on non-compete payments. Additionally, there is also the issue of the new TCS provision (introduced by the Finance Act, 2020) applying to purchase of shares, where the seller may be required to collect TCS from the buyer.

With these amendments, not only will parties be required to verify the permanent account numbers (PANs) of their counterparty, but also their tax return history. Unless the government creates an e-portal through which the verification can be made by the tax deductor or collector by entering the PAN of the payee, it will be impractical for them to reliably verify another person’s tax filing history.

It would be unfair to saddle the tax deductor/collector with onerous and penal consequence for short deduction of tax in such cases. In the absence of any such functionality available to the tax deductor/collector, they will be required to undertake this due diligence themselves. Parties may take tax warranties, or seek proof of tax filings, in the M&A documentation going forward.

Tax on slump exchange

A business transfer, referred to as slump sale in Indian tax parlance, has been an effective way to acquire a business lock, stock and barrel on a going-concern basis. The tax computation provisions for a slump sale specifically refer to the term “sale”. This was often used by taxpayers to argue that a transfer of a business undertaking that was not structured as a sale, but an exchange, or was a transfer through a court approved scheme, was not taxable as the tax computation provisions specifically refer to a sale.

This view was supported by Bombay High Court in CIT v Bharat Bijlee Ltd, where it was held that transfer of a business undertaking by any mode other than a sale will not be covered within the meaning of slump sale under section 50B of the ITA, and hence will not be subject to capital gains tax.

The Finance Bill proposes to amend the definition of slump sale to include in its ambit all forms of transfers, not limited to just sale. Therefore, structuring future transactions as slump exchanges, or through court approved schemes, will not result in any tax benefit.

Dividend tax for foreign investors

Though not an M&A-related amendment, the rationalisation of withholding tax provisions applicable to foreign portfolio investors (FPIs) deserves a special mention. Payments to FPIs are governed by a specific withholding tax provision that specifies that TDS will be at a flat rate of 20% (except on income classified as capital gains, and certain kinds of interest).

The Supreme Court, in its decision in PILCOM v CIT, held that if a withholding tax provision set out a fixed rate for withholding, then it would not be open for the payer to extend tax treaty rates (even if they were lower). This meant that an FPI would have to file a tax return in India to claim a refund of excess tax withheld.

This issue became glaring when India shifted from the dividend distribution tax to the classical dividend tax system, where the shareholder is subject to withholding tax in India. The Finance Bill has now aligned the TDS rate with tax treaty rates for FPIs as well. This should promote ease of investment in India.

Needless to say, in spite of being a quiet one, this budget is likely to have an impact on M&A structures and transaction documentation.

Amit Singhania and Gouri Puri are partners at Shardul Amarchand Mangaldas & Co.