Q&A: tax on acquisitions in India

Acquisitions (from the buyer’s perspective)

Tax treatment of different acquisitions

What are the differences in tax treatment between an acquisition of stock in a company and the acquisition of business assets and liabilities?

In the case of acquisition of stock, the consideration paid by the buyer becomes the cost of acquisition of the stock. Such cost is used for the purpose of calculation of capital gains on the transfer of stock in the future.

In the case of an acquisition of business assets and liabilities, the buyer can, subject to certain conditions, achieve a step-up in the cost basis of the assets, thereby enhancing the amortisation base of assets, including intangibles. The goodwill, if any, generated on the acquisition of business assets and liabilities is not eligible for amortisation.

Most tax holidays available to an Indian company would continue to be available despite an acquisition of stock (partial or complete) in such a company. Some carry-forward losses could, however, be denied. In the case of an acquisition of specific business assets and liabilities, the benefit of the tax holiday for the unexpired period may be available to the buyer subject to satisfaction of the conditions prescribed under the domestic law.

Further, if the seller is a non-resident, the buyer would need to withhold applicable taxes (basis determination under the domestic tax law read with applicable treaty) prior to making payment to the seller for the acquisition of the stock. This requirement does not arise in the case the seller is an Indian tax resident. However, this requirement would apply where the business assets and liabilities are sold by the Indian branch or liaison office of a non-resident seller.

In the case of the sale of stock, the consideration is received directly by the shareholders, whereas in a sale of business assets and liabilities, the consideration is first received by the company. If it is then distributed to the shareholders, it results in two levels of tax: capital gains tax for the seller company; and, subsequently, tax for shareholders at the time of the profit or dividend distribution. Although these are seller issues, they could impact the pricing and negotiation of the deal from a buyer’s perspective.

Step-up in basis

In what circumstances does a purchaser get a step-up in basis in the business assets of the target company? Can goodwill and other intangibles be depreciated for tax purposes in the event of the purchase of those assets, and the purchase of stock in a company owning those assets?

A step-up in the cost basis of the business assets is only possible in the case of the acquisition of the business assets of the target company on a going-concern basis. The step-up would have to be justified by an independent valuation report. There are specific anti-abuse provisions, under which the step-up could be denied if the only purpose of the acquisition is to achieve a tax advantage. The excess of the consideration over the fair value of the assets is recognised as goodwill or intangibles in the books of the buyer. Intangibles (such as trademarks, patents and brand names) are clearly specified to be depreciable assets under the law.

Amortisation of goodwill for tax purposes is prohibited from 1 April 2020.

In the case of the purchase of stock of a company owning intangible assets, depreciation on intangible assets (excluding goodwill) is allowed. There is no step-up in the cost basis of the assets of the target company in the case of acquisition of stock of such company.

Domicile of acquisition company

Is it preferable for an acquisition to be executed by an acquisition company established in or out of your jurisdiction?

An acquisition of business assets and liabilities in India would have to be undertaken by a company incorporated in India, since a foreign company may not directly own assets and carry on a business in India, except through a branch office, a project office, a liaison office or a wholly owned subsidiary in certain cases, subject to prescribed restrictions.

The following are the differences in tax treatment if the stock is acquired by an Indian company in comparison to a foreign company.

Change in the scheme of taxation of dividends

• Until 31 March 2020, the distribution of dividends attracted dividend distribution tax (DDT) at the rate of 20.56 per cent in the hands of the company. Such tax paid was not tax-deductible in the hands of the company or creditable in the hands of the shareholder. Such dividend income received was exempt in the hands of shareholders. However, Indian Finance Act 2020 abolished the DDT regime with effect from 1 April 2020, and brought back the traditional approach wherein dividends are taxable in the hands of shareholders instead of the distributing company;
• dividends received by an Indian holding company are taxable at the rate applicable to such company since it is treated as an ordinary income. Whereas there is a special regime for non-residents (including foreign portfolio investors) that provides for a tax rate of 20 per cent (plus applicable surcharge and cess) on dividends. This rate can be further reduced by availing a treaty benefit by such non-resident subject to satisfaction of conditions prescribed under the applicable tax treaty; and
• in the case of an Indian acquisition company, repatriation of profits from the target company by way of distribution of dividends could be subject to tax (namely, first, when the target company distributes dividends to the Indian acquisition company, and second, when the Indian acquisition company distributes dividends to its foreign parent). However, in the case of a foreign acquisition company, taxes shall only be levied when the target company distributes dividends to its shareholders.

Capital gain taxation

• Upon the sale of stock of the target company by an Indian acquisition company, there would be two levels of tax: first, capital gains tax on the sale of shares, and second, tax on the distribution of such gains as dividends. In addition, the quantum of distribution of dividends is subject to Indian corporate laws, which permit dividends only to be paid out of profits. On the other hand, if the acquirer company is outside India, there would be one level of tax in India; namely, capital gains tax;
• ordinarily, long-term capital gains on the sale of shares are subject to tax at 20 per cent (plus surcharge and cess) with indexation benefit, whereas short-term capital gains are taxable at 30 per cent (plus surcharge and cess); and
• for non-resident shareholders, long-term capital gains special tax rate of 10 per cent (plus surcharge and cess) without the benefit of indexation is available in addition to the 20 per cent tax rate. However, short-term capital gains are taxable at the rate of 40 per cent (plus surcharge and cess). This tax rate can be reduced by availing of the treaty benefit subject to the satisfaction of conditions prescribed under the tax treaty read with the multilateral instrument (MLI), wherever applicable.

Additionally, Indian tax laws provide for offshore indirect tax provisions (see the response to ‘Disposal methods’ for more details). Parents of foreign companies can be taxed in India on the transfer of shares of the foreign company, if the foreign company derives 50 per cent or more of its value from an Indian company. Detailed rules are prescribed for computing the 50 per cent threshold.

Other points

• Having a tax residency certificate (TRC) (disclosing prescribed particulars either in the TRC itself or in a separate prescribed form) from the revenue authorities of the home country is the basic and most essential requirement for claiming a tax treaty benefit; and
• India does not permit the consolidation of profits and losses for tax purposes for group companies.

Indian tax treatiesMauritius tax treaty

• The India–Mauritius tax treaty was amended in May 2016 to introduce source-based taxation of the capital gains earned by a Mauritian resident on the transfer of shares acquired on or after 1 April 2017 in an Indian company;
• all investments made in shares of Indian companies before 1 April 2017 are grandfathered and will continue to enjoy the exemption under the India–Mauritius tax treaty; and
• aside from the above, the Financial Services Commission, Mauritius, has also notified requirements to be complied with by a Mauritius Global Business License Company – Category 1 (GBL-1) (primarily used for Indian acquisitions) to be eligible for obtaining a TRC. These requirements essentially necessitate GBL-1 companies to have economic substance in Mauritius, such as having office premises in Mauritius, employing a full-time Mauritian resident at a technical or administrative level, or having arbitration in Mauritius.

Singapore tax treaty

• The tax treaty with Singapore has undergone a third revision since its inception in January 1994, wherein a protocol has been inserted providing for taxing the capital gains earned by a Singapore resident on the transfer of shares acquired on or after 1 April 2017 in an Indian company; and
• shares acquired before 1 April 2017 are outside the scope of taxation in India and continue to enjoy the capital gains tax benefit in accordance with the prior tax-treaty provisions, subject to fulfilment of revised limitation-of-benefit (LOB) provisions (namely, shares of the Singapore transferor company should be listed on a recognised stock exchange in Singapore or total annual expenditure on operations in Singapore should be equal to, or more, than S$200,000 in the immediately preceding period of 24 months from the date the gains arise).

Cyprus tax treaty

• The government classified Cyprus as a notified (uncooperative) jurisdiction in 2013. However, subsequent to the revision of the bilateral tax treaty on 18 November 2017, the government rescinded its notification; and
• the amended India–Cyprus tax treaty provides for source-based taxation of capital gains arising from the sale of shares in the source country. Grandfathering provisions have been introduced pertaining to gains on the sale of share investments made prior to 1 April 2017, in respect of which capital gains will continue to be taxed in the country of residence of the taxpayer.

It is pertinent to note that the preference of acquisition of company jurisdiction for shares should be based on non-tax considerations. This is because India has implemented General Anti Avoidance Rules (GAAR) effective from 1 April 2017, which can lead to a denial of tax benefits if it is established that obtaining tax benefits was the main purpose of a step-in, or part of the arrangement, notwithstanding that the main purpose of the whole arrangement is not to obtain a tax benefit. The salient features of the law are:

• GAAR is applicable if an arrangement is declared an ‘impermissible avoidance arrangement’; in other words, an arrangement whose main purpose is to obtain a tax benefit, and satisfies certain other (tainted) tests;
• GAAR provisions lay down certain scenarios in which an arrangement or transaction would be deemed to lack commercial substance; for instance, if the situs of an asset or a transaction, or one of the parties to the transaction, is in a particular jurisdiction only for a tax benefit;
• interposing special-purpose vehicles in a tax-friendly jurisdiction, devoid of any commercial substance or rationale, would be one practice that the revenue authorities may seek to challenge through GAAR;
• certain exclusions have been specified from the scope of applicability of the GAAR provisions such as:
  • the revenue authorities will not be empowered to invoke GAAR in the case of income arising to a person from transfer of investments made before 1 April 2017;
  • the revenue authorities will not be empowered to invoke GAAR in cases where the tax benefit in a year arising to all parties to the arrangement (in aggregate) does not exceed 30 million Indian rupees; and
• as per Central Board of Direct Taxes Circular No. 7 (dated 27 January 2017), where anti-avoidance rules; namely, a LOB clause exists in a tax treaty, GAAR provisions should not be invoked in cases where such LOB provisions sufficiently address the tax avoidance strategy of the taxpayer.

India signatory to MLI

• Although India had expressed its preliminary position as at the date of signing the convention in June 2017, it adopted a final position including reservations by depositing the instrument of ratification on 25 June 2019, signalling its intent to make the MLI as being entered into force from 1 October 2019;
• India has opted for simplified LOB and a principal purpose test (PPT) for all its CTAs;
• PPT is broader than Indian GAAR, as, under the Indian GAAR provisions, the main purpose of an arrangement is to obtain a tax benefit. As opposed to this, the PPT provides ‘one of the main purposes’ of entering into an arrangement for obtaining a benefit under the tax treaty as the decisive factor for identifying treaty abuse; and
• carve-out has been provided from the application of the PPT wherein a treaty benefit is obtained and such benefit is in accordance with the object and purpose of the relevant tax treaty.

Company mergers and share exchanges

Are company mergers or share exchanges common forms of acquisition?

Mergers and demergers are the preferred forms of acquisition in India. This is primarily due to a specific provision in the tax law that treats mergers and demergers as tax-neutral, both for the target company and for its shareholders, subject to the satisfaction of the prescribed conditions. Other reasons why mergers and demergers are preferred include the following:

• the unabsorbed business losses and depreciation of the transferor company can be carried forward, subject to certain conditions. In the event of a merger, all the losses of the target company are transferred to the buyer, while in a demerger only the losses pertaining to the undertaking being sold are transferred. An undertaking is broadly understood to mean an independent business activity operating as a separate division on a going-concern basis, comprising its independent assets, liabilities, employees and contracts;
• in a merger, the period of carry-forward of the unabsorbed losses is renewed for a period of eight years from the date of the merger, while in a demerger, the unabsorbed losses can only be set off and carried forward for the unexpired period;
• generally, tax holidays and other incentives would continue to be available to the acquiring company; however, there are specific tax holidays that may cease to be available in the event of a merger or demerger; and
• transfer of prepaid taxes and other tax credits from the target company to the acquiring company is permitted in certain cases.

However, the ability to achieve a step-up in the cost basis of the assets is difficult in both mergers and demergers. Further, these involve a court or National Company Law Tribunal (NCLT) approval process, and therefore are at present time-consuming. The NCLT deals with all business reorganisations and acts as a single window approving authority for all business reorganisation schemes. Moreover, the Act specifically provides for a simplified and faster process for mergers and demergers for specified ‘small private companies’ and between holding and wholly owned subsidiary companies, whereby the central government’s approval is sought and the requirement to approach the NCLT for approval is absolved, subject to fulfilment of prescribed conditions.

Tax benefits in issuing stock

Is there a tax benefit to the acquirer in issuing stock as consideration rather than cash?

In mergers and demergers, issuing stock as a consideration instead of a cash consideration ensures the tax-neutrality of such mergers and demergers, subject to fulfilment of prescribed conditions. Apart from the above, there is no tax benefit to the acquirer in issuing stock as consideration instead of cash.

There could be tax implications if shares are issued at a price that differs from the fair market value (FMV). In the case of shares issued at a premium to Indian residents (and not to non-residents), the issuer company could be made liable to tax for the amount of the premium received in excess of the FMV of the shares. The FMV is determined as per the prescribed manner in the domestic tax law by the specified valuer.

This tax does not apply to specified categories such as venture capital undertakings issuing shares to a venture-capital fund, where the shares are issued to an Indian fund having registration as a Category I or a Category II Alternative Investment Fund and is regulated under the Securities and Exchange Board of India (Alternative Investment Fund) Regulations 2012, etc.

Transaction taxes

Are documentary taxes payable on the acquisition of stock or business assets and, if so, what are the rates and who is accountable? Are any other transaction taxes payable?

All forms of business acquisitions involve transaction taxes in some form, although the nature, incidence and quantification of the taxes vary. Typically, these include stamp duty and goods and services tax (GST). The Indian government introduced GST with effect on 1 July 2017. Stamp duty is payable on the execution of a conveyance or a deed. GST is an indirect tax that subsumes an array of indirect taxes, such as excise duty, service tax and value added tax (excluding stamp duty) and is payable on the supply of goods and services. Who bears the stamp duty is negotiated between the buyer and the seller, although it is common for the buyer to bear it. GST, being an indirect tax, is normally collected from the seller and paid or borne by the buyer. Depending on the facts, the buyer may be able to offset the GST paid against its output GST liability, if any. The impact of transaction taxes and applicable rates for different forms of acquisition is given in the following.

Acquisition of stock

Transfers of shares (both held in physical and dematerialised form) in a company are liable to stamp duty at the rate of 0.015 per cent of the value of the shares. Securities transaction tax (STT) at 0.1 per cent is applicable on the purchase or sale of shares listed on a stock exchange. In 2019, the law was amended to levy STT on the difference between the strike price and market price, which was earlier levied twice on the aforementioned prices individually. There is no GST on the sale of shares since the definitions of ‘goods’ and ‘services’ under the GST regulations exclude securities.

Acquisition of business assets

Acquisition of business assets as part of an acquisition of an entire business does not attract GST. GST should not apply to the sale of a business as a whole as an undertaking on a going-concern basis. Stamp duty would apply on specified movable property and immovable property if the transfer is undertaken by way of a conveyance. Stamp duty is a state levy and the rate of stamp duty differs depending on the nature of the assets transferred and their location. Generally, however, stamp duty is payable only on the immovable property transferred, on the basis that movable property is transferred by way of physical delivery. In the event of an acquisition of specific business assets, GST is applicable to the transfer of movable assets. The rate of GST depends on the nature of the assets and varies within a range of 12 per cent to 28 per cent. However, an input tax credit for the same should be available to the payer (depending on the nature of the asset). The stamp duty implications are the same as for the acquisition of stock.

Mergers and demergers

In most states, mergers and demergers attract stamp duty, which is normally based on the value of shares issued as a result of the merger or demerger and the value of the immovable property transferred.

Net operating losses, other tax attributes and insolvency proceedings

Are net operating losses, tax credits or other types of deferred tax asset subject to any limitations after a change of control of the target or in any other circumstances? If not, are there techniques for preserving them? Are acquisitions or reorganisations of bankrupt or insolvent companies subject to any special rules or tax regimes?

Unabsorbed business losses are allowed to be carried forward and set off for a period of eight years from the year in which they are incurred, while there is no time limit for carry-forward and set-off of unabsorbed depreciation. A change in shareholding or voting power, depending on the relevant provisions of a closely held company (namely, a private company whose shares are not listed on a stock exchange) by more than 49 per cent of shares carrying voting power in any year may result in such unabsorbed business losses not eligible for carry-forward and set-off in the future.

Also, this law is not applicable in certain scenarios subject to satisfaction of prescribed conditions such as a change in shareholding as a result of the amalgamation or demerger of a foreign parent, eligible start-ups, or company covered under a resolution plan of the Insolvency and Bankruptcy Code 2016, etc.

Tax credits (such as minimum alternate tax credit) or deferred tax assets are not impacted by a change in control of the target or upon its insolvency. In the case of the acquisition of stock in a company, prepaid taxes and other tax credits (such as indirect tax credits, including GST) would continue to be available. Such prepaid taxes and tax credits do not normally transfer to the buyer upon an acquisition of business assets and liabilities.

Interest relief

Does an acquisition company get interest relief for borrowings to acquire the target? Are there restrictions on deductibility generally or where the lender is foreign, a related party, or both? In particular, are there capitalisation rules that prevent the pushdown of excessive debt?

Deductibility of interestAcquisition of stock

The deductibility of interest on acquisition finance used by the acquisition company to acquire stock in a target company would depend on the characterisation of income received from the target company, in other words, ordinary income versus investment income. Further, generally, under the domestic tax law, where any expense is incurred for earning tax-exempt income, no deduction is allowed for such expenditure. The Apex Court in Maxo Investment Ltd v CIT (Civil Appeal Nos. 104–109 of 2015) ruled that if a taxpayer acquires shares of a company to gain a controlling interest over the company and earns exempt income, the portion of the expenditure attributable to such exempt income should be disallowed. However, if the taxpayer holds the shares as stock-in-trade, then the income earned shall be business income. Accordingly, expenditure incurred in relation to such income shall be deductible as a business expenditure.

Acquisition of business

In the event of acquisition of business assets, whether in the form of a business as a whole, or specific assets, the interest on borrowings, which is relatable to a capital asset until the date the asset is put to use, should be capitalised as the cost of the asset, while the interest payable on an ongoing basis should be allowed as a deduction, as such expenses would be incurred for the purposes of the business of the acquisition company.

Withholding taxes on interest payments

Payment of interest by an Indian company to a foreign party that is a related party would be subject to Indian transfer pricing regulations, thin capitalisation provisions and restrictions under exchange control regulations. In the case of foreign-related party loans, arm’s-length interest is allowed as a deduction. With effect from 1 April 2017, taxable deduction of interest expenditure claimed by an Indian company in excess of 30 per cent of earnings before interest, taxes, depreciation and amortisation of such a borrower renders the entire interest deduction taxable in the hands of such a borrower. Such disallowed interest can be carried forward for up to eight years to be allowable as a deduction against future taxable income, provided the deduction is maintained. The strict source-based rule is applied for the taxation of interest in India. Generally, the interest payable by a resident is taxable in India. However, in certain cases, the interest payable by a non-resident is also taxed in India if it is payable in respect of any debt incurred for the business or profession carried on in India by such a person. Thus, the interest payments made from India would be liable to tax in the hands of the recipient and would, therefore, be subject to withholding-tax implications. The rate of withholding tax would depend on whether the borrowing is in foreign currency or Indian currency. In the case of monies borrowed in foreign currency before 1 July 2023, the rate of withholding tax would be 5 per cent (plus applicable surcharge and cess) on the gross amount subject to the satisfaction of certain conditions. This withholding tax rate is more beneficial compared with the treaty rate (at 7.5 per cent to 15 per cent under various treaties). In cases where the conditions are not satisfied, the rate of withholding tax on interest payments on money borrowed in foreign currency is 20 per cent (plus surcharge and cess). Interest payments on monies borrowed in Indian currency and payable to a non-resident would be subject to withholding tax at the rate of 40 per cent (plus applicable surcharge and cess) on a gross basis. In such cases, the tax beneficial rate under tax treaties could be used.

Debt pushdown

Debt pushdown for offshore financing for acquiring an Indian company or business assets is not feasible due to exchange control restrictions and thin capitalisation rules. On the other hand, debt pushdown by way of local financing (through a banking institution) procured by an Indian company for acquiring either stock or a business asset is not common due to restrictive banking and corporate regulations.

Protections for acquisitions

What forms of protection are generally sought for stock and business asset acquisitions? How are they documented? How are any payments made following a claim under a warranty or indemnity treated from a tax perspective? Are they subject to withholding taxes or taxable in the hands of the recipient? Is tax indemnity insurance common in your jurisdiction?

In the case of a stock acquisition, the seller normally warrants that the target has been compliant with all tax matters and that all disputed matters are either provided for or otherwise disclosed. An indemnity is provided if there are any tax dues that arise over what is disclosed, and the seller shall indemnify the buyer for such claims. Since tax dues can arise several years later, indemnities are provided for a seven-to-10-year period, often without any monetary cap unless they are quantifiable. To implement the indemnity, part of the consideration could also be placed in an escrow account, particularly if a claim of the tax administration is imminent. These aspects are documented in the share purchase agreement between the parties. The buyer could also insist that the seller obtains a nil tax withholding order from the revenue authorities for tax withholding on consideration for such a sale, particularly in cases where the seller is claiming capital gains tax exemption under a favourable tax treaty or where tax on offshore acquisition of shares with underlying assets is exempted due to threshold.

In the case of an acquisition of assets and liabilities, the warranties and indemnities are less stringent, since the buyer does not acquire control over the selling company itself, and any tax due would fall upon the selling company. The sale agreement should contain a general indemnity clause for indemnifying the buyer against representations and undertakings made by the seller. Further, a specific indemnity clause can also be placed indemnifying the buyer against any action that the revenue authorities may take on the buyer or assets acquired by such a buyer (or both).

The acquisition of business assets and liabilities or sale of stock may require a no-objection certificate (NOC) from the revenue authorities to ensure that the transfer is not treated as void due to any tax demand arising from pending proceedings against the seller as of the date of transfer. The intention of the legislature is to safeguard the interests of the revenue against a defaulting taxpayer who may part with assets to avoid payment of any outstanding tax dues. The High Court in Vedanta v ACIT 406 ITR 439 held that if the taxpayer has a sufficient asset base to secure the pending demand, the revenue authorities cannot refuse to grant a NOC.

There are guidelines issued for streamlining the procedure for the issue of NOCs by the revenue authorities, laying out specific timelines. If the NOC is either not issued by the revenue authorities or cannot be obtained owing to lack of time, the buyer could seek an indemnity from the seller pertaining to the potential loss that may arise to the buyer for the transaction being treated as void (which is typically agreed between the parties to be an amount equal to the sale consideration paid by the buyer) or may negotiate with the seller to seek tax insurance for the above. However, the denial of a NOC shall not declare the transfer contract as null or void (Gangadhar Vishwanath Ranade v TRO (1989) 177 ITR 176 (SC)).