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In this era of globalization and revolutionary business ideas, it is not uncommon for established businesses as well as budding startups, expanding overseas from India or vice versa. The spread of business operations over multiple jurisdictions may create the need for cross border structuring and arrangements. The structuring or the re-structuring exercise would facilitate streamlining of operations at a group or country level, better flows of funds globally, effective exit from a business or jurisdiction, efficient tax planning along with a multitude of other business specific commercial and geographical merits.
Some of the commonly used mechanisms for cross border structuring may include:
Cross border mergers and demergers are a means of achieving commercial and/ or geographical consolidation or segregation, winding up of presence in a particular jurisdiction and inward or outward fund remittance in a tax efficient and regulatory compliant manner.
With and intent of enabling the ease of doing business and maneuvering operations from one jurisdiction to another, countries around the globe have eased the procedural and legal barriers in regard to cross border structuring, over a period of time.
In India, a major milestone was achieved in this regard with the introduction of Section 234 of the Companies Act, 2013 (‘Companies Act’), which was notified on 13 April 2017. Section 234 of the Companies Act provides for merger or amalgamation of an India company with a foreign company (both inbound and outbound) with a prior approval of the RBI.
Further, rules governing such cross-border mergers have been laid out in Rule 25A of the Companies (Compromises, Arrangements, and Amalgamations) Rules 2016 (‘Companies Rules’). Rule 25A of the Companies Rules provides that in case of an outbound merger i.e. in case an India company is merging with a foreign company, merger shall be permitted only if the foreign company is located in a jurisdiction (‘Jurisdiction test’):
a.) having a strategic Anti money laundering or combating financing of terrorism deficiencies to which counter measures apply; or
b.) jurisdiction that has not made significant progress in addressing deficiencies or has not committed to an action plan developed by FATF
It is pertinent to note that though Rule 25A requires the foreign company jurisdiction test to be satisfied only in relation to outbound mergers only, yet practically, this jurisdiction test may be required to be fulfilled by a foreign company in case of an inbound merger as well. For instance, in case of a Kolkata NCLT approved scheme[1], involving inbound merger i.e. merger of Oasis Chartering Private Limited (a UAE company) with Seavoyage Chartering Holdings Private Limited (an India company), the RD specifically made a reference to the jurisdiction test and since UAE satisfies the above-mentioned jurisdiction test, this question was accordingly responded in affirmative by the petitioner company and the Scheme was approved by the Kolkata NCLT via order dated 6 April 2021.
Also, the Reserve Bank of India (‘RBI’) notified Foreign Exchange Management (Cross Border Merger) Regulations, 2018 (‘RBI regulations’) on 20 March 2018 which need to be complied with, in case of inbound and outbound mergers, as provided for under Section 234 of the Companies Act.
As per the RBI Regulations, merger transactions in compliance with these regulations shall be deemed to have been approved by RBI, and hence, no separate approval would be required. However, in other cases, merger transactions would require prior RBI approval.
Section 234 of the Companies Act refers only to cross border mergers and amalgamations and it does not specifically refer to demergers or any other arrangement per se.
Accordingly, permissibility of cross border demerger is a conundrum, existing since the notification of Section 234 of the Companies Act and doesn’t seem to have been resolved yet.
This is evidenced by two contrary views taken on cross border demergers by the Ahmedabad NCLT, as provided below:
Demerger of a specified undertaking of Sun Pharma Global FZE (Incorporated in UAE) to Sun Pharmaceutical Industries Limited was allowed by the Ahmedabad NCLT vide order dated 31st October 2018[2].
The Regional Director made an observation that Section 234 talk about only merger or amalgamation and same does not refer to a demerger. In response to the observation of the Regional Director, the following explanations were provided by the petitioner company as to why cross border demerger is permissible –
“In case a Scheme of merger or amalgamation of two or more Indian companies or a reconstruction by way of demerger or otherwise of an Indian company has been approved by the National Company Law Tribunal (NCLT)/ Competent Authority , the transferee company or the new company, as the case may be, can issue capital instruments to the existing holders of the transferor company who are resident outside India, subject to the following conditions” (emphasis supplied).
The above arguments were accepted by the NCLT and the Scheme was approved.
Another Scheme of Sun Pharmaceuticals group involved demerger of two specified investment undertakings of Sun Pharmaceutical Industries Limited to two overseas Resulting companies i.e. Sun Pharma (Netherlands) B.V. and Sun Pharmaceutical Holdings USA Inc. Both these overseas companies are the wholly owned subsidiaries of the India company.
The Ahmedabad NCLT rejected this scheme via order dated 19 December 2019[3]. The NCLT observed that though Section 230 and 232 contain the words compromise and/ or arrangement, which is inclusive of the term demerger, but Section 234 mentions only about the words merger and/or amalgamation and does not seem to contain the words compromise and/ arrangement and/or demerger. Accordingly, it can be construed that Section 234 does not provide for or rather restrict the demerger of the Indian companies with foreign company.
With respect to RBI’s stand on demerger, the NCLT order provides the following –
On one hand highlighted that the draft RBI Cross border regulations, which were prepared in the month of April 2017 defined cross border merger to include the term demerger, however the final regulations notified on 20 March 2018 specifically excluded demerger from the ambit of cross border merger definition; and
On the other hand, it has been recorded in the order that the RBI refused to review the scheme on a case to case basis and directed that the petitioner should comply with the prescribed rules and regulation and therefore NCLT took on record that RBI has not objected to the scheme.
Accordingly, the Scheme involving an outbound demerger was disallowed by the same Ahmedabad NCLT, which had sanctioned a Scheme of inbound demerger, almost a year back.
Further, it is pertinent to note that Foreign Exchange Management (Transfer or issue of any foreign security) Regulations, 2004 (ODI Regulations) does not contain any specific regulation (similar to Regulation 9 of FDI regulations) expressly discussing the scheme of merger/demerger.If the ODI regulations covered this aspect, this could have been a strong argument in favour of the petitioner company in this case of outbound demerger.
As per the provisions of the Income Tax Act, 1961 (‘Income Tax Act), merger and demerger would be a tax neutral capital gains transaction in the hands of:
The transferor company upon transfer of assets and liabilities to the transferee company; and The shareholders of transferor company upon receipt of consideration in the transferee company in lieu of the shares/rights foregone in the transferor company
Such tax neutrality is provided by Section 47 of the Income tax Act, which exempts the abovementioned transactions to be treated as transfer and accordingly, keeping them outside the purview of Section 45 of the Income Tax Act i.e. not attracting the chargeability of capital gains on the same.
Section 47, however provides the exemption only if certain conditions as outlined below are complied with:
From the foregoing, it is evident that in case of an inbound merger or demerger, i.e. where the Transferee company is an India company, the benefit of Section 47 would be available and no capital gains tax liability would arise in the hands of the Transferor company and its shareholders.
However, in case of an outbound merger or demerger i.e. where the Transferee company is a foreign company, benefit of Section 47 would be lapse as the conditions that the Transferee company should be an Indian company is not complied with. Thus, an outbound transaction of merger or demerger would lead to capital gains tax liability in the hands of the amalgamating company, its shareholders and the demerged company. This may render the avenue of outbound merger or demerger as less viable for the companies looking for investments overseas.
Another critical aspect is availability of accumulated tax losses and unabsorbed depreciation of the transferor company to the transferee company, pursuant to a merger or demerger.
Section 72A of the Income Tax Act provides for carry forward and set off of accumulated loss and unabsorbed depreciation allowance in merger or demerger transactions. In this regard, it is pertinent to note that if the amalgamating or demerged company is a foreign company, its tax benefits are not likely to qualify as ‘accumulated loss’ and ‘unabsorbed depreciation’, as provided under Section 72A.
This is because the foreign amalgamating company or the demerged company would not have been entitled to carry forward and set off its accumulated loss and unabsorbed depreciation under the provisions of Income Tax Act if such amalgamation or demerger had not taken place. Accordingly, the amalgamated or resulting company will not be allowed to carry forward and set off such accumulated loss and unabsorbed depreciation pursuant to amalgamation or demerger under the provisions of Section 72A of the Income Tax Act.
This aspect should also be analysed while choosing an efficient mode of cross border structuring.
The introduction of Section 234 of the Companies Act 2013, permitting cross border mergers and amalgamations had been a major step forward by the legislature to promote globalization and facilitate ease of structuring or re-structuring operations by companies. However, more clarifications are desirable with respect to the issue of cross border demergers, as discussed in foregoing paragraphs in the Companies Act, RBI cross border merger regulations and the ODI regulations (with regard to outbound demergers).
Further, the provisions of the Income Tax Act, 1961 need to be aligned with the concept of outbound merger or demerger. Otherwise, due to lack of specific exemption for the same under Section 47, substantial capital gains tax liability shall devolve on the transferor company as well as its shareholders.
Additionally, Section 72A of the Income Tax Act, 1961 may provide for carry forward and set off of accumulated tax business losses and unabsorbed depreciation in case of cross border mergers and demergers. This would be a major incentive for the companies to opt for cross border structuring transactions.
Thus, we have come a long way in opening up the legislative environment for cross border structuring transactions, yet some finer aspects need to be refined for effective and smooth implementation of the same.
This article was originally published on Taxsutra.