SPACs: Understanding tax and regulatory framework

Sneha: Hello everyone hope you're well and staying safe. Welcome to the second episode of Grant Thornton Bharat's knowledge podcast on special purpose acquisition companies. In our first episode, partner and overseas listings leader Raja lahiri introduced us to the concept of SPACs and what are the benefits and risks for the companies. In case you missed tuning into it, here is a quick snapshot. SPACs also known as blank check companies require additional capital through a PIPE transaction mode, that is private investment in a public entity in order to fund the growth plans of the acquisition targets. It is the quickness of time that is causing companies to consider SPAC, and why not a SPAC transaction can be completed in just a few months as compared with a traditional IPO. However, one must be prepared, a robust business model with the right mindset, transparency and good corporate governance can sustain the growth for the company. Without much ado, let me welcome our tax expert and partner Sridhar R to delve in detail about the tax and regulatory framework that one company must adhere to while going down a SPAC route. Thank you so much for joining us.

Sridhar R: Thank you Sneha. It's always a pleasure to address the audience through this innovative mode. Look forward to the discussion.

Question: Let us begin with the most pertinent question on the tax and regulatory framework in India around SPAC Could you please elaborate on the same.

Sridhar R: So, there is quite a bit of oversight from both the regulator that is the Reserve Bank of India and the Ministry of Finance as well as the Indian income tax authorities, particularly in a De-SPACing transaction. Some of these are very significant issues that need to be addressed in detail before any transaction is undertaken. Given the current regulatory norms a direct SPAC listing in India is still a very early concept stage and therefore, is not a choice for us at this stage. There are however, active discussions within the government happening on to position the ifsc or the gift city as the front runner to consider and allow such a structure. SEBI has also set up an expert group to examine the feasibility of an Indian SPAC and effectively an overseas direct listing of an Indian company is being considered by the government. And there are some enabling provisions that have come through under the company law. But the rules around this have yet to be framed in detail, while a draft is still out. These are early days for direct overseas listing or a direct SPAC listing in India. Therefore, what it means is that typical SPAC jurisdictions that are invoked today are the US that is Delaware, Cayman Islands and the BVI. And from an India perspective, what it means is a SPAC that is listed overseas acquires a target in India, which means essentially buying out the shares of the Indian entity. that essentially means that the tax framework of India as far as the buying of the investment applies to that kind of a transaction. A swap has its own challenges, and we will discuss about this in detail as we go along.

Question: So what would be your views for a company which is owned over 50% by Indian investors, founders, an externalisation is yet to be done.

Sridhar R: So that's a difficult question in the Indian context, today. And let me explain the reason why I say that. That's because the SPAC is expected to own at least a majority of the Indian target, which means that at least 50% or more should get folded up into the target, if not, ideally, all of the 100% and the ideal structure is therefore the SPAC owning 100% of an Indian target, which means that the promoters have a very limited way to be accommodated in the SPAC and there is a significant regulatory oversight on this matter, where RBI is averse to any structure that has a resident owning a foreign entity, which in turn owns an Indian entity. In tax and regulatory world. This is known as the ODI FDI structure and there are very limited ways to overcome this restriction and therefore, it is recommended that an inverted foreign owned entity is set up at an early stage of the business and well before any De-SPACing transaction is contemplated. Now, why I say early stage is because the values at which the investment is done at an early stage of business is much lower than at a stage when the De-SPACing transaction is being contemplated. And therefore, while the regulatory oversight of a resident owning a foreign entity which owns an Indian entities still remains a concern. The limited ways that this can be achieved through is either through the promoters getting some form of sweat equity or stock options, as we call it, or the Indian resident shareholders participating through the limited window available under the liberalised remittance scheme window that is the USD 250,000 window as we call it.

Question: So, do you think the liberalised remittance scheme or this investment route is sufficient for resident investors or what could be the limitations or the precautions that the companies must take?

Sridhar R: The USD 250,000 limit is certainly not sufficient for resident investors. But if you see this in the perspective that this is for individual investors, as well as for investors who are more investing in the portfolio manner, it is a fairly decent limit as far as an annual amount is concerned. And USD 250,000 is per financial year and per person. So if you have a family of four people, we are talking of 1 million limit. So there is a fair bit of flexibility in the current LRS route. But it doesn't certainly allow the promoter group to get invested under the LRS route to come to a shareholding at the SPAC level. And that is still a concern. And unless government kind of comes out clearly permitting this and allowing such a round trip, in the circumstances, it is difficult for promoter groups to get to the SPAC entity unless they have already inverted a structure given that they were at some point, non residents or given that they were at some point, offered shares of the Indian target through a sweat equity or ESOP mode. And in that circumstance, we already have an inverted structure from inception or from early on, and in that situation, getting into the De-SPAC mode can even be achieved through a merger of the foreign parent with the SPAC or an SPV of the SPAC and a merger is a tax neutral way of getting the Indian resident shareholders to participate in the De-SPAC entity. Having said that, there is still a small gap in the law where a swap in itself of Indian company shares with the shares of a foreign company still need the RBI's permission, which again get you back to the round tripping issue which RBI will be averse to give and therefore, a swap can be done only when there is already an inverted structure which means that the parent entity of the Indian target is already owning 100% of the Indian target and its business and then that parent is then merging into an overseas SPAC or the SPV of the SPAC.

Question: So, what are the tax consequences of a De-SPACing transaction then. Could you explain it for you residents as well as for non residents.

Sridhar R: So, like I said, a De-SPACing transaction in the Indian context effectively means acquiring the shares of the Indian target. And if you see it in that context, it means a transfer of the Indian company shares. Now, whether that is done through a swap or for cash of the Indian target, both result in a capital gains event. And the shareholder therefore, ends up paying tax on any gain that is made on the exchange for the sale. Now, given that respect targets are likely to be in high growth or innovative sectors, there is an interplay of tax with the exchange control law provisions in India which expect a fair value realisation of such sale or swap for resident shareholders particularly and this becomes a significant element of tax because, if you have to fair value, the sale or the swap, you you would expect the resident shareholders to pay that much as capital gains tax. And therefore, to that extent, they would have a higher tax incidence potentially keeping into the into the transaction for non resident shareholders, where they have invested early through Mauritius or Singapore or Netherlands, there is treaty protection and grandfathered tax benefit that they may want to claim on, on claiming the exemption for capital gains tax. Now, resident shareholders may also benefit if they were holding a special status like AIFs in India, which are entitled to a capital gains exemption per se. And therefore, for for non resident shareholders, we are saying that the 3d protection is available and typically ranges from 10 to 20%. Typically for long term or short term capital gains, whereas, the domestic tax law for resident shareholders expects residents to pay capital gains tax if long term at the rate of 20%. And if short term at their applicable tax rate and therefore, at a promoter level, this could be a significant tax incidence if there were individuals earning more than significant threshold of income in a year.

Question: So, how does indirect transfer rules under Indian income tax laws impact future transactions?

Sridhar R: So, there is a extraterritorial reach of the Indian income tax law where the income tax law taxes and indirect transfer of an Indian asset and creates a tax event for the SPAC shareholder whether resident or non resident, this is actually accentuated in the event the Indian asset contributes significantly to the overall value of the SPAC entity and Indian tax law does provide for an exemption from this mischeif if two foreign companies were to merge in a tax neutral manner, like I said in the previous question, but it is an important element to plan as the investors may not be entitled to treaty protection in such a situation. And this is something which needs a deeper dive into the facts of all cases for us to kind of come to an answer on how would indirect transfer rules apply in that situation, this is more relevant also for both the buyer and the seller, given that India also taxes the buyer in the event, where there is a benefit to the buyer on account of him getting the shares of the SPAC or of the foreign SPV at a lower than the book value the underlying book value of this pack which includes the value of the Indian target. And therefore, in all situations, where the shareholder buying the investment gets the shares of the SPAC either free of cost or at a benefit that is lower than the book value, there is a tax exposure on the buyer. And on the other hand, there is always a tax exposure on account of the indirect transfer at the SPAC level if India was to contribute significantly to the overall value of this bank, and therefore, this is this is a question that needs to be addressed every time a transaction at the SPAC level is being proposed. And of course, at the time of De-SPACing as well.

Question: So then, according to you should SPAC just hold shares of Indian target or the Indian target should be folded into the SPAC ?

Sridhar R: That's a good question Sneha see the cross border merger rules in India. Do permit an Indian company to merge into a foreign company which means in legal parlance is called an outbound merger. And RBI has also come out with a set of guidelines to permit such an outbound merger. However, the challenge is in tax where such an outbound merger is not considered to be tax neutral in itself and therefore, there is a capital gains event which triggers both at the level of the shareholder holding the shares of the Indian target as well as at the level of the target itself, which gives up its assets in favour of a foreign company when the merger happens. So, there is a double layer taxation which we have to address in coming to this answer. But in theory, it is possible for an Indian company to merge with say, a Delaware based company under under corporate law in India, what it also results in is that the foreign company ends up having a branch in India as as a consequence of the merger and that in itself has tax consequences given the fact that a branch of a foreign company gets taxed at a higher rate of 40%. One and two, it also has a regulatory restriction, if the Indian branch were to do activities which are not permitted otherwise, for foreign company branches in India, for instance, manufacturing is not permitted in a branch model and therefore, it becomes significant showstopper for us from a tax and regulatory regime to consider the possibility of an Indian company merging into a foreign company and resulting in a branch as a consequence of the merger in India. Therefore, in the current tax and regulatory regime, the logical possibility seems to be where the Indian company ends up being owned by the foreign SPAC through a shareholding relationship, the Indian target not necessarily folding into the SPAC, if tax were to consider this or some relaxation was to be given under income income tax law in India, this could be a good possibility to explore and a better possibility in the long run for the SPAC as well.

Question: Other than what you just mentioned a Sridhar what are the other things a company must watch out for post De-SAPCing

Sridhar R: one important elements may have that needs to be factored in post De-SPACing is potential exposure on account of place of effective management rules in India under Income Tax Law, to kind of briefly explain what place of effective management means is that if a foreign company was to be effectively managed from India, the Indian income tax rules say that that entity should be treated as a resident in India and therefore, all income that it owns globally should be offered to tax in India. Therefore, if a SPAC were to be effectively managed from India post the De-SPACing transaction, the exposure for the SPAC to be treated as a resident therefore becomes accentuated Of course, a SPAC if it was to be seen as business, it seems like it will be a passive business entity and in which situation the test of the place of effective management lies in who takes decisions as well as where those decisions are taken from a management and control perspective. So, we certainly have to ring fence any potential exposure on account of place of effective management for a De-SPACed entity if the promoters are continuing to play an important role in the SPAC management. The other thing that needs to be kept in mind is the revenue upstreaming of returns from the Indian target in India in the form of dividends or interest, and there could be some capital structuring that could be necessary to be making this efficient and this also ties up with The question around the jurisdiction of the De-SPACed entity, and there is a lot of flexibility in considering US, a Cayman Island or BVI for the De-SPACed entity to be most efficient from a tax perspective, there's always a need to protect the carry forward of losses and map credit in a De-SPACing transaction and therefore, this needs a bit more evaluation. Specifically, at the point of De-SPACing as well as thereafter, considerations such as the country's from where the PIPE investors or the other investors are coming through also need to be evaluated post De-SPACing or at the point of De-SPACing itself. In summary, quite a bit of planning needs to be done while you're considering De-SPACing for all of this in future.

Question: So, what is the role of FDA policy on De-SPACing or externalisation as you may put it

Sridhar R: So FDI norms typically applied to the activities of the Indian target and therefore, in our situation where the De-SPACing transaction involves acquiring the shares of an Indian target, which is normally what we would expect to happen in the current scheme of things. The FDI norms would play a very important and active role in deciding the limitations of how much FDI can come into that particular entity. For instance, if you have sectors such as the financial services or if you're into trading or e commerce or or you are an investor coming from China or from the neighbouring countries of India, all of this needs to be factored in, in the De-SPACing exercise. And therefore FDI norms would play a very significant role in coming to an answer on what is permitted under the FDA rules or what is otherwise limited by regulation in India. Further, De-SPACing anyway involves possibly an outbound cross border merger. And there, you still have to be aware of the RBI regulations, like I said, if you were to actually consider an outbound cross border merger. Like I said, the regulations permit this, but tax does have a fairly significant role to play in dissuading a cross border merger at this point in time. But this is a possibility that still has to be addressed fully. And to that extent, while it may not be FDI, but the regulatory oversight under exchange control law would apply to such a situation.

Sneha: Thank you, Sridhar for sharing your insights with us. That's all from this special episode of our knowledge sharing podcast. Stay tuned for our next episode, where we will talk about the auditing framework requirements while going public via SPACs