Tax-implics-of-Mergers-Acquisitions.pdf

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Even though a foreign tax credit should be available,the high effective Indian tax rate will result in excesscredits for the USMNC unless the USMNC generatessome additional low-taxed foreign-source income. Anyexcess credits can be carried back one year or forward10 years.11

The following discussion is organized in five parts:acquisitions of Indian subsidiaries, purchases of assetsfrom an Indian target entity, considerations in enteringinto an Indian joint venture, merger transactions, andspinoffs involving an Indian target entity. In each case,we address the Indian consequences first, and then ad-dress key U.S. tax considerations.

I. Acquiring an Indian Subsidiary

In a typical scenario, a USMNC will be purchasingan Indian target corporation for cash (or a combinationof cash and debt instruments) from an unrelated share-holder of the Indian target corporation. See Figure 1.Although it is possible to use the USMNCs shares as

part of the acquisition currency, this is atypical in thecase of an Indian target corporation. There are disad-vantages to using the USMNCs stock as the acquisi-tion currency. For example, an Indian resident whoexchanges stock of the Indian target corporation forUSMNC stock is required to pay capital gains tax tothe extent that the value of shares received is greaterthan the cost price (basis) of shares exchanged. Thus,the Indian resident shareholder will be in the unenvi-able position of being subject to taxation on his built-ingain, but lacking the cash with which to pay the tax.Also, share-for-share exchanges involving an Indiantarget corporation require prior governmental approval,which can add time, uncertainty, and expense to the

transaction.

A. Indian Tax Considerations

In this section we address the tax consequences tothe seller of the Indian targets shares, various buyerconsiderations, and the corollary effects of the sale onthe Indian target entity itself.

1. Sellers Considerations

Taxation of income in India is governed by the pro-visions of the ITA as amended by the Finance Acts.According to section 4 of the ITA the total income of

an individual is subject to income tax in India. Section5 discusses the scope of total income. Section 5 statesthat residents are taxable in India on their worldwideincome, whereas nonresidents are taxed only onIndian-source income (that is, income received ordeemed to be received in India, income that accrues orarises to them in India, or is deemed to accrue or arise

in India). Section 9 of the ITA is a deeming provision,which under some circumstances, deems income tohave accrued or arisen in India.

Section 9(1) states that capital gains income issourced in India if it arises from the transfer of a capi-tal asset in India. Therefore, when there is sale ofshares of an Indian company, the capital gains incomefrom such transfer would be considered taxable in In-dia regardless of whether the shareholder is an Indianresident or nonresident. Unlike the rules in the UnitedStates, this is true regardless of whether the seller is anIndian tax resident.

Section 45 is the charging provision for capitalgains, according to which a person is considered tax-able on the profits and gains derived from the transferof a capital asset. Further, capital gains tax is payablein the tax year in which the capital asset is transferred,regardless of the year in which consideration may actu-ally be received. This could lead to a situation in whichcontingent or future consideration may be subject totax in the year of transfer of the capital asset.

Capital gains tax in India is payable at differentrates depending on the holding period of the securityand whether the shares are listed on the Indian stockexchange. There are also differences depending onwhether the seller is an Indian resident or a nonresi-dent.

Shares held for more than 12 months are consideredlong-term capital assets and gains therefrom are taxableat the rate of 22.145 percent in the hands of the resi-dent shareholder. Shares held for less than 12 monthsare considered short-term capital assets and gainstherefrom are taxable at the rate of 33.21 percent inthe hands of residents and 42.23 percent in the handsof nonresidents. The 12-month holding period appliesonly to specific securities12 including shares in a com-pany; other kinds of securities such as debentures, op-tions, or bonds are required to be held for more than36 months in order to qualify for the long-term capital

gains tax rates. Short-term capital losses can be offsetagainst long-term capital gains and short-term capital

distributing corporation. The tax was also imposed on both ac-tual distributions of earnings and deemed distributions of cor-porate earnings. Nevertheless, the identity of the taxpayer shouldnot be relevant to the creditability determination. Moreover, thefact that the example addresses both actual and deemed distribu-tions whereas the Indian dividend distribution tax is only im-posed on actual distributions should not matter, because the ex-ample concludes that the tax on both actual and deemeddistributions satisfy the realization requirement. See also Rev. Rul.78-222, 1978-1 C.B. 232; and TAM 8114016 (Dec. 18, 1980).

11IRC section 904(c).

12Under section 2(42A) of the ITA, the 12-month holdingperiod is available only for shares held in a company, or any se-curity listed in a recognized stock exchange in India or a unit ofthe Unit Trust of India established under the Unit Trust of IndiaAct, 1963 (52 of 1963) or a unit of a mutual fund as specified ora zero coupon bond.

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gains. Long-term capital losses can only be offsetagainst long-term capital gains.

Listed securities are entitled to a beneficial rate oftax. Long-term capital gains are taxed at 0 percent ifarising from the transfer of listed securities sold on thestock exchange. Short-term capital gains from the trans-fer of securities on the stock exchange results in tax atthe rate of 16.61 percent. However, these beneficialrates apply only if the securities transaction tax13 has

been paid at the time of transfer.

Indian tax residents are permitted to avail them-selves of indexation benefits on the sale of long-term

capital assets (excluding debentures).14 Thus, if an In-dian tax resident purchased the shares of an Indianprivate company in 2000 for INR 1,000, and then soldthose same shares in 2010 for INR 1,700, the entireINR 700 gain is not considered taxable. Instead, theshareholder is entitled to reduce his gain by the in-dexation allowance, which recognizes that at leastsome portion of the INR 700 gain was simply due toinflation.

Nonresidents may compute capital gains in a foreigncurrency and take advantage of the exchange rate fluc-tuation.15 Thus, for example, if a U.S. person were topurchase shares of an Indian target for INR 1,000 in

13Securities transaction tax is applicable to the transfer of se-curities on the stock exchange:

Equity-oriented mutual funds: Unit sellers to pay STT of0.25 percent.

Debt-oriented mutual funds: No STT. Delivery-based equity: Buyer to pay STT of 0.125 percent

and seller to pay STT of 0.025 percent. Nondelivery-based equity: Day traders and arbitrageurs to

pay STT of 0.025 percent.

Derivative traders: Seller to pay STT of 0.017 percent ofthe option premium for the sale of options, 0.125 per-cent of settlement prices for the sale of an option whenthe option is exercised, and 0.017 percent of the pricefor the sale of futures.

Government securities: No STT.14Second proviso to section 48 of the ITA.15Proviso to section 48 of the ITA.

USMNC(U.S.)

Indian Target

(India)

Shareholder(s)

Indian Target

(India)

Cash

Shares of Indian Target

Figure 1. Stock Purchase for Cash

Corporation Disregarded Entity Hybrid Partnership

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2000 at a time when the U.S. dollar to Indian rupeeexchange rate was $1 to INR 50, and then sell thoseshares in 2010 for INR 1,700, when the exchange rateis $1 to INR 55, the shareholder would actually have again of INR 600 and not INR 700 (55 x ((INR 1,700/55) - (INR 1,000/50))). The U.S. person would, how-ever, not be entitled to any indexation allowance.

The nonresident would also be eligible to set offcapital gains against capital losses incurred during therelevant previous year.16 Long-term capital losses can

be set off against long-term capital gains while short-term capital losses can be set off against long-term orshort-term capital gains. A capital loss that is not so setoff can be carried forward to be set off against futurecapital gain income in the manner described above;however, the carryforward is permitted only for aneight-year period following the year in which the loss isincurred.

If the seller is a nonresident, the seller should alsoconsider whether income tax treaties could apply toreduce the capital gains tax rate. According to section90 of the ITA, when India has entered into an income

tax treaty with another country, the provisions of theITA will apply only to the extent that they are more

beneficial. Therefore, unlike in the United States, taxtreaties in India can enjoy a superior position in com-parison to domestic law. Therefore, in determining thetax liability of a nonresident in India it becomes im-portant to analyze the applicability of the relevant in-come tax treaty.

In the context of capital gains, India has a favorabletax treaty with Mauritius. According to article 13 of

the India-Mauritius treaty, when a Mauritius residententity transfers an Indian capital asset (such as sharesof an Indian company), the gains from such a transferare considered taxable only in Mauritius. Since Mauri-tius does not tax capital gains, the result is an overall

beneficial position for the taxpayer. Several investorshave chosen this route to make investments into India,

because tax is only payable in the country of residenceof the investor. The popularity of Mauritius also stemsfrom the landmark ruling in Azadi Bachao Andolan.17 Inthat case, the Supreme Court of India confirmed that aMauritius company is entitled to avail itself of treaty

benefits if it was granted a tax residency certificate bythe Financial Services Commission in Mauritius.18 AMauritius-based company should be granted a tax resi-dency certificate if it is a company holding a category1 global business license. Further, the company is re-quired to have at least two directors resident in Mauri-tius, board meetings held in Mauritius, maintain booksof accounts in Mauritius, and channel banking transac-tions through a bank in Mauritius. Tax residency cer-tificates have recently begun to be issued by the Mauri-tius tax authorities on an annual basis.19

16Section 74 of the ITA.17263 ITR 706.18This has been reiterated in cases such as M/s Saraswati Hold-

ing Corporation Inc [ITA No. 2889/Del./2007].19India generally respects the rule of form over substance.

Therefore, if the Mauritius company has been issued a tax resi-dency certificate, it should generally be eligible for Indian tax

Table 2. Indian Capital Gains Tax Rates

Type of Shares Type of Gains Taxa Section

Unlisted shares LTCGb 21.115% 112

STCGc 42.23% Finance Act

Listed shares on the stock exchanged LTCG 0% 10(38)

STCG 15.836%d 111A

Listed shares off the stock exchange LTCG 10.558% 112 Proviso

LTCG (FII Investor) 10.558% 115AD(6)(iii)

STCG 42.23% Finance Act

STCG (FII Investor) 31.67% 115AD(6)(ii)

Investment through Mauritius all shares 0%e Article 13 of the DTAA

aThese rates are inclusive of the currently applicable surcharge on tax and education cess.bLong-term capital gains mean gains on sale of shares held for a period of more than 12 months.cShort-term capital gains mean gains on sale of shares held for a period of 12 months or less.d

Sale on the stock exchange will attract transaction tax at applicable rates.eProvided there is no permanent establishment in India.

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fund (QEF) election has been made regarding the sell-ing shareholder, the seller will want to determinewhether the buyer intends to make a section 338(g)election for the Indian target.

a. Creditability of Indian Capital Gains Tax. To obtain acredit for the Indian capital gains tax, there are twohurdles that must be overcome. First, the seller mustconclude that the Indian capital gains tax is a credit-able tax under U.S. federal income tax law. Second, theseller must ensure that it has sufficient foreign-sourceincome to absorb the credit.

i. Creditability. Regarding creditability, there are twoways the seller could be comfortable that the Indiancapital gains tax is creditable under U.S. law. The firstis by simply applying the U.S. regulations that define aforeign levy as a creditable tax if it is a tax and thepredominant character of the levy is an income tax inthe U.S. sense.30 The Indian capital gains tax can beconsidered a tax because it is a compulsory levy im-posed by the Indian government under its authority to

levy taxes.31 It can also be considered an income tax inthe U.S. sense because the tax is imposed on the gaininherent in (and not the gross revenue from the sale of)the shares that are actually sold (not on some deemedrealization event) and the imposition of the tax is notdependent on the availability of a corresponding creditin the United States.32 Alternatively, the seller could becomfortable that the tax is creditable because the India-U.S. treaty specifically requires the United States toprovide a foreign tax credit for those taxes identified inarticle 2(1)(b) and 2(2) of the treaty. Article 2(1)(b) re-fers to the Indian income tax. The capital gains taxthat the Indian government imposes on the sale bynonresidents of Indian target companies is considered

an income tax in India. Therefore, the tax should beconsidered creditable under the India-U.S. treaty.

b. Sufficient Foreign-Source Income. The United Statesdoes not permit U.S. persons an unlimited foreign taxcredit. Instead, the U.S. persons ability to claim a for-eign tax credit is limited by an amount equal to hiseffective U.S. tax rate multiplied by the foreign-sourceincome that he has in the foreign tax credit basket towhich the taxes relate.33 There are currently two for-eign tax credit baskets, general34 and passive.35 Excesscredits can be carried back one year and forward 10years within their appropriate income baskets.36 If theseller has foreign-source income in the appropriate bas-

ket from other activities (that is, foreign source royal-ties or interest payments), then it need not worry aboutthis hurdle. Otherwise, the seller must determine howmuch foreign-source income will be created regardingthe sale of the shares of the Indian target company.Normally, when a U.S. person sells the stock of a for-eign corporation, the gain (if any) on the sale is con-

sidered to have a U.S. source, because the gain issourced by reference to the sellers residence.37 Al-though the India-U.S. treaty does not provide assist-ance on this point,38 there are exceptions to the generalU.S. source rule under U.S. law that may conceivably

be helpful.

The exception that most commonly applies is onethat is applicable to Indian targets that are currently (orwere at some point during the preceding five years)considered CFCs and held by U.S. sellers that own 10percent or more of the voting shares of the Indian tar-get. In those cases, the seller is likely to have a section1248 amount regarding the shares of the CFC. The

section 1248 amount should equal the portion of theIndian targets earnings and profits attributable to theshares held by the seller for periods after 1962 whilethe seller held the shares and the Indian target wasconsidered a CFC. To the extent that the seller has asection 1248 amount regarding the sellers shares, thegain is recast as if it were a dividend from the CFC tothe selling shareholder. Normally, an actual or deemeddividend from a foreign corporation will be consideredto have a foreign source.39 To the extent the section1248 amount is significant enough, this may providethe selling shareholder the foreign-source income nec-essary to claim a credit for the tax, without resorting tothe other exceptions.40

30Treas. reg. section 1.901-2(a)(1)(i) and (ii).31Treas. reg. section 1.901-2(a)(2).32Treas. reg. section 1.901-2(a)(3).33IRC section 904(a).34IRC section 904(d)(2)(A)(ii).35IRC section 904(d)(2)(A)(i).36IRC section 904(c).

37IRC section 865(a).38In many treaties the U.S. is a signatory to, if the counter-

party is entitled to impose tax on the sale of stock of a companythat is resident in the counterpartys jurisdiction, the seller is en-titled (under the treaty) to consider the income from the sale ashaving a non-U.S. source. In these cases, the U.S. requires thatthis income that is deemed to arise from non-U.S. sources beplaced within its own separate foreign tax credit basket that isneither active nor passive. IRC section 865(h). In the case of In-dia, article 13 of the India-U.S. treaty does not prohibit Indiafrom imposing capital gains tax on the U.S. sellers sale of stockin an Indian target company. Article 25(3)(a) and (b) of theIndia-U.S. treaty provides that if a U.S. seller is subject to tax inIndia on income, then the income will be treated as arising fromIndian sources. This would ordinarily be a helpful rule. Theproblem is that in the case of the India-U.S. treaty, this provisionunfortunately only applies to income from royalties and fees forrelated services governed by article 12 of the India-U.S. treaty. Itdoes not apply to gain from the sale of shares of an Indian tar-get that would be governed by article 13 of the India-U.S. treaty.

39IRC sections 861(2)(A) and 862(a)(2). There are exceptions,however. See, e.g., IRC section 904(h).

40Presumably the inclusion will fall within the shareholdersgeneral foreign tax credit basket, because the E&P the inclusion

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have been other cases such as KT Corporation103 andIKEA Trading104 that have held that an LO should notbe considered to be a PE. The principle underlying allthese rulings seems to be that the LO should carry outa very limited range of commercial activities andshould as far as possible only act in a representationalcapacity. An increased involvement of the LO may re-

sult in greater PE exposure for the USMNC in India.

c. Indian Corporate Entity. An Indian corporate entityis the simplest and most common form of entity inIndia. The preferred vehicle would be a private limitedcompany so that the entity could make an entity classi-fication election as a partnership or disregarded entityfor U.S. federal income tax purposes.

In the event that the joint venture is set up as anIndian company, a corporate tax rate of 33.21 percentis presently applicable. A dividend distribution tax(DDT) of 16.61 percent is payable on distribution ofdividends to the shareholders.105 The liability for thistax is imposed on the corporation, not the shareholder.

However, such dividend income is then tax exempt inthe hands of the shareholders irrespective of their resi-dential status. DDT is payable regardless of whetherthe company making the distributions is otherwisechargeable to tax.

d. Limited Liability Partnerships. It is possible to enterinto joint venture arrangements that do not involve theset-up of companies. Recently there has been introduc-tion of the limited liability partnership regime in India.The Indian LLP embodies more features of a corpora-tion compared with its counterparts in other countries.Investments into an LLP may involve the same foreigndirect investment restrictions as are applicable to com-

panies. However, for tax purposes the LLP would beconsidered as a partnership.

If the joint venture is made into an LLP, tax wouldbe levied at the LLP level. However, as the LLP is con-sidered a partnership for Indian tax purposes, thereshould be no further implications at the limited partnerlevel. Further, the rate applicable to an LLP is lowerthan that applicable to a company (at 31 percent).There is also no incidence of DDT or MAT, whichmay make the LLP a better investment structure. How-ever, the Finance Act 2010-2011 has introduced a pro-vision under which an LLP may not make distribu-tions to its partners, out of accumulated profits, for aperiod of three years from the date of conversion of a

company into an LLP. Further, while the Finance Act2010-2011 has introduced provisions for exemption onconversion of a company into an LLP, the exemptionhas only been extended to conversion of turnover di-

vided by total sales divided by gross receipts of lessthan US $120,000 in any of the preceding three years.This provision could limit the tax exemption to verysmall companies.

Given the more favorable tax regime applicable toLLPs, one would logically assume that the USMNC

would want to own its investment in the LLP directlyor through a Mauritius holding company. The difficultyis that the foreign exchange rules do not currently per-mit non-Indian persons to own an interest in anLLP.106 If that restriction is lifted, India will likely wit-ness a large and significant shift to the LLP form ofdoing business. At the same time, however, an LLPmay not be the best vehicle to take the Indian businesspublic since Indian laws do not currently permit listingof an LLP. Further, conversion of an LLP into a com-pany that could then be listed may not only turn out to

be a tax inefficient process, but also result in a deter-rence to listing since the listing process may requirefulfillment of conditions such as track record, mini-

mum net worth, or minimum distributable profit forthe last three years, which the new company would beunable to fulfill.

e. Association of Persons. Section 2(31) of the ITA de-fines the term person to include an association ofpersons or a body of individuals, whether incorporatedor not.107 The Supreme Court of India has held108 thatin order to constitute an association, persons must joinin a common purpose or common action and the ob-

ject of the association must be to produce income.Thus, a consortium formed by two or more companiescould be chargeable to tax as an association of persons(AOP). Section 6(2) of the ITA also provides that anAOP will be considered to be resident in India, except

in cases when the whole of the management and con-trol of the affairs of the AOP is situated outside India.Thus, an AOP is considered to be resident in Indiaeven if a fraction of its control and management issituated in India. This is important since a resident istaxed in India on its worldwide income.

If the joint venture is structured as a contractualarrangement, the venture could be considered as anAOP for Indian tax purposes. In this case, the entireincome of the AOP could be subject to tax in India ifeven a portion of the AOP is situated in India. Thistreatment may apply even though a treaty exists be-tween India and the country in which the nonresident

103181 Taxman 94.104[2009] 308 ITR 422.105Section 115 O of the ITA.

106The government is considering allowing 49 percent foreigninvestment in LLPs with prior approval. See LLPs with FDImay not get to float arms, Economic Times, Mar. 16, 2010, avail-able at http://economictimes.indiatimes.com. However, no formalannouncement has been made by the government as of the writ-ing of this article.

107Subclause (v) of section 2(31).108CIT v. Indira Balkrishna, 39 ITR 546.

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Tax-implics-of-Mergers-Acquisitions.pdf