India: Income-Tax Issues In Buying A Business In India

1. Introduction

1.1. A jump of 30 ranks (from 130th to 100th) to make an entry into the top 100 in the World Bank's Ease of Doing Business index in its Doing Business Report 2018¹ clearly shows the results of the legislative improvements and overhauling measures taken in the recent past by the government to make it easier for businessmen to do business in India. This reflects an advancement in the overall economic and business environment in the country. With such a gigantic leap, there is bound to be an upsurge in business acquisitions in India, and thus, the legislative framework must provide strong support for such acquisitions.

1.2. When it comes to the income-tax framework in the country, though the government is taking constant steps in its reformative process to reduce litigation and create certainty and stability in tax law, the road to reach higher frontiers is still long pending. Resultantly, when it comes to buying a business in India, income-tax issues arising therefrom often become a matter of detailed deal negotiation between the parties. Many times, such issues have become deal breakers as well. In fact, several protracted litigations have resulted in the past where such issues have not been addressed properly.

2. Some significant income-tax issues

2.1. Withholding tax implications

An acquisition of a business from a resident transferor through slump sale – a transaction whereby a business 'undertaking' as a whole is sold as a "going-concern" on an 'as is where is' basis, without values being assigned to the individual assets and liabilities in such sale – does not obligate the buyer to withhold income-tax at source. However, if the transferred undertaking consists of immovable property, the position is not very clear and in practice, we have noticed that in such cases, in view of Section 194IA of the Income-Tax Act, 1961², the stamp duty authorities require submission of evidence of taxes deducted at source at the time of registration of the document of sale.

2.2. Splitting the sale consideration: Non-compete arrangement

Often, the covenants from the seller's side in a business transfer agreement (BTA) include non-compete covenants (NCA's) as well. In such a scenario, it is always recommended to attribute some portion of the sale consideration towards the NCA's upfront. This is because payment of non-compete fee triggers a withholding obligation for the buyer, and in the absence of such express splitting of sale consideration by the parties, the tax authorities may seek to allocate a higher amount towards NCA's resulting in the buyer being considered as an assessee in default for such shortfall in withholding tax. Given that withholding tax default has wide ramifications, transaction parties should carefully evaluate this aspect as well with their tax advisors. This evaluation also becomes critical as to the manner in which the buyer needs to account for such consideration paid to the transferor.

From the seller's perspective as well, this allocation of sale consideration becomes extremely essential because of the differential rates at which non-compete fee and capital gains are taxed, viz. income from transfer of slump sale would be taxed as capital gains (which may be taxed at the rate of 20% if the transferred undertaking had been held by the transferor for more than 36 months) while non-compete fee is taxed as business income at the rate of 30%.

2.3. Valuation of business

In respect of certain assets³, the Indian income-tax law has specific valuation norms and prescribed valuation mechanisms which provide that acquisition of such assets for nil/inadequate consideration could result in a tax trigger in the hands of the acquirer. Technically, while these provisions should not be applicable to a slump sale because a 'business undertaking' does not fall within the ambit of such assets; to avoid any risk of litigation, it is advisable that the sale consideration paid by the buyer conforms to such valuation mechanisms. Having said so, it may be noted that in case the transferred business undertaking comprises of immovable property and/or shares, then, the case for applying such valuation mechanisms and taxing the buyer (if acquisition is for nil/inadequate consideration) is much stronger.

From the seller's perspective as well, the valuation aspect is critical as there are statutory provisions in India's domestic tax laws (Section 50CA, Section 50C) which provide for taxing the seller on a 'deemed consideration' in certain cases.

Thus, enough care should be taken to ensure that the valuation aspects of the transaction are handled appropriately, so that there are no adverse income-tax implications for either of the parties.

2.4. Depreciation on 'Goodwill'

Buyers generally undertake a purchase price allocation to be able to account for the assets and liabilities acquired by it pursuant to slump sale. The costs so allocated are treated as cost of acquisition of each of the asset for tax purposes and in case of depreciable assets, depreciation becomes available to the buyer entity based on such cost basis. In this regard, it is noteworthy that though the Honourable Supreme Court, in the case of Commissioner of Income Tax v Smifs Securities Limited⁴, has held that goodwill is a depreciable asset, it is often seen that depreciation on goodwill becomes a disputed issue and is often litigated by the tax authorities at a lower level.

To mitigate such issues, it is essential that the language in the BTA is such that it can clearly demonstrate that the amount attributed (and paid) towards goodwill is actually on account of some business or commercial rights – for instance, customer lists, business expertise, etc. Thus, it is imperative that the transaction documents are carefully drafted and the above aspects are considered carefully.

2.5. Successor liability risk

Under the Indian income-tax law, there is a risk that upon acquisition of a business, the buyer, as a successor, would inherit the tax liabilities, if any, of the seller. This risk is triggered in cases where the transferor cannot be found or where any tax liability is not recoverable from the transferor (for example, on account of inadequacy of assets). In case the provision is triggered, the buyer may be held liable for the tax liabilities of the transferor for a specific period, i.e. for the financial year in which the transfer of business takes place and the financial year immediately preceding the date of the transfer.

How to safeguard against such risks?

Contractual protections (such as tax indemnities, etc.) should be suitably built in the transaction documents to secure oneself from such risks. Alternatively, parties may also consider adopting the escrow model for settling the consideration. While selecting the mode of protection to be adopted, it is also essential to evaluate the effectiveness of the seller to honour its indemnification obligations. This becomes more important in case the seller is a Special Purpose Vehicle (SPV) entity. In such a case, seeking protection from the ultimate parent entity of the seller entity may also be evaluated.

2.6. No Objection Certificate (NOC) from income-tax authorities

Under the Indian income-tax law, if the business comprises of certain specified assets⁵, transfer of such assets would be regarded as void to the extent of any outstanding tax claims of the seller, unless a tax clearance certificate (Tax NOC) from the relevant tax authorities is obtained in respect of such transfer. It has been observed that procuring a Tax NOC is a time-consuming process. Thus, it is important that this requirement is discussed early in the transaction so that in case a push-back is experienced from the seller on obtaining the Tax NOC, alternative protections (in terms of appropriate covenants and/or tax indemnities from the seller) can be explored.

3. Conclusion

3.1. Tax issues have never been so important and at the forefront as they are now. With India Inc's increasing appetite and hunger for growth – organic as well as inorganic – there is no doubt that business acquisitions will increase manifold in the near future. Further, with India being among the top 10 improvers in the Ease of Doing Business rankings index this year⁶, India centric business acquisitions are only going to rise. One would expect that with the Insolvency and Bankruptcy Code (IBC) also being implemented now, business acquisitions will continue to be on the rise.

3.2. Thus, going forward, it will be imperative for all business persons to undertake adequate income-tax related diligence before buying a business because any non-compliance with the tax laws may attract penal consequences (the much-known Vodafone deal and the resulting consequences are clear evidences of this). In addition to the (monetary) tax cost that is a result of such consequences, a substantial amount of management time is also lost in handling any tax litigation. Further, given that the new accounting regime (Ind-AS, which focuses on a substance based accounting rather than a form based accounting) has become effective for some companies, the accounting aspects would also need to be kept in mind in business acquisitions. Moreover, given that General Anti Avoidance Rules (GAAR) have already become effective in the Indian income-tax law, all aspects of business acquisitions – be it mode of acquisition, choice of entity, etc. – would need to be carefully evaluated and analysed in every business acquisition.

This article was first published in Business India, January 29-February 11, 2018.

Footnotes

1. World Bank. 2018. Doing Business 2018: Reforming to Create Jobs. Washington, DC: World Bank. DOI: 10.1596/978-1-4648-1146-3. License: Creative Commons Attribution CC BY 3.0 IGO.

2. In terms of Section 194IA of the Income-tax Act, 1961, acquisition of non-agricultural immovable property from a resident transferor for a consideration of INR 50 lacs or more obligates the buyer to deduct 1% of the consideration as income-tax at source.

3. Immovable property, shares and securities; jewellery; archaeological collections; drawings; paintings; sculptures; any work of art; or bullion.

4. [2012] 348 ITR 302 (SC).

5. Specified assets mean land, building, machinery, plant, shares, securities and fixed deposits in banks, to the extent that any of the above-mentioned assets do not form part of the stock-in-trade of the business.

6. Supra note 1.

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