Deferred consideration and its impact on M&A transactions
Published: Jan 02, 2017
By Rekha Bagry, Partner - M&A Tax, PwC India
Often, in today's dynamic business environment, the only means available for organisations to grow, and sometimes even survive, is to seek inorganic routes such as mergers and acquisitions (M&A).
Generally, in all M&A transactions, parties seek to balance the commercial scales between themselves to protect their respective interests. While a seller generally prefers to cash out up front, for a buyer, the economic uncertainties of obtaining the "promised" returns makes them averse to up front payments. Thus, often, acquisitions are structured to divide the risks between buyers and sellers. One such popular mechanismis having a part of the consideration payable in future, i.e., deferred. While such consideration may be a fixed number, only payable at a future date, generally, the determination of such consideration is contingent upon a future event (such as earnings target, reaching a specified share price, defined performance criteria, etc.) with a potential minimum guaranteed payout. For a buyer, this mitigates economic risks to whatever extent possible, and for a seller, it often enables them to partake in an upside.
Until recently, any transaction involving the transfer of shares between a domestic party resident and a non-resident, which had a deferred consideration clause, required prior RBI approval. This posed a major challenge and resulted in increased time lines in completing the transaction.
However, the RBI recently issued a notification No.FEMA.368/2016-RB, dated May 20, 2016, which allows up to a maximum limit of 25% of the total consideration to be paid by the buyer on a deferred basis within a period of 18 months from the agreement date, without the need for an approval.
This is a welcome move towards giving more comfort to the international investor community;however, further tweaks may be necessary to bring it closer to business realities. In business terms, a period of 18 months seems a very short time and may not be commercially viable, especially in large deals where the stakes are high. In addition, in case of a contingency attached to the deferred consideration, the 25% cap may become a roadblock. Thus, despite some relief, the regulations probably need further liberalization to keep up with the changing times.
From an accounting perspective, deferred consideration is a complex topic. India is already in the process of converging with the IFRS. For this purpose, the Ministry of Corporate Affairs has notified new Indian Accounting Standards (Ind AS), under which, several accounting practices have changed. While hitherto, little guidance was available as to the timing and method of accounting for the deferred portion of the consideration, under Ind AS, the accounting treatment for the acquirer has been specifically prescribed. The underlying principles of determining fair value in the Ind AS also have a play here.Thus, on the acquisition date, the fair value of the acquirer's future liability towards the deferred portion has to be determined and accounted for. Thereafter, the difference, if any, between such fair value and the amount actually paid out is accounted for depending on whether the consideration is deferred unconditionally (in which case, any excess amount paid is potentially treated as interest in case of cash consideration) or is conditional (an evaluation is done to determine the reasons for the difference, and the treatment is accordingly decided). Undoubtedly, this has to be dealt with in depth based on the surrounding facts and circumstances.
However, interestingly, no specific guidance has been provided under the Ind AS from a seller's perspective—one would need to draw analogies from the guidance available under the IFRS on the matter and potentially recognize gains/ losses up front, on the date of transfer itself, based on the fair value/ likelihood of recovery. This again requires a detailed analysis.
The other important aspect is the taxability of the seller. With no express provisions in the tax laws (except for covering compulsory acquisitions), many questions arise in a case where contingent consideration is involved, such as the year in which the contingent consideration should be taxed (i.e.,year of transfer or the year of receipt), the nature of the income if it is taxed in the year of receipt, etc. Based on available judicial precedents, it is clear that the issue is not free from litigation. Predominantly, two views emerge, which are discussed below.
View 1: Taxed in the year of transfer
The Hon'ble Delhi High Court in the case of Ajay Guliya vs ACIT - 2012-TIOL-553-HC-DEL-IT held that even though the payment of consideration depends upon happening of certain events, the income still accrues in the year of the transfer. Thus, receipt of the entire consideration has no relevance towards incidence of taxation.
In this scenario, under the provisions of the tax laws, where the consideration received or accruing as a result of the transfer of a capital asset is not ascertainable or cannot be determined, then, potentially, the fair market value of the asset as on the date of the transfer would need to be considered.
View 2: Contingent payment taxable in the year of receipt
Recently, the Hon'ble Bombay High Court dealt with this issue in the case of CIT vs Mrs. Hemal Raju Shete - 2016-TIOL-836-HC-MUM-IT wherein they held that since the formula prescribed in the agreement made it clear that the contingent consideration receivable in four years was dependent upon the profits in each of those years, no right to claim any particular amount was vested in the year of the transfer. Therefore, amounts to be received as contingent consideration could not be subject to tax in the year of the transfer. While this does provide some relief to the taxpayer, inasmuch they would be taxed only when they actually receive the consideration, the issue of how the amount was to be taxed upon receipt has still not been addressed.
It is noteworthy that in the context of compulsory acquisitions, the tax laws provide that consideration received in a year other than the year of transfer would be taxed under the head "Capital Gains." While one may draw an analogy from this, there are no express provisions for other situations. Thus, the question that follows is: if not "Capital Gains" (which is generally taxed at concessional rates), whether such income, upon receipt, needs be offered to tax under the head "Income from Other Sources," taxable at normal rates, instead of the concessional rates applicable to capital gains. There is some debate around this issue and it may take some more time and careful thinking before its resolution.
Clearly, it is important that various laws and regulations are aligned to provide comprehensive and clear guidance on matters that affect all the concerned parties. From a tax perspective, this issue assumes even more relevance since, in transactions where the seller is a non-resident, the buyer has to withhold taxes, with severe penalties for non-compliance; often, this leads to protracted negotiations between the parties. Hence, clarity on tax laws would go a long way in providing certainty and closure to transactions.
Article has inputs from Neelu Jalan Director, M & A Tax PwC India
