The Indian indirect tax regime has seen significant changes in the past few years with the introduction of goods and services tax (GST) in July 2017 to subsume varied Federal and State taxes. With the changing tax landscape leading to more questions than answers, understanding the indirect tax considerations becomes crucial from a transactional perspective.
Typically, in a cross-border transaction, direct tax (corporate/income tax) considerations often take center stage while determining a structure. A common option that gained popularity to optimize the impact of corporate tax was to effectuate payments towards the supply of intangible goods and services from the parent entity to the subsidiary.
With India being a moderately high tax jurisdiction with a soaring number of consumers, it is fast becoming the end cog in the chain of transactions and the subject of indirect acquisitions.
Therefore, with India (as one of the G-20 nations) committing to Action Plan I of Base Erosion and Profit Shifting (BEPS) as proposed by the Organization for Economic Co-operation and Development (OECD), attention should be given to the evolution of indirect taxes in India when planning a cross-border transaction. Transactional taxes, in the form of hidden indirect tax costs, could result in unwanted costs which may take many an investor or insurer by surprise.
At the heart of any M&A activity is the construct adopted for the transaction. Lately, in sectors heavily relying on operational activities (like the energy and infrastructure sector), the characterization of the upstreaming of revenue, i.e. whether to have a composite contract for supply of goods or services or have stand-alone contracts for both, has become a necessity as the GST impact could range from 5% to 28% of the value created.
Additionally, the character of the acquisition, i.e. whether it is a slump sale/transfer of business as a going concern, or asset sale, or pure stock acquisition, apart from determining the depth of the diligence activity to be undertaken, has different tax impacts. While a stock acquisition (share transfer/share purchase) may not have GST implications (such transfer of securities/money is exempted under GST), the test for evaluating whether a transaction qualifies as a transfer of business as a going concern (TOGC) or remains an asset sale is fluid as ever.
In the past, Indian courts and tax authorities have examined each case on a standalone basis and the broad principles evolved require the transferor to prove that:
- the intent of the transaction was to transfer the business on an “as is where is” basis, meaning transfer of all assets and liabilities;
- there is continuity in the business without any breaks (meaning the carved-out business should not be discontinued post transfer to start on a new venture);
- the transferred business should be capable of independent operation; and
- should not be an itemized sale of assets and liabilities.
The impact of a transaction being determined as an asset sale instead of a TOGC would result in a direct hit of 18% of GST on the transaction value payable by the transferor. From the perspective of a seller or an insurer (who is providing cover of seller transaction taxes), it becomes crucial for one to analyze the transaction closely and to check for any semblance of round-tripping of assets in the transaction. One way to get ahead of the game is to ring fence themselves in terms of adequate protection in the form of indemnity or exclusions for such unexpected tax costs.
Although GST kicked in on July 1, 2017, the savings and repeal clause ensured the carry forward of historical litigation baggage from previous indirect tax statutes (central excise duty, value-added tax/sales tax, service tax and other local levies). The lookback provisions which existed under former regimes allowed the revenue officers to go as far back as seven years to investigate business transactions.
At the time of acquisition, it may not be sufficient to ensure that the target is tax compliant as of that date, but thorough diligence and understanding of sectoral indirect tax issues could help identify potential tax pay-outs and would help negotiate adjustment of the transaction value as an immediate relief.
With the cryptic nature of certain tax demands (for example, demands relating to anti-profiteering affecting real estate, fast-moving consumer goods and hospitality sector players), it is difficult to measure the financial impact. These issues often remain pending in Indian courts and take time to reach a logical conclusion, which could prove to be a pain point if not appropriately addressed at the time of determining the exposure.
While an asset transfer was traditionally known to exempt the transferee from all historical tax liabilities, there are ambiguous provisions introduced under the GST regime which may indicate transfer of historical liabilities even in case of asset sale. Akin to the “No Objection Certificate” certifying no tax dues that could be obtained from tax authorities in respect of direct taxes, even the GST legislation prescribes such certificates in respect of GST dues. However, the lack of awareness and operational guidelines has stalled its use to date. In spite of these challenges, there are adequate mechanisms like the process of obtaining advance rulings that have been put in place that could help parties involved in determining the tax liability in case of a proposed transaction, which shall be binding on the applicants and is an option that can be explored by investors.
Export Obligations and Commitments
Businesses operating from special economic zones (SEZ), export obligation units (EOU), Software Technology Parks (STP) and GIFT cities or special export status holders enjoy tax benefits as provided by the Indian government. The idea behind providing such exemptions to selected businesses is that they are primarily engaged in export of goods and services ensuring foreign revenue to narrow the trade deficit. Such units are viewed as profitable investment avenues due to their access to international markets.
At the time of investments in these units, extra caution has to be exercised. The tax exemptions/benefits that are provided are subject to fulfillment of certain export obligations. As such, the acquiring entities would have to ensure that the target units have met the export obligations specified and there are no historical defaults, as deficiency thereof could lead to penalties and eventual shut down of units leading to a loss-making investment.
A recurring concern that surfaces post the closure of the transaction is the deployment of personnel for integration in India and the treatment of such deployment resulting in permanent establishment risks.
From an indirect tax perspective, their presence in India may not by itself necessitate registration and payment of taxes by the foreign investing entity in India. It is found that the indirect tax authorities may simply choose to follow the analysis of their direct tax counterparts when determining if such employee presence would amount to a permanent establishment in India. Even though indirect tax jurisprudence requires further evolution, what can help avoid such risk is to ensure that salary payments are made to such deployed personnel by the foreign entity and such deployments are kept short. Also, another aspect to be avoided is leasing of separate premises by the foreign entity from where such personnel would conduct operations.
Although diligence activities and tax analysis may help hedge against a potential indirect tax risk, it is crucial that the evolving issues and jurisprudence are always borne in mind at the time of investment. The comfort that either party to a transaction can draw against such unforeseen and hidden tax risks is to provide for sufficient avenues for recovery of such indeterminate tax costs from the counter party. Accordingly, it is of utmost importance to identify these hidden risks at the very beginning based on which the subsequent commercial negotiations could take shape.
Rashmi Deshpande is a Partner and Anjali Krishnan is a Senior Associate at Khaitan & Co, India.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.