Indian Court Issues Significant Tax Ruling from M&A Perspective

As we continue to witness an increasing number of deals taking place globally, one of the key provisions that is often negotiated at length is a holdback of part of the consideration, or parking some amount of the consideration in an escrow account, to be released to the seller on completion of agreed upon conditions or the seller’s obligation towards contingencies that may arise.

This clause also is widely used in deals involving acquisition of startups, where, while the acquirer sees potential value in the target, some part of the deal value is withheld, to be paid upon the target company performing well and meeting identified parameters.

There is a general debate in India on the taxability of such holdback or escrow amount. Certain common tax issues with respect to the holdback or escrow amount relate to characterization of the income, year of taxability, and consequences if the holdback or escrow amount is not eventually received.

In this context, the High Court at Bombay in an important ruling in the case of Dinesh Vazirani, has held that the consideration for sale of shares by a seller (Taxpayer), which has been deposited in an escrow account but withdrawn by the purchaser towards the liabilities contemplated under the share purchase agreement (SPA), cannot be taxed in the hands of the Taxpayer.

Facts of the Case

The Taxpayer sold the shares in WMI Cranes Ltd (Company) to Konecranes Finance Corporation (Purchaser) under the SPA, as a part of the share sale by all the promoters. As per the SPA, the Purchaser was liable to pay a total consideration of 1.55 billion Indian rupees ($20 million) to the promoters, of which 1.25 billion rupees was paid at the time of transfer of the shares and the balance of 300 million rupees deposited in an escrow account. With respect to the escrow amount, the SPA provided that such amount be released on completion of two years provided there is no liability on the promoters towards the specific indemnity obligations envisaged under the SPA.

The Taxpayer filed its tax return and offered the capital gains on the share sale considering its proportionate share in the total consideration of 1.55 billion rupees (though the amount under escrow account was not received). The tax return was scrutinized by the tax officer and the income as offered to tax by the Taxpayer was accepted.

Subsequently, certain liabilities arose in the Company in the sum of 91.7 million rupees, for which the promoters had an indemnification obligation under the SPA. Accordingly, this amount was withdrawn from the escrow account by the Purchaser. The Taxpayer then filed an application before the income tax authority claiming that as the amount of 91.7 million rupees had been withdrawn from the escrow account, the capital gain for the Taxpayer needed to be recomputed by reducing its proportionate share in 91.7 million rupees.

The tax authorities rejected the Taxpayer’s application, on the basis that the Taxpayer was entitled to receive its share in the total consideration of 1.55 billion rupees and, therefore, the consideration towards meeting contingent liability which may arise subsequent to the transfer could not be reduced. Further, for computing the capital gain, only the cost of acquisition and cost of improvement, and expenditure incurred wholly and exclusively in connection with the transfer, can be reduced, and hence there is no scope for reduction of the amount as claimed by the Taxpayer.

Aggrieved by the order, the Taxpayer filed a writ petition before the High Court.

Ruling of the High Court

The High Court ruled in favor of the Taxpayer and directed the tax officer to recompute the capital gain (by reducing the Taxpayer’s proportionate share in the amount withdrawn from the escrow account) and to grant a refund to the Taxpayer of additional tax paid, along with the interest.

In arriving at this conclusion, the High Court noted that the amount of 91.7 million rupees was neither accrued nor received by the promoters and was withdrawn from the escrow account. Therefore, such amount cannot form part of the full value of consideration for computing the capital gains.

The High Court also mentioned that the consideration under the SPA was not an absolute amount, but subject to certain liabilities as provided under the SPA itself, and therefore, the full value of consideration will be the amount ultimately received by the promoters (post reduction of adjustment made towards the liabilities).

The High Court relied on the landmark decision of the Supreme Court in the case of Commissioner of Income Tax vs Shoorji Vallabhdas and Co [1962] (46 ITR 144) and applied the “real income” principle, to hold that consideration which is neither accrued nor received cannot be brought to tax and if the Taxpayer has paid taxes higher than its actual liability, it is entitled to refund of such excess tax paid.

Comment

This is an important and welcome ruling from a mergers and acquisitions perspective, and provides much needed clarity on the taxability of consideration such as escrow amount, earn-outs, or holdback, the payment of which is linked to contingencies and/or fulfillment of obligations provided under an agreement. In substance, the ruling affirms the principle that for income to be taxed, there should be “right to receive” the income and the corresponding liability on the payer to make payment of such income.

Nonetheless, the impact of this ruling would need to be determined based on the specific facts of each transaction.

The High Court has also reaffirmed the important principle that it is an obligation of the tax authorities to levy tax only on the income chargeable under the Income Tax Act and, even if higher tax has been paid, it is the tax authorities’ duty to compute the correct tax liability and refund the excess tax paid. This becomes even more relevant for escrows and holdbacks, as in most instances the escrow and holdback payments or determinations happen after the tax return for the year of the original transaction has been filed.

Another key issue that has been the subject of debate is the timing of taxability of consideration which is linked to contingencies/satisfaction of certain conditions—that is, whether such consideration is taxable in the year of sale of shares or the year of receipt of consideration. While the High Court ruling affirms the position of the Taxpayer where capital gain from the entire consideration was offered to tax in the year of sale and subsequently sought to be recomputed (on withdrawal of cash from the escrow account), the aspect of timing of taxability has not been dealt with specifically and hence remains open for further examination and analysis.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners. 

The views of the author(s) in this article are personal and do not constitute legal/professional advice of Khaitan & Co.

Author Information

Sanjay Sanghvi is a Tax Partner and Rahul Jain is Principal Associate with Khaitan & Co.

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