The Finance Act, 2010, as well as recent circulars issued by the Reserve Bank of India (RBI) regarding pricing of share transfers between residents and non-residents is bound to have significant impact on mergers and acquisitions (M&A) involving unlisted companies' shares in India.
Given that the relevant provisions of The Finance Act, 2010, have become effective from June 1 and the RBI pricing guidelines have become operative since May, it is worthwhile to study these legislative changes and attempt to assess their implications on transactions.
Anti-abusive provisions of The Finance Act, 2010
The Finance Act, 2010, has introduced anti-abuse provisions to include within its ambit transactions involving the transfer of shares of a closely held company where a firm (including a limited liability partnership (LLP)) or closely held company is a recipient. Earlier, the anti-abuse provisions were applicable only if an individual or a Hindu Undivided Family ('HUF') was a recipient.
The provisions have been introduced to prevent the practice of transferring unlisted shares at prices much below their fair market value—for no or inadequate consideration. These provisions have come into effect from June 1 this year.
Simply stated, post-June 1, the difference between 'aggregate fair market value' of shares of a closely held company and the consideration paid would be taxed in the hands of 'recipient' of such shares. At the same time, exceptions have been carved out in respect of share transfers through transactions like business reorganisations, amalgamations and demergers.
Central Board of Direct Taxes (CBDT) has also notified the methodology for determination of 'fair market value' of shares of closely held companies. As per the notification, the valuation for equity shares shall be determined as per the 'net asset value' method whereas, for other shares/securities, it shall be at such price as may be fetched in the open market on the valuation date.
While the Explanatory Memorandum to The Finance Act, 2010, does mention the intention behind introduction of these provisions, the manner in which the relevant sections introduced in the Income-tax Act, 1961, seems to indicate that these anti-abuse provisions would be triggered in any situation where a firm or a closely held company "receives for less than fair market value" shares of a closely held company (barring certain defined exceptions). This has given rise to considerable debate as to applicability of these provisions to following types of transactions:
* Transactions involving bonus issues, rights issues, preferential allotments, put/call options, etc.
* Transactions which are exempt from tax (in the hands of transferor) under the current provisions of Income-tax Act, 1961 (gift, transfer of capital asset (including shares) between parent companies and their 100% subsidiaries, etc).
* Transactions where a partner contributes shares of a closely held company to a partnership firm as his capital (presently, the value at which such shares are recorded in the books of partnership firm is deemed to be the transaction value for the purpose of computing capital gains tax in the hands of the contributing partner).
* Transfer of shares of investee closely held companies by an amalgamating company to an amalgamated company as a part of the amalgamation (the present exceptions carved out from these anti-abuse provisions exempt only the shareholders of the amalgamating company, but not the company itself).
* Buy-backs, capital reductions, etc, at less than 'fair market value', where percentage shareholding of all shareholders remains same pre and post the transaction, etc.
However, it is hoped that the provisions shall be weighed in the background of the objects for which they were introduced, namely, to restrict taxability to cases where there is a deliberate attempt to evade/ avoid tax and/or to accomplish value transfer from one person to another through transfer of shares. Further, it is also hoped that the interpretation may be relaxed in cases where the transaction is commercial and bona fide between two persons at arms' length.
It would only help if the legislative intention is notified by CBDT, as th same may bind the tax authorities.
Impact of change in pricing guidelines by RBI
A certain amount of ambiguity has arisen with respect to valuing transfers of shares of closely held companies between residents and non-residents with the recent amendment to the pricing guidelines issued by the RBI.
The revised RBI pricing guidelines provide that, inter-alia, the price at which the shares of Indian unlisted companies can to be transferred by a non-resident to a resident shall not be more than the fair value determined by SEBI-registered merchant banker or a chartered accountant as per the 'discounted cash flow' method.
Thus, difficulty may thus arise in cases where the pricing as per the CBDT notification ('net asset value') is higher than the pricing as per the RBI circular ('discounted cash flow' method) as in such cases, the resident Indian purchaser will not be able to buy shares at the price mentioned in the CBDT notification and may hence end up being unfairly taxed on the difference. Again, there is currently no recourse available to settle the ambiguity.
In light of the above, it is but imperative that the transactions involving closely held companies shares be structured carefully, keeping in mind the paradigm shift in the governing legislations.
At the same time, it can only be hoped that the authorities would adopt a view that is likely to lean in favour of an interpretation which supports the object behind introduction of the anti-abuse provisions—which is to act as a counter-evasion mechanism to prevent laundering of unaccounted income, to curb bogus capital building and money laundering, etc.
However, until such issues are not specifically clarified by the CBDT for the benefit of the assessees and for the sake of clarity, it shall continue to be a wait and watch syndrome!
—The writer is national leader, transaction tax, Ernst & Young. Nachiketa Deo, a senior tax professional with Ernst & Young, has also contributed to the article. Views expressed are personal
