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Schemes of Arrangement: Fine Line Between Potential To Avoid Tax Vs Planning To Save Tax

It is a norm for scheme of amalgamation that the assets of the transferor company are transferred to the transferee company, as a result of which, either cash is paid or shares of the transferee company are allotted to the shareholders of the transferor company.

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2018 witnessed M & A deal transactions touching a record of USD 125.2 billion[1] – nearly twice the amount as compared to transactions of USD 63.2 billion in 2017. Be it financial advantages, taxation benefits, technology transfers or leveraging skills, corporate India is increasingly looking at consolidation as the way forward. It is against this backdrop of that this article examines an important issue of tax planning versus tax avoidance with respect to scheme of arrangements in M&A’s.

In India, in order to undertake mergers, amalgamations, compromises and arrangements, companies are required to frame a scheme, as per the norms and terms of the Companies Act, 2013. Thereafter, this scheme is required to be approved by the jurisdictional National Company Law Tribunal (NCLT), in order to come into effect. 

Under the erstwhile Companies Act, 1956, the High Courts were empowered to approve such schemes, however, their role was very limited as the provisions therein were judicially held to be a complete code in itself, which made the courts reluctant to delve into the commercial wisdom of the parties. This was also held in the case of Miheer H. Mafatlal v. Mafatlal Industries Limited[2], where the question before the Court was whether it had jurisdiction akin to an appellate authority to minutely scrutinize the scheme and to arrive at an independent conclusion whether the scheme should be permitted to go through or not, even though the majority of the creditors or members or their respective classes have approved the scheme. The Supreme Court was also of the view that the Court could be compared to an umpire in a game of cricket - one who has to ensure that both teams play according to the rules and do not overstep limits.

Curious case of Gabs Scheme

However, the aforementioned role of judicial body to act as umpires, can be questioned, with NCLT’S approach in the case of In Re: Gabs Investments and Ors., (decided on August 30, 2018). In this matter, the NCLT rejected a restructuring undertaken through a scheme of amalgamation and arrangement between Gabs Investment Private Limited (Gabs) and Ajanta Pharma Limited (APL) (Gabs Scheme) on two grounds. The first reason was that there would be a loss of taxes to the income-tax department (Department) as per General Anti-Avoidance Rules (GAAR) and the second was that huge tax liability was being avoided, even though the Gabs Scheme was approved by the requisite majority of the shareholders. 

In the Gabs Scheme, it was envisaged that Gabs (transferor company) being a group holding company will amalgamate with APL (transferee company) and in consideration thereof, shares of APL will be allotted and issued to the shareholders of Gabs, as per the agreed share exchange ratio. 

One of the grounds of objection resorted by the Department was that the amalgamation is a deliberate measure to avoid tax burden by using the via media of NCLT. The Department contended that the Gabs Scheme is purely Impermissible Avoidance Agreement (IAA) and should not be allowed by the NCLT. 

The Department however had raised objections before the NCLT that the assets of Gabs cannot be transferred or distributed directly without payment of dividend distribution taxes (DDT) at the rate of 20% and the liability towards DDT would be approximately INR 134 crores. The Department further contended that sale of shares held by Gabs in APL would generate business profits, on which income tax at the rate of 30% is required to be levied since dealing in shares of a company is a business activity for Gabs and in this instance, Gabs would earn a business profit of approximately INR 958 crores. Accordingly, the Department submitted that the Gabs Scheme is an IAA and involves round trip financing under GAAR and therefore approval of the same would result into loss of approximately INR 421 crores.

Tax planning vs Tax avoidance & GAAR provisions 

This rejection raises a debatable question about tax planning versus tax avoidance. It is a settled proposition that tax planning is lawful in India. In several landmark cases, the legality of the tax planning has been upheld. In McDowell and Co. Ltd. Vs. Commercial Tax Officer[3], the Hon’ble Supreme Court had held that, “Tax planning may be legitimate provided it is within the framework of law”. Even in the case of Vodafone International Holdings B.V. vs. Union of India and Ors.[4], the Apex Court had held that: “…it cannot be said that all tax planning is illegal/illegitimate/impermissible…”.

Tax planning, therefore, has been legal and permissible in India, but in view of the aggressive tax planning by the corporates, and to plug tax avoidance, the Government introduced GAAR under the Income-tax Act, 1961 (IT Act) in the year 2016. In its very essence, GAAR basically applies to all those transactions, which have the potential to avoid tax, in any manner.

Section 96 of the IT Act defines IAA as an agreement, the main purpose of which is to obtain a tax benefit, and it (a) creates rights, or obligations, which are not ordinarily created between persons dealing at arm's length; (b) results, directly or indirectly, in the misuse, or abuse, of the provisions of the IT Act; (c) lacks commercial substance or is deemed to lack commercial substance under Section 97 of the IT Act, in whole or in part; or (d) is entered into, or carried out, by means, or in a manner, which are not ordinarily employed for bona fide purposes. 

The definition of IAA seems to be very wide. The extent of considering an arrangement as IAA can be seen from Section 96 (2) of the IT Act wherein, an arrangement is presumed, unless the contrary is proven by the assessee, to have been entered into, or carried out, for the main purpose of obtaining a tax benefit, if the main purpose of a step in, or a part of, the arrangement is to obtain a tax benefit, notwithstanding the fact that the main purpose of the whole arrangement is not to obtain a tax benefit. 

Way ahead

It is a norm for scheme of amalgamation that the assets of the transferor company are transferred to the transferee company, as a result of which, either cash is paid or shares of the transferee company are allotted to the shareholders of the transferor company.

With the advent of GAAR and by incorporating a provision under Companies Act, 2013 for issue of notice to the Department for raising objections to a scheme, the Department has been given extra bandwidth to not just have a say in the reorganization of companies, but also in persuading NCLTs to reject schemes where the Department raises objections. Many companies will be hesitant to follow the scheme of amalgamation/ arrangement as part of the M&A route, as these companies would want to avoid questions from the tax authorities. 

The aforesaid approach of the NCLT in the Gabs Scheme may not only delay the process of sanctioning of the schemes but worryingly, may also prove to be an impediment in M & A’s going forward. In light of the above, it is paramount that the schemes of reorganization are drafted and planned to draw lines between the potential to avoid tax versus planning to save tax.

Disclaimer: The views expressed in the article above are those of the authors' and do not necessarily represent or reflect the views of this publishing house. Unless otherwise noted, the author is writing in his/her personal capacity. They are not intended and should not be thought to represent official ideas, attitudes, or policies of any agency or institution.

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Bhavin Gada

The author is Partner, Economic Laws Practice (ELP)

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Hitesh Agarwal .

The author is Associate Manager,Economic Laws Practice (ELP)

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