It was a watershed in the history of Indian mergers and acquisitions. The Finance Bill 1999 has the distinction of being the first ever finance bill to propose dedicated provisions in tax laws relating to mergers, demergers and slump sales. Earlier, most M&A deals were guided just by practice and precedence. Thus, the Finance Bill 1999 can hog the honours for doing away with codification for the first time in the history of Indian tax laws relating to mergers and acquisitions.

Tax neutrality
The M&A-related provisions in the Finance Bill 1999 have one common objective: make M&A deals tax-neutral provided certain conditions are fulfiled. What is this tax-neutrality all about? As long as a company acquires substantially the same ownership of assets from the seller, there should be no tax incidence.

This concept has a rationale behind it: mergers and acquisitions are just reorganisation of businesses with an eye on improving productivity and hence should be tax-neutral. Says Sudhir Kapadia, a director in the Mumbai-based KPMG India: "Put simply, tax neutrality means there should not be any tax advantage if there is no substantial change in ownership of assets."

Tax neutrality is a laudable concept. But, there are quite a few black holes in M&A taxation. Here is an example of a black hole. One requirement of tax-neutrality is that all assets and liabilities of a business is transferred to the acquirer in an M&A deal. This poses a practical difficulty: there are certain assets and liabilities which cannot be identified with a particular business. Says Kapadia: "It is essential to clarify that only those assets and liabilities which are exclusively identifiable with a business need to be transferred to the acquirer."

Consider this example. The selling company might have a line of credit for working capital from a bank with a floating charge on a group of assets which includes even those assets waiting to be hived off. So, it is essential that tax laws clarify that only those assets and liabilities which are exclusively identifiable with the business to be hived off be transferred to the acquirer. Plant and machinery belonging to the division to be hived off are good examples of exclusively identifiable assets and loans raised against mortgage of specific assets of a division are good examples of exclusively identifiable liabilities.

Thorny issues
How mergers and demergers are defined is another thorny issue that needs to be resolved. In a merger, the purchase consideration is settled by the merged entity issuing its shares to the shareholders of merging entities. In a demerger, a company hives off one of its divisions to another company. Here, the acquiring company issues its shares to the shareholders of the selling company.

But, what happens when the merged entity wants to settle the purchase consideration partly by paying cash and partly by issuing its shares depending upon the selling company's business and capitalisation? There is no provision in the tax laws to deal with such a situation. Says Kapadia: "Indian tax laws have no provisions to deal with a cash payment in demergers." So, the tax laws need to be amended suitably to deal with such situations.

Shift to CLB
Then there is this court process which is mandatory to put through a merger or a demerger. This court process should be restricted only to listed companies where many interests are involved. The logic: there is no need for a court process in closely-held companies if majority of its shareholders approve the merger or the demerger. Says Kapadia: "Let the court process be there even if one of the parties in the merger or the demerger deal is a listed company."

There is a suggestion here. Instead of the cumbersome court process, one could have a special bench in the Company Law Board to handle mergers and demergers. This could reduce the delays involved in putting through mergers and demergers. This way the labyrinthine court process can be done away with.

Stock swaps
Quite often, in M&A deals involving companies from sunrise industries such as software, the acquisition price is settled by swapping shares and not through cash payments. Clarity is needed in such cases as far as taxation is concerned. For, guidelines regarding valuation of shares for fiscal purposes are not clear. Stock swaps are generally capital gains tax-exempt in the United States.

"We should have similar capital gain tax exemptions for share swaps in India too," says Kapadia. Alongside, it is essential that Indian tax laws deal with the valuation issue objectively and carry detailed guidelines on valuation so that companies could get out of the tax net.

Stock swaps are taxable today in India. Taxing stock swaps in the case of listed companies is easier since there are market quotes available. However, Indian tax laws are not clear about which market value to consider and whether the market value on the date of the deal is relevant.

There is a bigger challenge ahead, when it comes to share swaps involving two unlisted companies. Neither is there any legal provision governing such share swaps nor are there any precedents.

There is a suggestion here. Since wealth tax guidelines are based on net asset values, such values can be used for taxing share swaps too. Since one is liable to pay tax when the shares received in a stock swap deal are sold, there is no need to tax them when they are received. Says Kapadia: "Do not tax-exempt share swaps, but defer tax on them to the point of sale."

Tax laws relating to share swaps need to be clarified urgently. For, there could be more stock swaps soon, thanks to the fact that they are convenient means of achieving M&A objectives both in mega and mini deals.

Cross-border issues
Cross-border M&A deals too have their own thorny issues that need to be sorted out. One such issue is this: how will the court process work when a foreign company wants to merge with an Indian company? The issue is really contentious because one of the companies is outside the jurisdiction of the Indian courts. We need to grant approvals to such cross-border M&A deals in a distinctly different way.

There is a solution here. It is possible for the Indian courts to accept the approvals granted by the foreign authorities and the approval of the shareholders of the domestic company. We can do away with the domestic court process. Says Kapadia: "You may still need the courts in a cross-border M&A deal. So, you go by the orders issued by the foreign court." The Indian Companies Act in its present form does not contemplate such a scenario.

Now consider a situation when an Indian company wants to merge with a foreign company. There is no tax-exemption here since the merged entity is a foreign company. As the volume of cross-border deals rises, it is essential to extend the scope of tax exemptions to overseas companies too.

Another interesting cross-border issue arises when a non-resident Indian doing software business, who has his holding company in USA and its subsidiary in India, wants to reverse the structure. He wants to have his holding company in India and its subsidiary in USA because he wants to take his holding company public in India. This deal would involve a stock swap. But, there are no guidelines in Indian tax laws on how to deal with such situations.

A clarity in all these issues will help to accelerate the pace of M&A in India.