(This article was first published on Taxsutra at: https://www.taxsutra.com/dt/experts-corner/hybrid-acquisition-unlisted-company-partial-share-purchase-merger)
Background
Consider a case where a listed company intends to acquire an unlisted company, but the listed company does not want to utilize or exhaust its liquidity or leverage its balance sheet as a result of an all-out cash deal for the acquisition of shares of the target unlisted company. At the same time, the shareholders of the target unlisted company (“Exiting Shareholders”) may want an assured exit through the sale of shares for cash consideration to ensure a fixed price upon the sale of shares of the target unlisted company.
In such a scenario, a combination of share acquisition and merger of the target unlisted company with the listed company could be considered by the listed company to acquire the unlisted company.
Mechanics
In the context of the above background, as step 1, the listed company may consider acquiring a partial stake in the unlisted company from the Exiting Shareholders, and the listed company could discharge the consideration in the form of cash. This step would ensure a partial but assured exit to the Exiting Shareholders.
Subsequently, as step 2, the unlisted company could merge with the listed company through a Scheme of Arrangement u/s 230-232 of the Companies Act, 2013 (“Scheme”), whereby the shares held by the listed company in the unlisted company would be cancelled, and new equity shares would be issued by the listed entity to the Exiting Shareholders of the unlisted company. Such new equity shares issued would then be listed on the stock exchanges in terms of the SEBI Master Circular on Schemes of Arrangement dated 23 November 2021 (“SEBI Circular”) and which could then be sold on the stock exchange by the Exiting Shareholders.
Key Considerations
While the concept of “hybrid acquisition” in the form of a combination of share acquisition and merger of an unlisted company with the listed company may appear to be relatively straightforward, it involves various commercial, regulatory, and tax issues, which are dealt with as under:
1. Overview of the Approval Process: As would be seen later, the time lag between entering into definitive documentation (say, through a Share Purchase and Merger Agreement) and the actual approval of the merger by the regulatory authorities could entail a commercial risk on the Exiting Shareholders. In terms of the timeline for approval of the Scheme, the approval of the board of listed/ unlisted company (audit committee and independent directors, as well, for listed company), stock exchange/ SEBI approval, approval of the National Company Law Tribunal, other regulatory authorities (such as Regional Director, Registrar of Companies, and the Official Liquidator, amongst others) would be required, which typically takes around 10-11 months. Additionally, it is imperative to note that approval of the Competition Commission of India would be required, if the unlisted company and the listed company are engaged in the same sectors, or if the combined value of assets/ turnover exceeds a certain threshold. Lastly, if the public shareholders of the listed company are being diluted by more than 5%, then the majority approval of public shareholders (who are voting) of the listed company would be required in terms of the SEBI Master Circular. This, especially, could become tricky in a case where large blocks of shares of the listed company are held by financial institutions, HNI investors, etc. since the promoters would not be able to vote in this case.
2. Commercial Considerations: Owing to the significant time gap, as stated above, the price at which the share swap ratio (for merger) has arrived at the time of definitive documentation could vary significantly with the prevailing price of the listed company as of the date of approval of the merger of the unlisted company with itself. Therefore, if the price of the listed company has fallen, the effective consideration that the Exiting Shareholders are discharged would be lower than that agreed upon at the time of definitive documentation. As a result, the Exiting Shareholders would effectively be undertaking an equity or market risk pending the approval of the merger and subsequent issuance of shares. However, at the same time, any upside in the price of the listed company during the pendency of approval of the Scheme would also accrue to the Exiting Shareholders, in the form of the higher value of shares being issued.
3. Plugging the Equity or Market Risk: As an alternative to the equity/ market risk taken by the Exiting Shareholders, as consideration for the merger, redeemable preference shares could be issued to the Exiting Shareholders (instead of equity shares) to ensure a fixed consideration at the time of redemption. However, from the listed company’s perspective, this is a mere deferral of discharge of consideration till redemption and not an actual share swap. Further, till such time such preference shares are redeemed, the same would be classified as a financial liability in the books of the listed company under IndAS 109, which may not be desirable for the listed company.
4. Tax Considerations: At the time of the sale of shares of unlisted company, the Exiting Shareholders (who are Indian tax residents) would be subject to a capital gains tax of 20% (plus surcharge/ cess, and assuming long term), after considering the indexed cost of acquisition, and at 10% similarly, if the Exiting Shareholders are non-residents.
It is interesting to note that while the sale of shares would be subject to upfront taxation, the subsequent merger and issuance of shares would be considered as a tax-neutral amalgamation u/s 2(1B) of the Income-tax Act, 1961 (“ITA”), and therefore, not be subject to tax. However, at the time of the sale of shares of the listed company by the Exiting Shareholders, the Exiting Shareholders would be subject to a 10% tax rate (assuming that the cumulative period of holding is more than 12 months), subject to indexation of cost of acquisition upto FY17-18, if the shares of the unlisted company were held on or before 31 January, 2018.
It is also interesting to note that while the original sale of shares of the unlisted company would have been subject to a 20% tax rate (for resident shareholders), the capital gains tax on the sale of shares of the listed company would be 10%; however, as against this, the Exiting Shareholders would be taking an equity/ market risk, as noted earlier, and a liquidity risk if the market float of the listed company is not significant (unless the sale is to an identified buyer through a block sale mechanism).
5. Valuation Aspects: On the one hand, there would be a commercially negotiated price for the acquisition of shares (either through sale or share swap on merger) between the listed company and the Exiting Shareholders, on the other hand, the said price would be required to adhere to various regulatory aspects, as stated hereunder:
a. Tax Aspects: For the share sale (of the unlisted company) not to be subject to deemed capital gains tax u/s 50CA of the ITA in the hands of the Exiting Shareholders, and as deemed income u/s 56(2)(x) of the ITA in the hands of the listed company on the acquisition, the minimum price at which the shares would be required to be sold would be the net book value of the unlisted company (as adjusted for the reckoner value of the immovable properties, the market value of underlying listed companies, the net book value of underlying unlisted companies, and the fair market value of any other instrument).
b. FEMA Aspects: Similarly, if the listed company is a Foreign Owned and Controlled Company (“FOCC”) under FEMA, then the minimum price required to be discharged to the Exiting Shareholders would at least be the price arrived at under Internationally Accepted Pricing Methodology (“IAPM”). Contrary to this, if the unlisted company is an FOCC, then the consideration to the Exiting Shareholders cannot exceed the price arrived at IAPM.
c. SEBI Aspects: Lastly, from a SEBI perspective, the share swap would be arrived at by a Registered Valuer (backed by a Fairness Opinion from a Merchant Banker) based on different weights given to net book value, DCF, and market comparables, SEBI Master Circular mandates that the minimum price at which the shares of the listed company could issue shares to the Exiting Shareholders would be the preferential allotment pricing guidelines under SEBI ICDR Regulations (i.e., 90 days or 10 days volume weighted average price of the listed company preceding the date of the board meeting, whichever is higher, in case of frequently traded shares, or basis a valuation report, in case of infrequently traded shares).
6. IndAS Aspects: Lastly, from an IndAS perspective, given that the listed company would be under IndAS, it would have to account for the merger of the unlisted company under the Acquisition Method under IndAS 103, whereby, the assets and liabilities of the unlisted company, previously unrecognized intangibles (say, brand, customer lists, etc., and which may or may not be subject to amortization depending on whether their useful life could be determined) would also be recorded at fair market value, and new shares issued would be recorded at fair market value, and the difference would be recorded as residual goodwill (not subject to amortization) in the books of the unlisted company.
This method should be adopted irrespective of the fact of previous share acquisition (even if it results in majority stake acquisition), since the ultimate control over the business of the unlisted company is transitioned from the Exiting Shareholders to the listed company/ its promoters, and therefore, the subsequent merger should not be classified as a common control business combination.
Summing Up
As seen from the above, while a hybrid acquisition of an unlisted company by a listed company through partial share purchase and merger to serve the commercial objectives of the acquirer and the seller could be an optimum structure, it would warrant a detailed analysis of various tax, accounting, and regulatory aspects, including valuation aspects tied to the said regulations.
Additional complexities could arise if contingent consideration to the Exiting Shareholders is envisaged, or, if there is a put option agreement between the Exiting Shareholders and the promoters of the listed company to give an assured exit to the Exiting Shareholders, or, if there are multiple immovable properties across various states from the perspective of stamp duty, reverse merger (i.e., a merger of the listed company into the unlisted company), or, if there are sectoral regulators involved (say, for companies involved in telecom, mining, real estate, aviation, BFSI, etc.).