By Binoy Parikh

Collapsing Holding Companies & Unlocking Value

( This article was first published on Taxsutra: https://www.taxsutra.com/dt/experts-corner/collapsing-holding-companies-unlocking-value )

Background

Consider a case where a listed company (“Listed HoldCo”) is holding say, 60%, in another listed company (“Listed SubCo”), with the balance 40% being held by the public shareholders of the Listed SubCo. In turn, the promoters of the Listed HoldCo hold 70% in the Listed HoldCo, while the balance 30% is being held by the public shareholders in the Listed SubCo.

On a see-through basis, theoretically, the value of the Listed HoldCo should at least be 60% of the market capitalisation of the Listed SubCo, assuming that the market capitalisation of Listed SubCo is a near approximation of its underlying valuation. In addition to that, the market capitalisation of the Listed HoldCo should also reflect the valuation of any businesses carried out by the said Listed HoldCo.

However, in practice, the market capitalisation of listed holding companies, holding listed subsidiaries, in India is at significant deviation from the theoretical valuation, as stated above. This is due to the concept of “holding company discount”. For example, if the market cap of the Listed SubCo is INR 10,000 Cr, the market cap of the Listed HoldCo should at least be INR 6000 Cr (i.e., 60%); however, due to the holding company discount of 50%-60%, typically, it would not be more than INR 2500 Cr to INR 3000 Cr.

In such as scenario, a proposition to collapse the Listed HoldCo into the Listed SubCo through a merger could be considered. This article seeks to discuss various aspects of such reverse merger.

Key Mechanics

In the context of the above background, pursuant to a Scheme of Arrangement u/s 230-232 of the Companies Act, 2013 (“Scheme”), the Listed HoldCo could reverse merge with the Listed SubCo. In turn, the Listed SubCo would issue shares to the shareholders of the Listed HoldCo i.e., the promoter/ promoter group and the public shareholders.

The inter-company holding of Listed HoldCo (i.e., 60%) in Listed SubCo would get cancelled. If the Listed HoldCo does not have any business operations, the holding of promoters and public shareholders of Listed HoldCo would be pro-rated in the Listed SubCo, post-merger; however, if there is an existing business in the Listed HoldCo, in addition to holding of Listed SubCo itself, then the public shareholders of Listed SubCo would be diluted to the extent of additional shares issued to the promoters and public shareholders of Listed HoldCo, against the value of business carried on the Listed HoldCo. Given that this amalgamation would be considered as an “amalgamation” within the meaning of section 2(1B) of the Income-tax Act, 1961 (“ITA”), it should be considered as tax neutral from the perspective of Listed HoldCo, its shareholders, and Listed SubCo.

This could be diagrammatically represented (assuming no business in Listed HoldCo) as under:

Key Commercial Considerations

In the above-mentioned structure, the key commercial considerations are elucidated as under:

  1. From the perspective of the promoters, currently, the promoters hold majority in the Listed HoldCo (i.e., 70%) and in turn, the Listed HoldCo holds majority in the Listed SubCo (i.e., 60%). Therefore, the promoters, indirectly, continue to exercise control through majority holding in the Listed SubCo, even though, on a see through basis, the promoters only hold 42% in the Listed SubCo. This see-through holding of 42% of the promoters in the Listed SubCo would become a reality upon merger of the Listed HoldCo with and into the Listed SubCo, and therefore, the promoters would then hold less than 50% in the Listed SubCo, with the majority being held by the public shareholders. If there are substantial institutional investors amongst the public shareholders, then the promoters may not prefer dilution of their holding as a result of the aforementioned reverse merger.
  2. However, from a value unlocking perspective, given that the Listed HoldCo is eliminated through the reverse merger, the value of the aforesaid 42% held by the promoters and 18% held by the public shareholders should get unlocked as a result of direct participation in the business of the Listed SubCo, and therefore, irrespective of holding less than 50%, the promoters may consider such collapse of the Listed HoldCo.
  3. There could be complications from the perspective of the public shareholders of the Listed SubCo, if there is an existing business in the Listed HoldCo. This is because additional shares would be required to be issued by the Listed SubCo to the promoters and public shareholders of the Listed HoldCo, against the value of such business, resulting in dilution of the public shareholders of the Listed SubCo. Therefore, appropriate care should be taken while valuing the existing business of the Listed HoldCo, such that the interest of the public shareholders of the Listed SubCo are not prejudiced.
  4. Lastly, in order to not prejudice the interests of the public shareholders of the Listed SubCo, it would be worthwhile to consider that the promoters of the Listed HoldCo give an indemnity to the Listed SubCo (post-merger) with respect to any liabilities (contingent or otherwise) with respect to the Listed HoldCo prior to the merger.

Key Regulatory Considerations

  1. Process Overview: Firstly, the approval of the audit committee, independent directors, and the boards of the Listed HoldCo and Listed SubCo would have to approve the Scheme. Therefore, an approval of the stock exchanges and SEBI approval would be required under Regulation 37 of the SEBI LODR Regulations, and thereafter, the approval of the jurisdicational National Company Law Tribunal, and regulatory authorities (such as Regional Director, Registrar of Companies, and the Official Liquidator), and sectoral authorities, if any, would be required. Therefore, it would typically take around 10-12 months from the date of board approval, till the consummation of the Scheme and admission of the newly issued shares to trading on the bourses.
  2. Majority of Minority Approval: One key condition is that the majority approval of public shareholders of the Listed HoldCo and the Listed SubCo would be required under the SEBI Master Circular governing Schemes of Arrangement dated 20 June 2023. The said SEBI Circular   provides, inter alia, that in case of a merger involving a promoter company (i.e., Listed HoldCo, in the present case) with the listed company (i.e., Listed SubCo), then approval of the public shareholders of both the listed companies would be required. 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.
  3. Risk of being classified as NBFC/ CIC mitigated: If there are no business activities in the Listed HoldCo other than holding shares in the Listed SubCo, then, effectively, 100% of its assets would be considered as financial assets (as a combination of investment in Listed SubCo and other investments), and 100% of its income, in essence, would be financial income. Ordinarily, if 90% of the total assets of a company are invested in group company investments, 60% of the same are in the form of equity investments in group companies, and if there are no public funds raised, then such company, while an NBFC, is classified as a Core Investment Company, albeit not required registration with the RBI. However, assuming that any financial income of the Listed HoldCo is reinvested in other financial securities/ non-group companies, then the Listed HoldCo runs a risk of requiring registration with the RBI as an NBFC-CIC. This risk would be mitigated post-merger of Listed HoldCo with the Listed SubCo.

Key Tax Considerations

1. Grandfathering of Cost vis-à-vis Listed HoldCo and the shareholders of Listed HoldCo:

Had the Listed HoldCo sold the shares of Listed SubCo, then the Listed HoldCo would have gotten the benefit of market price prevailing on 31 January 2018, and only gains subsequent to 31 January 2018 would be subject to capital gains tax in the hands of the Listed HoldCo. However, since the subject matter (i.e., shares held by the Listed HoldCo in Listed SubCo itself) would be extinguished upon merger, the grandfathered cost in the hands of Listed HoldCo would be lost.

However, since the cost of acquisition of new shares issued by the Listed SubCo in the hands of the shareholders of Listed HoldCo would be the cost of acquisition in the hands of previous owner, and since the cost of acquisition of Listed HoldCo in the hands of its shareholders would have been grandfathered basis the market value of Listed HoldCo as on 31 January 2018, such grandfathering benefit should be available to the shareholders of Listed HoldCo vis-à-vis the new shares issued, even if, technically, the new shares issued by the Listed SubCo were not “acquired” (obviously) prior to 31 January 2018.

2. Grandfathering of Cost vis-à-vis Certain Foreign Shareholders: From the perspective of investors from Mauritius, Cyprus, or Singapore, the relevant DTAAs only provide for grandfathering of capital gains, if the shares were acquired prior to 1 April 2017. Therefore, in the present case, even if the original shares of Listed HoldCo may have been acquired prior to 1 April 2017, given that, technically, the new shares would be issued by the Listed SubCo, post 1 April 2017, it may not be considered as having been “acquired” prior to 1 April 2017. An express clarification that the period of holding relates back to the original date of acquisition and should not be reckoned afresh from the the date of new shares issued, is warranted.

3. Double Taxation Mitigated: Had the Listed HoldCo sold the shares of Listed SubCo, it would firstly have been subject to capital gains tax at 10% (assuming grandfathering of cost available). Thereafter, if the said consideration would have been declared as dividend, it would have been subject to a maximum of 36% tax in the case of individuals, or 25% in the case of corporate shareholders. However, pursuant to the merger, given that the shares of Listed SubCo would directly be held by the shareholders, there would only be one level of taxation i.e., capital gains tax upon sale of shares of the Listed SubCo by the shareholders of erstwhile Listed HoldCo. If there are genuine commercial and regulatory considerations driving this merger, then the risk of GAAR should not be attracted, especially, if the promoters do not intend to sell the shares of Listed SubCo immediately after the merger.

Key Stamp Duty Considerations

One important aspect is the stamp duty cost in case of collapse of a holding company with its subsidiary. Technically, when any holding company reverse merges with its subsidiary, the existing shares are extinguished, and in lieu of which, new shares are issued by the subsidiary to the shareholders of the holding company. Therefore, given that new shares are being issued, stamp duty would be leviable on the “value” of such shares issued. In Maharashtra, and in other states as well, the value of shares would be market price prevailing on the Appointed Date. For example, in the present case, assume that the market capitalisation of Listed SubCo is INR 10,000 Cr, the value of holding of Listed HoldCo is INR 6000 Cr (i.e., 60%). The said 60% gets extinguished first on merger, and thereafter, new shares worth INR 6000 Cr would be issued. At 0.7% (in Maharashtra), the resultant stamp duty would be INR 42 Cr (maximum cap on stamp duty was increased to INR 50 Cr from INR 25 Cr in Maharashtra).

Key IndAS Considerations

Given that ultimately the shareholders controlling the Listed SubCo and Listed HoldCo are the same, prior to and post the merger, assuming that the promoters control the management of Listed SubCo and Listed HoldCo, irrespective of the 42% shareholding, then the applicable accounting method should be “Pooling of Interests”, as applicable to common control business combinations, as per Appendix C to IndAS 103.

This provides that the assets and liabilities of the Listed HoldCo would be recorded at carrying amounts, inter-company investments would be cancelled, new share capital issued would be recorded at face value (irrespective of the market value of shares issued), and resultant difference, if any, would be debited or credited as capital reserve.

Summing up

There are various dimensions to this structure.  Firstly, the concept of a reverse merger to unlock value of the holding of Listed SubCo held by the Listed HoldCo is germane to address the substantial holding company discount, irrespective of dilution of direct holding of the promoters post the merger. Secondly, from a regulatory perspective, procedural challenges, regulatory approvals, and public shareholders’ approvals certainly pose complexity in merger consummation.

From a tax perspective, while there is an advantage to mitigate double taxation on sale of shares, as stated above, the impact of grandfathering of cost, both for Indian shareholders, and foreign shareholders, in absence of an express CBDT clarification, could not be undermined. From a stamp duty perspective, given that stamp duty is linked to the market value of shares issued, it could result in a substantial outflow.

Lastly, accounting for business combinations itself has varied aspects and therefore, one needs to be cognizant of how the balance sheet would look ultimately upon merger/ demerger. This is a good example of interconnect between commercial imperatives, regulations, tax, stamp duty, and accounting aspects.