Background
PTSD or Post-Traumatic Stress Disorder is a disorder generally attributable to an adverse mental health condition that is triggered by a traumatic event. In a deal context, PDRD or Post Divestment Regulatory Disorder is an adverse regulatory setback faced by a company that has recently undergone a divestment. Of course, this is neither this a legal jargon nor is it terminology belonging to corporate M&A lexicon! But this phrase, if at all it were not apocryphal, would be a phrase which would squarely apply to the deal leading to divestment of its dairy business by Prabhat Dairy in 2019 – Prabhat Dairy had sold its dairy business, constituting approximately 98% of its consolidated turnover, to Lactalis, a French-based giant in the dairy space, for INR 1700 Cr, 1.1x of FY18 Consolidated Turnover totaling to INR 1554 Cr.
The present article attempts to recognize the shortcomings that Prabhat Dairy may have faced in a post divestment scenario from a regulatory and tax perspective, given the complex, two-level deal construct and the consequential costs in relation to the extraction of the divestment proceeds.
Deal Construct
As can be inferred from the above diagrammatic representation of the structure, Prabhat Dairy directly held 29% in SAIPL and the balance 71% stake was held by CLAIPL in SAIPL, CLAIPL being a 100% subsidiary of Prabhat Dairy. Hence, SAIPL was a 100% subsidiary of Prabhat Dairy through a combination of direct and indirect holding.
The deal i.e. divestment of dairy business was structured in a two-step process:
- Sale of shares of SAIPL by CLAIPL and Prabhat Dairy for an aggregate cash consideration of INR 1227 Cr; and
- Slump Sale of Dairy business, carried out by Prabhat Dairy directly, in its belly, for an aggregate cash consideration of INR 473 Cr.
N.B.: Slump Sale is a term evolved under the Income-tax Act, 1961 (“ITA”) u/s 2(42C) and means a sale of business division (or part thereof), lock, stock, and barrel, on a going concern basis, together with all assets, liabilities, employees, contracts, legal proceedings, inherent intangibles, etc. From a tax perspective, the aggregate consideration received on account of slump sale is reduced by the net worth of that business division (technically, an “Undertaking”) and the resultant gains is offered to tax either as long-term (if the Undertaking is operated for more than 36 months) capital gains at ~23.3% tax rate or as short-term capital gains at ~25% tax rate, if a company has opted for lower tax regime under the Taxation Laws (Amendment) Act, 2019.
Further, Prabhat Dairy had stated that a substantial portion of the proceeds from the sale shall be shared with shareholders after meeting the customary closing adjustments, tax and transaction cost obligations. Furthermore, it was proposed that the funds received on sale will be kept in Escrow Account which operates on the decision of the ‘Transaction committee’ which is formed by the board of directors to monitor, oversee and manage the funds received on completion of the aforesaid transaction.
Post Divestment Scenario: Merger of CLAIPL with Prabhat Dairy
In order to facilitate the consolidation of cash generated in the books of CLAIPL upon the sale of shares of SAIPL, Prabhat Dairy had contemplated a merger of CLAIPL with itself i.e. a merger of a wholly-owned subsidiary with its 100% holding company.
One question that may arise, at this juncture, is whether a merger of a wholly-owned subsidiary, solely with cash reserve, with its 100% parent company, could be considered as a deemed distribution of dividend, notwithstanding the fact that such a merger may be tax neutral otherwise? Interestingly, vide Circular No. 5-P, dated 9 October 1967, the Central Board of Direct Taxes had clarified that the provisions of deemed dividend (u/s 2(22) of the ITA) shall not apply in cases of amalgamation, even though accumulated profits of the transferor entity are embedded in the assets so transferred, pursuant to an amalgamation!
In the above context, the Board of Directors of Prabhat Dairy had considered and approved a merger of CLAIPL with Prabhat Dairy on 13 February 2019 in order to consolidate the cash reserves of CLAIPL with Prabhat Dairy; any dividend distribution from CLAIPL to Prabhat Dairy would have entailed an effective Dividend Distribution Tax (“DDT”) of 20.56% in the hands of CLAIPL.
Fast Track Merger under Companies Act, 2013: A Myth?
Strangely, the Board of Directors (“Board”) on Prabhat Dairy, at their board meeting held on 14 February 2020, had again approved a Scheme of Arrangement u/s 230-232 of the Companies Act, 2013 (“Cos Act 2013”) providing for a merger of CLAIPL with Prabhat Dairy. It is peculiar since, as mentioned earlier, the Board of Prabhat Dairy had already approved an amalgamation (or merger) of CLAIPL with Prabhat Dairy on 13 February 2019 (i.e. exactly a year earlier).
The difference between the two approvals is that earlier, in 2019, the Board had approved amalgamation u/s 233 of the Cos Act while in 2020, it had approved the amalgamation u/s 232 of the Cos Act; And the sequential descension of one numeral (i.e. from section 233 to section 232) makes all the difference in terms of consolidation of entities i.e. merger of CLAIPL with Prabhat Dairy.
Section 233 of the Cos Act, typically referred to as a Fast Track Merger, contemplates to reduce the administrative process (and therefore, the timelines), if, inter alia, it involves a merger of a wholly-owned subsidiary with its holding company. A normal merger requires that approval of the National Company Law Tribunal (“NCLT”), in addition to the approval from the Ministry of Corporate Affairs through the Regional Director (“RD”) and Official Liquidator (“OL”); this process of multiple approvals leads to a cumbersome timeframe of 6-7 months for consummation of a merger once a scheme is filed with the NCLT. Therefore, to untangle this cumbersome process, the Cos Act provides for a Fast Track Merger, wherein a merger of a wholly-owned subsidiary with its 100% holding company would not require the approval of the NCLT and would directly be approved by the RD.
This “contemplation” of a Fast Track Merger is merely in theory and not in practice. The reason for this misalignment between theory and practice is the concept of “90% approval”. The provisions of section 233 require that the scheme shall be approved by the members of a company at a general meeting holding at least 90% of the total number of shares and the scheme is approved by majority representing 90% in value of creditors of a company indicated in a meeting convened by the company or otherwise approved in writing.
Under a normal merger, the requirement for approval is that any scheme shall be approved by members of creditors, majority in number and 3/4ths in value who are voting; therefore, the universe of the approving members/ creditors is limited to the extent of members or creditors who actually exercise their vote and the denominator does not (artificially) widen to the actual total number/ value of members or creditors who may not choose to exercise their vote.
However, since the requisite wordings in case of a Fast Track Merger are lacking, the RD had, purportedly, taken a view in the case of Prabhat Dairy that since the scheme was not approved by 90% of the members and creditors (denominator being the total number/ value of members/ creditors and not the actual members/ creditors who, in reality, exercise their vote at the meeting convened by the meeting), the scheme was not fit for approval under the Fast Track Merger route u/s 233 of the Cos Act. This interpretation would prove to be extremely tedious in the case of a listed company.
Consequently, the Board of Prabhat Dairy would have chosen to undertake the more cumbersome route of normal merger route u/s 232 of the Cos Act (which would, inter alia, require the approval of the NCLT in addition to the approval of the RD) owing to the lack of intent of legislation being transcribed in the law u/s 233 of the Cos Act and therefore, the subsequent Board approval, vide the meeting held on 14 February 2020.
Risk of being classified as Deemed Non-Banking Finance Company (“NBFC”)
In addition to the aforementioned regulatory hurdle of consolidating the cash reserve through a Fast Track Merger (in theory!), Prabhat Dairy and, more particularly, CLAIPL face a continuing challenge of being classified as a deemed NBFC. Conceptually, an NBFC is a company that is engaged in the business of lending money and earning interest thereon. However, the Reserve Bank of India deems any company which has financial assets constituting more than 50% of the total assets and financial income accruing on such financial assets constituting more than 50% of the total income, as NBFC and therefore, such a company, if so deemed, would be subject to the rigors of registration as NBFC with the RBI and consequently, be subject to various capital adequacy, prudential and provisioning norms, as prescribed by the RBI for NBFCs.
Therefore, even in the context of being classified as a deemed NBFC, merger of CLAIPL with Prabhat Dairy would result in a partial shelter for Prabhat Dairy since it would have income from the residual operating business (which would not constitute as a financial income); more so, if Prabhat Dairy does distribute the cash so consolidated to its shareholders, then the risk of it being classified as a deemed NBFC would reduce since the financial assets may not constitute more than 50% of the total assets. However, in order to do so, a merger of CLAIPL with Prabhat Dairy would prove to be a “Condition Precedent”.
Post Deal Extraction Costs
In addition to the capital gains tax that Prabhat Dairy and CLAIPL would have paid on slump sale of dairy business and sale of shares of SAIPL, there would be significant extraction costs for the promoters, especially post 1 April 2020, since DDT would then have been abolished and the tax incidence would lie in the hands of the promoters at approximately 36% (versus an effective DDT + recipient dividend tax @ 29% presently). Therefore, structures, wherein trusts or individuals who directly hold shares in a listed company, may need reconstruction given the substantial negative delta in terms of tax outflow on account of additional dividend tax in the hands of the recipients.
Deal Consummation in an Indian Scenario
As is the purpose of Traversing Transactions, the foregoing discussion illustrates post divestment regulatory and tax hurdles that a company may face even after consummation of an apparent sweet deal. From a deal consummation perspective, this underlines the importance of a holistic construct to dovetail the commercial imperatives into the requirements of various regulations which are governed by regulators (i.e. Ministry of Corporate Affairs, Securities and Exchange Board of India, Reserve Bank of India, etc.) and the tax roadblocks and speed-breakers in the backdrop.