(This article was first published on TaxSutra: https://www.taxsutra.com/dt/experts-corner/cash-neutral-acquisition-strategic-divestment-through-demerger)
Background
In India, cement industry has been a sector which has been important from a strategic perspective. Focus on housing and real estate, especially low-cost housing in urban areas, and rural housing, expansion of public infrastructure, and capital expenditure outlay for industrial expansion, have been key growth drivers for cement industry in India. In this context, consider a scenario, where a medium sized player in the cement industry (“Seller Co”) seeks to divest its cement business to a larger player in order to focus on other core businesses, whereas the larger player (“Acquirer Co”) seeks to consolidate its market position through inorganic M&A, especially where the cement market is largely oligopolistic, with the larger players having partial pricing control.
However, given the cash outlay for such an acquisition, the Acquirer Co intends to structure the acquisition through an all equity deal, resulting in a cash-neutral acquisition. This article seeks to deliberate on the various commercial, regulatory, tax, accounting, and fiscal cost considerations of such an acquisition.
Key Mechanics
In the context of the above, the Acquirer Co, a listed company, and the Seller Co, also a listed company, would enter into a Scheme of Arrangement u/s 230-232 of the Companies Act, 2013 (“Scheme”), whereby the Cement Undertaking of the Seller Co would be demerged into the Acquirer Co. As consideration, the Acquirer Co would issue its listed equity shares to the shareholders of the Seller Co. As a sweetener, the Acquirer Co could also issue redeemable preference shares to the shareholders of the Seller Co, making the deal more attractive and poised for an approval by the shareholders of the Seller Co.
Key Commercial Considerations
- From the perspective of the Seller Co: From the perspective of the Seller Co, through the said strategic divestment of its cement business, the Seller Co would be able to focus on its other core businesses, and deleverage its balance sheet by way of reduction of debt and outflow of interest as the liabilities pertaining to the cement business would be demerged along with the cement business.
- From the perspective of the Acquirer Co: From the perspective of the Acquirer Co, the Acquirer Co could potentially increase its manufacturing capacity, expand into markets where the Acquirer Co may not have a presence, optimize logistics/ distribution capabilities, and achieve economies of scale.
- From the perspective of the shareholders of Acquirer Co and Seller Co: From the perspective of the shareholders of Seller Co, divestment of a leveraged business and possible focus on core businesses going forward could lead to value creation in the residual Seller Co, and at the same time, they could participate in the equity upside with respect to the equity shares that would be issued to the shareholders by the Acquirer Co. Additionally, any sweetener in the form of redeemable preference shares could also result in a fixed cash consideration, with an appropriate coupon to compensate for the time value till the redemption, for the shareholders of the Seller Co. From the perspective of the shareholders of the Acquirer Co, due to the strategic reasons stated above, it could also lead to value creation through equity upside in the shares of the Acquirer Co, once the acquisition is consummated.
- Equity Risk for the Shareholders of Seller Co: Owing to the significant time gap between the board approval and the consummation of the acquisition, as would be seen hereinafter, the price at which the share swap ratio (for the demerger) has been arrived at the time of board meeting approval could vary significantly with the prevailing price of Acquirer Co as of the date of approval for the demerger. Therefore, if the price of the Acquirer Co, the effective consideration that the shareholders of Seller Co are discharged would be lower than that agreed upon at the time of board meeting approval. As a result, the shareholders of the Seller Co would effectively be undertaking an equity or market risk pending the approval of the demerger and subsequent issuance of shares. However, at the same time, any upside in the price of Acquirer Co during the pendency of approval of the Scheme would also accrue to the shareholders of the Seller Co, in the form of the higher value of shares being issued.
Key Regulatory Considerations
- Overview of the Approval Process: In terms of the timeline for approval of the Scheme, the approval of firstly, the Board, Audit Committee, and Independent Directors’ Committee of the Acquirer Co and Seller Co, after taking into consideration various aspects such as relative valuation of both companies, commercial rationale for the acquisition, synergies and need for the acquisition, cost benefit analysis, etc. Thereafter, the Acquirer Co and Seller Co would be required to file requisite documents within 15 working days with BSE/ NSE and seek approval of stock exchanges and SEBI under Regulation 37 of the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 read with SEBI Master Circular on Schemes of Arrangement dated 20 June 2023. Once the stock exchange and SEBI approval are in place, approval of the National Company Law Tribunal, other regulatory authorities (such as Regional Director, Registrar of Companies, amongst others) would be required, which typically takes around 10-11 months. Further, if the Seller Co and the Acquirer Co are situated in different jurisdiction, then the NCLT and RD/ RoC approval of both such jurisdictions would be required.
Additionally, it is imperative to note that approval of the Competition Commission of India could also be required, as the Seller Co and Acquirer Co are operating in the same industry.
- Role of Implementation Agreement: Given the significant time frame between the board approval and consummation of the acquisition, and given that this acquisition is between unrelated parties, an “Implementation Agreement” would be imperative. Key components of such an agreement would typically include the due diligence process, manner of implementation, timelines of execution, responsibility allocation for execution, detailed representations and warranties, indemnities, conflict resolution mechanism, conduct of business during the interregnum, standstill provisions, post-acquisition integration of operations, people, financial statements, IT Systems, shared services, etc.
- Majority of Minority Approval: If the cement business represents more than 20% of the consolidated net worth or consolidated turnover of the Seller Co (given that the consideration is not wholly in the form of listed equity shares, as preference shares are also being issued), and since the shareholding of the public shareholders of the Seller Co would be diluted by more than 5% in the Acquirer Co, majority approval of the public shareholders of the Seller Co who are voting of the Seller Co (“Majority of Minority Approval”) would be required in terms of the said SEBI Circular. This, especially, could become tricky in a case where large blocks of shares of the Seller Co are held by financial institutions, HNI investors, etc. since the promoters would not be able to vote in this case. Similarly, if the public shareholders of Acquirer Co are also diluted by more than 5%, Majority of Minority Approval of the Acquirer Co would also be required.
- Promoter Declassification: If the promoters of the Seller Co are not envisaged to manage or control or participate in the administration of the Acquirer Co, then it is possible for the Scheme to provide that such promoters of the Seller Co would be declassified as promoters and be re-classified as public shareholders of the Acquirer Co post listing.
- FEMA Perspective: Under FEMA (Non Debt Instrument) Rules, 2019, while issuance of equity shares is considered under the automatic route, if the target segment does not require government approval, which is so, issuance of preference shares to non-resident shareholders is considered as a debt instrument, and therefore, does not fall under the automatic route. Consequently, RBI approval for the same would be required for issuance of preference shares.
Key Tax Considerations
- Tax Neutrality: From the perspective of the Seller Co, Acquirer Co, and their respective shareholders, the said demerger of cement business should be considered as tax neutral if the identified undertaking constitutes a business, and not merely a group of assets or liabilities constituting a business, which would be so, and if such undertaking/ business is transferred on a going concern basis. Further, given that at least 75% of the value of shareholders in the Seller Co would be issued shares by the Acquirer Co, the said demerger should comply with the tax neutrality provisions of demerger, irrespective of the fact that post demerger shareholding of shareholders of the Seller Co in Acquirer Co is not significant, and irrespective of the fact that a combination of equity and preference shares would be issued.
- Tax Losses: If there are any tax losses or unabsorbed depreciation attributable to the demerged undertaking, such losses would also be vested with Acquirer Co for the remainder of the 8 years (in case of business losses), even if the transferred undertaking does not constitute an “industrial undertaking” (which includes manufacturing business, amongst others) as is required to be satisfied in case of merger.
- Certain Shareholder Issues: From the perspective of the shareholders of the Seller Co, while the receipt of new shares should not be taxable, there are certain issues in relation to the cost and manner of acquisition of such new shares issued pursuant to demerger.
- Cost of Acquisition Split: Firstly, the cost of acquisition will be split basis the net book value of the assets transferred as a proportion to the net worth of the demerged company. A question arises in case as to what would be the split cost of acquisition if the net book value of assets transferred is negative.In such a scenario, the cost of acquisition of shares of the Acquirer Co issued may be considered as NIL. Conversely, if the net worth of the Seller Co, is negative, then the cost of acquisition of shares of the Seller Co may be considered as NIL.
- Grandfathering of Cost on 31 January 2018: Secondly, if the shares of the Seller Co were acquired prior to 31 January 2018, then the deemed cost in the hands of the shareholders would be the current market price prevailing on 31 January 2018 (assuming that the original cost was lower than the current market price on 31 January 2018).However, since the new shares issued by the Acquirer Co were not “acquired” prior to 31 January 2018, would the split of cost of acquisition be basis the said grandfathered cost? Logically, it should be, since the cost of acquisition and the period of holding relates back to the cost and date of the original acquisition. An express clarification in this regard is warranted.
- Grandfathering for Mauritian, Cypriot and Singaporean Investors: Lastly, 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, even if the original shares may have been acquired prior to 1 April 2017, since, technically, the new shares would be issued post 1 April 2017, it may not be considered as having been “acquired” prior to 1 April 2017. Recently, the Delhi Tribunal, in the case of Sarva Capital LLC [TS-467-ITAT-2023(DEL)], held that in case of conversion of CCPS into equity shares, if the CCPS were acquired before 1 April 2017, but were converted into equity shares post 1 April 2017 and subsequently sold post 1 April 2017 as equity shares, then also the said sale should also be eligible for grandfathering under the DTAA. Similar principle can be applied in this case.
Key Accounting Considerations
From an IndAS perspective, the said demerger should be accounted under the acquisition method of accounting in the books of the Acquirer Co, whereby the assets (including previously unrecognized intangibles (say, brand, licenses, customer lists, etc., and which may or may not be subject to amortization depending on whether their determinable useful life) and liabilities of the identified undertaking, would be recorded at fair values, the consideration issue would be recorded at fair value, and the difference would be recorded as residual goodwill.
From a tax perspective, such specifically recognised intangibles may be subject to amortisation, whereas the residual goodwill will not be.
From the perspective of the Seller Co, since this would not be a common control transaction, such demerger would be recorded as “deemed dividend distribution” by the Seller Co to its shareholders, in relation to the new shares issued. Irrespective of the accounting being treated as deemed dividend distribution, it should not impact the tax neutrality of the demerger.
The preference shares that would be issued would be would be classified as a financial liability in the books of the listed company under IndAS 109 till such time such preference shares are redeemed, and the coupon thereon, would be classified as interest expense, denting the PBT/ PAT of the Acquirer Co, since it would not be a below the line item in its P&L statement.
Stamp Duty Considerations
Depending on the state in which the registered office of the Acquirer Co is situated, a certain percentage of the fair market value of shares issued (say, 0.7% in Maharashtra) would be considered for the purposes of stamp duty adjudication. Further, if there are any immovable properties situated in any other state, separate stamp duty relating to conveyance of such immovable properties will also be levied.
Summing it up
In conclusion, the scenario outlined reflects a sophisticated and strategic maneuver in the cement industry, emblematic of the broader trends in corporate restructuring. The decision by the Seller Co to divest its cement business to a larger entity, Acquirer Co, represents a strategic pivot to concentrate on its core businesses while leveraging the benefits of a cash-neutral transaction.
The complexity of the mechanics, involving a Scheme of Arrangement and regulatory approvals, underscores the importance of meticulous planning and strategic foresight in such deals. The role of an Implementation Agreement becomes crucial here, ensuring a smooth transition and alignment of interests for all parties involved. Tax considerations, especially for the shareholders of the Seller Co, IndAS considerations, and stamp duty considerations further add to the complexity, necessitating a thorough and multifaceted approach.