(This article was first published on 23 December 2019)
A. Background
One of the most important changes that IndAS has brought about is uniform accounting in relation to of all types of business combinations, whereby an “acquirer” either assumes control over the business or over the entity of the acquiree. Therefore, a business combination may either be in the form of a merger, demerger (or hiving off), slump sale, share purchase, or even a buy-back or capital reduction, or any other form or manner, whereby control over a business or entity is acquired. This uniformity in relation to accounting for business combinations has been introduced under IndAS 103.
The core of any IndAS, and especially, IndAS 103, is recognizing the true substance of the transaction and not merely rely on the legal form of a business combination. One such concept that recognizes a series of steps involved in an acquisition as one is the concept of transitory control under IndAS 103.
As a live example, analyzing the acquisition of Zero Waste Organics Limited (“Zero Waste”) by Rallis India Limited (“Rallis”) by way of a share acquisition followed by a merger under a Scheme of Arrangement u/s 230-232 of the Companies Act, 2013 (“Scheme”), this article seeks to provide a practical perspective vis-à-vis the concept of transitory control under IndAS 103 at the time of amalgamation or merger, its impact on statement of profit and loss of the acquirer (or transferee) company going forward and its treatment under the Income-tax Act, 1961 (“Act”).
B. The Transaction: In Brief
Zero Waste was acquired by Rallis over a number of years; 22.81% in FY 2012-13 and subsequently, the stake then increased in Zero Waste over the subsequent years (i.e. FY 2013-14, FY 2014-15 and FY 2015-16) upto 73.63%, and finally it acquired the balance 26.81% in FY 2016-17.
Thereafter, in July 2017, a scheme of amalgamation (“Scheme”) providing for merger of Zero Waste with its 100% holding Company (viz. Rallis) was approved by the board of directors of the respective companies.
The appointed date (i.e. the date from which the assets, liabilities, business, contract, etc. of the transferor company, being Zero Waste, in this case, vests with the transferee company, being Rallis, in this case), as provided in the Scheme was April 1, 2017.
It is in the above concept that the accounting treatment provided under the Scheme, as filed with the stock exchanges, needs to be understood. The Scheme had provided for accounting of assets and liabilities of Zero Waste at their respective book values and the difference between the amount of investments cancelled and the net assets so recorded, was proposed to be recorded in goodwill/ capital reserve account.
C. Concept of Transition Accounting
Appendix C to IndAS 103 defines “Common Control Business Combination” to mean a business combination involving entities or businesses in which all the combining entities or businesses are ultimately controlled by the same party or parties, both before and after the business combination, and that control is not transitory. Further, business combination is defined to mean a transaction or other event in which an acquirer obtains control of one or more businesses.
In the context of acquisition of Zero Waste by Rallis, one could contend that the “business combination”, in this case, is a series of steps as under:
a. Acquisition of control by way of acquisition of 100% shares in Zero Waste over a couple of years; and thereafter
b. Merger of Zero Waste with its 100% holding company (i.e. Rallis) thereafter.
Therefore, the steps of “intermediate acquisition” together with merger of Zero Waste with Rallis could be contended to mean a single business combination whereby the control over Zero Waste is being transitioned from a third party to Rallis. Consequently, the ultimate step of merger of Zero Waste with Rallis should not be looked at on a standalone basis but should be looked at as a composite process to consolidate the business of Zero Waste with that of Rallis as a combination of a series of steps, viz., share acquisition followed by a merger.
In the context of the above, while the plain reading of Appendix C to IndAS 103 could recognize the standalone step of merger of Zero Waste with Rallis, being essentially a merger of a wholly owned subsidiary with its holding company (and therefore, common control business combination, at first blush), in substance, if the said step of merger is looked at along with the preceding steps, it could sufficiently be established and demonstrated that this merger is the ultimate step to acquire the business of Zero Waste by Rallis.
Since the core of IndAS is based on the principle of substance over form, mere discrete legal steps (such as share acquisition and merger) should be disregarded if the overall substance of the transaction is that of acquisition of business of the acquiree entity.
A parallel of the above concept could also be inferred from the provisions of General Anti-Avoidance Rules (“GAAR”) as stipulated under the Act which provides that if there are a series of pre-ordained steps, which, effectively, would result in a tax avoidance, if the intermediate steps were to be ignored, then the Revenue Authorities could disregard the intermediate steps so as to ascertain the tax benefit derived by the taxpayer. This fundamental concept under GAAR, viz., giving precedence of substance over form, is a similar concept prescribed under “Transitory Control” under IndAS 103 as well.
In relation to IndAS 103, reference of the same could further be sought from Q 40 of Education Material on IndAS 103 (issued by ICAI). In the said question, it has been deduced that the word ‘transitory’ has been included in the definition of “common control” to ensure that the principles of acquisition accounting apply to those transactions that look as though they are combinations involving entities under common control, but, which in fact, represent genuine substantive business combinations with unrelated parties.
Therefore, if the intermediate step of acquisition of shares is excluded, then it could sufficiently be established that a direct merger of Zero Waste with Rallis (without the said intermediate acquisition) would have resulted in a direct acquisition of business from an unrelated party and therefore, it should have been accounted under the acquisition method of accounting.
Owing to the above, in effect, the said merger should not be considered as a merger of a wholly owned subsidiary with its 100% holding company and therefore, should not be accounted under the “pooling of interests method” (i.e. line-by-line consolidation of assets, liabilities and reserves of the transferor company) as required, if the merger is a common control business combination. Underpinning the concept of substance over form, the said merger should, therefore, be accounted for as per the “acquisition method” of accounting.
D. Impact on the Statement of Profit and Loss of the Acquirer
Under IndAS 38 (Intangibles), an intangible asset is defined to mean an identifiable non-monetary asset without any physical substance. The definition of an intangible asset requires an intangible asset to be identifiable to distinguish it from goodwill. Goodwill recognized in a business combination is an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognized. The future economic benefits may result from synergy between the identifiable assets acquired or from assets that, individually, do not qualify for recognition in the financial statements.
As a result of the above, goodwill arising on account of a business combination (if the business combination is between unrelated parties and therefore, the business combination is being accounted under the “acquisition method” of accounting), is not subject to amortization (since it is not an identifiable intangible asset). The resultant goodwill would only be subject to the test of impairment. Therefore, from the perspective of statement of profit and loss of the Acquirer, such goodwill would not impact its bottom line, unless impairment on the same is provided for.
E. Inter-Play with Income Tax
Although the goodwill accounted as a result of business combination is not subject to amortization and therefore, not impacting the statement of profit and loss account of the Acquirer, such goodwill so recorded should be subject to depreciation u/s 32 of the Act.
Recently, the Hyderabad Tribunal[1] had the occasion to decide on a similar subject matter. A pharma company had acquired shares of two (unrelated) companies and had thereafter, sought to merge both the companies with itself. The excess of investment made over the aggregate value of net assets acquired was treated as goodwill by the pharma company and depreciation/ amortization was claimed u/s 32 of the Act on the same.
The Revenue Authorities contended that since such goodwill was non-existent in the books of the transferor company, allowance of depreciation would be restricted to the written down value of the assets recorded in the books of the transferor companies prior to the amalgamation and not on the goodwill so recorded in the books of the transferee company, only upon the merger becoming effective, which is akin to a self-generated goodwill.
The Hyderabad Tribunal reversed the said decision and observed that goodwill on depreciation is not on account of self-generated goodwill since the acquirer had acquired the shares from unrelated parties. Relying on the decision of the Supreme Court in the case of Smifs Securities[2], and distinguishing the ruling in the case of United Breweries[3], the Hyderabad Tribunal allowed the claim of depreciation on goodwill so recorded as a result of a third-party acquisition, albeit through a two-step process (i.e. share purchase followed by amalgamation).
Therefore, at this juncture, it is imperative to note the divergent treatment of depreciation in the books of the acquirer and under the Act; while the goodwill would remain intact in the books (subject to impairment), such goodwill would be subject to depreciation u/s 32 of the Act. Of course, as a corollary, companies which are subject to Minimum Alternate Taxes u/s 115JB of the Act, would not get the benefit of such tax amortization u/s 32 of the Act since the goodwill is not amortized in the books.
F. Key Takeaways
It is for the first time in the Indian accounting landscape that IndAS 103 has introduced the concept of “transitory control” which in turn is underpinned by the concept of substance over form. By focusing on the core or ultimate objective of a transaction, this concept permits the acquirer to disregard the intermediate steps so as to account for the “objective” as opposed to the “individual steps” to individual steps to achieve that objective.
Further, “acquisition method” under IndAS of accounting (which was akin to “Purchase Method” under AS 14) is more palatable from an EPS standpoint since goodwill, under IndAS, is not subject to a mandatory amortization charge (unlike under the erstwhile AS 14 where goodwill was subject to mandatory amortization) and therefore, the net profits of a company are not adversely impacted; at the same time, from a tax standpoint, since an acquirer has indeed discharged consideration for the same, it is only equitable that the acquirer should get a tax deduction on the amount of goodwill embedded in the amount of consideration so discharged.