The Interconnect

Cross Border Mergers – The Outbound Stitch

Ketan Dalal (Managing Partner, Katalyst Advisors LLP)
Jun 7, 2018

Part II - Continuation from Part I on Inbound Stitch

India has been one of the fastest growing major economies in the world attracting foreign investors across the globe promising lucrative opportunities. Continuous liberalisation in the regulatory framework over the last decade has improved the investment climate which has reported a significant rise in the Foreign Direct Investment (“FDI”) inflows in the country. The biggest e-commerce deal recently witnessed is the Walmart-Flipkart deal wherein the US retail giant is acquiring 77% stake in the Indian operations for ~USD 16 billion. The other significant acquisitions are Russia’s Rosneft in Essar Oil, Japanese SoftBank’s significant chain of investments in leading consumer internet start-ups like OYO Rooms, PayTM and Ola Cabs etc.

In this backdrop, the Ministry of Corporate Affairs (“MCA”) and the Reserve Bank of India (“RBI”), for the first time, have also incorporated enabling provisions[1] for cross border merger of an Indian Company into a Foreign Company. As this article seeks to bring out, these provisions may enable an outbound merger in limited situations, pursuant to which global companies may restructure their operations in India; however, a significantly more integrated ecosystem is needed to make such an initiative truly meaningful.

Regulatory framework for Outbound Cross Border Merger:

In an outbound merger of the type envisaged by the RBI regulations, the Indian Company would go out of existence as a body corporate and would become a branch and the shareholders of the Indian Company would be issued shares and / or securities of the amalgamated Foreign Company. In this context, Outbound Merger Regulations under Regulation 5 provide for a deemed approval of the RBI, subject to the specified conditions, primarily the following:

  1. A person resident in India may acquire or hold securities of the resultant company in accordance with FEMA 120[2] - Overseas Direct Investment (“ODI”) (such as financial commitment of the Indian company to be within the overall threshold of 400% of its net- worth)
  2. A resident individual may acquire securities outside India provided that the fair value of such securities is within the limits prescribed (i.e. of USD 2,50,000 per person per financial year) under the Liberalised Remittance Scheme (“LRS”).
  3. An office in India of the Indian company, pursuant to sanction of the Scheme of cross border merger, may be deemed to be a branch office in India of the resultant company in accordance with the Branch Office ("BO”) / Liaison Office (“LO”) Regulations, 2016[3]. Accordingly, the BO / LO may undertake any transaction as permitted under the said FEMA Regulations.
  4. The guarantees or outstanding borrowings of the Indian Company which become the liabilities of the resultant company shall be repaid as per the Scheme sanctioned by the National Company Law Tribunal (“NCLT”). The resultant company shall not acquire any liability payable towards a lender in India in Rupees which is not in conformity with FEMA. A no–objection certificate to this effect should be obtained from the lenders in India of the Indian Company.
  5. The resultant company may acquire and hold any asset in India which a foreign company is otherwise permitted to acquire under FEMA. Such assets can be transferred in any manner for undertaking a transaction permissible under the FEMA.
  6. Where the asset or security in India cannot be acquired or held by the resultant company under FEMA, it shall sell such asset or security within two years (“transition period”) from the date of sanction of Scheme and the sale proceeds shall be repatriated outside India immediately through banking channels. Repayment of Indian liabilities from sale proceeds of such assets or securities within the transition period is permissible.
  7. The resultant company may open a Special Non-Resident Rupee Account in accordance with the Foreign Exchange Management (Deposit) Regulations, 2016 for the purpose of putting through transactions under these Regulations. The account shall run for a maximum period of two years from the date of sanction of the Scheme.

Further, Rule 25A of Companies (Compromises, Arrangements and Amalgamations) Rules 2016, permits outbound merger of Indian companies with such Foreign Companies which are incorporated in the specified jurisdictions as under:

i. whose securities market regulator is a signatory to International Organization of Securities Commission’s Multilateral Memorandum of Understanding (Appendix A Signatories) or a signatory to bilateral Memorandum of Understanding with SEBI, or

ii. whose central bank is a member of Bank for International Settlements and a jurisdiction, which is not identified in the public statement of Financial Action Task Force as:

a) A jurisdiction having a strategic Anti-Money Laundering or Combating the Financing of Terrorism deficiencies to which counter measures apply; or

b) jurisdiction that has not made sufficient progress in addressing the deficiencies or has not committed to an action plan developed with the Financial Action Task Force to address the deficiencies.”

This article primarily focusses on key issues arising on account of Outbound Merger i.e. a cross border merger where the resultant company is a Foreign Company. The issues arising on account of Inbound merger are discussed in detail in Part I of this article (to access the same, click here).

Inbound structures of Foreign companies:

A Foreign Company can have its business presence in India in various forms as depicted in the chart below:

  • Wholly Owned Subsidiary (“WOS”) and Joint Ventures (JVs): 100% FDI is permitted in a company under automatic route undertaking permissible activities as per Schedule I of 20(R) [4] (“Inbound Regulations”) such as manufacturing, trading and service operations (subject to sectoral limits and valuation norms). Regulated sectors would require a prior Government approval.
  • Limited Liability Partnerships (“LLPs”): 100% FDI in LLP is permitted under automatic route under Schedule 6 of Inbound Regulations in sectors where there are no FDI linked performance conditions.
  • LOs/BOs/POs: A Foreign company may also establish a LO / BO / PO in India undertaking limited activities as permitted under FEMA 22(R)[5].

Some challenges faced by Foreign Companies operating in India:

One of the issues faced by Foreign Companies under a corporate set up in India is the challenge in repatriating profits earned out of the Indian business. For instance, if an Indian company declares dividend to its foreign shareholders, it is liable to pay Dividend Distribution Tax (“DDT”) @ ~ 20% under section 115 -O of the IT Act. Alternatively, the Indian company may consider to distribute its accumulated profits to the foreign shareholders as buy back or reduction of its share capital. In the former case, it would be liable to Buy back Tax (“BBT”) (for unlisted shares) under section 115QA @ ~ 23.30% and in the latter, DDT to the extent of accumulated profits (whether capitalized or not) and capital gains tax over and above the same[6]. Further, since these taxes (i.e. DDT or BBT) are directly borne by the Indian Company and not by the recipient shareholders, it may not be possible to obtain a Foreign Tax Credit (“FTC”) in the home jurisdiction. This would also lead to double taxation on the net dividend income.

Further, the onerous requirement of complying with host of annual regulatory compliances by an Indian Company under the Companies Act 2013 makes it even more challenging for Foreign Companies to operate in India. Consequently, such issues, could be the reasons the Foreign Companies may want to revisit their existing group structure in India.

Key issues surrounding Outbound Merger of Indian companies with Foreign entities:

With the introduction of the Outbound Cross Border Merger regulations, Foreign MNCs facing challenges (such as outlined above) may explore opportunities for internal reorganisation under this regime. However, there are various issues which could arise from a commercial, tax and regulatory standpoint which will make an outbound cross border merger unworkable in most situations. The key issues are outlined below:

No Tax-neutrality in case of Outbound Merger:

Unlike inbound mergers, the existing provisions of the Indian tax laws do not afford the benefit of tax neutrality in an outbound merger scenario. Section 47(vi) and Section 47(vii) of the IT Act provides for a tax neutral treatment on transfer of capital assets in an amalgamation only if the resulting company is an Indian Company.  However, in an outbound merger scenario, the resulting company would be a Foreign Company and therefore, any transfer of capital assets under this regime could attract capital gains tax in the hands of the Foreign Companies and the shareholders as under:

  • In the hands of the erstwhile Indian Companies: In an outbound merger, the amalgamating Indian company being the transferor entity could be liable to capital gains tax on transfer of its assets on account of merger, up to the date of amalgamation. However, one could take a view that since the Indian Company does not receive any consideration in lieu of amalgamation, there may not be any capital gains tax liability arising as such.
  • In the hands of the Shareholders: The shareholders receiving the shares of the Foreign amalgamated Company will also be taxable either as long term or short-term capital gains tax.

Unless the above provisions are amended under the IT Act for granting a tax-neutrality for an outbound merger, the resultant capital gains tax will in itself be a huge deterrent for Foreign Companies to even consider such a cross border merger.

Outlining certain scenarios:

Let us look at some scenarios to see whether the outbound cross border merger would be possible under such circumstances:

1)Merger of Indian WOS - A Foreign Company could consider to fold up its 100% Indian WOS, pursuant to which the Indian WOS would cease to exist and the shares held by the Foreign Company, would be cancelled. Whilst the non-grant of tax-neutrality would continue to subsist (more so from shareholder’s perspective), the additional key considerations for an outbound merger of an Indian WOS are outlined as under:

A. WOS engaged in manufacturing activities:

As per Regulation 5(3) of the Cross-Border Merger, post outbound merger, the Indian office shall be deemed to be the LO / BO of the Foreign Company. As per FEMA 22(R), a branch of a Foreign Company is permitted to undertake the following activities:

  1. Export/import of goods;
  2. Rendering professional or consultancy services;
  3. Carrying out research work in which the parent company is engaged;
  4. Promoting technical or financial collaborations between Indian companies and parent or overseas group company;
  5. Representing the parent company in India and acting as buying/ selling agent in India;
  6. Rendering services in Information Technology and development of software in India;
  7. Rendering technical support to the products supplied by parent/group companies;
  8. Representing a foreign airline/shipping company

The FEMA regulations do not permit a BO of a Foreign Company to undertake any manufacturing activities in India. Accordingly, in case the Indian WOS or JV is engaged in manufacturing activities pre-merger, the resultant branch will not be permitted to continue such activities post-merger. Further, ongoing liabilities such as, commercial loans, employee’s contracts, vendor payables etc. of the Indian WOS would continue to prevail and consequently will become the liabilities of the Foreign Company. The resultant Branch may not be permitted to service such liabilities directly. Due to such reasons, it is unlikely that a Foreign Company will choose to amalgamate its manufacturing arms / units in India.

B. WOS engaged in Trading or Service activities: Since a branch of a Foreign Company is permitted to undertake trading or service activities in India, an outbound merger on an Indian WOS engaged in such activities with its Foreign Holding Company seems workable. However, even under such circumstances, the following issues may arise:

a) Permanent Establishment (“PE”) issue: In an outbound merger, the assets, liabilities and the employees of the Indian amalgamating Company would be transferred to the Foreign resultant Company. Since the business would continue through the branch office, such place of business in India would have a potential exposure of it being considered as Fixed Place PE of the Foreign amalgamated company. In such cases, the profits attributable on account of Indian operations to the branch of Foreign Company in India, may be taxable at a higher rate of 40% (plus surcharge and cess). As seen, branch taxation in India not suffers a higher rate of tax, but it has complexities of computation of profits, due to which the Foreign amalgamated Company, may ultimately, not even prefer a Branch office in India.

b) Transfer of Indian employees on payroll of Foreign Company:

  • Impact on Indian Employees: Employees of the erstwhile Indian company who would be transferred on the payroll of the resultant Foreign Company, may be subject to tax not only in India but may also suffer tax in the home jurisdiction of the Foreign Company thereby leading to double taxation on the salaries / emoluments earned (subject to FTC in the relevant DTAA).
  • Impact on the Foreign Company as an Employer: The Foreign Company being the employer of Indian resident employees would also be liable to deduct and pay the taxes withheld on any salary payments. Further, the Foreign company would also have to determine if it would be required to undertake the compliances under various statues for the welfare of the Indian employees (such as Payment of Gratuity, Employees Provident Fund, Employees State Insurance etc. 

c) Stamp Duty – Stamp duty implications will be another key consideration for the Foreign Company. Stamp Duty is payable on the conveyance relating to amalgamation of Companies and is levied as per the respective state Stamp Act.

Because of the above issues, it seems that an outbound merger could be workable only for such Indian WOS having a very small-scale set up in trading or service sectors. In other cases, it seems highly unlikely.

2)Merger of an Indian unlisted JV – The issues as cited above will continue to persist even in a situation where an Indian JV is proposed to be merged with a Foreign Company with additional challenges as under:

  • Commercial issue: An outbound merger of an Indian JV may require a significant deal negotiation with the Indian JV partner along with a detailed swap ratios evaluation supplemented with appropriate valuations.  
  • Regulatory issue: Regulation 5(2) of the Cross-Border Merger Regulations, permits a resident individual to acquire securities outside India within the limit of USD 2,50,000 (~ INR 1.60 crore) as per the LRS. Considering a scenario wherein the value of shares issued by the Foreign company in lieu of an outbound merger of an Indian Company would be higher than the permissible threshold of USD 2,50,00,00; such a situation would be dissented by the Indian JV partner, thus making the overall deal unworkable.

3)Merger of Listed Indian Company – Lastly, a merger of a Listed Indian company with a Foreign Company, is highly unlikely to work due to a variety of reasons such as the following:

  • Company’s perspective: The Indian Listed Company will have to comply with host of SEBI regulations and guidelines as applicable to it prior to the outbound merger. This process in itself could be a highly complex and possess several regulatory challenges. Further, currently, there are no specific guidelines issued by the SEBI clarifying the mechanism of how the cross-border mergers of a listed Indian entity would be dealt with.
  • Indian shareholders perspective: From a public shareholders perspective, discharge of consideration by the Foreign Company could be challenging as under:

- Firstly, as a consequence of such outbound merger, the Foreign Company would be required to issue its shares to shareholders of the Indian Company which may not be practicable from an Indian shareholder standpoint and is likely to be a SEBI regulation issue.

- Secondly, the value of Foreign Companies shares as issued to the Indian promoters or individual shareholders of the Listed Indian Company, may be over and above the permissible threshold of USD 2,50,000 as per the LRS, which would be another regulatory issue, which would be another a regulatory constraint.

- Even after acquiring the Foreign Company shares (pursuant to above), the Indian shareholder could face challenges in selling such shares to another person and complying with the extant FEMA guidelines; hence, requiring some kind of depository mechanism.

- Lastly, Indian Institutional shareholders such as Asset Management Companies investing in Listed Indian Companies are regulated by SEBI, Companies Act, RBI etc. Such regulations may have restrictions and may not have envisaged holding of shares of a Foreign company by such Institutions causing another regulatory challenge in this regard.

Also, an Indian Listed Company is likely to be a substantial company. Obviously, even de-hors the above issues, it seems inconceivable that such a company could cease to exist and become a branch of a Foreign Company. Net – net such a merger seems highly improbable.

4) Share swap transactions: Under an outbound merger, the Indian Company ultimately ceases to exist. However, there may be instances wherein the parties may agree that the consideration to be paid to the Indian shareholders could be in the form of shares of the Foreign Company by way of a share swap transaction, wherein, resultantly, the Indian Company continues to exist. Under FEMA, such share swap transactions are permissible under the FDI and ODI regulations; however, even in such scenarios, there would be significant regulatory challenges to be evaluated. While such transactions may be akin to an outbound merger, but generally, they will not classically fall within this regime. As a preliminary thought, the regulatory bodies may envisage to try and create a regulatory framework to enable such transactions possible instead of a complete liquidation / non-existence of the Indian entity.

Concluding Remarks:

As seen from the above issues, the regulatory framework for an outbound merger would apply to very limited scenarios wherein Indian entities are involved in relatively small trading or service activities and the Parent Foreign Company would like to hold such operations as a branch, possibly to scale it down. However, even in such circumstances, the issues arising post-merger, could be a deterrent to even consider such outbound mergers, making the applicability of these regulations very limited.  One may have to further wait for the regulations to become more holistic to give meaning to such an initiative.

This article has been co-authored by Neha Lala

[1]Section 234 of the Companies Act 2013 read with Rule 25A of the Companies (Compromises, Arrangements and Amalgamations) Rules, 2016

[2]Foreign Exchange Management (Transfer or issue of any Foreign Security) Regulations, 2004

[3]Foreign Exchange Management (Establishment in India of a branch office or a liaison office or a project office or any other place of business) Regulations, 2016

[4]Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017

[5] Foreign Exchange Management (Establishment in India of a branch office or a liaison office or a project office or any other place of business) Regulations, 2016

[6] Refer CIT v G. Narasimham [1999] 102 Taxman 66 (SC)

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