India has witnessed many inbound and outbound cross-border mergers and acquisitions, which have been financed mainly through the international capital markets through innovative structures and financing schemes.
While the size of such transactions generally follows the ebb and flow of global economic tides, the established practice of “bed and breakfasting” in terms of deals structured through tax havens or low-tax jurisdictions, has been upset by Indian tax claims recently. This in turn means banks and investors financing such transactions, and even existing investors of both the seller and purchaser, must evaluate certain risks and perhaps also, their commitments.
It is a misconception that tax issues impacting an acquisition are only a driving factor for the seller and purchaser, especially since such considerations are now relevant for lenders and investors.
For existing or prospective lenders, it is essential to evaluate whether the financing is matched by the creditworthiness of the borrower and/or the resultant entity post-merger. The creditworthiness will now increasingly be dependant on tax issues impacting acquisitions since tax claims, which include penalties and interest, could result in bankruptcies.
The Vodafone controversy is a prime example of the way in which banks and lending institutions, which have advanced funds for such purposes, may be affected. There are issues and caveats which need to be considered by all lenders and investors (regardless of whether they are contributing funds towards a transaction) to safeguard their interests due to the current legal landscape.
Vodafone Holdings Hong Kong (VH) bought a controlling stake in Hutchinson Essar (HEL) by acquiring the shares of CGP Investments of the Cayman Islands (the ultimate holding company of HEL), from Hutchinson Telecommunications International. The Indian tax authorities issued a notice to VH for failure to deduct withholding tax for capital gains tax on the transfer of the stake in HEL. Its contention was that control of the assets in India had been acquired by Vodafone. From an acquirer’s perspective it would have been ideal to ensure the company was not taxable in any jurisdiction.
The challenge for financing transactions now, especially where there are a chain of companies in multiple jurisdictions, is to create a structure with commercial elements which, even if scrutinized by the tax authorities, would avoid allegations of tax evasion.
Documentation plays a critical role in ensuring legal and regulatory compliance as well congruence with regards to representations, warranties and capturing the commercial intent of the parties to the transaction. Documentation also enables lenders to exercise certain levels of control on the actions of the borrower. Adequate information and regulatory compliance covenants should be documented. Appropriate tax indemnities specific to transaction nuances should be built in to ensure that tax liabilities and/or attendant compliances do not upset transaction economics from the perspective of lenders or investors.
While concerns have arisen regarding the Vodafone ruling, another interesting aspect, which may affect the financial viability of acquisitions, is the ability to carry forward losses due to changes in shareholding. Significant positive value could be created if such losses were carried forward, as they would constitute a tax shield and largely reduce cash outflows on income tax until the losses have been exhausted against future profits.
Given that the main object for any lending transaction is to ensure that loans are regularly serviced without defaults, any added tax leakages would be problematic. This applies particularly to layered cross-border structures, especially where there is an upstream of funds from India. A deduction of withholding tax on interest payments, the payment of capital gains and dividend distribution tax could adversely impact the fund flows relied on to ensure regular servicing either of principal and/or interest.
In the current market scenario and even during good market conditions, banks scout for opportunities to free up their balance sheets to facilitate further lending by transferring loans. One of the hurdles of such transfers is whether the tax treatment or the tax benefits available either to banks, or a particular class of investor, will continue if there is a transfer of the loan.
The current trend in Indian cross-border tax jurisprudence further reinforces the need for sellers, purchasers, lenders and investors to evaluate tax issues in a stringent manner. While the funding of cross-border acquisitions will continue and closely follow the global economic position, due diligence processes, documentation and structure evaluations must be revamped to address the potential landmines which may upset structures and calculations due to tax risks.
Lenders and investors should seek independent tax consultations to safeguard their interests and avoid the problems associated with complex multi-jurisdictional structures. This will prevent pitfalls at a later stage of transactional structuring and allow for the early initiation of remedial measures where necessary.
Sonali Sharma is a partner and Freddy Daruwala is an of counsel at Juris Corp. The firm is a full-service law firm based in Mumbai and specializes in financial transactions including capital markets and securities, banking, corporate restructuring and derivatives.
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