Monday, April 11, 2011

Scheme of Arrangement: Role of Tax Authorities

The role of the tax authorities in challenging a scheme of arrangement under sections 391 to 394 of the Companies Act, 1956 has been called in question in the demerger of the passive infrastructure assets of various Vodafone Essar entities into Vodafone Essar Infrastructure Limited. This was an intra-group transaction as all companies enjoyed a wholly owned subsidiary relationship with one of the transferor companies. Accordingly, the demerger of the passive infrastructure business was effected at nil consideration, whereby the transferee company was not required to issue any shares or pay cash for receiving the assets.

Since companies were situated in various states, the scheme required the approval of the High Courts at Bombay, Calcutta, Madras, Gujarat and Delhi. While the Gujarat High Court refused to bless the scheme, all the other High Courts sanctioned it, with the Delhi High Court’s order being issued a few days ago, on March 29, 2011. The purpose of this post is to highlight the different approaches adopted by the Gujarat and Delhi High Courts on the same scheme.

In December 2010, the Gujarat High Court delivered its judgment refusing to sanction the scheme. Specifically, the court found that the transaction did not fall within the scope of “arrangement” within the provisions of the Companies Act as the transaction was considered to be a gift due to the lack of consideration. The court found the existence of a number of other grounds to reject the scheme, primarily because the transaction would result in a loss to the revenue. The memos from KPMG and Ernst & Young contain a discussion of the arguments put forth by the parties and the decision of the Gujarat High Court.

The decision of the Gujarat High Court appears to have taken the M&A fraternity by surprise as the court not only provided a restrictive interpretation to a scheme of arrangement under section 391, but also seemed to confers immense powers to tax authorities to object to the scheme at the outset. This was a setback of sorts because sections 391 to 394 of the Companies Act provide sufficient flexibility to companies to carry out mergers, demergers, reconstructions and other similar forms of transaction albeit with shareholder (and sometimes creditor) approvals and under the supervision of the court. In fact, court schemes have become quite popular in India to implement restructurings, and more so than in other Commonwealth jurisdictions such as the U.K. and Singapore where similar statutory provisions exist. It is no surprise, therefore, that Vodafone Essar preferred an appeal from the decision of the single judge of the Gujarat High Court to a division bench, which is understood to be pending.

On the other hand, the Delhi High Court was concerned with the same scheme, but approved it despite objections by the tax authorities. At the same time, the court reserved certain powers to the revenue that therefore operates as a midway path adopted by the Court. In its decision, the Delhi High Court accepted the wide amplitude of the expression “arrangement”. The Court examined the lexicographic scope of the expression by noting that the expression “arrangement” is not defined in the Companies Act. [Note: However, section 390 does define “arrangement”, although only in inclusive and illustrative terms.] Even a transaction that does not involve payment of consideration can fall within the scope of an arrangement, and it does not matter that the transferor companies are effectively giving up the assets for free. The Court had this to say:
The Income Tax Department cannot conceivably have the same interest in the company proposing the scheme as the shareholders of that company. And, to my mind, the Income Tax Department is also not in any sort of loco parentis to the shareholders of the transferor companies who have unanimously agreed to transfer their assts without recompense, nor are they the guardians of their interests, and therefore, the Income Tax Department cannot be heard to plead that the scheme must be thrown out because, in its opinion, the Scheme operates as a confiscation of the transferor shareholders rights. The essence of the idea of confiscation is the taking away or abstraction of something from someone without his consent. Once there is consent, there can be no confiscation.
Furthermore, the court did not accept the arguments of the tax authorities regarding the accounting and tax matters pertaining to the scheme. It found that the object of the scheme was not merely to avoid tax. The Delhi High Court, however, clarified that it was only concerned with sanction of the scheme and was not ruling on the merits of accounting and taxation of the scheme. The via media adopted by the court was to accord sanction to the Scheme of Arrangement under Section 391 and 394 of the Companies Act, 1956 while reserving the right of the income tax authorities to determine any tax liability.

The Gujarat and Delhi High Courts have adopted somewhat contrasting approaches. The Gujarat High Court examined the taxability of the demerger transaction in detail and also whether the transaction was effected as a matter of tax planning. The Delhi High Court, on the other hand, merely confined the scope of its jurisdiction to an examination of the typical factors considered in schemes, including public interest, but reserved powers to the tax authorities to subsequently pursue their tax determination. In that sense, parties seeking sanction of the scheme will necessarily have to assume the risk of adverse determination by the tax authorities. The Delhi High Court’s approach introduces greater predictability in schemes of arrangement by more closely circumscribing the court’s jurisdiction.

Given the varying approaches, it is natural to expect some level of clarity on the issue. Perhaps when the Gujarat High Court is considering the matter on appeal, it will have the benefit of the Delhi High Court judgment and will have the opportunity to consider both approaches before deciding the issue.

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