Mergers, demergers and other forms of corporate restructuring are usually effected through a scheme of arrangement that not only requires the approval of different classes of shareholders and creditors, but also the sanction of the relevant court of law. The provisions of the Companies Act, 1956, specifically sections 391 to 394, contain an elaborate framework to give effect to such schemes of arrangement. This framework has functioned quite well, and it has been used extensively by the corporate sector in India. Although many other countries in the Commonwealth too have similar provisions in their corporate statutes that deal with schemes of arrangement, a broad survey of corporate law in various countries would suggest that the utilization of these legal provisions in India to effect M&A transactions far exceeds that in those other jurisdictions. The Indian courts too have played a pioneering role in developing the jurisprudence on schemes of arrangement, by clearly laying down the parameters within which such schemes of arrangement may be initiated, approved by classes of shareholders and creditors and then accorded the sanction of the court.
One of the specific requirements of a scheme of arrangement is that under section 394A of the Companies Act, 1956, the court shall take into account any representations made by the Central Government before passing any order. This power of the Central Government is exercised by the Regional Director, Ministry of Corporate Affairs.
The precise role of the Regional Director in making representations, particularly on matters pertaining to income tax, came up before the consideration of the Bombay High Court in Casby CFS Pvt. Ltd., with the judgment being rendered on March 19, 2015. The judgment gives rise to a number of issues pertaining to schemes of arrangement in general, and hence requires discussion.
The scheme involved an amalgamation of Casby CFS Private Limited (the transferor) into Casby Logistics Private Limited (the transferee). Upon filing of the scheme before the court and during its consideration by the court, the Regional Director filed objections on several issues, which were followed up by objections from the Income Tax Department. More specifically, the scheme carried a retrospective appointed date of April 1, 2008. The issue in question was whether the transferor was a subsidiary of the transferee as on that date.
The companies suggested that such a parent-subsidiary relationship existed as on that date because certain individuals were holding shares in the transferor as nominees of the transferee. On the other hand, the Regional Director disputed the existence of such a nominee relationship between the transferee and those individuals. In essence, the existence and establishment of the nominee relationship was crucial to determine whether the transferor was a subsidiary of the transferee. The Regional Director alleged that not only were relevant facts suppressed by the companies, but also that the scheme and the retrospective appointed date were devised so as to engineer tax benefits that otherwise did not exist. In otherwise, it was alleged that the scheme was motivated for the purpose of obtaining undue tax advantages. All of these were countered by the companies.
After considering all the factual allegations as well as legal arguments, a single judge of the Bombay High Court allowed the scheme to stand (with suitable modifications), but imposed costs on the companies.
In this post, I discuss some of the rulings of the court on key legal issues and their implications on M&A practice involving schemes of arrangement.
Role of the Regional Director
One of the contentious issues raised before the Court related to the role of the Regional Director, and particularly whether he was entitled to raise objections pertaining to income tax. Moreover, the objections of the income tax authorities were raised belatedly. In addressing this issue, the court first considered the role of the Regional Director generally:
31. Further, the right/duty of the Regional Director to make a representation and offer his comments in respect of a scheme has received statutory recognition in Sections 394 and 394A of the Act. Both these provisions postulate that the Regional Director is required to examine the scheme and offer his comments and views thereon, which are required to be considered by the Court. It is therefore clear that the legislature intended that the Regional Director will examine a scheme from all aspects and place his observations and views before the Court and the Court will consider the same before sanctioning the scheme. It is obvious that the Regional Director, while making his observations and comments is entitled to consider the scheme from all aspects and is not restricted in any manner. He is entitled to consider the effect and implications of the scheme on any law and place his views before the Court if he finds that the scheme violates any law or prejudicial to public interest or to the interests of the shareholders of the company or companies involved. In fact, it is the duty and obligation of the Regional Director to consider every scheme in the aforesaid manner and place his views and observations before the Court. To hold otherwise would be to defeat the intention of the legislature as reflected in Sections 394 and 394A of the Act.
The more detailed legal issue pertained to the interpretation of the Ministry of Corporate Affairs’ (MCA) Circular of January 15, 2014 (previously discussed here). According to this Circular, the Regional Director is required to invite comments from the Income Tax Department within 15 days of receipt of notice before filing his response to the Court. If the Income Tax Department does not respond within the said 15-day period, then it is to be presumed that the Income Tax Department has no objection to the scheme. In the present case, the Income Tax Department failed to respond within the stipulated time-period, and hence the question was whether the Court can entertain the Department’s objections made belatedly.
On this issue, the Bombay High Court refused to be drawn into the technicality of the Circular. It found that the provision of the Companies Act conferring powers on the Regional Director were wider than those specified in the Circular. Hence, “a circular cannot fetter or restrict the rights of the Regional Director conferred and imposed on him by statute. The Circular must yield to the statutory provisions and cannot be construed to override the statutory provisions.” On this basis, the Court concluded that it was entitled to take on board the objections raised by the Income Tax Authorities as represented before it by the Regional Director.
It is quite customary in schemes of arrangement to assign a retrospective appointed date to which the scheme would relate back. This is primary to indicate that the financial statements of the companies involved would disclose the effect of the transaction from the appointed date. However, in this case, the validity of choosing an appointed date of April 1, 2008 was challenged. Not only was this a retrospective appointed date, but it also related back a number of years. This was because the income tax returns of the two companies involved would have to be amended from the appointed date so as to give effect to the scheme.
Specifically, the choice of appointed date was challenged on the ground that it contravened section 139(5) of the Income Tax Act. Under that provision a revised income tax return can be filed only if the conditions stipulated therein are satisfied, i.e. (i) that the assessee discovers any omission or wrong statement in the income tax return already filed, and (ii) the revised return is filed before the expiry of one year from the end of the relevant assessment year or before the completion of the assessment, whichever is earlier. In the present case, it appears these conditions were not satisfied. The question therefore is whether the use of the appointed date mechanism amounts to circumvention of section 139(5).
On this issue, the Court decided as follows:
50. … Prima facie, I am satisfied that there is some substance in the contentions of the Regional Director. It is clear from the various decisions cited by the Regional Director that revised income tax returns can be filed only if the conditions prescribed by Section 139(5) are satisfied. It would appear that by virtue of the retrospective appointed date, the Petitioners may file revised income tax returns with effect from 1st April 2008 without satisfying the conditions. … Accordingly, in my view it would be better to leave it to the Income Tax Department to decide whether the revised income tax returns, if filed, would be valid or would be violative of Section 139(5) of the Income Tax Act.
51. … In the circumstances, in my view, it would be proper to direct that the Income Tax Department shall not be bound by the appointed date fixed under the scheme while carrying out pending and/or future assessments of the Transferor and Transferee companies whether on the basis of the income tax returns already filed or revised returns, if any, that may be filed or otherwise and shall carry out such assessments without being influenced by the observations made herein.
Although the Court left the issue somewhat open-ended, the observation clearly put paid to the use of the “appointed date” mechanisms by raising some doubts regarding its use.
Role of the Court in a Scheme of Arrangement
This issue has been expounded quite clearly in two landmark decisions of the Supreme Court, Miheer Mafatlal and Hindustan Lever, which have acquired the status of jurisprudential folklore in M&A. However, the precise role of the courts was again raised in the present case wherein the Bombay High Court adopted the following view:
30. … It is an undisputed proposition that the court can interfere with the decision/commercial wisdom of the shareholders if the Court is satisfied that the scheme has been framed with the intention of contravening the provisions of any law. It is also well settled that the Court can interfere with the decision/commercial wisdom of the shareholders if the Court is satisfied that the scheme as framed in fact contravenes the provisions of any law, albeit unintentionally. There can be again no disagreement on the issue that the shareholders of companies are free to choose any date as an appointed date in their commercial wisdom. However, if the Regional Director nurtures any doubt qua any of the clauses in the scheme, including the date chosen as the appointed date, and finds that the same is contrary to law or apprehends that on the strength of such a clause contained in the scheme, the Company, after obtaining sanction from the Court, may use or misuse the same for contravention of any law including the provisions of the Income Tax, he is entitled to voice his doubt/apprehension before the Court, at the time the Court considers the grant of sanction to the scheme and it is always open to the Court to consider the doubt/apprehension expressed by the Regional Director and pass necessary orders either rejecting the scheme or sanctioning the same with/or without necessary clarification. I also do not agree with the argument advanced by the Petitioners that the Regional Director cannot object to the scheme on the ground that the same violates the provisions of the Income Tax Act and it is only the Income Tax Authorities who may raise an objection and that too only within the specified period stipulated in the circular dated 15th January 2014. Since this Court is required to ensure that a scheme of amalgamation does not contravene any provision of law, in my view, the Regional Director is not only entitled to but is duty bound to bring to the attention of the Court any provision in the scheme which may contravene/circumvent the provisions of any law including the law pertaining to Income Tax. This is to ensure that a company does not obtain sanction of a scheme and thereafter use the same as a shield to protect itself from the consequences arising out of the contravention of provisions of law.
Thus, the Court is clear in its jurisdiction to ensure that the scheme is not in contravention of any law, and more specifically, the Income Tax Act.
Finally, the Court also made some observations regarding non-disclosure by the companies.
Despite raising a number of issues and expressing strong views on matters relating to the scheme, the Court nevertheless sanctioned the scheme based on the facts of the case. However, this was subject to deletion of clause 6.2.1 of the scheme relating to filing of revised tax returns. Moreover, the Court left it open to the Income Tax Department determine the tax liability of the companies without being influenced by the judgment. In doing so, it was clarified that the Department would not be bound by the appointed date of April 1, 2008.
Although there are number of decisions of Indian courts relating to schemes of arrangements, in the last few years there has been greater uncertainty in dealing with objections to scheme on grounds of taxation. Schemes have previously been rejected (but some upheld on appeal). The contribution of the Bombay High Court in this case has been the attempt to introduce some level of clarity. At the same time, the effect of this judgment leaves several issues open for debate.
First, although the MCA circular of January 14, 2014 was intend to bring about clarity to objections on taxation grounds, that has been effectively disregarded by the Court. This may require the MCA to reexamine the process for objecting to schemes. If the Regional Director or the Income Tax Departments are allowed to raise objections belatedly, that will make the process for sanctioning the scheme uncertain and inefficient.
Second, the judgment seems to question the fundamental premise and very purpose of “appointed date” in a scheme. While the concept has been used in the past with judicial blessing, the present judgment raises some issues regarding its viability, especially when tax filings are to be revised. Although the Court’s observations towards such an appointed date mechanism have been rather negative, it did not decide on the merits of the issue by leaving it open for examination by the Income Tax Department.
Finally, there is yet some room for debate regarding the role of the court in a scheme of arrangement, particularly on tax matters. Arguably, the Bombay High Court has assumed a more interventionist role in the scheme, and more so than set forth by the Supreme Court in its landmark judgments.
In all, the judgment epitomizes some of the complexities that may arise in implementing schemes of arrangement in India. Although efforts are being made constantly by the legislature and the executive arms of the government to streamline the process, several questions remain.
(I would like to acknowledge a reader who brought this judgment to our attention)