India

In keeping with international trends, Indian corporations are realizing that synergy of business operations, employee related issues, cultural issues and finally legal issues form the crux of any M&A activity. This article seeks to encapsulate various legal, regulatory and tax issues relevant to a M&A transaction in India.

Due diligence

The basic function of due diligence in the context of M&As is to assess the benefits and the liabilities of a proposed acquisition by inquiring into all relevant aspects of the past, present and predictable future of the business to be purchased. The regulatory and legal framework applicable to companies effectively distinguishes between private companies, public unlisted companies and public listed companies.

Private companies are not subject to extensive regulation and therefore many Indian private companies do not maintain all legally required records. A combination of inefficiencies of the Registrar of Companies (RoC) and the fact that Indian companies often do not file all necessary records with the RoC often results in information not being available to the general public. Searches with respect to immovable property, especially land that a company owns and the litigation that it is involved in, can be undertaken only if the company itself provides basic information – as records are maintained in local land registries and courts and not in central databases of the same. Hence, the legal, business and financial due diligence phase forms an important part of any M&A transaction.

Corporate governance

India has made rapid strides with respect to corporate governance and its importance in the functioning of public listed companies. The basic premise of the entire regulatory framework acknowledges that the goal of corporate governance is the enhancement of long-term shareholder value, while simultaneously protecting the interests of the other stakeholders, ie suppliers, customers, creditors, bankers, employees, the government and the public at large. The challenge of increased transparency in the functioning of Indian listed entities is being met with globally recognized responses.

Despite significant developments, India has a long way to go, particularly in the development of specific continuous disclosure norms in the context of M&A. Currently information with respect to M&A needs to be disclosed to the board and in certain situations shareholder approval is required. All decisions of the board, including those in the context of M&A, need to be in the interests of the company. Recently, the listing agreements were amended to provide for the appointment of non-executive directors and independent directors to the board of listed companies, thereby improving the quality of the board. Furthermore, the Companies Act, 1956 has been recently amended to provide compulsorily for the setting up of independent audit committees of the board of directors.

Takeover code

India has had an elaborate Takeover Code for a few years now and its impact on the acquisition of shareholding and control of a listed company has been significant. A few provisions of the Takeover Code are detailed below:

• An elaborate definition of the term "acquirer" has been provided which includes a "person acting in concert", which has also been defined.

If an acquirer (along with persons acting in concert) directly or indirectly:

- Acquires shares or voting rights which taken together with its existing shares or voting rights touches or exceeds 15% of the target company; or

- Acquires control (defined in the Takeover Code) over the target company;

then the acquirer would be required to make a public offer for a minimum of 20% of the total shareholding of the target company.

• Boards by companies are by and large prevented from resorting to poison pill tactics and are required to act in the interests of the company and its shareholders at large. To permit those acquirers who already hold a substantial shareholding in the target company to increase their shareholding, the Takeover Code permits a creeping acquisition of not more than 5% of the shareholding or voting rights of a target company in any given period of 12 months. If the acquirer crosses the 5% limit, a public offer for a minimum of 20% of the public shareholding of the target company would need to be made.

Recent takeover attempts have shown that corporate India feels that the hands of existing management are fettered when a takeover is mounted against the companies they control. While persons with absolutely no shareholding can go up to 15% without making a public offer, those already in control would trigger the public offer provisions if they acquire more than 5% of the shareholding or voting rights of the target company. Consequently, there is an increased pressure on Indian regulators to establish a level playing field between existing management and those seeking to takeover the target. Even so, it is important to note certain exceptions to the public offer requirements of the Takeover Code:

• Inter se transfer of shares between existing promoters of a company. This is subject to the conditions that the transferor promoters as well as the transferee promoters should have been holding individually or collectively not less than 5% shares in the target company for a period of at least three years prior to the proposed acquisition.
• Preferential allotment of shares by the target company through the passing of the required resolution by the shareholders of the target is exempt from the public offer provisions of the Takeover Code, subject to certain conditions being fulfilled.

Given the elaborate definitions mentioned in the Takeover Code, any takeover involves a detailed reading and re-examination of the ambiguities.

Competition policy

India currently lacks an effective competition and anti-trust policy. Control over industry for the last 50 years has been through a combination of extensive public sector participation, licensing and other restrictions on private participation in industry, price control and significantly exit barriers. Most of these controls have been considerably diluted over the years. Of particular importance is the announcement by the Government of India of plans to privatize a number of public sector industrial undertakings over the next few years.

India has sought to control competitive tendencies through the Monopolies and Restrictive Trade Practices Act, 1969 (MRTP Act). The thrust of the MRTP Act has been directed towards:

• Prevention of concentration of economic power to the common detriment;
• Control of monopolies through the control of dominant undertakings, which is elaborately defined in the MRTP Act; and
• Prohibition of monopolistic and restrictive trade practices.

The government recently set up a committee to examine the need for a competition policy and to make recommendations. The committee has examined the entire framework of the competition policy since India's independence and has recommended the establishment of a Competition Commission of India, which would have the authority to examine the competitive impact of the steps taken by corporate India, and in particular M&A activity. Based on the recommendations of the committee, the government has proposed draft legislation. However – it is still some way from being legislated.

Exchange controls

Foreign investment in Indian companies is governed by the provisions of the Foreign Exchange Management Act, 1999 thereunder and rules/regulations prescribed (FEMA) which came into effect on June 1 2000. FEMA has replaced the Foreign Exchange Regulation Act, 1973 (FERA) which was a draconian piece of legislation. FEMA is more liberal and is accompanied by rules made by the central government and regulations made by the Reserve Bank of India (RBI). Contravention of the provisions of FEMA attracts monetary penalty unlike contravention of the provisions of FERA which attracted criminal prosecution in certain cases.

For the purposes of this paper, the author has examined the following two scenarios: a foreign company acquiring a company in India; and an Indian company acquiring overseas companies or setting up operations abroad.

Acquisitions of shares

Secondary purchases of shares of an Indian company by a foreign investor (including non-resident Indians (NRIs)), from Indian residents would require the prior approval of the Foreign Investment Promotion Board (FIPB). Additionally, the foreign investor would need to approach the RBI for its approval. The RBI regulates the price at which the transfer takes place. Although not prescribed, the price is generally - where the Indian company is listed in India - pegged at a price which is not lower than the market price of the share as quoted on the Indian stock exchange on which the shares of the company are traded. If the company is unlisted, then the RBI uses the price, which is an average of the aggregate of share price based on (i) net asset value per share and the (ii) profit earning capacity value per share.

Transfer of shares by a person resident outside India (who is not an NRI or an overseas corporate body held to the extent of at least 60% by NRIs) to another non-resident does not require the prior approval of the FIPB in certain cases. The transferee however, would need this prior approval if it has a previous venture or tie up in India in the same or allied field as the Indian company whose shares it proposes to acquire – unless it is a company falling in the IT sector in which case, no prior approval of the FIPB would be required.

Transfer of shares from a person resident outside India to an Indian resident would require the prior approval of the RBI. The RBI regulates the price at which such transfers take place and will generally approve a price which is not higher than that arrived at by following the prescribed method of valuation.

Indian companies going global

The provisions relating to investment by an Indian company in a foreign company were liberalized considerably by the FEMA.

Now there are special circumstances under which an Indian company is permitted to make an investment in a foreign company. However, an Indian party is not permitted to make any direct investment in a foreign entity engaged in real estate business or banking business without the prior approval of the RBI.

Some routes available to an Indian company which intends to invest in a foreign company are described below.

Direct investment in a joint venture or wholly owned subsidiary

An Indian company is permitted to make a direct investment in a joint venture or a wholly owned subsidiary outside India of a sum not exceeding $50 million or its equivalent in any one financial year provided the following conditions are met:

• The direct investment is made in a foreign entity engaged in the same core activity carried on by the Indian company;
• The Indian company is not on the RBI's caution list or under investigation for exchange control violations;
• The Indian company routes all the transactions relating to the investment in the joint venture or the wholly owned subsidiary through only one branch of a bank in India to be designated by it; and
• The Indian company files the prescribed form with the RBI.

There are special additional conditions that apply to an Indian company making a direct investment in a foreign company that is engaged in financial services activities.

The FEMA stipulates that any direct investment (as discussed above) can be made only from the following sources:

• The amount held by the Indian company in its Exchange Earners Foreign Currency (EEFC) account;
• Drawal of foreign exchange from a bank in India, provided that the foreign exchange so drawn does not exceed 25% of the networth of the Indian company as on the date of the last audited balance sheet; and
• Up to 100% of the proceeds of an American Depositary Receipt (ADR) or Global Depositary Receipt (GDR) issue.

Acquisition of a foreign company pursuant to the ADR/GDR share swap mechanism

An Indian company can also acquire a foreign company which is engaged in a similar activity as the Indian company in exchange for the Indian company's ADRs/GDRs issued to the shareholders of the foreign company. The issue of ADRs/GDRs needs to be in accordance with the ADR/GDR Scheme. In addition, certain other conditions need to be complied with. These include, the investment by the Indian company not exceeding an amount equivalent to $100 million or an amount equivalent to 10 times the export earnings of the Indian company during the preceding financial year, which ever is more.

Prior approval of RBI

In the event that the Indian company does not satisfy the conditions set forth above, then it can make an application to the RBI for special approval. In considering the application the RBI may, inter alia, take into account the following factors:

• The viability of the joint venture / wholly owned subsidiary abroad.
• Contribution to external trade and other related benefits to the Indian economy;
• Financial position and business track record of the Indian company and the foreign company; and
• Expertise and experience of the foreign company in the same or related line of activity of the joint venture or the wholly owned subsidiary abroad.

Legal issues in Indian companies going global

Apart from the exchange control implications, there are several Indian law provisions that an Indian company will be required to comply with. These include, provisions of the Indian Companies Act, 1956 (Companies Act) as well as regulations prescribed by the Securities and Exchange Board of India (SEBI), which is the Indian capital markets regulator. These issues are discussed below.

• If the Indian company is incorporated as a public limited company under the provisions of the Companies Act and the Indian company proposes to acquire the shares of the foreign company by issuing its shares as consideration to the shareholders of the foreign company, then the shareholders of the Indian company will be required to pass a special resolution 75% or more permitting the issue of shares to the shareholders of the foreign company;
• If the Indian company that is issuing its shares to the shareholders of the foreign company as consideration for acquiring shares of the foreign company is listed on any stock exchange in India, then it will be required to comply with the guidelines for preferential allotment under the SEBI Disclosure and Investor Protection Guidelines. These guidelines regulate, among other things, the price at which the shares are issued; and
• If the investment by the Indian company in the foreign company exceeds 60% of the paid-up share capital and free reserves of the Indian company or 100% of the free reserves of the Indian company, whichever is more, then the Indian company is required to obtain the prior approval of the shareholders by way of a special resolution.

M&A under sections 391-394 of the Companies Act

For the purposes of the Companies Act, the terms "merger" and "amalgamation" are used synonymously. The Companies Act contains provisions on "compromises, arrangements and reconstructions". An amalgamation may be said to be an "arrangement" or "reconstruction" under the Companies Act.

The procedure to be followed in an amalgamation of two or more Indian companies, or a foreign company into an Indian company is covered in sections 391-394 of the Act. At the outset, the board of directors of the transferor and transferee company would be required to convene a board meeting to consider and approve the amalgamation in principle, and appoint an expert (generally a chartered accountant or a merchant banker) for the valuation of shares to determine the share exchange ratio.

The next step is the drafting of the scheme of amalgamation. It includes detailed information on the transferor and transferee companies, their capital structure, the share exchange ratio, the appointed date, the continuance of legal proceedings of the transferor company by transferee company after the effective date of the merger. The appointed date (or transfer date) is the date on which the property of the transferor company vests in and is transferred to the transferee company. This is usually retrospective in nature.

With regard to the share exchange ratio, there is no uniform and inflexible method of arriving at the valuation of shares. The Supreme Court held in the famous Hindustan Lever Employees Union vs Hindustan Lever Ltd that unless the person who challenges the valuation satisfies the Court that the value arrived at is grossly unfair, the Court will not disturb the scheme of amalgamation which has been approved by the shareholders of the two companies.

Every amalgamation, except one which involves a sick industrial company, requires the sanction of the High Court that has jurisdiction over the State/area where the registered office of a company is situated. If transferor and transferee companies are under the jurisdiction of different High Courts, separate approvals are necessary.

The process of dissolution without winding up of the transferor company involves the appointment of an official liquidator. After the liquidator has scrutinzed the books and papers of the transferor company it will make a report to the High Court that the affairs of the company have not been conducted in a manner prejudicial to the interests of its members or the public.

The scheme of amalgamation has to be approved by members and creditors (if so directed by the High Court), at a specially convened meeting of the transferor company. Voting at these meetings is taken by poll only. Simple majority in number, and special majority (75% or more) in value must approve the scheme of amalgamation. The transferee company would also be required to conduct a general meeting of its shareholders at which a special resolution, authorizing the transferee company to commence the business of the transferor company as soon as the amalgamation becomes effective, needs to be passed.

An amalgamation is effective only when a copy of the High Court order is filed with the Registrar of Companies. The date on which this filing is made is termed as the effective date of the merger. On this date the transferor company stands dissolved.

Once the High Court order approving the scheme of amalgamation has been passed, the share certificates held by the transferor company's shareholders are called back to be exchanged after fixing a record date in accordance with the listing agreement between the company and the stock exchanges on which it is listed. Shareholders of the transferor company are then allotted shares of the transferee company.

Stamp duty

Under The Indian Stamp Act, 1899, transfer of shares of Indian companies attract stamp duty at the rate of 0.5% of the consideration paid. This may be borne by either the transferor or the transferee. Traditionally, it is paid by the transferee.

Under the Bombay Stamp Act, 1958, any conveyance attracts stamp duty. Conveyance includes an order made by a High Court under section 394 of the Companies Act in respect of amalgamation of companies. Therefore, in an amalgamation the transferee company is liable to stamp duty at the rate of 7% of the true market value of immovable property of the transferor company located in the state of Maharashtra; or 0.7% of the value of shares issued by the transferee company to shareholders of the transferor company and the amount of consideration paid by the transferee company, whichever is higher.

Proposed labour law reforms

The Indian Finance Minister, Yashwant Sinha in his Budget speech on February 28 2001 acknowledged that there are inherent rigidities in Indian labour legislations. Provisions in the Industrial Disputes Act, 1947 make it almost impossible for industrial houses to exercise any labour flexibility. The Finance Minister announced that the Government has decided to modify Chapter VB of the Industrial Disputes Act, 1947 which stipulates that employers in specified industrial establishments must obtain prior approval of the appropriate government authority for effecting lay-off, retrenchment and closure, after following the prescribed procedure. It is proposed that these provisions apply to industrial establishments employing not less than 1000 workers instead of the present 100. The separation compensation is proposed to be increased from 15 days to 45 days for every completed year of service.

Taxation

A crucial part of any M&A transaction is the tax incidence on the shareholders and the companies.

The Indian Income-tax Act, 1961 (ITA) is the central taxing statute in India. There are no state level income taxes. Indian companies are taxed at the rate of 35% on their net profits. Long-term capital gains in the hands of Indian companies are taxed at the rate of 20%. Short-term gains are taxed at the rate applicable to ordinary income ie, 35%. Dividend paid by an Indian company is exempt in the hands of shareholders (including foreign shareholders). However, an additional income tax (referred to as dividend distribution tax) of 20% is payable by Indian companies at the time of declaration, distribution or payment of dividend. The Finance Bill, 2001 proposes to reduce this to 10% with effect from April 1 2001. Within India, no tax credit is available to the shareholders. But, depending upon the tax treaty provisions, foreign shareholders may be able to get a tax credit in their home country against the additional tax borne by the Indian company.

In India M&As can be structured in different ways. They can be structured as mergers which require the sanction of the High Court, asset acquisitions, slump sales, share acquisitions and in many other ways. Some of these methods and the accompanying tax implications are discussed below.

All the rates mentioned above are exclusive of surcharge.

Mergers requiring High Court approval

A merger/amalgamation between two or more companies is tax exempt in India if the following conditions stipulated in section 2(1B) of the ITA are complied with:

• All the property of the amalgamating company(ies) vests with the amalgamated company;
• All the liabilities of the amalgamating company(ies) become the liabilities of the amalgamated company; and
• The shareholders holding not less than 75% in value or voting power in the amalgamating company (other than shares held by the amalgamated company or its subsidiary(ies) should become shareholders of the amalgamated company.

Asset acquisitions

In an asset acquisition, where only certain assets are purchased from the target company, the gains realized by the target from sale of assets will be subject to tax in India.

Slump sales

When an entire unit or undertaking is sold on a going concern basis for a lump sum consideration, without values being assigned to the individual assets and liabilities, the sale is described as slump sale as opposed to sale or acquisition of assets. The ITA provides that profits derived by a company from a slump sale will be regarded as long term capital gains if the undertaking is owned and held by the selling company for a period of more than three years, otherwise such gains will be regarded as short term capital gains. The gains will be computed as a difference between the sales consideration and net worth of the undertaking as of the date of the transfer.

Share acquisitions

When the shares of a company are acquired by an entity from its existing shareholder, the seller will be subject to capital gains tax on gains realized by it from such transfer. The gains will be computed as a difference between the sales consideration and cost of acquisition of such shares. If such shares are held for a period of more than twelve months, the gains realized from the sale of such shares will be regarded as long term capital gains otherwise it will be regarded as short term capital gains.

Cross-border taxation issues

Non-Indian companies looking to acquire Indian companies could avail of the option of using a Mauritius company to acquire the shares of the target Indian company and thereby benefit from the favourable provisions of the double taxation avoidance treaty between India and Mauritius. Pursuant to the tax treaty, capital gains earned by ordinary offshore companies organized in Mauritius on divestments made from Indian companies are not taxed in India if the Mauritius company does not have a permanent establishment in India. The tax treaty also does not contain a limitation of benefits provision (otherwise known as the anti-treaty shopping clause). Furthermore, politically, Mauritius is considered more stable than some other jurisdictions with which India has favourable tax treaties.

Conclusion

The liberalization drive which began in the early 1990s resuscitated India's industrial appetite. The changes in the MRTP Act made it possible for companies to restructure, merge, acquire and consolidate. M&As saved costs and proved to be an efficient way to expand and develop. Even though much ground has already been covered, especially on the exchange controls front, lots more needs to be done. For instance, the age-old practice of getting courts to approve mergers and demergers under the Companies Act needs to be done away with as the process of getting High Court approval is a time-consuming one.

Another reason why the process of M&A is still in its infancy in India is because Indian industry does not have access to funds for acquisition and buyback of shares. Hostile takeovers and hostile bids were unheard of till a few years back.

The M&A scene in India has been heating up recently with a spate of mergers especially in the technology, telecoms, financial services and cement industries - with the most controversial of these being the hostile takeover bid by Arun Kumar Bajoria for Bombay Dyeing and the not-so-recent bid by Sterlite Industries for control over Indal. India is on the verge of moving from plain vanilla structures to more advanced forms of M&A like MBOs and LBOs.

Nishith Desai Associates

93-B Mittal Court
Nariman Point
Mumbai 4000021
India

Tel: +91 22 2820609
Fax: +91 22 2875792
Email: nda@nishithdesai.com