In merger and acquisition (M&A) transactions involving acquisition of shares of a company (target company), payment is often structured in two stages, viz. (i) upfront consideration, payable immediately on the execution of the Share Purchase Agreement (SPA), and (ii) additional consideration, payable at a later date (typically referred to as “deferred consideration”). Deferred consideration allows the buyer to defer part of the acquisition cost.
Often, the business parameters of the target company—achievement of milestones of turnover, profitability, growth etc.—are the trigger for deferred consideration. However, in some other cases, deferred consideration is linked to the existence/non-existence of mutually agreed covenants(s) between the buyer and the seller. For example, uncertainty surrounding the outcome of long-drawn-out litigation is captured through the deferred consideration mechanism. Since, the consideration is contingent on the agreed covenant, the funds are generally parked in an escrow account and released as and when the arranged terms are fulfilled.
As per Indian tax laws, capital gains on the transfer of shares of an Indian company are taxable. Furthermore, in the case of sale of shares of an Indian company by a non-resident, the buyer has an obligation to withhold the taxes on payment of a consideration to the non-resident seller. Hence, the determination of capital gains and consequential tax on transfer of shares become extremely critical. On the taxability of deferred consideration, the issue that has been a matter of debate is the timing of the transfer—taxability in the year of transfer/ execution of SPA vis-à-vis taxability in the year of receipt of the deferred consideration.
Although the tax laws provide for some specific cases where capital gains are taxed in the year of receipt of consideration, as a general rule, capital gain which arises on the transfer of a capital asset is deemed to be chargeable to tax in the year in which the transfer takes place. In light of such deeming fiction, the entire consideration including the deferred consideration, may be taxed in the year in which the change in ownership of the shares takes place.
The Delhi High Court, in the case of Ajay Guliya versus Asstt. CIT, held that the entire sale consideration would be chargeable to tax in the year of the transfer of shares. The court observed that mere deferment of the consideration does not alter/ impact the timing of accrual of income, especially when the SPA does not provide for the release of shares back to the seller in the event of non-payment of such deferred consideration. In a similar case, of ITO versus Indira R Shete, the Mumbai Income Tax Appellate Tribunal (ITAT) held that irrespective of actual receipt, capital gains on the transfer of shares effected during the year shall be taxable in the year in which the transfer took place. The Mumbai ITAT noted that the right to receive the total consideration (including the deferred consideration) had already been accrued in the year of transfer.
In both the aforesaid cases it was held that capital gains accrue in the year of transfer even though the deferred part of the consideration was contingent upon certain future events. This is likely to result in an inherent unfairness in cases where the seller eventually does not receive any consideration in the future or receives a lower consideration. Also, where the amount of deferred consideration is contingent—linked to the future performance of the business, the taxability in the year of transfer leads to practical difficulties surrounding the computation of capital gains, since the exact value of the consideration is not known at the time of transfer. Although, one may consider the fair value of shares as on the date of transfer, the same may not necessarily represent the total sale consideration (both the upfront and deferred consideration) under the SPA.
Contrary to the above rulings, the Bombay High Court, in the case of CIT versus Hemal Raju Shete, has adjudged the issue in favour of the taxpayer. The judgment lays down that the concept of accrual of income is equally applicable to capital gains. Accordingly, even capital gains cannot be said to be accrued and chargeable to tax unless the taxpayer has the right to receive the income. Interestingly, the Bombay High Court did not take into account the judgments of the Delhi High Court and Mumbai ITAT and held that deferred consideration (dependent on occurrence of certain events), is contingent income and hence, cannot be said to have accrued. The Bombay High Court pointed out that unless the future contingent event takes place, there is no assurance of receiving the deferred consideration and thus, it cannot be treated as income accrued in the year of transfer. Furthermore, it also noted that the taxpayer had actually offered the deferred consideration to tax in subsequent year(s), in which the amounts were received based on the performance of the target company.
Having said this, in view of the interest and stringent penalties associated with income-tax defaults, the taxpayer can take a conservative stand and pay taxes in the year of transfer itself. As regards subsequent non-receipt of deferred consideration, there are no specific relief provisions available to the taxpayer. Nevertheless, practically, the taxpayer may consider claiming a refund by means of filing a revised income tax return (provided the time limit has not expired) or providing this information at the time of assessment/appeal proceedings, etc.
Though the recent Bombay High Court ruling has settled the issue in favour of the taxpayer, the issue is not entirely free from doubt due to the contrary Delhi High Court ruling. As always, clarity on this issue will only emerge from the Supreme Court.
The author is partner, Dhruva Advisors LLP. Views are personal