In today’s robust and dynamic business environment, corporate entities endeavour to grow and expand by adopting various inorganic growth strategies through mergers and acquisitions (M&A). More often, acquisitions are structured as an upfront consideration payable at the time of acquisition and deferred consideration which is payable in future, determination of which is dependent upon future contingent event.
The determination of such deferred consideration could be based on various performance metrics like the future revenue, net income, EBITDA or is dependent upon compliance with certain contractual conditions or is linked to the outcome of some litigation. Such a pricing arrangement allows the seller to command a better consideration based on the future events of the target and also the buyer to pay only where there is certainty of a contingent event.
Whereas the use of such a pricing arrangement has increased remarkably, its taxation under the law has remained nebulous. Simply put, the seller is liable to capital gains tax on the gains arising from the transfer of its capital assets. For determination of the resultant capital gains, one of the key components is the consideration being accrued to the seller at the time of transfer. In normal circumstances, where the entire consideration is payable upfront, the determination of consideration and the resultant capital gains is straightforward. However, in case of deferred consideration, the entire amount to be received by the seller is dependent upon occurrence of a future contingent event. Therefore, at the time of transfer of business or shares of the target, the entire consideration cannot be determined, thereby impeding the determination of resultant capital gains.
Recently, the Bombay High Court in the case of CIT versus Hemal Raju Shete addressed this issue. In this case, the taxpayer and other shareholders had transferred 100% shares of the target for an initial upfront consideration and an additional consideration on the basis of future earnings of the company. The income-tax authorities sought to tax the entire consideration including the deferred consideration in the initial year of transfer itself. The Bombay High Court, ruling in favour of the taxpayer, observed that at the time of transfer of shares, no right to receive such additional consideration had accrued to the taxpayer and its determination was entirely dependent upon the future performance of the company. Therefore, such contingency cannot lead to taxation of the entire consideration, since there is no assurance of receiving such consideration in the year of transfer of shares.
This decision of the Bombay High Court is definitely positive, whereby the seller would not be unfairly taxed in the year of sale on the entire consideration even when the determination itself is contingent on future performance metrics. Thus, where the consideration is not payable to the seller due to under-performance of the target, the seller would not be taxed on such notional consideration in the initial year of transfer. Further, this judgment will help in providing some guidance on the withholding obligation cast on the buyer if the seller is a non-resident.
On the flip side, the Delhi High Court in the case of Ajay Guliya versus ACIT had held that the entire consideration on sale of shares was chargeable to tax in the year of transfer of shares of the target, even if such consideration was deferred to be received by the seller at a future point in time. In this case, however, the entire consideration was determined upfront; merely the payment of such consideration was deferred. A determined consideration where the payment is deferred is distinct from a deferred consideration where the payment is linked to occurrence of a future contingent event. In the former case, the entire consideration is taxable upfront, whereas in the latter case only the determinate consideration is taxable in the year of sale. The Delhi High Court observed that mere deferral of payment of consideration cannot lead to deferral of capital gains tax liability. Thus, the Bombay High Court order distinguishes the Delhi High Court order in the case of Ajay Guliya versus ACIT on the basis that a determined consideration is different from a contingent consideration.
Although the decision of the Bombay High Court answers the question of taxability of deferred consideration in the initial year of transfer, it does not answer the taxability of consideration on receipt basis, i.e. as and when the deferred consideration is received in future. Drawing an analogy from the case of compulsory land acquisition by the government, one view could be taken that the consideration could be taxable in the year of receipt.
Having said that, this judgment nonetheless acts as a welcome decision as it positively answers one of the most pertinent issues in today’s M&A backdrop, where many deals are structured with a contingent clause for determination and payment of consideration on deferred basis.
The author is partner, M&A Tax, PwC Views are personal