Basic considerations for buyers in an M&A deal
(Xerxes Antia, Amit Baid and Rebecca Condillac)
Typically, when evaluating an M&A deal, buyers/ acquirers primarily consider commercial aspects such as the potential of a specific sector, client base, growth avenues, sustainability of the business etc. These aspects influence and shape not just the negotiations leading to an M&A deal but also the contours of an M&A deal. However, there are other aspects that need to be considered and which should influence the contours of any M & A transaction.
Prior to any acquisition, a prudent buyer should conduct a detailed due diligence review of the target and its business and operations to understand the nature and intricacies of the business and the liabilities it would be taking on. We have covered in our previous article – Basic considerations for vendors in an M & A deal key areas that a vendor would have to identify, and remedy in an M & A deal. These areas are of equal concern to a buyer who would, at the time of diligence and acquisition, consider each of those aspects as well. Based on our past experiences, we have tried to identify certain additional key areas to be considered by buyers/acquirers in an M&A transaction.
1. ROLE OF PROMOTERS POST ACQUISITION AND EARN OUT STRUCTURES
Promoters or founders of a company usually play a key and integral part in the success of early-stage businesses and the future performance of such a business and can continue to influence and direct a company and its business and operations even after a company has substantially grown. In addition, and especially in case of acquisitions of start-up companies, the valuation of such entities would be substantially based on the future potential/prospects of a business. The necessity of the promoters’ involvement in the target to achieve this potential and a buyer’s risk appetite to pay upfront on the basis of future potential must be well-thought-out. It needs to be carefully considered whether a buyer would want to retain the promoters/ vendors of a target as part of the entity going forward and if yes, the capacity in which they must be retained, the degree of involvement and whether the value that the buyer is willing to pay today meets the vendors’ expectations of the value for the business.
Once a buyer completes its analysis of these aspects, then in the event that the involvement of the target’s promoter is required post investment, the buyer can consider suggesting structures that would tie the eventual exit and pay out of the promoter to the future performance of the target’s business such as an earn out structure (whereby all shares of the target are acquired upfront against payment of part consideration with the balance consideration being payable subject to the target achieving certain agreed post-acquisition milestones) or a tranche wise buy-out structure (where vendors would divest their stake in two or more tranches over time) or by way of a salary bonus incentive structure (where all the target’s shares are acquired in a single tranche with the promoter being retained as an employee of the target post-acquisition and with the promoter being incentivized through bonus pay-outs in the form of either cash or ESOPS being provided/granted to the promoter in question with the cash or ESOP grants being linked to performance of the target).
If the buyer is a non-resident entity/person, the buyer must be mindful of the restrictions under Indian foreign exchange control laws which inter alia restrict the amount that can be paid to a resident vendor on a deferred basis (no more than twenty five percent of the total consideration) and the time period within which such deferred amounts must be paid (no more than eighteen months from date of the transfer/share purchase agreement). It would also be necessary for the total consideration that is actually paid to the Indian resident vendor to also comply with pricing guidelines i.e., this consideration should be at least equal to or higher than the fair market value of the shares acquired.
It is also critical that the tax implications on any earn-out or deferred structures be evaluated by the parties prior to finalization, as the impact of each structure would have a different bearing on the buyer and/or vendor and/or target. For example, in the case of deferred consideration on sale of shares, the vendor/promoter would be liable to pay tax on the total consideration upfront in the year of the transfer of the shares and not on receipt basis. Therefore, even if the balance pay out may never actually be paid, the vendor/promoter will be taxed upfront. In case of an employment structure, the payments would be characterized as salary income and the tax payable by the promoter would be based on the applicable slab rates which could range up to 42.744%. Common considerations:
Is the nature of the target’s business such that the promoters/founders or other vendors would be required to be associated with the business even post acquisition of the target?
How to ensure that the target achieves its potential post acquisition?
How to ensure the promoter or other key employees remain invested in/committed to the business to achieve targets? Hold back of purchase consideration for the shares, tranche-wise acquisition of shares, retention of the promoter as key employees with performance linked bonus pay out on achieving milestones?
2. APPLICABILITY OF FOREIGN EXCHANGE LAWS
Under the provisions of the Foreign Exchange Management Act, 1999 read with its related rules and regulations (collectively, “FEMA”), foreign investment into India can be broadly divided into investments under the automatic route (where no specific prior approval of the Government of India or the Reserve Bank of India would be required for such investment) or the approval route under which the prior approval of the Government of India would be required for such investment (there is a small list of sectors into which foreign investment is prohibited).
Whilst the approval route for investment is typically applicable for foreign investment into companies carrying on business in certain identified sectors or up to certain limits1, prior approval of the Government of India is also required in a scenario where a proposed buyer is a non-resident entity that is either registered in any of the countries that share a land border with India2 or whose ultimate beneficial owners are individuals situated in such countries that share a land border with India. In addition, citizens/ entities incorporated in Pakistan can only make investments with prior government approval in sectors or activities which are not prohibited for foreign investment such as real estate, lottery or defence, space, atomic energy sectors.
Even if a prospective buyer is an entity resident in India, if such prospective buyer is also not owned3 and controlled4 by a person resident in India, then in such an event the investments made by such a prospective buyer would be treated as being ‘indirect’ foreign investment or a downstream investment and would be required to comply with entry route restrictions, sectoral caps, pricing guidelines and other conditions as applicable for foreign investments. In case the acquisition of the target is considered a downstream investment, the funds to be used by the buyer to acquire the target must be brought from abroad or could be gathered through internal accruals (i.e., profits transferred to reserve account after payment of taxes) but cannot be borrowed from domestic markets. Further, such investment would have to be reported to relevant authorities and the statutory auditor of the buyer would have to certify compliance with foreign exchange laws.
Lastly, care needs to be taken to ensure that save and except without the prior approval of the Indian government or in certain limited circumstances: (i) any non-resident acquirer directly or indirectly acquiring the shares of an Indian target entity, does not itself have any investment made by either Indian individuals or entities controlled by resident Indian individuals; (ii) any non-resident acquirer who has acquired an Indian target subsequently receives investment from a resident Indian individual or from any entity controlled by resident Indian individuals. Common considerations:
Whether the buyer is an entity which is (a) registered in; or (b) who have ultimate beneficial owners being individuals situated in any of the countries that share a land border with India?;
Which sector does the target’s business falls within and are there any restrictions applicable for foreign investment in such sectors including in light of the response to (a) above?
If the buyer is an Indian entity, is it owned or controlled by persons resident outside India? If yes, conditions on downstream investments would apply;
If the buyer is a non-resident entity, does the buyer have any existing Indian investors?
3. OUTSTANDING OBLIGATIONS AND CONTINGENT LIABILITIES
A large number of companies incentivize their employees by issuing of stock options, sweat equity, phantom options, cash incentive schemes, etc. Under the terms of such schemes, directors as well as employees could be entitled to shares of the target or cash pay-outs based on a pre-determined price or formula. The terms and conditions of such schemes would need to be considered by the buyer including whether the terms of such schemes provide for an acceleration of the vesting of options/other invectives that have been granted/provided to employees due to the proposed acquisition by the buyer. Further, a buyer may wish to accelerate the vesting of options/other incentives that have been granted to directors/ employees for various reasons including where a buyer wishes to acquire and hold the entire share capital of a target or to provide liquidity to a target’s employees or to implement its own incentive plans.
Finally, for cash-settled options, a buyer may want the target to settle the same prior to the buyer’s acquisition of the target to avoid a scenario where the buyer would be required to increase the amount of consideration payable for the target’s shares due to the cash that it would take to settle such options remaining on the balance sheet of the target entity.
Further, targets may have certain liabilities that have not yet crystallised, these could include liabilities payable on account of pending litigation or claims, guarantees given by the target, warranties, etc. A buyer must be cognizant of such liabilities and consider the same for the purposes of valuation of the target. In the event that any valuation adjustment may be required to be made to purchase consideration (whether an upward or downward revision), then the use of appropriate earnout structures can be considered (please see the above section on earnouts).
Are there any employee stock option schemes, or incentive schemes granted by the target – if yes, how do the vendors intend to deal with such schemes? Do the terms of the schemes permit cash settlement in case of an event of change of control?
Does the target have any contingent liabilities? If yes, what is the nature of such liabilities and the likelihood of them getting crystallised? Would a valuation adjustment be required?
4. REPRESENTATIONS & WARRANTIES AS WELL AS INDEMNITIES
Typically, as a part of the definitive transaction documentation entered into for any transaction, a buyer will ask for (and receive) detailed representations and warranties covering a target as well as its business and operations. These representations and warranties would typically be backed by indemnities that are provided by the vendors. In addition, and depending on diligence findings, a buyer may also require specific indemnities from vendors. While a buyer would of course preferably have the vendors’ indemnification obligations remain uncapped and unlimited in terms of value and time, it is typical to agree to value/time caps linked to the type of indemnification being sought. Most indemnities survive for fixed periods. For example, indemnities for breach of representations and warranties relating to the title of sale shares would typically be uncapped in terms of value and unlimited in terms of time whilst indemnities for breach of business focused representations and warranties would typically survive for a period of one to three years from the date of on which the representation/warranty is provided and would be capped to an aggregate value of between 25% to 70% of the consideration paid whilst indemnification for breaches of tax focused representations/warranties surviving for a period of seven to eleven years in line with the applicable statute of limitation and for a value up to 100% of the consideration paid. Under the provisions of FEMA, in case of transfer of shares by a person resident in India to a person resident outside India, the buyer may be indemnified by the vendor for an amount not exceeding twenty five percent of the total consideration and for a period not exceeding eighteen months from the date of payment of the full consideration. Any indemnity payments beyond such time period and limits would require prior approval of the Reserve Bank of India.
Given the nature of India’s tax regime, from a commercial standpoint it becomes essential to, as part of the definitive transaction documentation, negotiate suitable tax indemnity agreements/arrangements which would cover not only any actual tax that may become payable, but which would also provide for costs associated with prolonged litigation such as interest, penalties, advisory and litigation costs. A few other important considerations could include the manner of conduct of proceedings between the buyer and vendor i.e., manner of communication on receipt of a tax notice, the manner of communication with tax authorities, consequences in case of delay in communication between parties, the manner of bearing costs of proceedings (including for example which party would be responsible for providing any amounts to be deposited with any judicial bodies as part of any appellate process) etc.
Taxability of the indemnity payment once the vendor(s) pays such amount could also be an important consideration for the buyer. While there is limited jurisprudence on this point, the Authority for Advance Ruling (AAR) which is part of the Ministry of Finance, Government of India In Re: Aberdeen Claims Administration Inc.  283 CTR 387 held that payments received out of a contractual settlement should be considered to be capital receipts and should not be taxable in the hands of the receiver.
It is possible for vendors or buyers to obtain indemnity insurance that would pay out to a buyer for breaches of representations and warranties provided by vendors under transaction documentation. Whilst this is a growing trend in India this is not a common practice as of yet in Indian transactions due to various factors including the cost of obtaining such policies as well as the scope of coverage of such policies.
5. ANTI-TRUST LAWS
The Competition Act, 2002, as amended from time to time (“Competition Act”) has been enacted in India with a view to prevent practices which have an adverse effect on competition and to promote and sustain competition in markets. To this end, the Competition Act seeks to regulate “Combinations” i.e., acquisitions, mergers and amalgamations exceeding certain thresholds laid down thereunder. A Combination (not meeting the Target Exemption (set out below) or falling within the categories specified in the regulations issued under the Competition Act) is to be mandatorily notified to the Indian competition regulator namely the Competition Commission of India (“CCI”) in the format specified under the regulations under the Competition Act together with payment of applicable fees.
At present and up to March 26, 2022 - there is a ‘de minimis’ or ‘target’ exemption in force which exempts any transaction where the target enterprise (whose shares, assets, voting rights or control is being acquired or the entity being merged or amalgamated) either has assets of less than INR 3.5 Billion (equivalent to approximately USD 47 million) in India OR turnover of less than INR 10 Billion (equivalent to approximately USD 133 million) in India (“Target Exemption”), from notifying the CCI.
In the event the CCI is to be notified, such notification needs to be made after the (i) approval of the proposal relating to the merger or acquisition by the board of directors of the parties concerned with such merger or acquisition, or (ii) execution of any agreement or other document for acquisition of control, shares, voting rights or assets, as the case may be. A Combination cannot come into effect unless the same has been approved or been deemed to be approved by the CCI.
Common considerations: Does the proposed acquisition fall within any of the exemptions provided under the Competition Act and the regulations prescribed thereunder? If not, the CCI would have to be notified and appropriate steps and filings would have to be made.
6. WITHOLDING TAX OBLIGATIONS
Withholding tax compliance is quite stringently monitored by Indian tax authorities. A buyer is required to withhold tax from the consideration payable to the vendor, deposit the same with the Indian tax authorities and undertake various compliances which include obtaining a Tax Deduction Account Number, filing of a withholding tax return and providing a withholding tax certificate to enable tax credit of the same to the vendor(s). Default in withholding tax and/or the compliances could lead to liability on the buyer for the withholding tax amount, interest at 12% per annum and a penalty up to 100% of the tax amount for the buyer.
In the event the vendors are persons resident outside India, the buyer has to withhold tax at the rates prescribed under the Indian Income Tax Act, 1961 (“ITA”) or the applicable Double Taxation Avoidance Agreement (“DTAA”), as beneficial to the vendor in question. The regular withholding tax rates under the ITA on capital gains arising to persons resident outside India on transfer of unlisted shares is 10% (plus surcharge and cess) provided the shares are held for more than 24 months and is 40% (plus surcharge and cess) if the shares are held for less than 24 months. Lower withholding tax rates may apply if provided for in an applicable DTAA.
However, in cases where the vendor(s) intends to avail benefits under a DTAA, the buyer should evaluate in detail whether the benefits under the DTAA may be denied on the ground of substance requirements as per General Anti Avoidance Rules (“GAAR”) in the ITA or anti abuse provisions incorporated in India DTAAs by the operation of Multilateral Instrument (“MLI”). Therefore, the buyer should consider obtaining appropriate representations and warranties from a GAAR and MLI perspective. Also, in such cases, in addition to an enhanced indemnity, the buyer may consider various other options to protect its interest by asking the vendor(s) to provide a “should” level opinion from a reputed tax firm, or a tax insurance or entering into escrow / holdback arrangements, or a lower withholding order from tax authorities.
The aforesaid withholding tax obligation on the buyer could also apply on indirect transfer of Indian shares i.e., transfer of shares of a foreign company deriving “substantial” value from assets in India. A foreign company would be deemed to be deriving value substantially from Indian assets if the value of Indian assets is more than INR 100 million (USD 1.34 million approximately) and the value of Indian assets represent at least 50% of the value of all the assets of the foreign entity.
In the event the vendors are held by persons resident in India, as per a recent amendment in Indian tax laws, withholding tax @ 0.1% is required to be deducted by the buyer on purchase of goods from the vendor if the consideration exceeds INR 5 million (approximately USD 67,000). As the term “goods” is of wide import it could be interpreted to include stock and shares as per the definition contained in the Sale of Goods Act, 1930. Although there is ambiguity whether such buyer would include persons resident outside India, in the absence of an explicit clarification and the adverse consequences in case of default in the form of interest and penalties, a conservative approach could be preferred. An exception to these withholding tax provisions whereby the buyer is not required to withhold tax could be a scenario whereby the vendor levies tax collection at source @ 0.1%.
Whether the shares of the target held by persons resident outside India? If yes, whether the residential status of the vendors supported by a valid Tax Residency Certificate and Form 10F?
If the vendor intends to avail tax benefits under a DTAA, whether the vendor meets the GAAR and MLI tests from a commercial rational and substance perspective and if yes, whether the claim is supported by a “should” level opinion from a reputed tax firm?
If the transaction involves transfer of shares of a foreign company, does it lead to indirect transfer of Indian assets and consequently, withholding tax obligations?
7. CARRY FORWARD OF TAX LOSSES
While the general rule is that a company may continue to carry forward and set off accumulated tax losses and unabsorbed depreciation despite a change in its shareholding pattern, there are certain restrictions in case of closely held companies to suppress the mischief of taxpayers acquiring control over a company which has incurred losses only to reduce their tax liability.
If there is change in shareholding of closely held companies whereby shares representing at least 51% of the voting power of the company are no longer beneficially held by persons who had beneficially held them on the last of day of the year in which the losses were incurred, carry forward and set-off of tax losses is not allowed.
There are few exceptions to this rule as well and the carry forward and set-off of losses is not impacted in such situations, viz. change in shareholding of start-up companies, or pursuant to death or gift of shares to relatives, or pursuant to a resolution plan approved under the Insolvency and Bankruptcy Code, 2016, or pursuant to an amalgamation or demerger of a foreign company whereby the shareholding of its Indian subsidiary changes. Common considerations: Is the target is closely held? If yes, whether it has brought forward tax losses which could be impacted pursuant to the direct or indirect acquisition?
In addition to the above, there are other steps that a buyer can take to ensure its preparedness for a potential M&A deal, including, tax valuation requirements prescribing the floor price to be paid as consideration and the implications if the valuation requirements are not met, determining the quantum of stamp duty payable on the transfer of shares and the transaction documents, planning for smooth integration of employees of the target.
[End caveat] The views set out in this article are personal. This article is intended to provide a general guide to the subject matter and is not intended to be exhaustive or conclusive. Specialist advice should be sought about your specific circumstances.