While the past 15 months have been a source of great pain and disruption for everyone, it was also a time when governments around the world approved trillion-dollar stimulus packages, markets were flooded with liquidity, and M&A activity was booming. India was no exception – we saw several public market transactions; Lots of new unicorns have been created and there has been hectic M&A activity in various sectors. Interestingly, some of these transactions were structured as “slump sales” in FY 20-21. Put simply, a slump sale is the transfer of business from one company to another for an agreed value, payable in cash or in kind.
Several burglary transactions were signed and completed in fiscal year 20-21, while others were still in progress when two changes were proposed in the 2021 budget that fundamentally impacted burglary sales: (1) The goodwill (bonus for a business purchase) would cease apply to be tax deductible and (2) the tax law defines the consideration paid for a burglary sale as its fair market value (“FMV”). For example, even if a consideration for a break in of 100 were agreed, tax law could override the business contract and say the FMV is 125. These changes were effective as of April 1, 2020, which means they were effective retrospectively. The final catch was that the method of calculating FMV on a burglary sale would be announced in due course, so these rules were indeed eagerly awaited.
Earlier this week, the CBDT announced the rules (FMV rules) for determining FMV in a burglary transaction, and luckily, companies would collectively breathe a sigh of relief. The good news is that the FMV rules are structurally compatible with previous provisions where the tax law wanted to provide a minimum FMV on which taxes are levied even though the contractually agreed consideration may be lower. For example, if a property is transferred for 100 while its FMV (Stamp Duty Value) is 125, a tax will be charged, assuming a consideration of 125 for sale.
It was widely believed that the government’s intention to provide FMV in exchange for the slump in sales was to fill loopholes that were exploited to reduce the tax impact on transactions rather than creating new domestic transfer pricing standards. While the FMV rules for slump sales were apparently well meant, they could add tremendous uncertainty to taxpayers if based on market conditions or the discounted cash flow method. Whatever the controversy about the retrospective nature of the change, the content of the FMV rules does not disappoint. The FMV rules adhere to the script as anti-abuse rules, largely in line with other comparable cases where consideration is considered mandatory FMV.
The FMV rules stipulate that the sales consideration is considered to be the higher of the following:
FMV 1 is based on an adjusted book value approach where assets and liabilities are largely valued at book value, excluding jewelry, artwork, stocks, stocks and immovable property, which would be valued under specific tax rules.
FMV 2 is based on a sum of monetary and non-monetary consideration that the seller received when the business was sold. The non-monetary consideration would set the FMV tax price for certain assets (e.g. jewelry, stocks, real estate, etc.) and the market price for other assets.
So what are the immediate effects – (1) slump sales transactions no longer offer the cushion of not being subject to benchmark FMV, which means they are equivalent to stock sales transactions in this particular aspect, (2) real estate or stock transfer transactions can will no longer be “disguised” as burglary sales when the argument is made that there is no minimum FMV required. (3) The “burglary exchange” can no longer escape taxation, as it is not possible to determine the amount of the consideration, (4) companies will review the burglary transactions carried out in the last year to determine whether they have additional tax costs / interest need to budget. (5) It would be interesting to see if the new FMV rules provide ammunition to allow for a historically completed slump in sales transactions based on the intent of the new FMV rules, especially if real estate or stocks were an integral part of the business venture.
While the new rules provide clarity for taxpayers who want to restructure themselves through a business transfer primarily within group companies, the inevitable devil lies in the detail that has to be taken into account. For example, if the business entity has assets in the form of certain securities, such as unlisted convertible bonds, they will be valued at market price rather than book value. Accordingly, a detailed run through of the company’s assets and liabilities will be an important planning step. Depending on the size and complexity of the transaction, it may also be worth getting a valuation report to evaluate the business according to the new income tax rules.
In summary, there were no unpleasant surprises when the new FMV rules were drawn up. However, the retrospective nature of the change and the delay in announcing the valuation rules frustrated taxpayers, who had made arrangements based on the laws in force at the time the burglary sale took place.
Rajendra Nalam is Partner – M&A and PE Tax, and Amisha Singal is Director – M&A and PE Tax, KPMG in India.