Jigar Parikh
On 15 December 2016, Section 232 of the Companies Act, 2013 dealing with mergers and acquisition (M&A) was made effective. One of the key impacts of this development is requirement to ensure that the accounting treatment prescribed in the Court Scheme for any merger, demerger, amalgamation or group reorganisation (referred to as “business combinations”) scheme is in accordance with the notified accounting standards prescribed in the Companies Act, 2013.
The accounting guidance under Companies (Accounting Standards) Rules, 2006 (Indian GAAP) on M&A was not very comprehensive. It did not provide guidance in many situations such as demerger, reverse acquisition, contingent consideration, derivative over non-controlling interests and distribution to owners.
In the absence of any specific accounting guidance, various accounting alternatives were possible, which were beneficial to meet the tax conditions prescribed for achieving tax efficiencies for parties involved in the transaction.
Many companies in India have started reporting under the new Companies (Indian Accounting Standards) Rules, 2015 (Ind AS) from 1 April 2016. Ind AS are IFRS converged standards and lay down comprehensive guidance for all forms of M&As, demergers and group reorganisations.
Reporting under Ind AS may significantly impact tax-planning strategies for many deals and will also have a high impact on key performance indicators of companies. The following are some key impact areas:
- Method of accounting for business combinations
Under Ind AS, it is mandatory to use the purchase method of accounting for third-party transactions and the pooling of interest method for common control transactions. These requirements significantly cut down the accounting alternatives and impact the conditions prescribed in the Income-tax Act for achieving tax neutrality or create tax exposure for companies.
For example, Under Indian GAAP, many companies were able to account for common control transactions using the purchase method and were eligible for tax benefits for goodwill amortisation benefit in the tax accounts or for the purpose of computation of book profit for MAT purpose. On transition to Ind AS, such tax benefits will be curtailed.
- Accounting for demergers
Demergers are widely used to conduct group reorganisations or acquisition transactions in India because of the tax exemption benefit on transfer of business.
However, these tax benefits are available only if the demerger meets one of the key conditions prescribed in Section 2(19AA) of the Income-tax Act, of recording assets and liabilities at book value of the transferor company by the recipient company.
The requirement to record assets and liabilities at fair value in case of non-common control business combinations under Ind AS creates a big impediment for achieving tax neutrality for demerger transactions.
One other big issue that needs to be considered in case of demerger transactions is accounting in the books of the transferor company. As per explanation to sub-section (3) of Section 2 (19AA) of the Income-tax Act, any change in the value of assets consequent to their revaluation should be ignored for the purpose of determining the value of the property.
Ind AS requires measurement at fair value for many assets such as derivatives and equity investments. Many tax experts believe that the measurement of assets at fair value creates a risk of tainting the condition prescribed in sub-section iii of Section 2(19AA).
Another looming threat in demerger transactions is MAT risk exposure to the transferor company because of notional fair value gain being recorded under Ind AS (unless it meets the common control criteria) for giving in-substance distribution to the shareholders.
However, this risk is mitigated by the relaxation given in Finance Bill 2017 to ignore such fair value gains and losses for computation of book profit for MAT purposes.
- Appointed date vs. effective date
Under Indian GAAP, accounting for mergers and amalgamation was generally done from the appointed date once the court order became effective.
This practice is likely to change in the Ind AS regime. Ind AS requires accounting for any business combination from the date when it acquires control.
There is a raging debate whether accounting from the appointed date can continue even in Ind AS regime. Considering the requirements given in Ind AS, there is a strong view prevalent that accounting for merger and acquisition in a court-approved scheme can be done only from the effective date (and not from the appointed date).
Going with this view, companies need to ensure that the accounting treatment prescribed in the scheme clearly articulates that accounting will be done from the effective date and not from the appointed date to avoid any legal issue or hurdle in obtaining clearance from the auditors. However, this position will not be in sync with the treatment under the Income-tax Act.
- Accounting for goodwill
Unlike Indian GAAP, Ind AS prohibits amortisation of goodwill and is required to test goodwill for impairment annually. This change will result in volatility in the profit and loss account. Also, the tax shield from amortisation of goodwill to compute the MAT liability will not be available in the Ind AS regime.
Computation of goodwill is also likely to change significantly in the Ind AS regime. Under Indian GAAP, companies had an accounting policy choice to compute goodwill using either the fair value or the book value of the net assets taken over.
Most of the companies considered the book values of the net assets taken over. Ind AS mandates the computation of goodwill using the fair values of the net assets taken over, including the recognition of the intangible assets and contingent liabilities not recognised in the acquiree’s balance sheet.
Fair valuation of the net assets taken over will reflect the true value paid by the company for acquiring the net assets.
- Common control business combinations
Ind AS prescribes specific accounting principles for common control business combinations. It mandates the use of the pooling of interest method with restatement of the comparative period presented for the period the entities were in common control.
The requirement to restate comparatives may not be fully in sync with the tax treatment of considering the merger or amalgamation only from the appointed date.
Also, restatement may require reversal of the gains or losses arising from transactions in the earlier period between the combining entities. Companies may need to consider if such a reversal of gains or losses will impact the MAT liability computed earlier.
Concluding remarks
Accounting for business combination is very substance-based and can have significant impact on transaction dynamics. It is important for companies to assess the accounting implications of the proposed transaction structure on taxation, KPI and financial reporting before finalising the deal.
This will help companies mitigate any tax exposure or unintended financial reporting consequences.
(Author is a partner in an Indian member firm of EY Global)
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