When foreign turf is friendlier than home

What is common between the big ticket deals of Tata-Corus, Hindalco-Novelis, United Spirits-White & Mackay and Suzlon-RE Power? The answer is obvious: they are all outbound acquisitions, that is, Indian companies acquiring foreign companies, businesses or assets. Further, they are all Leveraged Buyouts (LBOs). An LBO is a transaction where debt is used to finance the acquisition. An important facet of an LBO is that the debt used for LBO is secured by the assets of the acquired business and the cash flows of the acquired business will be used to service the debt.

The economic benefits of LBOs are well-documented. So is the Indian corporates’ growing appetite for foreign assets. However, in the commonness of outbound deals and LBOs lies a story. A story about how both Indian and foreign corporates, who have full flexibility while structuring LBOs in most countries, suddenly find their hands tied while doing deals in India.

Let us consider outbound acquisitions first. The exchange control regulations are not concerned about how you fund the acquisition as long as the cap of 300% of the networth is met. Thus you can either take a domestic loan or a foreign currency loan (ECB) to fund the acquisition. Indian banks are specifically allowed by RBI now to fund overseas acquisitions. Most LBOs are, however, structured with debt taken outside India, which, obviously, is not restricted by Indian regulations.

The bigger advantage of this is the tax efficiencies. Interest on debt taken in India (whether ECB or domestic) is allowable as a deduction against the Indian company’s income, as dividend received on the shares of the foreign company is fully taxable in India. This has been clearly established by a recent decision of the Mumbai tax tribunal in a case that involves Birla Group Holdings. One of the key considerations of an LBO is tax reduction through interest payments.

When debt is taken abroad, it is usually through a special purpose vehicle (SPV). Tax laws in most countries are sophisticated enough to allow deductibility of interest relating to the acquisition debt against the operating income of the target. These laws either provide for group consolidation, where the SPV and the target are assessed as a single entity for tax purposes; or through rules which provide for pass-through status to certain entities. Some countries also allow interest deductibility once SPV is merged into the target and the debt passes on to the target.

The picture is not so perfect once we come to India-specific acquisitions. Let us first look at domestic M&A. Indian banks funding share acquisitions/LBOs face a host of restrictions — mostly it’s a No-No. Further, due to the end-use restrictions on ECBs, they cannot be used to fund Indian share acquisitions. From a tax perspective, a certain Section 14A poses a huge challenge as it provides that any expense incurred to earn tax — exempt income is not deductible for tax purpose. Since dividend on shares is tax-free, interest paid for acquiring such shares is not allowed as a deduction.

Though there are favourable arguments in case of acquisition of a controlling stake (that the acquisition is not for earning dividend but for running a business), the possibility of litigation is almost certain. Even if the acquired company is merged with the acquirer later, the interest deductibility is not free from doubt. The problem is compounded due to the absence of tax consolidation provisions in the Indian laws.

For inbound M&A through the FDI route, Press Note 9 of 1999 provides that foreign-owned Indian holding companies can acquire Indian companies only by bringing in funds from abroad and not by domestic leveraging. In addition, the restrictions on Indian banks/ECB funding for share acquisition remain.

A structuring option available to the foreign investor till now was to leverage abroad and bring in funds into India through preference shares — a quasi debt instrument. Our policymakers have also closed this option by terming all non-convertible and optionally convertible preference shares as ECBs. On the tax side, the same issue of interest deductibility arises.

The structure of forming a SPV in the target country, taking domestic debt and achieving interest deductibility through group consolidation/subsequent merger, which works in most cross-border deals, just does not work if your target country is India.

The government needs to take policy measurers to address the anomalies relating to LBOs so that M&A activity in India gets a further boost.

(The authors are with PricewaterhouseCoopers)