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CORPORATE RESTRUCTURING. Shahzad Hussain, FCA A. F. Ferguson & Co. Chartered Accountants. Introduction. Following are some of the examples of corporate restructuring that could lead to tax benefits: Mergers and acquisitions Acquisitions of shares Financing through debt Capital gains
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CORPORATE RESTRUCTURING Shahzad Hussain, FCA A. F. Ferguson & Co. Chartered Accountants
Introduction • Following are some of the examples of corporate restructuring that could lead to tax benefits: • Mergers and acquisitions • Acquisitions of shares • Financing through debt • Capital gains • To avail tax benefits, corporate restructuring should be carried out keeping in view the anti avoidance provisions contained in sections 108 and 109 of the Income Tax Ordinance, 2001
Tax avoidance Brief history: Tax avoidance is not a new phenomenon. One of the leading cases on avoidance was heard by the House of Lords 70 years ago (IR Commrs v Duke of Westminster (1935) 19 TC 490). In that case, the Duke of Westminster sought to minimize his tax exposure by covenanting with his gardener that he would pay the gardener an annuity in lieu of some of his wages. Payments made under a deed of covenant were then tax deductible. In a much quoted speech, Lord Tomlin observed: ‘Every man is entitled if he can to order his affairs so that the tax attaching under the appropriate Acts is less than it otherwise would be.’ Previously, ‘tax avoidance’ was distinguished from ‘tax evasion’ by virtue of the former being legal and the latter illegal. Now in England, recent pronouncements by Government functionaries appeared to have blurred this distinction (notwithstanding Lord Tomlin’s remarks above). The provisions of section 108 and 109 of the Income Tax Ordinance, 2001 appeared to be in line with these pronouncements. These provisions are as follows:
…Tax avoidance Section 108: Transactions between associates “(1) The Commissioner may, in respect of any transaction between persons who are associates, distribute, apportion or allocate income, deductions or tax credits between the persons as is necessary to reflect the income that the persons would have realised in an arm’s length transaction. (2) In making any adjustment under sub-section (1), the Commissioner may determine the source of income and the nature of any payment or loss as revenue, capital or otherwise.”
…Tax avoidance Section 109: Recharacterisation of income and deductions “(1) For the purposes of determining liability to tax under this Ordinance, the Commissioner may – (a) recharacterise a transaction or an element of a transaction that was entered into as part of a tax avoidance scheme; (b) disregard a transaction that does not have substantial economic effect; or (c) recharacterise a transaction where the form of the transaction does not reflect the substance. (2) In this section, “tax avoidance scheme” means any transaction where one of the main purposes of a person in entering into the transaction is the avoidance or reduction of any person’s liability to tax under this Ordinance.”
1. Mergers and acquisitions Reasons why mergers and acquisitions take place: • For expansion purposes, merging with a company within the geographical area is quicker than internal expansion • For diversification purposes, to allow the company to diversify into other lines of business • For financial motivation, the target company may be undervalued • Tax benefits
…Mergers and acquisitions Types of mergers: • ‘Horizontal merger’ – when two competitors combine; it would lead to increase in market power and it will have anti competitive effects (may have to be approved by monopolies control authority) • ‘Vertical merger’ – these are combination of companies that have buyer-seller relation, e.g., manufacturer of a product and distributor of that product. • ‘Conglomerate merger’ – when merging companies are not competitors and do not have buyer-seller relationship. These companies could be running different businesses.
…Mergers and acquisitions Accepted accounting methods of business combinations: • Purchase method: Generally speaking, the purchase method accounts for a business combination as the acquisition of one company’s net assets by another. The purchase price and costs of acquisition are allocated to all the identified assets acquired and liabilities assumed, based on their fair values. If the purchase price exceeds the fair value of the purchased company’s net assets, the excess is recorded as ‘goodwill’. Earnings or losses of the purchased company are included in the acquiring company’s financial statements from the closing date of the acquisition. • Pooling of interest method (purely for mergers): This method accounts for a business combination as a uniting of ownership interests of two companies by the exchange of equity shares. No acquisition is recognized because the combination is accomplished without disbursing resources of the constituents. In pooling of interest accounting, the assets, liabilities and retained earnings of each company are carried forward at their previous carrying amounts. Operating results of both companies are combined for all periods prior to the closing date, and previously issued financial statements are restated as though the companies had always been combined.
Purchase method • Assume a Company ‘B’ purchases net assets of Company ‘A’ for a consideration of Rs 250,000. The payment for consideration is agreed upon as follow: • Issue shares of Company ‘B’ for Rs 125,000 at Rs 15 per share; and • Pay cash of Rs 125,000.
…Purchase method • On the date of the acquisition, fixed assets of Company ‘A’ are re-valued in the following manner shown
…Purchase method • The ‘post acquisition’ balance sheet of Company ‘B’, under the Purchase method would appear as:
…Purchase method • The books of Company ‘A’ and its balance sheet would reflect the post acquisition position, in the manner shown opposite: • Gain on disposal of plant and machinery and other assets is taxable whereas, gain on land is not taxable under the Income Tax Ordinance, 2001
…Purchase method • For the acquiring Company ‘B’, tax depreciation will be available on the revalued amount of plant and machinery and other depreciable assets • Goodwill amortization may not be available as a tax expense. However, according to the impairment standard, goodwill can be charged off for accounting purposes – Debatable issue • Under the new IFRS 3, where only purchase method is allowed, some amount can be assigned to intangibles such as: • Advertising contracts • Favorable leasehold interests • Franchise agreements • Intellectual property • Patents • Trademarks • Customer relationship • Internet domain • Access to research and development • This will reduce the value of goodwill for accounting purposes • Whether the intangible allocation will be permissible as a tax allowable expense is yet to be tested. But costs incurred as intangibles are allowed as tax deduction over the useful life of the intangible
Pooling of interest method • Using the same information as given in Example ‘1’, but with the following exceptions: • Swap ratio being 1.5 shares of Company ‘B’ for every 1 share of Company ‘A’; and • Fixed assets are carried at their net book value, as shown below:
…Pooling of interest method • Legal merger through court; • Assets and liabilities of Company ‘A’ would vest in Company ‘B’, through court’s approval; and • Company ‘A’ is wound up without the winding-up process, through a court order • The ‘post merger’ Balance Sheet of the amalgamated (merged) Company ‘B’ would be as follows:
Corporate law and Pooling of interest • Corporate statutes allow the companies to re-organize or re-construct the business. This provision is contained in sections 282 to 284 of the Companies Ordinance, 1984. • Practical application of these sections reveal that combination undertaken by way of the provisions represents ‘pooling of interest’ for legal and fiscal purposes.
Tax benefits arising from merger • No taxable event in the hands of the amalgamating Company ‘A’ • No taxable event in the hands of shareholders (of the amalgamating company) acquiring shares in the surviving entity – no ‘Disposal’ • Definition of disposal - Section 75 states that: “(1) A person who holds an asset shall be treated as having made a disposal of the asset at the time the person parts with the ownership of the asset, including when the asset is – (a) sold, exchanged, transferred or distributed; or (b) cancelled, redeemed, relinquished, destroyed, lost, expired or surrendered.” • Tax losses of amalgamating company and surviving company are available to the surviving company; provided that the losses are from the same line of business, as provided for in section 57A of the Income Tax Ordinance, 2001 – restricted scope
2. Acquisition of shares • Under this option, the shares of a company are acquired to include it as a ‘subsidiary’ in the group. Group relief • The concept of ‘Group Relief’ was introduced in the Pakistan tax laws through Finance Act, 2004. A whole new section 59B was inserted in the Income Tax Ordinance, 2001 and subsequently it was further amended by Finance Act, 2005. It was a business friendly amendment aimed at promoting corporate growth and restoration of sick units. • Under the provisions of section 59B, any company is allowed to surrender its assessed loss for the tax year, other than brought forward losses, in favor of its holding company provided that the holding company owns 75% or more of the share capital of the subsidiary company. This is illustrated in the following example:
…Financing through debt Thin capitalization • A new concept of ‘Thin capitalization’ has been introduced in section 106 of the Income Tax Ordinance, 2001 to cover payments of interest (profit on debt) by the ‘foreign controlled resident companies’ to the non-resident holding company. The provisions of section 106 state that: “…(1) Where a foreign-controlled resident company (other than a financial institution [or a banking company)]has a foreign debt-to-foreign equity ratio in excess of three to one at any time during a tax year, a deduction shall be disallowed for the profit on debt paid by the company in that year on that part of the debt which exceeds the three to one ratio…” • Under the provisions of section 106, only that portion of interest payment will be allowed as a deduction from income which does not exceed the foreign debt-to-foreign equity ratio of 3-to-1. This point is further illustrated by the following example ‘3’
4. Capital gains • Capital gain would accrue to the seller in the event the shares of a resident company are disposed off – generally a taxable event. • The incidence of Pakistan tax on disposal of shares (under the above option) can be avoided through the mechanism of ‘tax planning’ i.e. treaty shopping. For instance, favourable provisions are available in the Double Tax Treaties with Netherlands and Mauritius.
