[By Kushagra Dwivedi]
The author is a student at Dr. Ram Manohar Lohiya National Law University.
INTRODUCTION
Escrow agreements are a dominant payment mechanism for M&A transactions. Escrow agreements are a form of deferred payment where the consideration for a contract is payable at a future date rather than the date of disposal of asset. With the advent of the new Union Budget being so focused on bolstering the start-up and business sector with changes like the abolition of Angel Tax, a closer look is warranted at how payment mechanisms for such businesses are taxed.
A capital asset is any kind of property held by a person, whether tangible or intangible. Whenever a capital asset is sold, the profits or losses on the amount realised is subject to capital gains. When dealing with transactions that involve a large amount of capital like Share Purchase Agreements (‘SPAs’) where shares of a company are purchased, the tax liability of the taxpayer needs to be carefully calculated. Section 48 of the Income Tax Act (‘IT Act’) describes how the capital gains tax is supposed to be computed. It, however, proves inadequate in computing the tax liability arising from transactions that utilise methods of deferred payment like escrow. The mechanism does not account for the nuances included in transactions with deferred considerations like adjusting for the change in market value at the time. When the consideration is received or when the deferred consideration is not received in the future, calculating the adjustments in the actual value of the consideration received after inflation proves complicated. One of the main points of contention being when the liability of paying capital gains arises on the taxpayer, in the year of accrual of the income or in the year of transfer of the income. For example, if A wants to sell his stake in XYZ Ltd. to B for 5,00,000 where 3,00,000 would be paid up front while the remaining 2,00,000 would only be paid after A meets certain obligations. In such a case, the capital gains tax would be levied on the 2,00,000 only when the amount is actually accrued to A whereas in the latter view, the entire sale of 5,00,000 would be chargeable to tax. While the judicial stance as to how deferred payment mediums are to be taxed is riddled with many seemingly contradictory judgments, a closer look at the logic behind the court’s reasoning shows the real income theory being used as a basis. This article aims to analyse its shortfalls and give suggestions to ensure efficiency for computing tax liability using real income. Firstly, it analyses cases that approved of taxing in the year of accrual. Then moving on to judgements that hold that the same should be taxed in the year of sale and further providing solutions to resolve such ambiguity.
CASE ANALYSIS
Real Income Theory & Legal Right to Income
The main reasoning adopted by the courts for taxing deferred income in the year of accrual is underlined in the case of Dinesh Varzani vs. DCIT. (‘Varzani Case’). The Bombay High Court, (‘HC’) relying upon the judgement of the Supreme Court (‘SC’) in CIT Vs. Shoorji Vallabhdas and Co. says that income tax can only be levied upon the real income earned by an assessee. In a case when income does not accrue towards the assessee, no tax can be levied even though in some cases. In the case of Ajay Guliya v. ACIT (‘Ajay Guliya Case’), the Delhi HC stated that an amount can accrue or arise towards the assessee if they acquire a legal right to receive the amount; mere raising of a claim does not create a legally enforceable right to receive the same. After taking a closer look at lawsuits concerning tax liability in escrow accounts, a common essential can be gleaned, that a right towards the amount parked in escrow should never have arisen on part of the taxpayer and the income must never have been accrued in the first place. The Ajay Guliya Case underlines the right to income doctrine while the Varzani case delineates the Right to Income theory that is often used by the courts to resolve such issues. The court relied upon the case of CIT vs Bharat Petroleum Corporation Ltd., owing to an oversight by the assessee company where they failed to adhere to the accounting principles set by the government for a price stabilizations scheme, the assessee ended up with an excess claim of about INR 44,47,482 that was to be settled via a dedicated scheme account. However, the Calcutta HC held that since neither the government accepted the claim for the aforementioned amount and neither any settlement via arbitration occurred, the inclusion of the amount would be unlawful. In Modi Rubber vs ACIT, (‘Modi Rubber Case’) the Income Tax Appellate Tribunal, Delhi (‘ITAT’) holds that because the deferred amount decided upon in their SPA was directly transferred to the escrow amount without the taxpayer ever having the legal right to claim it and the possibility of them recovering the entire amount deposited in escrow being too remote due to the terms of the SPA, taxing the entire sale consideration including the deferred payment would amount to taxing a notional income instead of the real income of the assessee. The court held that owing to special subsequent facts that led to the diminishment of the assessee’s claim towards the amount parked in escrow causing a decrease in the real income of the assessee, the same would not be taxable in the year of sale.
Contrasting Judgements – Furthering Judicial Uncertainty?
The same ratio has been followed in Caborandum Universal Ltd v. ACIT, (‘Caborandum Case’) where the Madras HC states that because the SPA which was entered into by the taxpayer agreed upon the full and final sale consideration and the entire amount was paid to the taxpayer without any deductions, it will be offered to tax. The right of the taxpayer on the money was never disputed. As stated by the ITAT in the Modi Rubber Case, a shadow must be cast upon the taxpayer’s right to the consideration set aside in the escrow in order to qualify for deduction. The Delhi HC held that since no provision was made in the agreement about the reversion of shares if the conditions weren’t fulfilled, therefore, just because the agreement provided for the payment of balance of consideration upon certain events does not mean that the income has not accrued towards them. In T.A Taylor v. ACIT ithe ITAT, Chennai held that mere division of the sale consideration into initial and deferred consideration does not make the taxpayer eligible to a deduction for capital gains tax. The deferred consideration was subject to setting off the claim of the seller’s warranty and other expenses arising from the slump sale agreement. The Tribunal refused to recognize the exclusion of the deferred amount from the sale consideration. Such contrasting judgements can add to the pendency of tax disputes in the country. The judicial uncertainty propagated by the ambiguities in the taxation framework over-shadows the real income theory that the courts often use to resolve them.
Solutions to the Inefficiency of Real Income
The use of Real Income as a basis to compute tax only leads to a multiplicity of disputes regarding the taxability of deferred amounts in an SPA or in the best-case scenario, an abundance of revised tax returns needing to be filed by the Seller. Since there is no clear way of determining the real income of the taxpayer until the consideration is actually transferred, the scales of tax liability of both parties are always skewed one way or the other. The real income theory is thus vulnerable to the incidence of over or under taxation on part of the taxpayer. Such inefficiencies in the system pile on to the pendency of tax disputes in the country. A better way of computing such tax then, would be the use of future-proofing techniques and probabilistic valuation of tax of income like-:
Indexation- Indexation is the process of adjusting the price of a commodity, or in this case, the deferred consideration with respect to the current inflation rate to ensure that the real value stays the same. This would follow to be the natural successor of the Real Income theory. Indexation would ensure that the tax levied upon future income would not be diminished due to inflation. For example, if A sells shares worth ₹10,000 to B with ₹2,000 being deferred by 10 years, indexation would ensure that A’s gains are not excessively taxed and does not disincentivize them from deferring consideration. Section 48 does provide for indexation upon the payment of Long-Term Capital Gains but it is mainly for whole transactions. Proviso II, however, fits the shoe perfectly for indexing deferred income upon the date of accrual using the Cost Inflation Index.
Probabilistic Valuation- Allowing the use of probability weighted amounts to calculate tax would ensure that the cycle of filing revised returns and disputed income amounts would end while being fair towards the assessee company. The logic being that the amounts that are at a higher risk of not being received by the seller would be taxed at a lesser rate and the amounts with a lower risk would be taxed proportionately. Weighted probability bands can be used to determine an industry average for the tax that the assessee should be required to pay. This would also solve over-taxation while also relieving the taxpayer from worrying about paying taxes when the amount is accrued. Many frameworks for lump-sum taxation using endogenous probabilistic valuations have been proposed and may even serve as being just as efficient, if not better than the current tax framework. Using internal tax data and trends, scholars propose that a Pareto improvement can be gleaned with regards to tax collection
Future Discounts/Standard Industry Discounts- Discount rates could be calculated based on the risk-free industry average or a base discount for the time period the consideration has been deferred for in order to mitigate the risk of over-taxation by the authorities. Discount rates would work in the same sphere as indexation but instead of affecting the consideration amount, the same would affect the amount of taxes to be paid. This approach would relieve the taxpayer from having to determine a consideration price while accounting for indexation margins and shift the work on part of the collector. Vietnam offers Preferential Corporate Income Tax Rates for different sectors and industries with an aim to bolster sector growth, however, the base approach can be modified to account for deferred considerations. India also offers tax incentives for businesses in the form of discounts that can be reframed to accommodate deferred considerations
Flexible Tax Rates- Flexible tax bands that account for changes in the regulatory and legislative environment for the industry during the time of deferment can ensure consistent and uniform taxation for such transactions.
Tax Deferral- Taxpayers could deposit a certain percentage of the median tax liability in a temporary amount which could be refunded on a time basis when the limitation for each amount expires. This would ensure maximum transparency and efficiency while eliminating the headache of tax liability after the transaction has been completed. Tax deferred accounts like Public Provident Funds and Employee Provident Funds exist to park money tax-free, the same principle could be used for tax locked due to consideration being deferred.
CONCLUSION
In conclusion, the taxation of deferred payments, such as those handled through escrow agreements in M&A transactions, remains a complex and contentious issue under current tax frameworks. The application of the Real Income theory, while intended to ensure tax liability matches actual receipt, often leads to ambiguity and disputes. Resolving such ambiguity can help ease the ever-increasing judicial pendency of tax disputes in the country, thus saving litigation costs and providing some much needed relief to market players in streamlining tax determination while also future-proofing transactions.