International Joint Ventures, Mergers & Acquisition

I n t e r n a t i o n a l J o i n t V e n t u r e s , M e r g e r s & A c q u i s i t i o n s

M B – I B 0 4 ( U n i t I I I )

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Tax Treatment of Joint Venture Agreement

A joint venture is subjected to taxation under the provisions of Income Tax Act, 1961. It is the umbrella Act for all the matters relating to income tax and empowers the Central Board of Direct

Taxes (CBDT) to formulate rules (The Income Tax Rules,1962 ) for implementing the provisions of the Act. The CBDT is a part of Department of Revenue in the Ministry of Finance. It has been charged with all the matters relating to various direct taxes in India and is responsible for

administration of direct tax laws through the Income Tax Department. The Income Tax Act is subjected to annual amendments by the Finance Act, which mentions the 'rates' of income tax

and other taxes for the corresponding year.

Taxation of a joint venture depends upon the agreement between the parties, forming the joint venture. If the joint venture is established in the form of a partnership firm or as a company, it is taxed accordingly i.e. as a partnership or as a company. But in all other cases, a joint venture is

treated as an association of persons (AOP) or a body of individuals (BOI).

An Association of Persons (AOP) means two or more persons who jo in for a common purpose with a view to earn an income. The term 'person' includes any company or association or body

of individuals, whether incorporated or not. The association need not be on the basis of a contract. Therefore, if two or more persons jo in hands to carry on a business but do not

constitute a partnership they may be assessed as an AOP. But, an AOP does not mean any and every combination of persons. It is only when they associate themselves in an income-producing activity that they become an association of persons.

Body of Individuals (BOI) means a conglomeration of individuals who carry on some activity

with the objective of earning some income. It would consist only of individuals. Entities like

companies or firms cannot be members of a body of individuals. Income tax shall not be payable

by an assessee in respect of the receipt of share of income by him from BOI and on which the tax

has already been paid by such BOI

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Tax Implication of Joint Ventures

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Key Consideration in Deal structuring

Choice of Jurisdiction

•Taxability of Distribution of Dividends,

In Indian context, any Jurisdiction is tax neutral due to the fact that DDT @ 16.995% is levied upon the distributing company

Capital Gains

•Capital Gains would arise upon the sale of the investment in India. Thus, this aspect concerns the exit option for the investor. In the Indian context, gains made on the sale of investment

attracts a capital gain tax of 20% if the holding period of the asset is less than 3 years and 10% if the holding period exceeds 3 years.

In view of the same, the investment can then be structured through a holding company set up at a location where such gains are exempt.

Interest on Debt funding

•Interest on debt funding is a very critical part of the entire transaction •The tax deductibility of these expenses is critical, since this would result in a considerable

amount of savings

Choice of juridiction

(Taxability of)

Dividend

Capital Gain

Interest on debt funding

Investment Vehicle

Regulations

Tax considerations

Funding Options

Equity

Preference

Convertible Debt

Differential Rights

Operational Synergies

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*DDT is payable by Indian company @ 16.995%

Investment Vehicle

•The choice of investment vehicle is largely based on the regulations and the tax considerations

existing in the country where the target company is situated. The overall guiding principle would be that the investment vehicle qualifies to claim treaty benefit under the tax treaty

between India and the relevant jurisdiction. The choice of investment vehicle would be considered at 2 levels i.e. Jurisdiction Level & Indian Level (Country of the target Company)

Jurisdiction level Parameters

1. Ease of formation and administration

2. Ease of Exit

3. Local Regulatory (non-tax considerations)

4. Tax treatment in the country of residence

5. Tax differentiator’s vis-à-vis tax treaties with India. This becomes critical due to the fact that the same income not be taxed twice under two different jurisdictions

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Indian level Parameters

1. FDI restrictions in India based on the sectoral caps in place

2. Regulatory registrations and administration Taxation and duties •The impact of tax treaties and agreement between various countries and the optimum use of

offshore finance centers and tax havens is critical for structuring a transaction Funding Options

Funding Options

The funding options available for the structuring would vary depending upon the present

structure of the company and the availability of debt. The normal options available would be Equity, Preference, Convertible Debt and Differential Rights apart from the structured funding

options. These would vary based on

The investor's preference for dividend or liquidation or both

Prevailing Indian exchange control laws, which do not permit foreign equity investment

beyond a certain level in certain sectors

The investor may wish to get disproportionate voting rights on its investment in return for the strategic value such investor may bring to the table

Restrictions placed by the Indian corporate and securities laws with respect to equity

shares which may not suit the commercial understanding between the parties. 1. Equity

Most sectors have been opened up for foreign investment and, hence, no approvals from the government of India are required for issue of fresh shares with respect to these sectors

The tax implications are as under:

a) Dividends

Dividends can be freely repatriated under exchange regulations

Transfer to reserves before declaring dividends

Dividends not taxable in hands of shareholders

The domestic company must pay dividend distribution tax (DDT) at the rate of 16.995%

(15% plus surcharge of 10% and education cess of 3%)

b) Capital Repatriation of funds not possible, as equity capital cannot be withdrawn during the life-span of

the company, except in the case of a buy-back of shares

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2. Preference Capital

Preference shares (except fully convertible) are considered as debt and has to be issued in conformity with ECB guidelines/caps

Tax Implications

Dividends

On fully convertible, can be repatriated but the maximum rate is capped

On any other type needs to confirm to the all- in-cost ceiling prescribed in the ECB

guidelines

Tax Implications same as Equity shares

Capital

No company can issue preference shares that are either non-redeemable, or are redeemable after 20 years from the date of their issue.

3. Convertible Debt

The policy was made significantly tighter by the Reserve Bank of India (RBI) in 2007 for preference shares and debentures whereby only fully and mandatorily convertible instruments

are now considered to be FDI. All other preference shares and debentures (a nd including those that are optionally convertible) are considered to be debt and hence governed by the guidelines

on ECBs.

Interest

On fully convertible, can be repatriated but the maximum rate is capped

Tax Implications as income on interest ( at par with treaty with jurisdiction)

Principle

Repatriation of funds not possible, as it will be converted into equity & equity capital

cannot be withdrawn during the life-span of the company, except in the case of a buy-back of shares

4. Differential Rights

Shares with differential voting rights (DVR shares) are like ordinary equity shares but with differential voting rights. They are listed and traded in the same manner as ordinary

equity shares. However, they mostly trade at a discount as they provide fewer voting rights compared to ordinary equity shares (sometimes called specific rights). Companies

generally compensate DVR investors with a higher dividend. Dividend and Capital treatment is same as that of ordinary Equity share

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Tax treatment in the hands of Indian partner

(Capital Expenditure and Revenue Expenditure)-Important court cases

UNDERSTANDING CAPITAL & REVENUE RECEIPT & EXPENDITURE WITH

LATEST CASE LAWS:

There is always a dispute in respect of capital and revenue receipt and expenditure. Let’s

clarify the same with the help of some of the latest judicial decision in this respect.

01. Non Compete Fees: Non-compete fee received by assessee for refraining from manufacturing and selling time pieces for a period of ten years after the sale of its units while it was continuing

with its other business activities constituted revenue receipt. Refer Tata Coffee Limited, 29 DTR 336.

However, in the case of Tecumseh India (P) Limited v ADD CIT, ITAT Delhi held that Non-compete fee is capital expenditure.

In the case of BASF India Ltd. vs. Addl. CIT, it was held that Amount received on account of transfer or assignment of marketing rights in exchange of source of income is a capital receipt.

Amount received as non-compete fee is a capital receipt. Capital gains not taxable where cost of acquisition not determined.

02. Reimbursement: Payment by way of reimbursement of expenses incurred on behalf of payer is not income chargeable to tax in the hands of payee. Refer Siemens Aktio ngesellschaft, 15 DTR

233.

Similar decision was given in the case of Rajesh Pilot, 175 Taxmann 8, it was held that It was

found that the money received by the agent was spent on the expenditure of jeeps required for the election campaign of the assessee. The Court held that every receipt is not taxable as income. It may be receipt, but not necessarily “income”.

03. Government Incentives: Incentives in the form of excise duty refund and interest subsidy which

has been granted for substantial expansion of unit, only after commencement of production and not for setting up of new industries or to purchase capital assets, same constitute reve nue receipt. Refer, Shree Balaji Alloys, 33 DTR 67.

However, in the case of Reliance Industries Limited, the Supreme Court held that the assessee received sales-tax incentive for setting up a new industrial undertaking in Patalganga. The

assessee claimed that the said subsidy was a capital receipt. The Special Bench (DCIT vs. Reliance Industries Ltd 88 ITD 273) upheld the assessee’s claim. On appeal by the department

(for a subsequent year), the Bombay High Court held (order enclosed) that as a finding had been recorded by the Special Bench that the object of the subsidy was to encourage the setting up of industries in the backward area by generating employment therein, the subsidy was, applying the

“purposive test” in Ponni Sugars and Chemicals Ltd 306 ITR 392 (SC), a capital receipt and held that a substantial question of law did not arise. The department filed an appeal to challenge the

judgment of the High Court. HELD allowing the appeal.

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Similar view was provided in the case of CIT v. Rasoli Ltd, 245 CTR 667, Subsidy received by assessee from the State Government under a scheme of industrial promotion, which was meant to

provide financial assistance to specified industries for expansion of capacities, modernization and improving their marketing capabilities, is capital receipt, though the amount of subsidy is

equivalent to 90 percent of the sales-tax paid by the beneficiary.

04. Prior Income before business commencement: Prior to commencement of business interest

earned by parking surplus funds in bank, constitutes a capital receipt and hence is eligible for being set off against pre-operative expenses. Refer, Indian Oil Panipat Power Consortium Ltd.,

181 Taxmann 249. However, please refer Tuticorin Alkali judgment also.

Similar view was given in the case of CIT vs. Arihant Threads Ltd, 49 DTR 251, where it was

held that Interest on deposit of margin money for opening of letter for credit for import of machinery at the stage of setting up of industrial unit of the assessee is a capital receipt and the same is to be set off against preoperative expenses.

Again, similar view was given in the case of CIT vs. Siya Ram Garg (HUF), 49 DTR 126, where

it was held that Interest on deposit of margin money for opening of letter for credit for import of machinery at the stage of setting up of industrial unit of the assessee is a capital receipt and the same is to be set off against preoperative expenses.

05. Termination Compensation : Termination of an agency agreement which has no major effect

on profit earning apparatus, the compensation received is taxable as revenue receipt but the part of the compensation which is attributable to restrictive covenant is capital receipt and not chargeable to tax. Refer Chemet, 122 TTJ 766.

In the case of S. Zoraster & Co., 31 DTR 10, it was held that Compensation received by assessee from the other party for termination of the agreement for transfer of property to be treated as

capital receipt and not as revenue receipt.

Further, in the case of CIT v Saurashtra Cement Limited, SC held that Compensation for sterilization of profit earning source is a Capital receipt.

In the case of Ansal Properties & Industries Ltd. vs. CIT, 238 CTR 126, it was held that Compensation received from the land owner on termination of development agreement was the deprivation of potential income and loss of future profits as mentioned in the settlement

agreement and not for divesting the assessee of its earning apparatus, as restrictive covenant in the said agreement only prohibited the assessee from undertaking a similar project in the vicinity

of the existing project without consent of the land owner for the limited duration of three years, and therefore, the compensation was a revenue receipt.

Again in the case of Ion Exchange (India) Ltd. vs. ITO, 52 DTR 411, Mumbai ITAT held that Consideration received for premature termination of the joint venture agreement constituted

revenue receipt.

06. Know How Acquisition : If Know how acquired relates to process of manufacture, then any

payment made for said purpose would have to be considered as a revenue expenditure. Refer CIT v Munjal Showa Limited.

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07. Advance : Assessee received advance of Rs. 9 crores from certain foreign buyers, however he could not export within one year as stipulated by RBI vide its regulation, notification No. FEMA

23/2000-RB dt. 3-5-2000, and assessee periodically withdrew the amount and used for other business purpose. Assessing Officer treated the said receipt as income and made addition. On

appeal CIT(A) deleted the addition. The Tribunal held that on the relevant year liability to pay was existing and foreign party’s claim was still enforceable under the law. After getting the approval from RBI the assessee remitted the amount to the buyer through banking channel,

therefore, the order passed by the CIT(A) was upheld. Refer, ITO vs. Eurostar Distilleries (P) Ltd, 41 SOT 434.

08. Goodwill Compensation: If good will of the business is damaged on account of action of supplier of goods and later on some compensation is awarded in lieu of that, it will fall in the same category of loss to the source of income and consequently such a receipt will qualify to be

characterized as a capital receipt. Refer; Inter Gold (India) (P) Ltd. vs. Jt. CIT, 47 DTR 150. 09. Gift from Public in Large : Where the devotees out of natural love and affection and veneration

used in large numbers on the birthdays of the assessee and voluntarily made gifts, it cannot be said that the amount received by the assessee by way of gift would amount to vocation or profession since it is not the case of the Department that the devotees were compelled to make

gifts on the occasion of the birthday of the assessee and therefore the same were not taxable as income in the hands of the assessee. Refer, CIT vs. Gopala Naicker Bangaru, 46 DTR 480.

10. Settlement : Assessee had availed various facilities from Madurai Bank over years, repayment of which was guaranteed by way of change on properties of assessee. As assessee failed to pay dues, bank filed a civil suit. Subsequently, out of settlement was reached at an amount of Rs. 160

lakhs. Vide Government resolution dt. 14-12-1994 and 19-7-1995, NSSK was permitted to buy spares, plant and machinery of assessee. It was to pay, on behalf of assessee a sum of Rs. 160

lakhs to Madhurai Bank towards settlement of amount due. The assessee claimed that as NSSK directly paid Madurai Bank it should be excluded from the sale consideration as that never became the income of the assessee as it stood diverted of overriding title and hence, should be

ignored for the purpose of calculating capital gain. The Tribunal held that payment to bank is only application of income not a charge on income. The payment to bank and sale consideration

of its assets are entirely two distinct transactions having no relat ion with each other except for the fact that there was a charge by bank on assets. Hence, amount not deductable from sale consideration. Refer, Shree Changdeo Sugar Mills Ltd. vs. Jt. CIT, 44 SOT 479.

11. Payment Received under degree of Court : In year 2004, the assessee had purchased certain land. On the eastern side of property, “P” a public company of developers, had trespassed

assessee’s property by using a private road to reach their land located the said property. To get the encroached portion retrieved, the assessee filed civil suit for restraining that company’s entry on assessee’s land. As per the Court decree resulted in to by way of compromise between parties,

the assessee permitted the use of private road enabling “P” to reach its property and in turn “P” paid certain amount to assessee. The assessee treated the said receipt as capital receipt. The

assessing officer treated the said receipt as rent and taxable as income from house property. Commissioner (Appeals), reversed the finding of Assessing Officer. The Tribunal held that there being no relationship of land lord and tenant, between parties, amount received by assessee was

only a capital receipt could not be taxed under the Act being an intangible asset having no cost. The Tribunal also held that the said receipt cannot be taxed as income from other sources. Refer,

Dy. CIT v. T. Kannan, 48 SOT 374.

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Income tax - Sec 28(va) - Whether compensation received on termination of Joint Venture

with non-resident is capital receipt - NO, it is revenue receipt: ITAT

By TIOL News Service

MUMBAI, JAN 03, 2011: THE issue before the Tribunal is - Whether compensation received upon the termination of Joint Venture Company is a capital or a revenue receipt. And the Tribunal's verdict goes in favor of Revenue.

Facts of the case

The assessee is engaged in the business of manufacturing and selling water treatment chemicals,

equipments etc. The assessee company i.e. Ion Exchange (India) Limited entered into a joint

venture agreement with M/s. W. R. Grace & Company of USA (for short WRG) on 16th

September 1994 and the joint venture was to be known as M/s. Dearborn Ion Exchange (India)

Limited (for short DIEI). In this joint venture Grace was to hold 51% shareholding whereas

assessee was to keep its holdings at 49%. WRG sold its business in June 1996 to M/s BETZ

Laboratory Inc. USA which were highly active competitors and which had affected the business

of joint venture DIEI. Subsequently, WRG terminated the joint venture agreement w.e.f. 31-3-

1997. The assessee company launched certain proceedings against WRG for recovery of

compensation for termination of the joint venture agreement before the International Chamber of

Commerce by way of an arbitration and ultimately the matter was settled between the parties

through a Settlement Agreement dated 31- 3-1998 by which WRG agreed to pay al sum of USD

2.25 millions equivalent to Rs.8,93,22,047/-. This amount was credited to profit & loss account

as revenue receipt and in the statement of income this amount was shown as extraordinary item

of compensation and included in the income returned by the assessee. Later on, a letter dated 19-

2-2002 was submitted to AO through which it was requested to treat this amount of

compensation as capital receipt. Through this letter it was mainly stated that to be an assessable

income the item must fulfill the basic condition that it should fall under one of the heads of

income. It was claimed that an amount received by an assessee as compensation for loss of profit

making apparatus is a capital receipt and, therefore, same is not taxable and for this reliance was

placed on the decision of the Bombay High Court in the case of CIT vs. Khushalbhai Patel &

Sons. The AO held that the compensation received by the assessee is connected with loss of

income or profits by virtue of loss of standing charges and fees and therefore, the receipt would

assume the form of a revenue receipt and not capital receipt and accordingly taxable. The CIT(A)

confirmed the action of the AO.

On further appeal, the ITAT held that,

No separate source or apparatus for earning a separate income was created through the

joint venture. It was a simple case of doing the business in a particular way and the whole

business was carried on even after the termination of the Joint Venture Agreement. The

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assessee company was engaged in the business of manufacturing and selling of water

treatment equipments and chemicals before entering into the joint venture and continued

to do the same even after termination of the joint venture;

If the receipt of compensation for cancellation of a contract does not affect the trading

structure of business of the assessee nor deprive him of what in substance is his source of

income and termination of contract being a normal understanding, then such

compensation has to be treated as revenue receipt. In this case, the assessee has not been

deprived of his business and, in fact, as observed repeatedly the same business continued

before the joint venture and after the termination of the joint venture

In view of the above discussion, the compensation received by the assessee company has

been rightly treated by the lower authorities as revenue receipt and accordingly confirmed

the order of the CIT[A].

Joint Ventures Abroad

The following requirements will have to be compiled with for setting up joint ventures abroad:

Companies act

FERA section 27 of Foreign exchange regulation act 1973

Approval of Reserve Bank

o For sending representative o For remittance of cash

Holding securities and shares abroad

Tax concessions under income tax act

Deduction of 50% of royalties, commission etc, received from foreign enterprises

Major Issues

Valuation Problems

Transparency

Conflict Resolution

Ownership and management control

problems

Changes in ownership shares

Marketing and staffing issues

Problems related to multi-nationality

Export rights

Tax issues

Dividend and investment policies

Differences in partner size

There may be other control problems

Product line disputes

Material and component sourcing

Technology utilization

Cultural problem

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Benefits of an International Joint venture

Access to new markets and distribution networks

Increased capacity

Sharing of risk with partner

Access to greater resources, including specialized staff and Technology

A joint venture can also be very flexible

Popular with transport, travel and courier companies that operate in different countries

Problems likely to arise if:

The objectives of the venture are not 100% clear and communicated to everyone involve

The partners have different objectives for the joint venture

There is an imbalance in the level of expertise, investment or assets brought into venture

by different partners

Different cultures and management styles results in poor integration and cooperation

The partners don’t provide sufficient leadership and support in early stages

A contractual joint venture, such as distribution agreement, can include termination

conditions

The company can give time periods notice to terminate the JV

One company can buy out other

The original agreement should also set out what will happen when the joint venture comes

to an end

How shared intellectual property will be unbundled

How confidential information will continue to be protected

Who will be entitled to any future income arising from the JV activities

Who will be responsible for any continuing liability e.g. debts and guarantees given to

customers Understanding the cultural background of all countries involved

Negotiating win-win contract

Having comprehensive JV agreements which lays down a road map of duties and

obligations of all the parties involved

Having a workable and efficient dispute resolution mechanism

Involving lawyers from all the jurisdictions early on

Giving scope for international contingencies and environment

Understanding legal and regulatory regime of all the jurisdictions involved

Termination terms and conditions

Some examples

Lee cooper’s joint venture with Pantaloon Retail (India) to market Lee cooper’s denim apparel in India

Fossil in 50:50 joint ventures with Rajesh Exports