The new Companies Act proposes many changes for mergers and acquisitions that have far-reaching consequences. While it is expected to make it easier for companies to implement M&A schemes, the anti-abuse measures, particularly for accounting, will reduce window-dressing and tax-planning opportunities.
Historically, M&A schemes were often used to write off expenses both past and future, accumulated losses, deferred tax liability or doubtful assets against securities premium or other reserves. This resulted in a better balance sheet, profit-and-loss statement and earnings-per-share. SEBI ended this practice by asking listed companies to comply with accounting standards in an M&A scheme.
Later, the Ministry of Corporate Affairs required all regional directors/ Registrar of Companies to ensure that the accounting treatment clause in an M&A scheme complied with standards. This applied to non-listed entities too. The measure was only partly effective because it was not part of the statute.
Now, under the new Companies Act the tribunal will not sanction any M&A scheme unless the company’s auditor certificate of compliance with accounting standards is filed with it.
Interestingly, while the law has finally caught up, the principal standard on M&A — AS-14 Accounting for Amalgamations, which was issued in 1994 — is outdated, nebulous and incomprehensive.
For instance, there is no standard dealing with accounting for demergers. This offers multiple accounting choices for demergers such as the pooling or purchase method; treatment as dividend distribution by subsidiary to parent; treatment as return of capital by subsidiary to parent; accounting as purchase of business/ net assets; or push down accounting. The impact varies significantly for each choice and can be very complex.
Common sense dictates there would be no goodwill when a subsidiary demerges its business with the parent company or into another subsidiary company at the parent’s behest. However, in the absence of standards and the numerous choices, it is possible to account for goodwill or other intangible assets in a demerger scheme. Goodwill and intangibles created from the demerger of a subsidiary may be tax deductible.
Further losses incurred by the subsidiary would now be reflected as goodwill or intangibles and will improve the net worth of the parent company.
Alternatively, these losses can be adjusted against reserves. The requirement to comply with accounting standards does not impinge on the company’s ability to use courts powers for certain other restructuring. For example, capital reserves can be converted into distributable reserves.
Overall, it may be fair to conclude that the requirement to comply with accounting standards under the new Companies Act will considerably reduce tax-planning opportunities and balance sheet management.
However, only a full-fledged standard on M&A can ensure full justice is done to the anti-abuse measures. Comprehensive standards on M&A already exist under International Financial Reporting Standards. India needs to adopt them as soon as possible.
Another related area is treasury shares. The Act prohibits holding own shares (known as treasury shares) either by the transferee company or a trust in an M&A scheme.
Consider a subsidiary merging into the parent company. Typically, the cross-holding between the parent and subsidiary should be cancelled.
However, it is seen that the parent issues its shares to a trust as consideration for its shareholding.
The holding of treasury shares through a trust makes free float available for the company to raise finance in future, without going through the lengthy process of issuing additional shares. It may also help promoters prevent a hostile takeover, as the trust holding the shares will typically comply with the promoters.
Treasury shares also provide an accounting advantage, as the standards do not deal with their accounting, thereby offering several options.
A perusal of the publicly available financial information of a few companies with similar treasury shares indicates that dividend income and gain/ loss arising on sale of treasury shares are recognised in the P&L account.
This is inappropriate because one cannot derive income from transacting with oneself. The prohibition on treasury shares will mean that such accounting practices cannot happen once the Act becomes effective.
The author is Partner in a member firm of Ernst & Young Global