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:
1.
2.
3.
4.
•
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
2
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:
3
…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.”
4
…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.”
5
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
company may be undervalued
• Tax benefits
target
6
…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.
7
…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.
8
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
Company
‘A’
Company
‘B’
100,000
300,000
60,000
100,000
160,000
400,000
Long term liabilities
50,000
60,000
Current liabilities
60,000
90,000
270,000
550,000
Fixed assets
150,000
390,000
Current assets
120,000
160,000
270,000
550,000
Example ‘1’
Share capital
Reserves
– Pay cash of Rs
125,000.
9
…Purchase method
• On the date of the acquisition, fixed assets of
Company ‘A’ are re-valued in the following
manner shown
Revaluation of fixed assets of Company ‘A’
Net Book
Value
(Rupees)
Land
Plant and machinery
Other assets
Fair Value
(Rupees)
30,000
50,000
100,000
150,000
20,000
30,000
150,000
230,000
10
…Purchase method
• The ‘post
acquisition’ balance
sheet of Company
‘B’, under the
Purchase method
would appear as:
Balance Sheet
Share capital
-Original shares
-New shares
(Rupees)
300,000
83,333
383,333
Share Premium
41,667
Reserves
100,000
Long term loans
(A:50,000 + B:60,000)
110,000
Current liabilities
(A:185,000+B:90,000)
275,000
910,000
Fixed assets
(A:230,000+B:390,000)
620,000
Goodwill
135,000
Current assets
(A:120,000+B:160,000-125,000)
155,000
910,000
11
…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
Balance Sheet of
Company ‘A’
Share capital
(Rupees)
100,000
Reserves
60,000
Gain on sale of net
assets
90,000
250,000
Shares in Company ‘B’
125,000
Receivable from
Company ‘B’
125,000
250,000
12
…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
13
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:
Fixed assets of Company ‘A’
Net Book
Value
(Rupees)
Land
Plant and machinery
Other assets
30,000
100,000
20,000
150,000
14
…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:
15
Comparison
Balance sheet of
Company ‘B’
Share Capital:
-Original equity
-New issue
Pooling of
interest
method
Purchase
method
(Rupees)
(Rupees)
300,000
150,000
300,000
83,333
450,000
383,333
-
41,667
Reserves
160,000
100,000
Merger reserve
(50,000)
-
Long term liabilities
110,000
110,000
Current liabilities
150,000
275,000
820,000
910,000
540,000
620,000
-
10,000
280,000
280,000
820,000
910,000
Share Premium
Fixed assets
Goodwill
Current assets
16
Corporate law and Pooling of
interest
• Corporate
statutes
allow
the
companies to re-organize or reconstruct
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.
17
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
18
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:
19
…Acquisition of shares
Example ‘2’: Consider the
following
Taxable income/ (loss) for the year
Holding
company
Subsidiary
company
(Rupees)
(Rupees)
100,000
(50,000)
Tax thereon @ 35%
35,000
-
Cash outflow
35,000
(Rupees)
Under Group relief:
Taxable income of holding company
100,000
Taxable loss of subsidiary company
(50,000)
50,000
Tax thereon @ 35%
17,500
Cash outflow under group relief
17,500
20
3. Financing through debt
Example ‘3’: Parent company (non-resident) would attract
incidence of Pakistan tax, through equity investment and through
debt instruments in the following way:
Profit and loss account
Profit before tax and interest
All equity
investment
Debt/ equity
investment
(Rupees)
(Rupees)
100,000
100,000
-
50,000
100,000
50,000
Tax @ 35%
35,000
17,500
Profit after tax, available for
distribution
65,000
32,500
Dividend
65,000
32,500
-
-
Less: Interest charges on
borrowed funds
21
…Financing through debt
Share of the (non-resident) parent company:
All equity
investment
Debt/ equity
investment
(Rupees)
(Rupees)
Interest
-
50,000
Less: Taxes @ 10%1
-
5,000
-
45,000
65,000
32,500
6,500
3,250
58,500
29,250
58,500
74,250
Dividend
Less: withholding taxes @ 10%
Net receipts
Loans through a favourable Treaty country. Exemption can also be considered in the light of
few advantageous provisions in the Second Schedule available for ‘industrial undertakings’.
1
22
…Financing through debt
Gain to the (non-resident) parent company in
financing through debt:
(Rupees)
Receipts from ‘leveraged’ company
74,250
Receipts from ‘all equity’ company
58,500
Increase in wealth
15,750
Saving in taxes on interest
(Rs 50,000 x 35%)
17,500
Adj: Tax payable on interest income
(Rs 50,000 x 10%)
5,000
Less: Taxes deducted at source on
dividend income (Rs 32,500 x 10%)
3,250
Net gain in taxes to the non-resident
1,750
15,750
23
…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 nonresident 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 debtto-foreign equity ratio of 3-to-1. This point is further
illustrated by the following example ‘3’
24
…Financing through debt
Example ‘4’: Assume a Company ‘A’, wholly owned subsidiary of
Company ‘B’ (the non-resident holding company) claims an
amount of Rs 150,000 on account of interest paid on money
borrowed from the Company ‘B’. Also assume that:
(Rupees)
Loan from Company ‘B’
3,500,000
Investment in equity by Company ‘B’
1,000,000
Excess amount of debt will be
[(foreign equity x 3) – total debt]
500,000
Computation of inadmissible deduction:
Total interest claimed
Less: inadmissible portion of interest
[(excess debt x total interest)  total debt]
Allowable deduction under section 106
150,000
21,429
128,571
25
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.
26
…Capital gains
Example ‘5’: Assume that the ‘non-resident holding
company’ is situated in ‘Mauritius’ and owns 10,000 shares
of a resident company. The balance sheet of the resident
company reveals that
Share capital
(10,000 shares @ Rs 10per
share)
Reserves
Share price (per share)
Year 1
Year 2
(Rupees)
(Rupees)
100,000
100,000
-
50,000
100,000
150,000
10
15
27
…Capital gains
(Rupees)
Receipts from resident company:
Dividends
Less: tax withheld @ 10%
Net dividend received
50,000
5,000
45,000
Gain on sale of shares:
Sales proceeds (10,000 shares @ Rs 15 per share)
150,000
Purchase price (10,000 shares @ Rs 10 per share)
100,000
Capital gain from sale of shares
50,000
(exempt under Article 13 of the DTT with Mauritius)
28
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