The stock market boom of 2003-07 marked a dynamic shift in the attitude of Indian promoters towards the exit from a family-run business. Not even a decade ago, India promoters would shy away from an exit call, but the last few years witnessed several promoter buyouts of Indian listed companies by foreign or large Indian players seeking to consolidate market position.
Indian promoters are, generally, hands-on when it comes to running (and not just managing) the business. They are often a repertoire of valuable high-end technical/commercial expertise or sensitive business data (clients, trade data, etc.), essential to run the company. So, to protect the interests of the target company upon their exit, the acquirer would impose a negative covenant on outgoing promoters to carry out similar business. Commercially, this translates into a non-compete payment to the promoter over and above the agreed purchase price of the shares being acquired.
While the commercial rationale cannot be doubted, non-compete payments have been a matter of debate, under both the Securities and Exchange Board of India’s (Sebi) takeover code and the Income-tax Act. Recently, the issue came up for consideration before the Securities Appellate Tribunal (SAT) in Tata Tea’s case in a 15 September ruling.
The SAT ruling dealt with the acquisition of 24.15% equity by Tata Tea (the acquirer) in Mount Everest Mineral Water Ltd (the target). As part of this, the acquirer also made a non-compete payment to the outgoing promoters of about Rs3 crore (less than 25% of the purchase price) over and above the purchase price of Rs150 per share. The acquisition (more than 15%) triggered an open offer under the takeover code. The key issue for evaluation was whether the non-compete component paid to the promoters should be factored in to calculate the offer price payable to the target shareholders under the open offer.
The Takeover Code [Regulation 20(8)] provides that where the non-compete fee payment exceeds 25% of the offer price, the excess thereof would be added to the offer price paid to the target shareholders under the open offer. This clause was inserted by a 2002 amendment made on the recommendation of the Bhagwati committee.
SAT observed that the Bhagwati committee report clearly recognizes the legitimacy of non-compete payment to outgoing promoters, and specific provisions are also introduced in the code to deal with this. Given that the non-compete payment was well within the 25% benchmark provided under the specific legislative framework, SAT held that Sebi has a limited role to play.
While SAT did not completely rule out a scrutiny by the board, it nonetheless highlighted that such an inquiry would be limited to evaluating that the non-compete is not a mere device to reduce the offer price and no further. Thus, if the payment is made to an outgoing promoter who can offer competition to the target company, having regard to the facts, the board should have no occasion to interfere. In this context, the key factor for evaluation should be whether the outgoing promoter is capable of providing competition and not just whether the business was dependent on it.
Illustration: Jayachandran / Mint
SAT further observed that the terms of the non-compete payment should necessarily be determined by the parties concerned and the business consideration on it are not open to question by Sebi or SAT. Thus, it would not be open to sit in judgement on the threat perception of acquirer vis-à-vis the quantum of non-compete payment.
Incidentally, in the said case, the outgoing promoters continued as minority shareholders of the target and were also on the company’s board. The issue arose as to whether the non-compete was justified given the continuing association of the outgoing promoter with the target company. It was argued that a director is in a fiduciary position vis-à-vis the company and cannot take up a private venture with conflicting interest and, thus, there was no possibility of competition to warrant a non-compete.
SAT observed that there was nothing on record to suggest that the continuing association cannot be terminated (director resignation or sale of minority stake). Thus, the association should not bar the non-compete, which is otherwise justified.
The key takeaway is that the ruling reiterates an important recognition that promoters who participate in the day-to-day operation and management of a company are to be distinguished from other institutional/retail investors. Such outgoing promoters can pose a serious threat to the interests of the new acquirer and the target company (as also its continuing shareholders) and, in such circumstances, a non-compete payment, separate from and over and above the purchase price, is commercially justified. Naturally, the parties involved are the best judges of the commercial rationale and it is best left to them to decide the commercial terms.
The tax aspects, really speaking, have two angles— taxability of recipient and deductibility in the hands of the payer. The theme though is common—whether the non-compete is to be treated as distinct and separate from the price of the shares/business and, hence, a separate tax treatment should follow.
The controversy relating to taxability was put to rest by amendments to section 55/28 of the Income-tax Act, seeking to specifically tax such receipts. Hitherto, courts had generally held non-compete as a capital receipt distinct from the sale consideration and, hence, not exigible to tax. Obviously, these cases are no longer relevant. Incidentally, the current law prescribes a 10% withholding on non-compete payments.
In so far as deductibility aspect is concerned, in the absence of any specific provisions, the test was laid down by the Supreme Court in Coal Shipments’ case. Where the non-compete is for an enduring benefit, the payment is on capital account; on the other hand, if the payment is for a transitory period or terminable at the volition of the parties, the payment is eligible for deduction. Incidentally, the direct tax code recognizes non-compete fee as a deferred revenue expenditure eligible for amortization @25% on written down value basis.
Summing up, the Tata Tea ruling should provide some certainty on determining the offer price where the non-compete payment is within the 25% benchmark provided under the takeover code and facilitate potential suitors seeking to acquire existing promoter stakes in Indian listed companies, involving non-compete payments. The arguments advanced in the SAT ruling should also help fortify the position that the non-compete fee is on a different footing than the acquisition price and hence, a differential treatment is warranted under the tax laws as well, as accorded under the Takeover Code.
Ketan Dalal is executive director and Vishal Shah is associate director, PricewaterhouseCoopers.
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