For the investment environment to be mellifluous, it is important for different arms of the state to orchestrate their policies in harmony. If each member of an orchestra were to play her instrument at a different pitch, or worse, if each were to strive hard to play better to hide the other members' errors, there would only be cacophony, not music. One such example is the long-standing problem of tax treatment for shares tendered in response to open offers under the takeover regulations, and how different arms of the state are acting in their own wisdom.
The tax regime in India is unjustifiably slanted against public shareholders who tender shares when an open offer is made under the takeover regulations. When one sells shares on a stock exchange, one only pays a tiny securities transaction tax. Payment of this tax leads to an exemption from tax on capital gains on the sale. When one sells outside the stock exchange, the seller has to pay capital gains tax - at a higher rate on short-term capital gains (profits on shares held for less than a year) and at a lower rate on long-term capital gains (profits on shares held for at least a year). Tendering the shares to an acquirer under an open offer is outside the stock exchange and therefore the benefit of paying the securities transaction tax is not available to the seller.
The very need for an open offer under the takeover regulations is to provide an exit to the public shareholders when there is a change in substantial shareholding in a listed company, on terms similar to the terms on which the substantial acquisition takes place. An open offer transaction is therefore a transparent public transaction with pricing, timing and scale of the transaction being intensely regulated by the securities market regulator. When an open offer is made for shares of a listed company at a premium to the prevailing market price - typically because a substantial shareholder has agreed to sell at a premium to the market price - the market would react with the price rallying upwards to the offer price. This is quite logical since it would make sense to buy on the stock exchange and sell to the acquirer by tendering in response to the open offer.
Now, when the market price nears the open offer price, a public shareholder is better off selling on the stock exchange, and paying just a tiny securities transaction tax instead of paying a higher capital gains tax. As a result, despite the intention of the law in mandating open offer transactions for a timely exit for public shareholders on terms similar to the substantial acquisition, the exercise becomes a farce with the intended beneficiaries not really fancying the benefit of tendering shares in response to the offer. If selling at a lower price on the stock exchange to pay securities transaction tax at a tiny tax rate is more remunerative than tendering at a higher price under the open offer and paying a high capital gains tax, it is evident that the policy choice is flawed.
Open offer transactions impose a significant compliance cost to the acquirers and the target companies and in reality to give a benefit to the public shareholder, who, because of the tax anomaly, sees no benefit in it at all. Therefore, the transaction cost inflicted on the market is without any commensurate benefit being enjoyed.
The Takeover Regulations Advisory Committee that re-wrote the takeover regulations (Disclosure: the author was a part of the committee) studied this flaw and its impact on the M&A market in 2010, and stated in its report that such a policy is undesirable. "Off-market deals, by their very nature, are entered into between private individuals in a non-transparent and largely unregulated manner. On the other hand, open offer, as an activity, is highly regulated and all the parties involved in the process are required to follow the provisions laid down in the Takeover Regulations, including various disclosures requirements," the report stated. "Also, the basic objective of an open offer is to benefit investors at large by granting them a just and fair exit opportunity. It would perhaps not be correct to club a regulated and investor friendly activity like open offers in the same bracket as an off-market deal." The Committee recommended that the securities market regulator should take this up with the government of India to "bring parity in the tax treatment given to the shareholders who tender their shares in an open offer and those who are selling the same in the open market". Now, the correct policy solution would be to reform this anomaly by either bringing sale in an open offer on par with selling on the stock exchange. That is not happening. Instead, the securities market regulator is now creating a framework whereby the tendering in response to an open offer is forced to be structured through a stock exchange clearing mechanism. Now, that is a new transaction cost on the acquirer, who would have to pay the stock exchange a fee for providing a clearing and settlement service.
Besides, there is no assurance that the taxation authorities who are reluctant to openly amend tax law would play ball. There is a risk that they would argue that such a transfer is not really on a stock exchange - in the past there have been reports of tax assessment officers seeking to claim that block trades are negotiated trades and are not truly sales in the market. The creative solution to a tax problem could spur creative perversions to tax the transaction. In the others words, the solution can pose new problems, for which there may be other patchwork solutions that become yet newer problems.
It is time to take the bull by the horns to clean up this anomaly. Using a thorn to remove a thorn is not always pleasant and surgically hygienic.
The tax regime in India is unjustifiably slanted against public shareholders who tender shares when an open offer is made under the takeover regulations. When one sells shares on a stock exchange, one only pays a tiny securities transaction tax. Payment of this tax leads to an exemption from tax on capital gains on the sale. When one sells outside the stock exchange, the seller has to pay capital gains tax - at a higher rate on short-term capital gains (profits on shares held for less than a year) and at a lower rate on long-term capital gains (profits on shares held for at least a year). Tendering the shares to an acquirer under an open offer is outside the stock exchange and therefore the benefit of paying the securities transaction tax is not available to the seller.
The very need for an open offer under the takeover regulations is to provide an exit to the public shareholders when there is a change in substantial shareholding in a listed company, on terms similar to the terms on which the substantial acquisition takes place. An open offer transaction is therefore a transparent public transaction with pricing, timing and scale of the transaction being intensely regulated by the securities market regulator. When an open offer is made for shares of a listed company at a premium to the prevailing market price - typically because a substantial shareholder has agreed to sell at a premium to the market price - the market would react with the price rallying upwards to the offer price. This is quite logical since it would make sense to buy on the stock exchange and sell to the acquirer by tendering in response to the open offer.
Now, when the market price nears the open offer price, a public shareholder is better off selling on the stock exchange, and paying just a tiny securities transaction tax instead of paying a higher capital gains tax. As a result, despite the intention of the law in mandating open offer transactions for a timely exit for public shareholders on terms similar to the substantial acquisition, the exercise becomes a farce with the intended beneficiaries not really fancying the benefit of tendering shares in response to the offer. If selling at a lower price on the stock exchange to pay securities transaction tax at a tiny tax rate is more remunerative than tendering at a higher price under the open offer and paying a high capital gains tax, it is evident that the policy choice is flawed.
Open offer transactions impose a significant compliance cost to the acquirers and the target companies and in reality to give a benefit to the public shareholder, who, because of the tax anomaly, sees no benefit in it at all. Therefore, the transaction cost inflicted on the market is without any commensurate benefit being enjoyed.
The Takeover Regulations Advisory Committee that re-wrote the takeover regulations (Disclosure: the author was a part of the committee) studied this flaw and its impact on the M&A market in 2010, and stated in its report that such a policy is undesirable. "Off-market deals, by their very nature, are entered into between private individuals in a non-transparent and largely unregulated manner. On the other hand, open offer, as an activity, is highly regulated and all the parties involved in the process are required to follow the provisions laid down in the Takeover Regulations, including various disclosures requirements," the report stated. "Also, the basic objective of an open offer is to benefit investors at large by granting them a just and fair exit opportunity. It would perhaps not be correct to club a regulated and investor friendly activity like open offers in the same bracket as an off-market deal." The Committee recommended that the securities market regulator should take this up with the government of India to "bring parity in the tax treatment given to the shareholders who tender their shares in an open offer and those who are selling the same in the open market". Now, the correct policy solution would be to reform this anomaly by either bringing sale in an open offer on par with selling on the stock exchange. That is not happening. Instead, the securities market regulator is now creating a framework whereby the tendering in response to an open offer is forced to be structured through a stock exchange clearing mechanism. Now, that is a new transaction cost on the acquirer, who would have to pay the stock exchange a fee for providing a clearing and settlement service.
Besides, there is no assurance that the taxation authorities who are reluctant to openly amend tax law would play ball. There is a risk that they would argue that such a transfer is not really on a stock exchange - in the past there have been reports of tax assessment officers seeking to claim that block trades are negotiated trades and are not truly sales in the market. The creative solution to a tax problem could spur creative perversions to tax the transaction. In the others words, the solution can pose new problems, for which there may be other patchwork solutions that become yet newer problems.
It is time to take the bull by the horns to clean up this anomaly. Using a thorn to remove a thorn is not always pleasant and surgically hygienic.
The author is a partner of JSA, Advocates & Solicitors. The views are his own. somasekhar@jsalaw.com