The outsourcing movement to India is gathering momentum with such force that it is fueling the start of strong M&A activity in India. This can be seen in the recent IBM acquisition of Daksh E-Services and the Flextronics acquisition of a majority stake in Hughes Software Systems.

The recent M&A activity has perhaps arisen because the normal setting up process of about 3-4 months is considered too long. Further, the quest for good human resources has become quite competitive in the recent past, fueling the need for international businesses to acquire existing Indian operations.

An acquisition in India can however involve numerous regulatory hurdles requiring some innovative solutions.

Asset Purchases
Buying over the assets of the target company is normally the preferred option of a U.S. company. This is because one can purchase the business only with identified liabilities and because historical corporate liabilities would not transfer.

Typically, a foreign investment approval is required from India’s Foreign Investment Promotion Board (FIPB) whenever a foreign company acquires existing shares in an Indian company. However, this does not prevent a foreign company setting up its own subsidiary that does not require FIPB approval. It can then buy over the assets of the target company.

This option is however limited in view of conditions attached to the tax holiday likely to be enjoyed by the target company. These companies are subject to a 100% income tax holiday that is expected to remain in place till 2009. A key condition of the tax holiday status is that the tax exempt unit cannot be set up through a re-construction of an existing unit or through the use of a stipulated percentage of previously used plant and machinery.

The option exists of selling the tax-exempt unit as a going concern, which is slightly different from an asset sale and referred to under Indian tax law as a “slump sale”. This can be quite beneficial for the sellers as it is likely to attract the lowest tax possible (long term capital gains tax) and is likely to avoid sale tax.

However, there are doubts whether the re-construction condition above would be attracted—only the ownership of the tax-exempt unit is transferred and no new unit is actually formed. In view of the importance of the income tax exemption to these businesses, this option is resorted to less frequently.

Another downside of this method from the sellers’ perspective is that the sale proceeds flow to the company and not to the shareholders. The company would probably have to pay tax on the sale proceeds (since this does not arise from software/BPO exports) and then, dividend the proceeds out to the shareholders, which could attract a further dividend distribution tax.

Stock Purchases
Purchasing the shares of the target company involves obtaining an approval of the FIPB. This typically involves a 2 month process, between signing and closing of the agreement during which the application is filed and the approval processed by the FIPB. One interesting aspect of these transactions is the differentiation between shares held or to be purchased by Indian residents and non residents. If a non resident is purchasing shares from another non resident, no approval is likely to be required. If on the other hand, the non resident wants to purchase the shares from a resident Indian or a Non Resident Indian (who might have purchased the shares earlier under a special scheme), approval is required.

RBI Approval
The bigger regulatory issue relates to the approval under exchange control laws from the Reserve Bank of India (RBI), India’s central bank. This approval is required if shares are purchased from Indian residents by a foreign company—RBI has standard valuation norms and needs to approve the price.

This is something that would normally surprise a foreigner —that the RBI would want to dictate what the price would be; something that would normally be a matter of negotiation between the parties. The approval relates to India’s intention of regulating the movement of foreign currency in and out of India—the logic is that the foreign company must pay an adequate price for the shares.

A way around this is where the foreign company sets up or has a subsidiary in India and the subsidiary purchases the shares. This does not necessarily follow the spirit of Indian law but appears to be the accepted view. This is not the cleanest structure from a tax perspective as it could create an additional layer of taxation.

Valuations and Payments
The effect of the above is that to the extent possible, a foreign company would prefer to purchase shares held by non residents directly but have the shares held by the Indian residents purchased by the Indian subsidiary of the acquirer. This eliminates the need for the RBI approval.

Obtaining an RBI approval is not necessarily a problem especially because typical valuations are based more on the worth of the human resources and the opportunity that can be harnessed by their addition to the acquirer. Therefore, the price is likely to be much higher than traditional valuation modes—book value, PE multiples, and so on.

The problem with RBI relates more to the process of obtaining the approval. One has to obtain an in-principle approval first, for the acquisition and then, a final approval, after the money has come into India. Until the final approval is obtained, the shares cannot be transferred. This creates a difficulty for the acquirer—why would he want to pay the sellers their money before the shares are transferred? In reality, transfer documentation is signed and delivered prior to receipt of payment or an escrow arrangement is adopted.

The biggest problem arises when there is a holdback—a very typical requirement of an acquisition. If the holdback reduces the price below the RBI norms, obtaining RBI approval until the holdback has been cleared is more or less impossible. Even if the price minus the holdback is higher than the RBI norms, it is difficult to obtain RBI approval.

In this situation, one could agree on the holdback separately but there would be a concern that one is not disclosing the full price. The amount could be treated as a bonus and de-linked from the share consideration. This however has a tax implication on the sellers, who would be taxed on the holdback amount as regular income rather than capital gains.

If the sellers are not agreeable to this, the option left is to pay the entire money to the sellers and have the holdback amount paid back to the acquirer. This involves a complicated escrow arrangement with the bank and even this, unless structured carefully, may fall foul of the RBI requirements.

Individual Shareholders and Stock Options
Another concern relates to purchase of shares or options held by employees. Typically, employee stock option regulations of many Indian companies are somewhat simplistic and do not necessarily deal with what happens in the case of an acquisition.

An international company would typically like to own the Indian company 100% and this means purchasing the shares from all the shareholders. If the ESOP regulations do not deal with what to do with options, the acquirer has to negotiate a way out with each employee.

Swapping the Indian stock for stock of the acquirer is one possibility. This is mostly possible in the case of employees as Indian exchange control laws permit exercise of stock options through a cashless method that does not involve payment of foreign currency out of India. However, it would be difficult for the acquirer to do a stock deal in the case of Indian individuals who are not employees because it is difficult to get permission for them to hold foreign stock.

Due Diligence on Indian Software Companies
Legal due diligence on Indian software companies can often be quite mundane. Ownership or dependence on intellectual property for revenue is rare. Indian private companies tend to be largely in compliance with regulatory, corporate and employment law requirements but rarely reach the level of compliance of an international company. Generally, this would not reflect badly on company management and is more attributive of the legal compliance culture in India.

Verifying whether the company is entitled to avail of the tax holiday is a more complicated and important issue. This involves checking various things, including the purchase of equipment, change in ownership, dates of setting up and expansion of the tax-exempt unit, and so on. The loss of the tax holiday could significantly impact such a company, especially if the parent intends to infuse further capital and expand the operations and has less flexibility under tax laws to re-organize the business.

Another key issue relates to tax inclusive prices in contracts signed by the Indian company—there is a possibility that the Indian government will impose a service tax on IT related exported services. Once this happens, Indian software companies that have agreed to tax inclusive prices, particularly in fixed price projects or where rates are locked in for longer terms would suffer. Consequently, this is an important issue to consider in the contracts that the company has with its customers.
Stephen Mathias co-chairs the Technology Law Practice of Kochhar & Co, a law firm in India. He is a renowned information technology lawyer in India and cited by Global Counsel as the Leading Lawyer in India for Information Technology and E-Commerce legal work. He can be reached at stephen.mathias@bgl.kochhar.com