Irritant for PE players as M&As face friction over tax indemnity clause

Buyers and sellers are clashing over how long they are willing to take responsibility for future tax liabilities, after the government allowed the tax department more time to relook at old transactions.

This has emerged as a headwind in transactions for private equity (PE) players in particular. It comes amid a record number of PE-backed mergers and acquisitions over the last two years. Private equity funds are essentially schemes, which take money from a number of rich investors and use it to buy large stakes in companies. Sometimes they buy out the existing owner entirely. Funds were doing as many as five such buyout transactions a week in 2019 and 2020, according to data from London Stock Exchange Group deal tracker Refinitiv. Both years marked a record in terms of the number (281) of such transactions.

Discussions are said to have been heating up over how long a tax indemnity clause, which is part of such deals, should run, according to multiple people familiar with the matter. People are unwilling to take responsibility over extended periods of time which can now result in scrutiny ten years after the deal.

"PE players are negotiating a middle ground, working out an indemnity for a period of seven years or so," said Bijal Ajinkya, Partner, Khaitan & Co. She added that it is easier for a strategic player to make such deals since they are not constrained by lifespan considerations.

Private equity funds often have a life of around five years which is extended by another two years or so, pointed out EY India financial services tax partner Anish Thacker. This would mean that a tax indemnity clause stretching to a decade would have to outlive the scheme.

"Fund lives are not that long," he said.

The tax department earlier had the power to look at transactions for a period of six years. This has been increased to ten years in the latest budget for transactions over Rs 50 lakhs. The average buyout transaction in 2020 was worth over Rs 300 crore, shows an analysis of Refinitiv data.

The budget actually announced that the reassessment window was brought down from six years to three years for all transactions. The government then also added an exception where the asset involved is worth Rs 50 lakhs or more.

Notice cannot be issued “unless the Assessing Officer has in his possession books of accounts or other documents or evidence which reveal that the income chargeable to tax, represented in the form of asset, which has escaped assessment amounts to or is likely to amount to fifty lakh rupees or more for that year”, said the finance bill document.

Shares and securities are also considered assets. This means that when a private equity fund buys shares in a company in 2021, it could be subject to reassessment in 2031. The total value of buyout transactions in 2019 was $12.8 billion in 2020 shows Refinitiv data. It was $25.5 billion in 2019. This translates into over Rs 2.5 lakh crore worth of deals over the last two years.

Tax insurance and escrow accounts (which hold amounts to cover future liabilities) are among the ways that people are said to be looking to resolve the deadlock.