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Service tax norm could make M&A deals costly
March, 29th 2012

Acquisitions made in India could become more expensive if service tax is levied on key elements of a transaction such as non-compete fees that have been excluded from the governments negative list of service tax exemptions.

With a possibility of a 12% service tax on such services, sellers could begin seeking an extra premium to offset the extra tax payout, experts said.

A non-compete fee, typically paid to promoters as part of an acquisition deal to prevent them from competing with the sold business for a stipulated period of time, will come directly under the service tax radar.

Almost all buyout and merger and acquisition (M&A) deals have non-compete agreements and the fee, at times, could account for almost a fifth of the deal value.

The cost of M&A deals will increase since the new service tax regime now includes certain declared services being subject to payment of service tax, said Rukshad Davar, partner, corporate and M&A, at law firm Majmudar and Co.

Specifically one of the declared services being included is agreeing to the obligation to refrain from an act which means that non-compete payments will also be caught in the service tax net, he added.

Service tax is an indirect tax imposed on certain services such as broadcasting, banking, advertising and intellectual property services, among others. It was introduced in July 1994 and covers all service providers in India, except those in Jammu and Kashmir. The rate of service tax has now been increased to 12.36% (including education, cess and surcharge) of the cost of services rendered, compared with 10.2% earlier.

If a non-compete agreement is accompanied with a consideration, then it will be taxable at 12% under the new list of service tax, said Prashant Deshpande, leader-indirect tax, Deloitte India.

The cost of buyout and M&A deals will go up, and a non-compete agreement is clearly taxable going forward, agreed Mayank Rastogi, partner, private equity and transaction advisory services, at Ernst and Young India.

If the proposal is implemented as it is, then there would be a tax exposure. It will increase cost of transaction by 12%, said Abhishek Jain, director, BMR Advisors. The service tax is paid by the service provider barring cases in which the service provider is not based in India. The definition of service is: any activity carried out by a person for another for consideration and includes a declared service.

The definition says that service does not include any activity that constitutes only a transfer in title of goods or immovable property by way of sale, gift or in any other manner.

According to the budget, the negative list of services primarily includes specified services provided by the government or local authorities, services in the fields of education, renting of residential dwellings, entertainment and amusement, public transportation, agriculture and animal husbandry.

A number of other services, including healthcare and services provided by charities, independent journalists, sportspersons and performing artists in folk and classical arts are also exempt from service tax. Escrow services will also attract service tax, said experts. In their bid to hedge unseen risks, buyers often demand warranties to protect themselves against the possibility of the company having unexpected liabilities, or information on which they had relied proving to be false.

For instance, in situations where a company under consideration for a takeover has a case going on in a court, investors often seek indemnification through an escrow account. Under this, the maximum liability amount is put in the escrow and the buyer will have access to it depending on the outcome of the ruling.

These escrow accounts are now liable to service tax as escrow is a service provided by the bank.

Direct dispute settlement going forward could attract service tax, said Rajendra Nalam, partner, BMR advisors.

Not just in buyout deals, non-compete agreements between former business partners, siblings or other family members and organizations could also attract service tax. Meanwhile, with the likelihood of service tax increasing the cost of deals, lawyers have already started working on restructuring agreements.

Promoters want maximum capital out of the deal for themselves. One way of restructuring is by reducing non-compete fees and increasing the enterprise value of the company, said a Delhi-based lawyer, who is working on two such transactions. He did not wish to be identified, citing client confidentiality.

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