Past Liabilities And Its Future Contingencies

To address the ambiguity of pre-transactional liability; is where the purpose of writing this article lies, in the interest of full disclosure it is of paramount importance to clarify it is not necessary that after reading the article the reader would be able to find clarity rather on the contrary the reader might end up feeling bemused about the grey areas of law.

Having said that, the author will find great pride if this article compels the reader to ponder and reflect on this topic.1

BACKGROUND

Although there are many avenues to acquire a business of one company, by means of the article our main focus will be towards two types of transactions: -

1. Share Purchase

2. Slump sale

Share purchase as the name indicates it encompasses in itself the purchase of shares of the target company by an acquirer, whereas, Slump sale is a sale of business/undertaking without assigning a specific value to all the assets.

Having said that acquisition of an existing business can bring liability issues not only to the buyer but also to the government departments/creditors and in view of the transaction it is to be ascertained who is liable to indemnify the department or other creditors.

Addressing the first and foremost situation when an acquisition takes place, among the many kinds of acquisition one thing that stays common is the preparation of inventory consisting of the list of assets and liabilities.

Generally in an asset purchase, the buyer company is not liable for the seller company's debt and liabilities, but that’s not what this article is about, rather it’s an attempt to unravel the tricky transactions such as a stock purchase/ stock sale where along with the assets the liability of the company is also purchased.

The first question that might arise in one’s mind is why does a transferee even assume the liability of the company, in the current paradigm, out of the many possible reasons, one reason can be that when the buyer assumes the seller’s liability in exchange he gets a lower sale price even for the assets, thus the venture becomes profitable.

The above-mentioned transaction thus becomes an act of stepping into the shoes of his predecessor/seller. The buyer takes on all of the seller’s debts and obligations. From the buyer’s perspective, the word liability can envisage from a bank loan to a lawsuit.

Now the issue which may arise with such transaction is about the liabilities which incurred prior to the sale and execution of the transaction when such liability is well within the knowledge of the purchaser at the time of execution of the purchase agreement and moreover the same is clearly spelled out in the recitals of the agreement, which is duly signed and verified by both the parties and the execution of which is not disputed by either party, this is precisely what this article attempts to contemplate.

Instead of addressing contingencies, we will address the liabilities which were in existence during the time of execution of the agreement and also acknowledged by the purchaser.

Assuming, a company is acquired by means of a share purchase agreement and at the time of execution of the agreement, along with the assets, the liabilities are also clearly stated and acknowledged by both parties. Once the agreement is executed and the liabilities are also purchased, then subsequently after the lapse of few years, the liability against a government department which was spelled out in the agreement matures, then in that case who will be liable to pay? Will it be the onus of the purchaser to indemnify the losses/liabilities of his predecessor as had assumed that liability or whether an arrangement between two private entities wouldn’t be of any consequence to the creditors/government department and they would continue to identify those liability accumulated during the time of predecessor as the seller’s liability.

Precisely this is the situation which this article tries to address.

LAWS INVOLVED: Legal analysis

The Hon’ble Supreme court has time and again held that the corporation has a legal personality and has its own existence, the entity of member is entirely distinct from its members and similarly, the liability of its shareholders is limited to the amount of capital invested by them.

For a more rudimentary understanding, let's understand the fundamental concept of Sale and where it's defined; as we all might be knowing Sale has been defined in the Transfer of Property Act, but more important than Sale, is an ancillary concept surrounding Sale, is Notice which has been defined in Section 3 of the Act, the concept of constructive notice

has been encapsulated within Section 3. The word notice in respect to the transfer of property Act is concerned with clean title and possession of the seller, likewise, an acquisition proceeding is concerned with due diligence of the company, having said that the fundamentals and the purpose of both remain the same.

For a better understanding of the term Slump sale we need to refer, now Slump sale as per Section 2(42C) of the Income-tax Act, 1961 is any sale where without values being assigned to the individual assets and liability and for a lump sum consideration.

Another major pre-condition of a slump sale transaction is that all assets and liabilities of the business undertaking must be transferred to the buyer.

Further, Explanation 2 specifically states that the determination of the value of an asset or liability for the sole purpose of payment of stamp duty, registration fees, or any other similar taxes or any kind of fees will not be regarded as an assignment of values to individual assets or liabilities.

According to Section 50B of the IT Act, the cost of acquisition of such sales should be the net worth (book value of assets and liabilities) of the undertaking.

Explanation 1 provides the method of computing the net worth of an undertaking or a division sold on a slump sale basis. As per Explanation 1 “For the purpose of this section “net worth” shall be the aggregate value of total assets of the undertaking or division as reduced by the value of liabilities of such undertaking or division as appearing in its books of account.

It will not be out of place to mention that a No objection certificate can also be obtained from the tax authorities: Under section 281 of the Income-tax Act, 1961, any transfer of any asset by a taxpayer during the pendency of any proceedings under the tax law shall be void as against any claim in respect of any tax or any other sum payable by the taxpayer as a result of the completion of the said proceeding, unless the taxpayer obtains a no-objection certificate from the income tax authorities for the transfer.

One must note that liabilities for indirect taxes are on the transaction and hence liability for the same is ascertained on each transaction. So, until transfer as a result of merger/demerger is completed, the liability of the transferor remains. Transferor Company continues to pay tax, file returns as if there is no proposal for merger/demerger as the case may be. In most cases, for past pending assessments both transferor and transferee remain jointly and severally liable.

The appointed Date is of no significance under the law. Till final merger/demerger order is received and filed with ROC to give effect to the scheme, the transferor/demerged Company continues to pay and files all the applicable indirect tax returns under its registration number. The liability relating to indirect taxes on the Transferor/demerged company remains until the effective date. The transactions between the Transferor Company and Transferee Company will be carried out on principal to principal basis. The Transferor Company continues to claim set-off in respect of transactions with Transferee Company up to the effective date. Similar provisions apply as regards payment and set off of customs and service tax and filing of various returns under the relevant acts.

In the case of ACIT v. HYT Engg. Co. (P.) Ltd. Where claims for export incentives and cash assistance formed part of assets of the undertaking acquired by way of slump sale, and the amount of the claim was received by the successor, the amount so received was held to be capital receipts. This was because the claims for export incentives and cash assistance were actionable claims purchased by the assess for a consideration. The same can be construed to be part of the cases of fructifying liabilities where the same is liable to be paid by the transferee.

Kerala High Court in the case of Zacharia vs. the State of Kerala held that in a situation where the entire assets of the transferor company along with only a few of the liabilities are transferred, the business may be considered to be transferred as a ‘going concern In this regard the Kerala High Court held that:

“The mere fact that the seller had undertaken to settle liabilities which had accrued prior to the sale of the business would not by itself show that the seller had not transferred the business as a whole. So long as there is nothing to suggest that any part of the assets was retained by the seller or any amounts standing to the credit of the business were taken over by the seller, it cannot be suggested that the business as a whole was not transferred”.

While an essential element of a ‘slump sale’ is that the assets and liabilities of theundertaking are transferred to ensure continuity of business, for a transaction to becharacterized as a ‘slump sale’, it is not essential that all assets are transferred. The Punjaband Haryana High Court has held that it is not essential that all assets are transferred for atransaction to qualify as a slump sale. Even if some assets of the transferor are retained by it, and not transferred to the transferee, the transaction may still retain the characteristic of aslump sale. However, for it to be considered a slump sale, it is essential that the assets (alongwith the liabilities) being transferred are an undertaking in itself, and can function ‘withoutany interruption’; held in Premier Automobiles Ltd. vs. Income Tax Officer and Anri. as approved in Commissioner of Income Tax vs. Max IndiaLtdii.

The continuity of business also assumes that all assets and liabilities of the concerned undertaking are transferred under the sale. This view has been upheld by the Supreme Court, whereby it held that an ‘undertaking’ was a part of an undertaking/ unit/ business when taken as a whole; held in R.C. Cooper vs. Union of Indiaiii. Additionally, the ‘net worth’ of the undertaking being transferred considers the book value of the liabilities to be reduced from the aggregate amount of assets of the undertaking, emphasizing the requirement of transferring liabilities.

The Supreme Court of India has, in a recent judgment McLeod Russel India Limited vs. Regional Provident Fund Commissioner, Jalpaiguri andothersiv, held the successor employer will also be liable to pay damages for any default in remitting provident fund (social security) contributions. While the default was committed by the transferor entity prior to the date of transfer of employees, the Supreme Court has clarified that the successor employer (i.e. thetransferee) shall not stand absolved of the liabilities even if such liabilities have been specificallyassigned to the transferor entity by way of an express agreement.

However it has been noted in the case of The Supreme Court, in CIT vs. Artex Manufacturing Cov, held that in order to constitute a slump sale there must be a sale of an ongoing concern as a whole and accordingly, where individual items cannot be bifurcated in respect of the entireconsideration.

In view of the above facts, reasons and legal analysis as stated hereinabove, it is amply clear that once a slump sale is done it is the complete liability of the successor to discharge his obligations, and any omission on the part of the successor cannot hold the predecessor liable, once he has sold his business in its entirety.