Corporate restructuring in response to COVID-19

Corporate restructuring in response to COVID-19

The outbreak of COVID-19 has resulted in a series of unprecedented challenges for economies around the world. Corporates worldwide are facing significant disruptions and uncertainties in terms of managing and operating their businesses. Taking swift measures for navigating through operational challenges such as blocked working capital, foreseeable losses, disrupted supply chains, business continuity risk and liquidity crisis has become a necessity.

In a recent report “Global Macro Outlook 2020-21 (April 2020 update),” Moody’s has projected that G-20 economies as a group to contract by 4% in 2020 with India’s growth forecast dropping to 0.2% for the said year. The uncertainty of the pandemic duration and the decline in economic activity is expected to coerce many companies to rethink the usual. In crisis times like these, businesses should identify measures to effectively utilize available resources. Albert Einstein rightly said, “In the middle of a difficulty lies opportunity.”In light of the same, some business restructuring opportunities that may not only aid but boost companies in these challenging times are discussed below:

1. Renegotiating inter-corporate debt contracts – In view of business halt and reduced liquidity, companies may find it difficult to meet regular interest and principal repayments. In an era where the Reserve Bank of India has also introduced interest moratorium, inter corporate debt contracts, both domestic as well as external commercial borrowings, may be renegotiated to provide for revised terms such as moratorium on interest and principal repayment, revised amortization schedule, extension of debt tenor, etc. This may lead to better cash availability, which was otherwise reserved to meet debt requirements; it can now be redeployed for core business operations. The above arrangement should be adequately documented such that there are no adverse corporate income-tax, transfer pricing or withholding tax issues.
2. Deleveraging by conversion of debt to equity – In order to deal with a situation where financial position has worsened due to the COVID-19 pandemic, Indian companies that had taken debt from group companies including overseas group companies may consider conversion of debt into equity or hybrid instruments. This may be important in situations where while the group company is earning interest income, the borrower company is in losses and not in a position to pay interest or take a tax deduction thereof. The situation becomes aggravated when the loan is taken from an overseas associated enterprise and the interest deduction is restricted to 30% of EBITDA for tax purposes. It will be imperative to retain the possibility of substituting the such converted instrument into debt in the future, if commercially sustainable.
3. Reorganising holding stake in listed companies -With significant drop in share prices, Indian groups may revisit their holding structure in listed companies. This may be considered as an ideal time for the consolidation or reorganisation of promoter shareholdings held in Individual hands into corporate structure/promoter’s holding company. It is important to note that dividend received by an Individual is subject to 35.88% tax, whereas if received by a company, such as a promoter holding company, it is subject to a lower tax rate of 25.17%. The promoter holding company may invest said dividend received from one business into another business as per the commercial requirement, or if need be, may distribute such funds to individual promoters at zero tax cost, in which case, individual promoters continue to be subject to the same taxation as if the dividend received directly from the listed company, i.e. remains at status quo from the promoter’s perspective.
4. Delisting – Companies contemplating delisting their securities in a pre-COVID situation, due to low trading volumes, low market capitalisation, low public holding, high compliance costs of listing, plans of increasing promoter stake, collaboration plans with other investors, etc., may assess if this is the right time for delisting, which would also reduce the overall compliance costs for them. Additionally, with stock prices touching all-time lows, valuations offered to public shareholders on exit in the present scenario may become an opportunity for the company.
5. Rationalisation of India holding structure – From financial year 2020-21, dividend tax law in India has been amended such that the dividend shall be taxable in the hands of the shareholder, unlike the pre-amendment era, where it was taxable in the hands of the Indian company. Thus, availing foreign tax credit of dividend paid in the source country should now become seamless for the overseas shareholder vis-à-vis the earlier regime, where dividend tax was levied on the Indian company. However, it is important to note that there may be challenges to claim foreign tax credit of the dividend paid by an Indian company by the ultimate shareholder where such Indian subsidiary is not directly held by the ultimate shareholder, i.e. held by an intermediate holding company. Thus, it may be evaluated if intermediate holding company is commercially required in the structure in view of overall group objectives or may accordingly be eliminated at current valuations to rationalise the overall structure, including easing availability of foreign tax credit of Indian dividend in the hands of the ultimate shareholder.
6. Withholding tax optimisation– With business impacted and reduced economic activity, businesses may reassess projections and explore if there is a need for obtaining a lower/nil-tax withholding order based on revised profit figures.
7. Optimisation of capital structure – For companies with retained earnings, dividend and buyback have been the primary modes of distribution to the shareholders. Dividend has now become more attractive with the availability of beneficial tax rate under the treaties due to the abolition of dividend distribution tax on Indian companies. At the same time while buyback continues to be taxed at ~23%, it may still be beneficial in some cases where the difference between the buyback price and subscription amount is not significant. Thus, performing an analysis of the two options before making a final decision may be beneficial.
For companies in the gestation period that have not yet reached break-even or have recently reached break-even, buyback may not be possible due to the paucity of profits. Such businesses may evaluate return of capital by way of capital reduction. Capital reduction is a Tribunal-driven process and may involve tax implications such as dividend tax and capital gains tax depending on the jurisdiction of the shareholder.
8. Realigning transfer pricing (TP) policies – Businesses should revisit their global/local TP policies, including reducing the margins for financial year 2020-21 to align it with the current economic situation to ease the financial burden, optimise cash flow management and ensure that the current policy does not create additional strain on deflated profit margins and cash flows. Various measures that could be evaluated in this context include interim margin reduction, invoking force majeure provisions to change pricing terms, extension in credit terms or deferral of invoicing, APA1 filings for long-term certainty or amendments in signed APAs, etc.
9. Salary optimisation – Amidst liquidity challenges, corporates may evaluate preparation of ESOP/ESPP2 schemes or a combination thereof for issuance of shares to employees. This will aid in managing cash flows of the company and simultaneously improve employee motivation and retention.
10. Tax implications for employees – The residential status of the employees based overseas who have travelled to India during COVID-19 and are stuck as such due to mobility restrictions needs to be evaluated under India domestic tax laws as well as tie breaker rules under the relevant treaty, and thus, may have adverse tax consequences in view of the extended period of stay. Although the Government has recently released an important circular for financial year 2019-20 on the issue of determining the residential status of persons who have been compelled to extend their stay in India owing to the outbreak of the COVID-19 and the suspension of international flights, it does not cover financial year 2020-21. Considering that the international flights ban and nationwide lockdown continued post March 2020, it is pertinent that relief be provided for the current financial year as well.
11. Place of Effective Management (POEM)/Permanent Establishment (PE) considerations – In continuation to the above, though the Govt has issued circular from an individual’s residential status perspective, no such relief has been provided for foreign companies. Overseas personnel stuck in India may also create a POEM or PE issue for the foreign companies, due to their period of stay. As per OECD guidance on the impact of COVID-19, such exceptional circumstances should not trigger a change in residency or PE status. While India is not an OECD member country, it needs to be evaluated on facts of each case whether the above guidance can be applied, and measures along with tax consequences may accordingly be enumerated.
12. Consolidation of businesses – Operating similar businesses through multiple entities leads to duplicity of costs and restricts utilisation of intra-group resources. Loans between group companies with common directors are not permitted and loans between companies having common shareholders are deemed as dividend for India income-tax purposes. Thus, having multiple entities within a group, particularly in a similar line of business, may not be optimal. Accordingly, consolidation of group companies at the domestic level can be explored as a way of addressing the liquidity concerns and for cash fungibility. Drop in valuations of assets during current time also makes consolidation of entities an attractive proposition from costs perspectives such as stamp duty.
13. Acquisition at attractive valuations – Present turmoil has disrupted deals as the emphasis of the businesses has shifted to survival and stabilisation from expansion. Investors and buyers in the near term shall be cautious of any fresh investment in view of the unpredictability of future events. However, on the other hand, this may be considered as an opportune period for businesses possessing surplus funds to invest in a quality asset at an attractive valuation in light of uncertainties.

Although these tough times call for tough measures, there are opportunities for businesses to realign themselves through the possibilities discussed above.

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