Amended §43B of Income Tax Act: Improved financial health or impediment in buyout of businesses?

Authors: Jeezan Riyaz & Koustav Bhattacharya

4th Year law students at National Law Institute University, Bhopal


I. Introduction

If there is a particular policy which is analyzed by numerous stakeholders to ascertain what their potential gains and losses from it could be for the coming year, it is the Union Budget. In a similar manner, this year’s Union Budget holds significant value as it has altered certain dimensions pertaining to the Mergers and Acquisitions (“M&A”) transactions in the Private Equity Market.

In the present article, the authors discuss the amendment sought to Section 43(b) of the Income Tax Act, 1961 (“the Act”) and attempt to evaluate its pros and cons of it. Further, the authors establish logical coherence surrounding the present discourse by taking a neutral stance from the perspective of the players involved in the field of Private Equity and M&A. The article, thereby, formulates whether this step actually helps the corporate players to blossom or makes the businessman more cautious to invest.

II. Previous Position of Law as held by The Apex Court

As per Section 43B(d) of Income Tax Act, 1961, interest on a loan or borrowing from any public financial institution shall be considered as a deduction while computing business income of that previous year in which such interest is actually paid. But Explanation 3C to the said provision states that if the interest payable has been converted into a loan or borrowing, it shall not be deemed that such an interest is actually paid.

Herein, the grey area of debentures arises where the Supreme Court clarified the position of law in 2021. In M.M. Aqua Technologies Pvt Ltd. v. Commissioner of Income Tax, the Court held that the discharge of interest payable to financial institutions by way of issue of debentures allows actual payment of interest and is allowed as a deduction under Section 43B. The Court reasoned that the interest was actually paid by the issuance of debentures which extinguishes the liability to make payment. Further, it was held that there was no misuse of Section 43B, as explanation 3C is clarificatory in nature. Therefore, nobody has the right to intervene and rewrite the arrangement for the parties stating that the parties cannot agree between themselves on what will be taken as the actual discharge of the liability to pay interest.

III. Status Quo and The Road Ahead

Section 43B of the Act provides for certain tax deductions to be allowed only on actual repayment of loan/borrowing. Explanation 3C, 3CA & 3D of this Section states “any sum payable by a person or a company on any loan or borrowing from banks and financial institutions is allowed, provided the said interest on the same is duly paid before filing the income tax return.”

In basic parlance, any interest payable under clause (d), clause (da), and clause (e), which has been converted into a loan or borrowing shall not be allowed unless such interest has been actually paid. However, in a breakthrough proposal, the Financial Bill 2022 proposes to amend section 43B of the Income Tax Act. It denies the allowance of deductions for interest on any loan borrowed by a taxpayer unless such interest is paid in the current year.

It’s no secret that for acquisition, businesses need money in the form of loans and advances. The acquirer that takes over the assets of the target company including its stressed assets will require a credit facility from the banks and financial institutions on which the interest is payable.

If argued from a tax law standpoint, in accordance with the Court’s interpretation, Section 43B of the Act allowed for the conversion of outstanding interest on the loan to debentures which would be considered as a payment of that interest. However, after the Finance Bill 2022, the said proposition has changed completely as the new amendment proposes to prohibit conversion of interest payable into debenture or any other instrument by which liability to pay is deferred to a future date. This amendment would take effect from Financial Year 2022-23 and may impact companies, which propose to acquire stressed assets whereby payment of such outstanding interest is proposed to be postponed by converting such interest into debentures.

Naturally, the banks and financial institutions would approve of it considering the implications under Section 43B of the Act. This is due to the fact that the outstanding loans can be converted to debentures and deferred payments would be possible. This shall prompt more businesses to opt for such loans from banks and financial institutions. Moreover, having converted outstanding interest on a loan to a debenture, the company would develop long-term obligations with a fixed rate of interest and encumbrance towards the bank, increasing the bank’s financial cover than ordinary bank-loans.

Similarly, the acquirer of any form of business could contend that the repayment of interest i.e., an expense in the books of accounts has been done by issuing of debentures, a financial instrument, which has increased the liability of a company, thereby entitling it to tax benefits. Under the proposed amendment, the same cannot be done as there has to be payment of actual interest thereby, deduction of interest by payment in cash, cheque, or other forms of superannuation fund.

IV. Legislative Intent and Proposed Benefits

The legislative intent with respect to the same has been very clear that actual payment of interest cannot be substituted by the issuance of debentures. Therefore, the company would not be in a position to inflate its assets and present a picture of sound debt financing as it cannot evade the tax benefits without incurring any actual expenditure.

The said provision is a welcome step in order to reduce the number of bad debts and is seen as a nuanced approach to addressing the fact that there are no underperforming assets in the Balance Sheet. It further ensures that the valuation of the Assets is accurate and exact because a company, after acquiring stressed assets, would not avail a credit facility fearing that there lies no option to defer the repayment of such a credit facility and its’ subsequent interest by converting them into debentures once the budget is passed-

It will also reduce the amount of insolvency proceedings as there will not be any issue with respect to the repayment of the loan at a future date as such an amendment negates the possibility of converting the outstanding interest on the credit facility to a debenture to be repaid at a future date. This is because the companies would themselves be more cautious in obtaining a loan or a credit facility for the purchase of an asset less if it turns out to be a bad asset.

This provision will affect the players in the private equity sector regarding mergers and acquisitions in a significant manner. The companies acquiring other buyouts shall be more vigilant in case of evaluating their assets and also to evaluate the outstanding loans. There shall be a prompt recovery in case of acquisitions of the interest spending on loans rather than deferring them for a long period of time. Furthermore, unjust tax benefits in the form of expenditure paid will also be reduced and this shall enhance the exchequer of the government.

Moreover, stressed assets shall be released more promptly and strategically and it shall reflect the sound financial health of the company. Inflation of the balance sheet by inflating the status of the assets even though they have lost their utility shall be foregone. This shall be possible as once the tax benefit and the subsequent option of conversion will no longer be available; the company shall be vigilant. It may not take loans against ‘bad’ assets or those assets which no longer can be put up as an encumbrance against a loan.

The Balance Sheet shall focus only on those viable assets that are financially sound and those that can be utilized and realized to pay off the credit and subsequent interest on them. This shall enable the corporate players to maintain the transparent financial health of the asset and make them more vigilant so as they shall not defer interest payments for a larger period of time but rather would pay them at the earliest in order to avail of the tax benefits. The government would also be benefitted from these reforms because in such cases the public exchequer would not be unjustly bound by providing tax benefits to expenditures, which are not even paid.

V. A More Vigilant Set of Mergers Transactions

On the flip side, however, one of the negative aspects of the said reforms might be experienced by the companies. They might become hesitant in cases of buyouts and may consider themselves held back from buying out another company with a lot of stressed assets and outstanding loans. Therefore, if a company wishes to acquire another company, it shall do a proper background check of the status of its assets and loans. Additionally, if a company wants to sell its business, it shall endeavor to maintain the good financial health of its assets rather than making them stressed.