Consideration Structuring And Working Capital Adjustments In Cross-Border M&A Transactions Under Indian Law

The structuring of consideration in a mergers and acquisitions ("M&A") transaction constitutes a critical element of deal architecture, particularly at the term sheet stage where commercial intent is translated into legally enforceable mechanisms. In the Indian context, consideration structuring for unlisted shares is not merely a matter of valuation economics but is deeply intertwined with regulatory compliance under the Companies Act, 2013, the Income Tax Act, 1961 ("Income Tax Act"), and the Foreign Exchange Management Act, 1999 ("FEMA"). Experience demonstrates that even minor oversights in relation to debt allocation, cash treatment, or working capital adjustments may result in unintended tax exposure or regulatory non-compliance.

In M&A transactions, it is a general practice to structure deals on a cash-free and debt-free basis, reflecting the commercial understanding that the acquirer takes over the operating business of the target company and not its historical financial liabilities. In practice, short-term debt forming part of the current liabilities of the target company is generally transferred to the acquirer as part of the ongoing business operations. Long-term debt, however, is treated differently and remains the responsibility of the seller. Such long-term borrowings are factored into the valuation mechanics by adjusting the enterprise value, either by netting off outstanding debt against cash and cash equivalents or by correspondingly reducing the share purchase consideration. Unless expressly agreed otherwise, the acquirer does not typically assume responsibility for the target company's long-term indebtedness.

The treatment of cash lying in the company at the time of closing is equally significant. From an economic perspective, excess cash belongs to the seller. However, practical constraints arise because pre-closing extraction of cash by way of dividend, bonus, or compensation triggers substantial tax liability. Since the abolition of dividend distribution tax with effect from April 1, 2020, dividends are taxable in the hands of shareholders at their applicable slab rates. For individuals in higher income brackets, the effective tax incidence on dividend distributions, inclusive of applicable surcharge and cess, can be substantially higher than the long-term capital gains tax rate applicable to unlisted shares.

Similarly, corporate shareholders receiving dividend income are subject to tax at their applicable corporate tax rates without any exemption. To mitigate this tax inefficiency, parties commonly agree that excess cash be added to the share purchase consideration and treated as part of the capital gains arising on transfer of shares. This approach subjects the amount to long-term capital gains tax at 12.5% without indexation for unlisted equity shares held for more than 24 months, as amended by the Finance Act, 2024 with effect from July 23, 2024. Accordingly, the cash-free and debt-free mechanism ensures that both excess cash and outstanding debt are adjusted through the pricing framework rather than being transferred, resulting in a materially lower effective tax incidence.

Net working capital adjustment represents another central pillar of consideration structuring. For transaction purposes, working capital is generally calculated as current assets excluding cash and cash equivalents, minus current liabilities. Current assets include inventory, trade receivables, and other debtor balances representing amounts owed to the company, typically collected within a thirty to sixty days cycle. Current liabilities primarily consist of trade payables and other short-term obligations. Working capital adjustments are intended to ensure that the company is transferred with sufficient operational liquidity to continue its business seamlessly post-acquisition.

When transaction documents stipulate that a certain level of working capital must remain in the company, this does not imply retention of liquid cash alone. Instead, it reflects the expectation that the business will be transferred as a going concern with adequate operating assets relative to liabilities. Since the acquirer has already paid the consideration, it expects that the company will not be stripped of its operating liquidity prior to closing.

The quantum of working capital to be retained is typically determined by reference to historical performance. Market practice suggests that an amount equivalent to two to three months of operational requirements is appropriate. This is calculated based on the trailing six to twelve months of financial data, with periods below six months or beyond twelve months generally considered unreliable for establishing a normalized baseline. Average working capital is computed by aggregating historical working capital figures and dividing them over the relevant period.

From a seller's perspective, the objective is to retain the minimum commercially acceptable working capital, whereas acquirers typically prefer higher retention, usually ranging between thirty to ninety days but not exceeding three months. The target working capital thus becomes a negotiated benchmark reflecting the parties' risk allocation.

The Actual working capital is determined as of the closing date based on a statement of accounts. Where actual working capital exceeds the targeted working capital, the excess is added to the purchase consideration payable to the seller. Conversely, where actual working capital falls short of the targeted working capital, the deficit is deducted from the purchase consideration. These adjustments ensure alignment between the agreed valuation assumptions and the economic reality at closing, thereby ensuring that economic parity is maintained.

In cross-border M&A transactions involving unlisted shares, post-closing consideration adjustments raise complex regulatory issues under FEMA. A commonly adopted solution is the holdback mechanism, under which a portion of the consideration is retained by the purchaser pending final working capital determination. However, this approach must be carefully structured to ensure that the fair market value ("FMV") reflected in regulatory filings corresponds to the actual consideration payable as of the closing date.

This is particularly relevant in transactions involving resident and non-resident parties, where the pricing must comply with FMV requirements prescribed under the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017. When a non-resident transfers shares to a resident, the transfer price must not exceed the FMV. Conversely, when a resident transfers shares to a non-resident, the transfer price must not be less than the FMV.

A critical distinction exists between valuation under Rule 11UA of the Income Tax Rules, 1962 ("Rule 11UA") and valuation under FEMA. Rule 11UA prescribes specific methodologies for determining FMV of unlisted shares for income tax purposes, including the net asset value method and the discounted cash flow method, among others. In contrast, FEMA permits valuation based on any internationally accepted pricing methodology determined on an arm's length basis, which may include discounted cash flow, comparable company analysis, or precedent transaction analysis.

In practice, the FMV determined under Rule 11UA is often lower than the FMV computed under FEMA methodologies. If the transfer price is below the FMV determined under Rule 11UA, the transaction is not prohibited but may result in additional tax liability for the parties as deemed income under sections 56(2)(x) or 50CA of the Income Tax Act. In contrast, if the transfer price in a cross-border transaction is below the FEMA FMV in a resident-to-non-resident transfer, or above the FEMA FMV in a non-resident-to-resident transfer, the transaction itself is restricted and cannot be consummated without prior regulatory approval. Consequently, the share transfer price must be structured to satisfy both the Rule 11UA valuation and the FEMA FMV requirements simultaneously.

Consequently, deferred consideration structures, including tranche-based payments and earn-outs, are therefore frequently employed to address valuation uncertainty and post-closing adjustments. Differential pricing in cross-border transactions involving unlisted shares is permissible under Indian law, provided that the applicable valuation norms are satisfied at each stage of payment. However, working capital adjustments cannot be considered independently of the overall pricing framework.

A significant regulatory risk arises where the entire consideration has already been paid upfront, and post-closing adjustments result in a downward revision of the purchase price below the FEMA FMV. In such a scenario, any downward adjustment that has the effect of reducing the final consideration below FMV may be viewed as non-compliant with FEMA, as resident-to-non-resident transfers are not permitted at a price below FMV.

Accordingly, while transaction documents may specify a contractual consideration quantum, the FMV must always be lower than or equal to the agreed consideration at the time of execution in resident-to-non-resident transfers. Following all post-closing adjustments, including working capital true ups, the final purchase price must continue to comply with both FEMA and Income Tax Act regulations to avoid regulatory exposure.

In addition to the foregoing considerations, Transactions involving foreign-owned and -controlled companies ("FOCC") present a distinct set of regulatory implications under FEMA. An FOCC is an Indian entity that has received foreign investment and satisfies certain ownership or control thresholds prescribed under the Foreign Exchange Management (Non-debt Instruments) Rules, 2019. When such a company undertakes downstream investment in another Indian entity, the investment is treated as indirect foreign investment and must comply with FEMA pricing requirements applicable to non-resident transactions.

Specifically, when an FOCC acquires shares from a resident seller, the pricing must be at or above FMV. When an FOCC transfers shares to a resident acquirer, the pricing must be at or below FMV. In both scenarios, pricing is generally required to be exactly at FMV to ensure strict compliance. The deferred consideration framework permitting an 18-month adjustment period with a maximum 25% holdback is applicable in such cases, subject to adherence to fair market valuation requirements. As a result, transactions involving FOCC must be structured with particular care to ensure strict adherence to fair market valuation requirements throughout the lifecycle of the transaction, from execution through post-closing adjustments.

In conclusion, consideration structuring in M&A transactions is a multidimensional exercise that requires alignment between commercial intent, valuation principles, tax efficiency, and regulatory compliance. Working capital adjustments, cash and debt treatment, and valuation methodologies are not standalone concepts but interdependent elements of a single integrated pricing framework. A failure to coherently integrate these elements can expose parties to significant tax liabilities and regulatory risk, thereby emphasising the need for meticulous structuring at the outset to ensure that transactions remain compliant while achieving optimal commercial and tax outcomes for all parties involved.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.