Mergers, Demergers and The Income Tax Act, 1961: Things said and unsaid

[This is a guest post by Sowmya Kumar. She is an Ex-BigLawFirm Associate who recently quit her job to indulge in pursuing her many interests and is currently doing just that!]

India Inc. is increasingly adopting permutations and combinations of the merger-demerger route in a bid to enhance value, consolidate businesses and achieve the elusive synergy of operations. The recent demerger of Grasim’s cement division into its wholly owned subsidiary Samruddhi and therafter Samruddhi’s merger into Ultratech is but one example. The icing on these court approved schemes is of course, the significant tax benefits prescribed under the Income Tax Act, 1961 (IT Act). Demergers and mergers satisfying certain specified conditions are exempt from tax on capital gains- both on the transfer of assets as well as on the transfer/issue of shares in consideration of the demerger/amalgamation.

Let’s focus on demergers first. Section 2(19AA) of the IT Act defines a tax neutral demerger inter alia, as follows:
(i) all the property of the undertaking and liabilities relatable to the undertaking become property of the resulting company by virtue of the demerger;
(ii) such property and liabilities are transferred at book value;
(iii) the resulting company issues, in consideration of the demerger, its shares to the shareholders of the demerged company on a proportionate basis;
(iv) the shareholders holding not less than three-fourths in value of the shares in the demerged company (other than shares already held therein immediately before the demerger, or by a nominee for, the resulting company or, its subsidiary) become share-holders of the resulting company or companies by virtue of the demerger;
(v) the transfer of the undertaking is on a going concern basis;

Interpretation of the above conditions has been insufficient so far. Avaya Global Connect v.  ACIT (discussed previously here) remains important even though it only tersely examined the demerger conditions. The issue here was whether a demerger where no consideration was paid to the demerged company/its shareholders would satisfy conditions (iv) and (v) mentioned above. The undertaking had a negative net worth, owing to which no consideration was paid and the scheme had already been approved by the concerned High Court. Despite these, the Mumbai ITAT held that only a demerger satisfying all the conditions mentioned would be considered tax neutral. “The legislature is deemed to have foreseen all possible contingencies and yet has thought it fit to impose the above conditions for qualifying as a demerger for the purpose of section 47(vib). There cannot be any presumption regarding omission by the legislature to provide for a situation where the consideration is not in the form of allotment of shares in the resulting company to the shareholders of the demerged company. A matter which should have been, but has not been provided for in a statute cannot be supplied”. While this transaction was ultimately not taxed since the capital gains could not be computed, the ITAT’s approach indicates that as regards the demerger conditions, a strict, literal interpretation is favoured.

Thus, it’s implied that only those demergers would be considered tax neutral where (i) consideration is present- for ‘no one ever hands over a division or an undertaking for nothing’; (ii) such consideration is only in the form of proportionate allotment of shares to the demerged company’s shareholders. This conclusion without more reasons to support itself, is on shaky ground. Let’s now briefly shift spotlight to relevant portions of the amalgamation definition enumerated in Section 2(1B) of the IT Act:

Amalgamation, in relation to companies, means the merger of one or more companies with another company or the merger of two or more companies to form one company (the company or companies which so merge being referred to as the amalgamating company or companies and the company with which they merge or which is formed as a result of the merger, as the amalgamated company) in such a manner that—

(iii) shareholders holding not less than three-fourths in value of the shares in the amalgamating company or companies (other than shares already held therein immediately before the amalgamation by, or by a nominee for, the amalgamated company or its subsidiary) become shareholders of the amalgamated company by virtue of the amalgamation

From the above, it seems that condition (iii) is mandatory for an amalgamation to be considered tax neutral. But from a mere reading, can it be said that (iii) gets satisfied when a wholly owned subsidiary X merges with its parent Y? For one, there are no other shareholders in X (i.e. apart from Y, so Y’s entire shareholding in X will be excluded for the purposes of (iii)) to become shareholders of Y ‘by virtue of the amalgamation’. Fortunately, a Circular clarifies this by way of an illustration. Thus, a merger of a subsidiary into a parent will be considered an amalgamation, if the other conditions mentioned in Section 2(1B) are satisfied. The crux of this view was also supported by a decision of the Authority for Advance Rulings (AAR) in Hoechst GmbH.

Given this interpretation of the amalgamation definition, where the impossibility of performance of a condition is recognised, why should the demerger definition be treated any differently? Why should all the conditions of Section 2(19AA) be insisted upon at all times? It certainly seems from Avaya, that consideration in the form of shares must now be issued even where an undertaking is demerged to a wholly owned subsidiary. Why should tax neutrality be denied to a demerger where (all other conditions being satisfied) the shareholders have expressly agreed that the subsidiary will not issue shares to them, and the High Court has sanctioned such a scheme? In any case, the shareholders indirectly control the subsidiary through their holding in the parent. Some clarification from the Mumbai ITAT would have certainly helped.

It may next be argued that the Mumbai ITAT in Avaya was merely following the general rule that tax statues should be interpreted strictly. However, this does not mean that each and every provision of the IT Act should be interpreted as it is- the Apex Court has noted that this general rule of interpretation only means that no one should be charged to tax unless he clearly falls within the four corners of the statute provisions. In other words, only the charging sections have to be interpreted strictly; if the words are clear and unambiguous, they have to be given full effect to irrespective of any equity considerations and the court here cannot add or subtract words to the text of the statute. The Mumbai ITAT presumed that the legislature while prescribing the demerger conditions had taken into account all possible situations- the legislature does not make omissions. But the legislature also does not intend what is inconvenient and unreasonable, especially given that the intention behind 2(19AA) was to promote demergers in the backdrop of a changing business environment. The Mumbai ITAT should have taken into account the facts of the particular case and interpreted the provisions of Section 2(19AA) so as to avoid any absurdity.

Maybe the Mumbai ITAT was guided in its decision by the spirit of tax evasion. Intra-group mergers-demergers are now being seen by the Tax authorities as a method of transfer of capital assets within the group companies without paying any tax on capital gains. The recent Gujarat High Court decision is a clearer example of this approach. Here, the passive infrastructure assets of Vodafone Essar Gujarat Limited (VEGL), along with those of group companies were sought to be demerged to another company Vodafone Essar Infrastructure Limited, (VEIL) which would ultimately be controlled by the VEGL’s shareholders. Pursuant to the demerger, VEIL would be merged with an independent company Indus Towers Limited. However, here the court was concerned only with the demerger scheme. No consideration was payable to VEGL/its shareholders for the demerger. The Tax authorities raised objections to the sanctioning of the scheme citing, inter alia, tax evasion- the sole purpose of VEIL’s existence was to hold the passive infrastructure assets before the merger, hence this was contrary to public interest. VEGL pointed out that the transaction had a definite business purpose and cited numerous examples where similar schemes (i.e. demerger of an undertaking to a subsidiary without consideration) had been sanctioned in the past. Despite these (and not in the least because of VGEL’s unclear arguments) the Court merely said, without giving reasons that VEGL’s demerger scheme was on a different footing and could not be sanctioned under the Companies Act, 1956, inter alia, owing to tax evasion. An appeal is being heard even as this post is published.

If tax evasion is the underlying consideration of courts, then every other transaction is in danger of being interpreted as one evading tax-even when a strict approach to Section 2(19AA) is adopted. Take this example- supposing a listed company P incorporates a wholly owned subsidiary Q with a small paid up capital. P proposes to demerge one of its undertakings with a substantial value to Q. Q, in consideration of this demerger will issue shares to P’s shareholders on a proportionate basis. However, the value of P’s shareholders’ shareholding in Q will be small (for example if P’s shareholders held shares in P in the ratio 1:4, they would be issued Q’s shares in that ratio but their total holding in Q would be around 20%). On a literal reading Section 2(19AA) conditions are satisfied- but the Tax authorities may very well challenge such a transaction for tax evasion as well.
There is thus, a definite need for clarity regarding mergers and demergers under the IT Act. The Mumbai ITAT in Avaya did not elaborate on its interpretation of Section 2(l9AA) and the considerations that guided it, thereby losing out on a good opportunity of bringing some clarity to the demerger provisions. What it did however was to indicate a shift in approach of courts towards intra-group mergers-demergers and resuscitate the tax avoidance-tax evasion debate. The locus classicus on demerger under the IT Act/ Direct Taxes Code is still awaited. Or maybe an Income Tax circular. Whichever comes first.