VIP Road Chartered Accountants Association

AMALGAMATION AND DEMERGER UNDER THE INCOME TAX ACT

By K.K.Chhaparia, F.C.A, A.C.S.

While finalizing the Business Restructuring proposals through Merger, Amalgamation, Demerger, Spin off, Sale of Business route or any other ways, a Company has to reckon the relevant laws relating to Income Tax, Sales Tax and Excise Duty very closely in order to avoid disputes in future. Such disputes may even lead to financial disaster if relevant points are not analyzed in advance and suitable actions are taken at the time of framing the Scheme of Arrangement. In fact all prudent management always discuss the Tax issues (both direct and indirect) separately before taking a final decision on any business restructuring proposal.

In this Article I would like to discuss the Direct Tax issues relating to any Business Restructuring proposal.

Amalgamation under Income Tax Act

Section 2(1B) of Income Tax Act, 1961 defines Amalgamation

It states: "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 _

i) all the property and liabilities of the amalgamating company or companies immediately before the amalgamation becomes the property and liability of the amalgamated company by virtue of the amalgamation; and

ii) 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.

Comments :

• It may be important to mention that the section talks about the shareholders of amalgamating companies to become shareholders of amalgamated company. It doesn't say what should be their percentage of holding in the amalgamated company. Thus, even if the shareholders of the amalgamating companies hold say less than 1% of the shares in amalgamated company, the requirements of the Act gets fulfilled.

• In a Scheme of Amalgamation, it is a usual system that shareholders of the amalgamating companies become the shareholders of the amalgamated company. Further, it is also a usual system that all the assets and liabilities of the amalgamating companies become the assets and liabilities of the amalgamated company. Thus, there is no extra precondition in the Income Tax Act, as far as the definition of `amalgamation' is concerned.

• However, certain provisions relating to "transfer" and "carry forward of loss" are important and discussed in the later part of this article.

Demerger under the Income Tax Act

Demerger is relatively a new concept in the Income Tax Act. Sections 2(19AA), 2(19AAA) and 2(41A) were inserted by Finance Act, 1999 to define Demerger, Demerged Company and Resulting Company.

As per section 2(19AA), "demerger" in relation to companies, means the transfer, pursuant to a scheme of arrangement under section 391 to 394 of the Companies Act, 1956 (1 of 1956), by a demerged company of its one or more undertakings to any resulting company in such a manner that _

i) all the properties and liabilities of the undertaking, being transferred by the demerged company, immediately before the demerger, becomes the properties and liabilities of the resulting company by virtue of the demerger; and such properties and liabilities are transferred at Book Value.

ii) the resulting company issues, in consideration of the demerger, its shares to the shareholders of the demerged company on a proportionate basis;

iii) 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 shareholders of the resulting company or companies by virtue of the demerger,

iv) the transfer of the undertaking is on a going concern basis;

v) the demerger is in accordance with the conditions, if any, notified under sub-section (5) of section 72A by the Central Government in this behalf.

As per section 2(19AAA), "demerged company" means the company whose undertaking is transferred , pursuant to a demerger, to a resulting company.

As per section 2(41A), "resulting company" means one or more companies (including a wholly owned subsidiary thereof) to which the undertaking of the demerged company is transferred in a demerger and, the resulting company in consideration of such transfer or undertaking, issues shares to the shareholders of the demerged company and includes any authority or body or local authority or public sector company or a company established, constituted or formed as a result of demerger;

Comments :

Thus, `Demerger' means transfer of a running business undertaking to another company under a Scheme of Arrangement under the Companies Act, 1956 by taking Sanction of the High Court. An essential feature is that the transferor company should not receive the consideration but the acquiring company should pay the consideration directly to the shareholders and that too apparently, only in the form of shares.

On the basis of the definitions, some broad fundamentals of demerger can be summarized as under:

i) Demerger Scheme to be sanctioned by High Court :
The demerger Scheme has to be filed with the High Court under Section 391 to 394 of the Companies Act. If the registered office of the demerged company and the resulting company(s) are within the same state, application has to be made in one High Court , but if the registered office are situated at different states, then simultaneous demerger applications have to be made in more than one High court.

ii) All the assets need not necessarily be transferred :
There is some misunderstanding among some person that the demerged company should loose its existence in case of demerger. But is it not so. The `demerger' means transfer of undertaking (not necessarily an `industrial undertaking') or division to resulting company.

iii) The resulting company(s) may be new/existing company :
The resulting company may belong to the same group or a different group. Suppose Reliance Industries Ltd. wants to demerge its Vimal Textiles division. It may demerge it into Raymonds Ltd. What is required is that the shareholders holding not less than three-fourths in value of the shares in the demerged company become shareholders of the resulting company or companies. It doesn't require that shareholders should hold 75% of the value of shares of the resulting company.

iv) The difference between the Face Value of shares allotted by the resulting Company and the net assets acquired by it may be treated as General Reserve

Extracts of Scheme of Arrangement between the Great Eastern Shipping Company Limited and GESCO Corporation Private Limited is being reproduced below :

"Upon the coming into effect of this Scheme, an amount representing the excess of the amount representing the surplus of the assets over the liabilities of the Demerged Undertaking being transferred to the Resulting Company in terms of Clause 2 above as reduced by the amount representing the reduction in share capital described in Clause 16(c) of this Scheme, shall be debited in the books of Demerged Company as follows :

1. an amount of Rs.46,53,36,123/- to the Share Premium Account; and

2. the balance amount, if any, to the General Reserve."

Comments : The Scheme involves transfer of undertaking at a price which is apparently much higher than the Face Value of shares to be allotted by the resulting company.

If a company doesn't satisfy the conditions laid down in the Income Tax Act as far as definition of `amalgamation' or `demerger' is concerned, it may still get amalgamated or demerged as per the provisions of the Companies Act. However, it shall not be entitled to benefits of exemption under capital gains, carry forward of loss etc.

Liability under Capital Gains in case of amalgamation and demerger

As per Section 47, certain transfers are outside the ambit of capital gains, which include:

• Any transfer, in a Scheme of Amalgamation, of a capital asset by the amalgamating company to the amalgamated company, if the amalgamated company is an Indian Company. [sub-section (via)]

• Any transfer, in a demerger, of a capital asset by the demerged company to the resulting company, if the resulting company is an Indian company. [sub-section (vib)]

• Any transfer or issue of shares by the resulting company, in a scheme of demerger to the shareholders of the demerged company if the transfer or issue is made in consideration of demerger of the undertaking. [sub-section (vid)]

• Any transfer by a shareholder, in a scheme of amalgamation, of a capital asset being a share or shares held by him in the amalgamating company, if _

a) the transfer is made in consideration of the allotment to him of any share or shares in the amalgamated company, and

b) the amalgamated company is an Indian company. [sub-section (vii)]

Comments

Thus, amalgamation and demerger doesn't involve capital gains liability either to the Company involved (for transfer of its assets) or to the shareholders (who gets the shares of amalgamated company/ resultant company) in terms of the scheme of amalgamation or demerger.

Carry Forward of loss in case of amalgamation
Section 72A(1) to Section 72A(3) contains provisions for carry forward of loss in case of amalgamation or demerger.

As per section 72A(1), where there has been an amalgamation of a company owning an industrial undertaking or a ship with another company, then, notwithstanding anything contained in any other provisions of this Act, the accumulated loss and the unabsorbed depreciation of the amalgamating company shall be deemed to be the loss or, as the case may be, allowance for depreciation of the amalgamated company for the previous year in which the amalgamation was effected, and other provisions of this Act relating to set off and carry forward of loss and allowance for depreciation shall apply accordingly.

Notwithstanding anything contained in sub-section (1), the accumulated loss shall not be set off or carried forward and the unabsorbed depreciation shall not be allowed in the assessment of the amalgamated company unless the amalgamated company _

i) holds continuously for a minimum period of five years from the date of amalgamation at least three-fourths in the book value of fixed assets of the amalgamating company acquired in a scheme of amalgamation;

ii) continues the business of the amalgamating company for a minimum period of five years from the date of amalgamation;

iii) fulfils such other conditions as may be prescribed to ensure the revival of the business of the amalgamating company or to ensure that the amalgamation is for genuine business purpose.

Comments

Thus, the following points are important for carry forward of loss:

(i) The amalgamating company owns an industrial undertaking or a ship. It is not important that loss or unabsorbed depreciation relates to industrial undertaking. Suppose, a company is carrying on a number of businesses, out of which industrial undertaking is running at a profit, while some of other divisions are running at a loss, then, it is immaterial that the loss is not arising out of industrial undertaking. It is also immaterial whether the company was owning an industrial undertaking or not in the year of loss. What is material is whether the company owns the industrial undertaking or a ship, just before the transfer date.

(ii) The loss is carried forward for a period of eight years from the year of amalgamation. Suppose a company has huge unabsorbed loss, being carried forward since last six years. It is not expecting profits in the coming few years. As we know, carry forward of loss is allowed for eight years. Thus, the company shall not be able to carry forward the loss, if it is not adjusted within eight years. Now, if this company goes into amalgamation, the loss shall be allowed for a period of eight years from the year of amalgamation in the hands of the amalgamated company. Thus, practically, the loss has been allowed for fourteen years in the instant case.

(iii) In view of the fact that in case of amalgamation, it is not always possible that the amalgamating company owns an industrial undertaking or a ship, we quite often find `reverse merger', i.e. profit making company merging into loss making company. Incase, of reverse merger, the loss of the amalgamated company is not affected by the merger. However, in that case, necessary care should be taken u/s 79 of I.T.Act.

(vi) It is worthwhile mentioning here that the vide Rule 9C of I.T.Rules, the conditions for carrying forward or set off of accumulated loss and unabsorbed depreciation allowance in case of amalgamation has been prescribed. One such condition include furnishing certificate in Form No. 62 to the assessing officer.

Carry Forward of loss in case of demerger
Section 72A(4) contains provisions for carry forward of loss in case of demerger. As per this sub-section, the accumulated loss and the allowance for unabsorbed depreciation of the demerged company shall where such loss or unabsorbed depreciation is directly relatable to the undertakings transferred to the resulting company, be allowed to be carried forward and set off in the hands of the resulting company.

b) where such loss or unabsorbed depreciation is not directly relatable to the undertakings transferred to the resulting company, be apportioned between the demerged company and the resulting company in the same proportion in which the assets of the undertakings have been retained by the demerged company and transferred to the resulting company, and be allowed to be carried forward and set off in the hands of the demerged company or the resulting company, as the case may be.

As per sub- section 5, the Central Government may, for the purposes of this Act, by notification in the Official Gazette, specify such conditions as it considers necessary to ensure that the demerger is for genuine business purposes.

Comments

The following points are important in a demerger case :

(i) No notification has been issued till date.

(ii) As we know, in the Income Tax Act, the depreciation is calculated on Block of Assets concept. As such, it is very difficult to calculate the unabsorbed depreciation of a particular division, especially in view of the fact that in practical world, profit of a division of company is calculated on the basis of depreciation as per Companies Act. No division normally prepares its taxable income as per income tax act.

Allowability of Amalgamation or Demerger Expenses

There were conflicting decisions of Courts whether amalgamation/demerger expenses is capital expenditure or revenue expenditure. A new section 35DD was inserted with effect from 01.04.99, which provides that the assessee shall be allowed a deduction of an amount equal to one-fifth of such expenditure for each of the five successive previous years beginning with the previous year in which the amalgamation or demerger takes place.

Transfer date retrospective_ How to file return and the procedure of assessment

Prior to Apex Court ruling in the case of Marshall Sons and Company (India) Ltd v. ITO [(1997) 223 ITR 809], there was some confusion with regard to the `date of amalgamation' for the purposes of computing income tax. The question was whether the date of amalgamation as provided in the Scheme of amalgamation has to be considered as the date of amalgamation or a date on which the Court sanctions the Scheme has to be considered as the date of amalgamation.

The question assumes importance since the sanction by the Court takes considerable time in view of the fact that the whole exercise of amalgamation is a long drawn process. In a number of Schemes, the transfer date is 1st day of financial year (usually retrospective). However, the Apex Court in the aforesaid judgement has resolved the controversy by holding that the date as provided in the Scheme of amalgamation, i.e. `transfer date' as it is usually called, would be the date from which the amalgamation shall be deemed to have taken place.

However, the Court observed that till the Court sanction the Scheme, a protective assessment could be made in the hands of amalgamating company. If further observed that there might be a certain practical difficulty in adopting this course in as much as separate balance sheets may not be available for the transferor company. The Court observed that in such case a best judgement assessment order may be passed on the basis of available records.

Thus, pending sanction of scheme by the Court, the transferor company shall be required to file the return and even the transferee company without giving effect of the Scheme. Once the Scheme becomes effective consequent to Court's order, revise return may be filed in the hands of Transferee Company and Transferor Company (as applicable).

Site Maintained & Promoted By Kolkatanetonline