Tax Implications of Demergers

(The following post is contributed by Mihir Naniwadekar)

Generally, the gains arising from a demerger are exempt from capital gains tax, while those arising from a slump sale are not. But, then, what exactly is a ‘demerger’ for the purposes of the exemption from capital gains tax? Can a demerger ever be characterized as a ‘slump sale’? Several sections of the Income Tax Act, 1961 deal with these issues.

The statutory provisions in the Income Tax Act:

A. Section 2(19AA) says that a ‘demerger’ means a transfer pursuant to a scheme under Sections 391-394 of the Companies Act, 1956 (by a demerged company of its one or more undertakings to any resulting company) such that a list of seven conditions enumerated in separate clauses is fulfilled. Clause [iv] is particularly relevant for the present discussion. It says that the resulting company must issue, in consideration of the demerger, its shares to the shareholders of the demerged company on a proportionate basis.

B. A slump sale is defined in Section 2(42C) to mean the transfer of one or more undertakings as a result of the sale for a lump-sum consideration without values being assigned to independent assets and liabilities.

C. According to Section 45, any profits or gains arising from the transfer of a capital asset are chargeable to capital gains tax.

D. Under Section 47(vii), the provisions of Section 45 do not apply to a transfer in a demerger of a capital asset by the demerged company to a resulting company if the resulting company is an Indian company.

E. Under Section 50-B, capital gains arising from slump sales are chargeable to tax. The capital gains from such slum sales are to be calculated by subtracting the net worth of the undertaking that is transferred from the lump-sum consideration (as per Explanations 1 and 2 to the Section).

In short, if a transfer is a demerger under the Income Tax Act, capital gains liability would not arise. If it is a slump sale, such liability would arise. For the transfer to be a ‘demerger’, the conditions mentioned in Section 2(19AA) must be complied with. But what happens when one or more of the conditions are irrelevant to a particular transaction? How this may happen is exemplified by the facts of the complex case of Avaya Global Connect v. ACIT, ITA No.832/Mum/07 (the judgment is available on the website of the Mumbai ITAT Bar Association at http://itatonline.org/archives/?p=118).

The Facts:

The assessee ‘A’ was a company having two divisions – ‘B’ and ‘T’. ‘T’ was transferred by ‘A’ to ‘I’, an Indian company. For this transfer, a scheme of arrangement filed before the Bombay High Court provided, “… ‘T’ without any further act, instrument or deed… shall stand vested in or deemed to be vested in ‘I’ as a going concern…” Significantly, the scheme went on to say “Upon the demerger of ‘T’ into ‘I’, ‘I’ would not pay consideration either to ‘A’ or to the shareholders of ‘A’…” (Emphasis supplied.) The Bombay High Court sanctioned this scheme. The value of the assets taken over by ‘I’ was less than the value of the liabilities; and ‘A’ showed the difference in the capital reserve account in the balance sheet. A question arose as to whether the gains which accrued to the assessee (as it had transferred more liabilities than assets) would be chargeable to capital gains.

The claims:

The Department took the view that the scheme would not qualify as a demerger; on the basis that clause [iv] mentioned above was not satisfied. The assessee contended that clause [iv] was inapplicable to the case, as the clause would have effect only when there was some consideration for the transfer. In the case, the value of its liabilities exceeded its assets, leading to negative net worth. Therefore, there was no consideration for the transfer – as a practical matter, it was impossible for there to be any consideration. As there was no consideration whatsoever, the question of complying with clause [iv] would not arise. Without prejudice, it was argued by the assessee that the transfer could not have been a slump sale given that no lump-sum consideration was paid. Further, it was contended that there being no sale consideration received in respect of the transfer, no question of computing capital gains arose.

The AO and the CIT (Appeals) however rejected these contentions. It was held that the transaction was a slump sale. The assessee had not received consideration as such; yet it had transferred liabilities in excess of assets and had credited the difference to its capital reserve account. This was sufficient to constitute consideration received on account of the transfer; and the assessee was liable to pay capital gains tax.

The issues before the Tribunal:

Essentially, the Tribunal faced the following questions:

A. Was the transfer to be characterized as a ‘demerger’ for the purposes of the Income Tax Act, 1961?

B. If not, could it be referred to as a slump sale? If it was a slump sale, would there be any capital gain on facts (considering the negative net worth of the assessee and the fact that no actual consideration was received)?

C. What would be the position if the transfer was categorized as neither a demerger nor a slump sale?

The decision:

A. The Tribunal agreed with the lower authorities that there was no ‘demerger’ in the present case. It was held that the legislature must be presumed to have foreseen all practical possibilities while adding the conditions. The fact that there was no consideration whatsoever (as a matter of practical impossibility) would not be sufficient to hold that the condition was inapplicable.

B. The Tribunal then went on to hold that it is only a transfer as a result of a sale which can be considered as a slump sale. The presence of a money consideration is essential for a sale. Also, when a Court sanctions a scheme under the Companies Act, the transfer in pursuance of that scheme would be not be a result of sale, but would be a result of the operation of law.

C. Essentially, the capital asset which was transferred in the case was a going concern. It would not be possible to “… conceptualize the cost of acquisition of … a going concern (or) the date of acquisition thereof…” As such, it was held that the computation provisions of the Act in Section 48 would fail in the given factual matrix. In such a scenario, no capital gains could be levied. Accordingly, the assessee’s appeal was allowed.

The significance:

From the point of view of the corporate world, the judgment serves to highlight an important point. Merely because a transfer is carried out in accordance with a scheme for a demerger under the Companies Act sanctioned by the competent High Court, the transfer will not be characterized as a demerger for the purposes of taxation. At the same time, such a transfer will not be a slump sale; and liability to capital gains will depend on whether or not the provisions for computation of capital gains would be workable. The safer course, it appears, would be to ensure that the requirements for a demerger under tax laws are complied with in the first place.