This article has been written by Akshay Verma pursuing the Diploma in M&A, Institutional Finance, and Investment Laws (PE and VC transactions) from LawSikho. This article has been edited by Ruchika Mohapatra (Associate, Lawsikho) and Dipshi Swara (Senior Associate, Lawsikho). 

Introduction 

A demerger is a kind of corporate restructuring, where an organization separates part of its business into a distinct entity. An organisation can decide to demerge for various reasons. The most common objective is to generate additional value for shareholders by splitting out various activities that may perform well if these are separated from the main business. Another rationale for a demerger can be separation, where parties who have worked together previously in a joint venture or as a part of an acquisition decide to choose their own paths.

A demerger can be undertaken through a process approved by the National Companies Law Tribunal (NCLT) wherein all the assets and liabilities, along with the employees of the identified business undertaking, are transferred to the transferee entity on a going concern basis. The transferee entity, in consideration for a demerger, provides its shares to the transferor entity’s shareholders. But do you know about the tax implications involved in a demerger? The demerger is defined under Section 2(19AA) of the Income Tax Act, 1961. Usually, a demerger is tax neutral in nature but it can also be subject to tax implications. In this article, the author aims to discuss the taxation provisions for a demerger. 

Demerger and Income Tax Act, 1961 

Section 2 (19AA) of the Income Tax Act,1961 defines demerger as a transfer of undertakings (one or more) to any resulting organisation pursuant to an arrangement scheme under Sections 391 to 394 of the Companies Act, 1956 in such a way that:

• All the liability/property of the undertaking becomes the liability/property of the resulting organisation.
• All the liabilities/properties are transferred at book value (excluding surge in value because of revaluation).
• The resulting organization issues shares to the shareholders of the demerged organization on a proportionate basis, except where the resulting organization is a shareholder of the demerged organisation.
• Shareholders holding minimum seventy five percent of the value of shares become shareholders of the resulting organisation (other than shares held already therein prior to the demerger by, or by a nominee for, the resulting organisation or its subsidiary).
• Undertaking is transferred on a going concern basis.

When will a demerger be tax neutral?

A demerger will be tax neutral in the following circumstances:

Section 47 of the Income Tax Act, 1961 provides various transactions which will not be considered as transfers for the motive of capital gains tax. According to Section 47(vi b), if in a demerger, there is any transfer of a capital asset by the demerged organisation to the resulting organization and if the resulting organisation is an Indian organisation, then the transaction will not be considered a transfer for the motive of capital gains tax.

According to Section 47(vi) (d), if there is an issue or transfer of shares by the resulting organization, in a demerger scheme to the shareholders of the demerged organisation and, if the transfer is made in consideration of the demerger of the undertaking, then the transaction will not be considered as a transfer for the motive of capital gains tax.

According to clause (v) of Section 2(22) of the Income Tax Act, 1961, there are no implications of deemed dividend on the issue of shares by the resulting organisation. When shares are distributed pursuant to a demerger by the resulting organisation to the shareholders of the demerged organisation (whether or not there is a capital reduction in the deemed organisation), it is excluded from the definition of the dividend. 

For a demerger, Section 72A (4) of the Income Tax Act,1961 provides with the benefit of set-off and carry-forward of loss and depreciation which is unabsorbed. This provision provides benefit in case a demerger has opted for the business reorganisation. It must be noted that such a demerger should have opted only for authentic purposes of business.

When will a demerger be taxed?

According to Section 41(1) of the Income Tax Act, 1961, the resulting organisation is subject to tax as a business successor. By virtue of  Section 41(1)(a), when there is deduction or allowance made in any assessment year in respect of loss, trading or expenditure liability suffered by the assessee (first-mentioned individual) and subsequently during any previous year; the assessee has gained any amount whether in cash or in any other way in respect of such expenditure or loss or some benefit in respect of such business liability by way of revocation or termination thereof, the amount gained by such individual or the value of benefit arising to him shall be deemed to be gains and profits of the profession or business and chargeable accordingly to income tax as the income of that previous year, whether the profession or business in respect of which the deduction or allowance has been made is in existence in that year or not; or 

(b) the successor in business (resulting organization) has gained any amount whether in cash or in any other way in respect of which loss or expenditure was suffered by the assessee (first mentioned individual) or some profit in respect to business liability referred to in clause (a) by way of revocation or termination thereof, the amount gained by the resulting organization or the value of profit arising to the resulting organisation shall be deemed to be gains and profits of the profession or business, and chargeable accordingly to income tax as the income of that previous year. 

Whether a demerger scheme could be sanctioned under Income Tax Act provisions and corporate laws of India if there is no consideration? 

The abovementioned question per se has been answered by the Gujarat High Court in the case of Vodafone Essar Gujarat Limited (Gujarat HC). The court rejected the demerger scheme. Further, it held that the scheme was a conduit/device having the only motive of evading and avoiding taxes including stamp duty, income tax, VAT, and registration charges. It was observed that the motive, being the avoidance of tax, was evident from the facts that distinct accounting treatments are provided to transferor organisations having a positive net worth as compared to those which have negative net worth with a motive to avoid maximum tax. 

Whether demerger of investments would be regarded as tax neutral demerger under Section 2(19AA) of Income Tax Act, 1961?

The incentive for demerger under Section 47 (vii a) is not obtainable if the transfer is not in accordance with Section 2(19AA) of the Said legislation.

In Income Tax Officer v. M/s Datex Ohmeda (India) Pvt Ltd (ITAT Kolkata), it was held that the transfer of trading and business division of the assessee-organisation was not in accordance with the provisions of Section 2(19AA) to treat the same as a demerger for the motive of Income Tax Act and the incentive of Section 47 (vii a) was not obtainable to the assessee-organisation. According to the provision enshrined under section 2(19AA) (ii) of the Income Tax Act,1961, all the liabilities relating to the undertaking, being transferred by the demerged organization, immediately prior to the demerger, should become liabilities of the resulting organisation. But in the said case, the transfer of the T&D division was not in accordance with the provision of Section 2(19AA) and hence could not obtain the incentive under Section 47 (vii a) of the Income Tax Act,1961. 

Treatment of cross border demergers 

Cross-border demergers are not expressly allowed or prohibited under the Companies Act, 2013. Cross-border demergers can be allowed in India only if there is an efficient interpretation of Section 232(I)(b) read with Section 234 of the Companies Act,2013. The Legislature through clarification or any appellate tribunal through its order or decision can settle the entire debate in this regard. So far, the Income Tax Act, 1961 also provides that the resulting organisation by virtue of a demerger should be an Indian organisation. There is no provision related to the cross-border demerger to date.

Conclusion

To recapitulate, a demerger is a kind of corporate restructuring, where an organisation separates part of its business into a distinct entity. Usually, a demerger is tax neutral in nature but it can also be subject to tax implications. According to Section 47(vi b), when there is the transfer of capital assets and the resulting organization is an Indian organization then there will be no capital gains. Similarly, according to Section 47(vi) (d), when shares are issued or transferred by the resulting organisation to shareholders of the demerged organisation there will be no capital gains. 

According to Section 41(1) of the Income Tax Act, 1961, the resulting organisation is chargeable to tax as a business successor. Cross-border demergers are not expressly allowed or prohibited under the Companies Act, 2013. Cross-border demergers can be allowed in India only if there is an efficient interpretation of Section 232(I)(b) read with Section 234 of the Companies Act, 2013. The Legislature through clarification or any Appellate Tribunal through its order or decision can settle the entire debate in this regard. So far, the Income Tax Act, 1961 also provides that the resulting organisation by virtue of a demerger should be an Indian organisation. There is no provision related to the cross-border demerger. 

References 

• https://www.bcasonline.org/Referencer2016-17/Taxation/Income%20Tax/amalgamation_and_demerger.html
• https://www.icsi.edu/media/portals/70/2FEB.pdf
• https://www.bcasonline.org/Referencer2015-16/Taxation/Income%20Tax/deemed_dividend.html
• https://www.aubsp.com/section-41-profits-chargeable-tax/
• https://taxguru.in/income-tax/incentives-business-reorganisation-amalgamation-section-72a-income-tax-act-1961.html
• https://taxguru.in/wp-content/uploads/2018/07/Income-Tax-Officer-Vs-Ms.-Datex-Ohmeda-India-Pvt.-Limited-ITAT-Kolkata.pdf
• https://taxguru.in/income-tax/benefit-demerger-u-s-47viia-transfer-219aa.html
• https://hnluccls.in/2020/07/09/cross-border-demergers-in-india-analysing-the-legislative-intent/

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