Unit 10: Tax Planning for Restructuring of Business-II - Subjective Questions

Under Section 2(1B) of the Income-tax Act, 1961, amalgamation means the merger of one or more companies with another company, or the merger of two or more companies to form a new company.

The following conditions must be satisfied:

• Transfer of property: All the property of the amalgamating company or companies immediately before the amalgamation must become the property of the amalgamated company.
• Transfer of liabilities: All the liabilities of the amalgamating company or companies immediately before the amalgamation must become the liabilities of the amalgamated company.
• Shareholder continuity: Shareholders holding at least three-fourths in value of the shares in the amalgamating company, other than shares already held by the amalgamated company or its subsidiary, must become shareholders of the amalgamated company.

A transaction involving only the acquisition of property by one company, purchase of shares, or distribution of property after winding up does not automatically constitute an amalgamation unless all the statutory conditions are fulfilled.

A qualifying amalgamation may receive the following capital gains exemptions under Section 47:

• Under Section 47(vi), the transfer of a capital asset by the amalgamating company to the amalgamated company is not regarded as a transfer if the amalgamated company is an Indian company.
• Under Section 47(vii), the transfer of shares held by a shareholder in the amalgamating company is not regarded as a transfer where:
  • the transfer is made in consideration for the allotment of shares in the amalgamated company, except where the shareholder itself is the amalgamated company; and
  • the amalgamated company is an Indian company.

These provisions defer capital gains taxation rather than permanently eliminating it. When the shareholder or amalgamated company subsequently transfers the new shares or assets, the inherited cost and holding-period rules become relevant.

If cash or other consideration is received in addition to shares, the shareholder-level exemption must be examined carefully because Section 47(vii) specifically contemplates consideration in the form of shares.

The tax basis generally carries over in a tax-neutral amalgamation.

• Under Section 49(1), where a capital asset becomes the property of the amalgamated company through a transfer covered by Section 47(vi), its cost is generally the cost for which the amalgamating company acquired it.
• Under Section 49(2), the cost of shares in the amalgamated company received by a shareholder is the cost of the shares held by that shareholder in the amalgamating company.
• Under Section 2(42A), while determining whether the transferred asset is long-term or short-term, the relevant period for which it was held by the previous owner is generally included where Section 49(1) applies.
• The period for which the shareholder held shares in the amalgamating company is also included in determining the holding period of shares allotted in the amalgamated company.

Thus, the transaction normally results in tax deferral with continuity of cost and holding period, rather than a step-up of the tax basis to market value.

Section 72A permits specified accumulated business losses and unabsorbed depreciation of an amalgamating company to be treated as those of the amalgamated company, subject to statutory conditions.

Important conditions generally include:

• The amalgamation must involve an eligible undertaking or company covered by Section 72A.
• The amalgamating company must have carried on the relevant business for at least the prescribed period before amalgamation.
• It must have held the prescribed proportion of the book value of its fixed assets for the required period before amalgamation.
• The amalgamated company must hold at least the prescribed proportion of the book value of the acquired fixed assets for the stipulated period.
• The amalgamated company must continue the acquired business for the stipulated period.
• Prescribed conditions relating to revival, production level, and filing of the accountant's certificate must be complied with where applicable.

The accumulated loss must relate to business income and does not ordinarily include speculative loss. If post-amalgamation conditions are violated, the benefit already obtained may be withdrawn and taxed in the year of non-compliance.

In a tax-neutral amalgamation, the amalgamated company generally succeeds to the tax basis of depreciable assets held by the amalgamating company.

• The actual cost to the amalgamated company is governed by the relevant explanations to Section 43(1) and is generally restricted to the tax-recognised cost or written-down value in the hands of the amalgamating company.
• The written-down value is determined under Section 43(6) so that a mere amalgamation does not ordinarily create a fresh depreciable base at market value.
• Under the proviso to Section 32, the total depreciation for the previous year in which succession by amalgamation occurs is restricted to the amount that would have been allowable had the amalgamation not occurred.
• That depreciation is apportioned between the amalgamating and amalgamated companies according to the number of days for which each used the assets.

These rules prevent duplication of depreciation and deny an artificial tax benefit based solely on revaluation of assets during restructuring.

Section 35DD allows an Indian company to deduct expenditure incurred wholly and exclusively for the purposes of an amalgamation or demerger.

The deduction is allowed in five equal annual instalments, beginning with the previous year in which the amalgamation or demerger takes place.

If qualifying expenditure is , the annual deduction is:

Key features are:

• The claimant must be an Indian company.
• The expenditure must be directly connected with the amalgamation or demerger.
• One-fifth is deductible in the year of restructuring and in each of the next four previous years.
• No deduction is available for the same expenditure under another provision of the Act.
• The provision spreads the tax benefit over five years even if the expenditure is paid entirely in one year.

For example, if qualifying expenditure is , the deduction is per year for five years.

Under Section 2(19AA), a demerger is the transfer, pursuant to a scheme of arrangement under the applicable company law, of one or more undertakings of a demerged company to a resulting company, subject to specified conditions.

The principal conditions are:

• All property of the transferred undertaking immediately before the demerger becomes property of the resulting company.
• All liabilities relatable to that undertaking become liabilities of the resulting company.
• Property and liabilities are transferred at values appearing in the books immediately before the demerger, subject to the statutory exception for accounting adjustments required by applicable law or accounting standards.
• The resulting company issues its shares to the shareholders of the demerged company on a proportionate basis, except where it is itself a shareholder of the demerged company.
• Shareholders holding at least three-fourths in value of the shares of the demerged company become shareholders of the resulting company, excluding shares already held by the resulting company, its nominee, or subsidiary.
• The undertaking is transferred on a going-concern basis.
• Any additional notified conditions are satisfied.

The transferred unit must constitute an undertaking or identifiable business activity, and not merely a collection of individual assets or liabilities.

For a demerger, an undertaking includes a part of an undertaking, a unit, a division, or a business activity taken as a whole. It does not include individual assets or liabilities, or a combination of them, which does not constitute a business activity.

An eligible undertaking normally has:

• identifiable business operations;
• assets used in those operations;
• liabilities relatable to the operations;
• employees, contracts, licences, and records, where applicable; and
• the capacity to operate as a going concern after transfer.

The transfer of isolated land, machinery, investments, or receivables is generally insufficient because a demerger contemplates the transfer of an integrated business undertaking. The substance of the transaction must therefore demonstrate continuity of the business activity, rather than a selective sale of assets designed merely to obtain tax-neutral treatment.

Section 47 provides tax-neutral treatment for specified transfers in a qualifying demerger.

• Under Section 47(vib), the transfer of a capital asset by the demerged company to the resulting company is not regarded as a transfer where the resulting company is an Indian company.
• Under Section 47(vid), the issue or transfer of shares by the resulting company to shareholders of the demerged company, in consideration of the demerger, is not regarded as a transfer.

The exemption is conditional on the arrangement satisfying the definition of demerger under Section 2(19AA). If the transaction fails any material condition, normal capital gains provisions may apply.

The exemptions preserve tax neutrality at the restructuring stage. Future transfers remain taxable using the allocated or inherited cost of acquisition and the applicable holding-period rules.

Under Section 49(2C), the cost of shares in the resulting company is determined by allocating part of the original cost of shares in the demerged company in the ratio of the net book value of assets transferred to the net worth of the demerged company immediately before the demerger.

Where:

• = original cost of shares in the demerged company;
• = net book value of assets transferred in the demerger; and
• = net worth of the demerged company immediately before the demerger.

Under Section 49(2D):

Suppose , , and .

Thus, no new aggregate cost is created; the original cost is apportioned between the two investments.

In a qualifying demerger, Section 72A allocates accumulated business losses and unabsorbed depreciation between the demerged company and the resulting company.

• Where the loss or unabsorbed depreciation is directly relatable to the transferred undertaking, it is carried forward by the resulting company.
• Where it is not directly relatable to a particular undertaking, it is apportioned between the demerged company and the resulting company in the ratio of the assets retained and transferred.
• The resulting company may carry forward and set off the allocated amount, subject to the applicable provisions and remaining carry-forward period.
• Unabsorbed depreciation is generally governed by the continuity rules applicable to depreciation, while business losses remain subject to statutory conditions.

The purpose is to place losses with the business that economically generated them and to prevent either duplication or arbitrary transfer of tax attributes.

Amalgamation and demerger differ as follows:

An amalgamation is typically used for consolidation and synergy, whereas a demerger is used for business separation, focused management, investor value discovery, or regulatory restructuring.

Under Section 2(42C), a slump sale means the transfer of one or more undertakings, by any means, for a lump-sum consideration without values being assigned to individual assets and liabilities in the transfer.

Its essential characteristics are:

• One or more complete undertakings must be transferred.
• The undertaking is transferred as a going concern in commercial substance.
• The transfer is for a lump-sum consideration.
• Individual values are not assigned to assets and liabilities for the purpose of the transfer.
• Values stated solely for payment of stamp duty, registration fees, or similar statutory charges do not by themselves prevent the transaction from being a slump sale.
• The expression covers transfer by any means, and is not confined only to a conventional sale.

If assets are separately identified and sold at individually negotiated prices, the transaction may constitute an itemised asset sale rather than a slump sale.

Section 50B contains the special computation mechanism for capital gains arising from a slump sale.

The capital gain is computed as:

Key rules are:

• The prescribed fair market value under Rule 11UAE is deemed to be the full value of consideration.
• Broadly, the prescribed mechanism considers the fair market value of the undertaking based on its assets and liabilities and the fair market value of consideration received or accruing; the higher prescribed amount is adopted.
• The net worth of the undertaking is treated as its cost of acquisition and cost of improvement.
• Indexation is not available for the net worth.
• If the undertaking was held for more than 36 months, the gain is generally long-term; otherwise, it is short-term.
• A report of a chartered accountant in the prescribed form must be furnished within the applicable statutory timeline.

Section 50B is a complete special provision for computing gains from the transfer of an undertaking by way of slump sale.

For Section 50B, net worth is broadly the aggregate value of total assets of the undertaking minus the value of its liabilities as appearing in the books, subject to prescribed tax adjustments.

The value of assets is generally determined as follows:

• Depreciable assets: written-down value of the relevant block determined under Section 43(6).
• Assets for which a full deduction under Section 35AD has been allowed: value is taken as nil.
• Other assets: book value is generally adopted, ignoring revaluation.
• Self-generated goodwill: the prescribed nil-value treatment must be considered under the applicable Section 50B framework.

Example:

• Written-down value of depreciable assets: lakh
• Book value of non-depreciable assets, excluding revaluation: lakh
• Section 35AD assets: lakh, taken at nil
• Book value of liabilities: lakh

Therefore:

If the deemed full value of consideration is lakh and transfer expenses are lakh:

The substance of the agreement, valuation method, transfer of business operations, and allocation of consideration are important in determining the correct character of the transaction.

A demerger is generally appropriate where ownership continuity and tax-neutral separation are intended. A slump sale is more appropriate where an undertaking is being commercially sold for consideration, though it ordinarily triggers immediate capital gains taxation.

The choice of restructuring method should be based on commercial objectives and a detailed evaluation of tax consequences.

Important considerations include:

• Commercial objective: consolidation, separation, fund-raising, disposal, or acquisition of a business.
• Tax neutrality: whether the conditions of Sections 2(1B), 2(19AA), and 47 can be satisfied.
• Immediate tax cost: slump sale normally creates capital gains under Section 50B, while a qualifying amalgamation or demerger may defer tax.
• Transfer of losses: availability and conditions of Section 72A.
• Asset basis: carryover basis in tax-neutral restructuring versus net-worth computation in a slump sale.
• Shareholder taxation: form of consideration, issue of shares, cost allocation, and future exit taxation.
• Indirect taxes and duties: stamp duty, goods and services tax implications, and registration costs.
• Minimum Alternate Tax: impact of accounting entries, book profits, and applicable adjustments.
• Regulatory requirements: company law, securities law, competition law, lender approvals, and sector-specific permissions.
• Anti-avoidance provisions: commercial substance, valuation, related-party terms, and the possible application of GAAR.

Tax planning should support a genuine commercial restructuring. A structure lacking business purpose may face recharacterisation, denial of exemption, or anti-avoidance scrutiny.

A going concern is a functioning business capable of continuing its operations after transfer, rather than a collection of disconnected assets.

In a demerger, Section 2(19AA) expressly requires the undertaking to be transferred on a going-concern basis. This generally implies transfer of the operational assets, relatable liabilities, employees, contracts, licences, records, and other elements required to continue the business.

In a slump sale, transfer of an undertaking as an operational whole is central to distinguishing the transaction from an itemised asset sale. Although every liability or employee need not necessarily move in every factual situation, the transferred components should retain the essential identity and commercial functionality of the business.

Evidence of going-concern transfer may include:

• uninterrupted business operations;
• transfer of key assets and liabilities;
• migration of employees and contracts;
• continuation of customers, licences, and records; and
• the buyer's ability to operate the undertaking immediately after transfer.

Failure to demonstrate this condition can jeopardise the intended tax treatment.

The company should apply the following decision framework:

• Identify the commercial objective: Determine whether the intention is to separate the business while preserving shareholder ownership or to sell it to a buyer for consideration.
• Define the undertaking: Confirm that the division constitutes an independent business activity with identifiable assets and liabilities.
• Examine consideration: A proportionate issue of shares by the resulting company supports a demerger, whereas lump-sum consideration payable to the transferor supports a slump sale.
• Test statutory conditions: For a demerger, verify every condition under Section 2(19AA), including transfer at book values, shareholder continuity, and going-concern status.
• Estimate tax cost: Compare tax-neutral treatment under Section 47 with capital gains under Section 50B using prescribed fair market value and net worth.
• Review tax attributes: Determine how losses, unabsorbed depreciation, asset costs, and holding periods will move.
• Evaluate non-tax costs: Estimate stamp duty, registration charges, regulatory approvals, and implementation time.
• Document business purpose: Record commercial reasons, valuation methodology, board decisions, and independent advice.

A demerger is generally suitable for a tax-neutral business separation with continuity of ownership. A slump sale is generally suitable for an outright business transfer where the seller intends to realise consideration.