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Saturday, Jan 17, 2004

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Getaways in the demerger route

T. C. A. Ramanujam

The definition of demerger requires a relook in the light of abuse of corporate tax incentives, says T. C. A. Ramanujam

TO ENABLE Indian industry become globally competitive, tax concessions were brought in by the Finance Act, 1999, to take care of the entire gamut of business reorganisation. Existing provisions relating to amalgamations of companies were rationalised and new ones relating to demerger of companies, or sale/transfer of business as a going concern through slump sales were introduced.

The Companies Act had no specific provision governing demergers. Recourse to Sections 391 and 394 of the Companies Act had to be made through schemes of compromise or arrangement. While presenting the Budget of 1999-2000, the then Finance Minister had observed at Para 86:

"With growing liberalisation of the economy has come the need for industrial restructuring so that companies can focus better on their core activities. The corporate sector has been voicing the need for a flexible fiscal policy for regulating business reorganisations. In response to this need, I propose a comprehensive set of amendments to the Income-Tax Act, to make such business re-organisations fully tax neutral."

In demergers, tax benefits and concessions available to any undertaking are made available to the undertaking on its transfer to the resulting company. The condition regarding continuity of the same business for the allowability of loss to an assessee under Section 72 of the Income-Tax Act, 1961 was dispensed with. The accumulated losses and unabsorbed depreciation in a demerger is allowed to be carried forward by the resulting company if these are directly relatable to the undertaking proposed to be transferred.

Where it is not possible to relate these to the undertaking, such losses and depreciation will be apportioned between the demerged company and the resulting company in proportion of the assets coming to the share of each as a result of demerger. Tax benefit to such business reorganisation is limited to transfer of specific assets, which would amount to sale of assets and not business reorganisation.

It is now nearly five years since these proposals came into the statute book. The amendments came into effect from April 1, 2000. In this short period, abuses of the liberal tax concessions for demerger and business reorganisation have come to the fore. Parent companies are seen to be hiving off assets for meagre consideration to subsidiaries. This, in turn, raises difficulties in the matter of collection of pending income-tax demands from the parent companies.

Questionable re-structuring exercises are undertaken with a view to strip parent companies of vital assets and defeat revenue. In the process, the parent company's business is reduced to the minimum and no significant assets are left from which the I-T Department can recover its dues. The parent company becomes a shell company though styling itself as a holding company.

When the amendments were made, the Central Government was able to prescribe guidelines or conditions so as to ensure that the demergers were made for genuine business purposes. Section 281 of the I-T Act declares certain transfers to be void. But this applies where such transfers are made during the pendency of any proceeding under the Act. It also does not apply to assets not forming part of the stock-in trade of the business. Now that abuses of the demerger provision have come to the notice of the Department, it is necessary that suitable amendments be further made to safeguard the interest of revenue. Asset-stripping is a favourite mechanism always used by errant taxpayers to defeat the Revenue.

When the Finance Minister declared that the demerger provisions in the law were to be tax neutral it was not anticipated that the provisions would be abused not merely to take advantage of tax concessions but also to defeat legitimate tax revenues. Such abuses have, however, not become widespread. The few cases that have come to the notice of the Department should be enough to alert the Department to prevent proliferation of abuses of tax concessions.

Proper amendments should be made to the law to safeguard revenue. The definition of demerger in Section 2 (19AA) requires fresh look. The property and liabilities of the undertaking being transferred by the demerged company, as per the definition, will be transferred at book value. Even a unit or a division or a business activity of an undertaking can be transferred.

No doubt, all the property of the undertaking, including liabilities relatable to the undertaking being transferred by the demerged company, shall become the property and liabilities of the resulting company. But it is necessary to specifically lay down that demergers should not result in defeating the Revenue by way of transfer of assets.

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