The Hindu Business Line : A formula that needs fixing up

STRANGE and funny denouements could be in store for both investors and the Income-Tax Department from the following two sub-sections to Section 49 of the Income-Tax Act, 1961 in the context of prescribing the mechanism for unbundling the cost of shares acquired before demerger in the demerged company and distributing them among the demerged and resulting companies:

"Section 49(2C): The cost of acquisition of the shares in the resulting company shall be the amount which bears to the cost of acquisition of shares held by the assessee in the demerged company the same proportion as the net book value of the assets transferred in a demerger bears to the net worth of the demerged company immediately before such demerger."

"Section 49(2D): The cost of acquisition of the original shares held by the shareholder in the demerged company shall be deemed to have been reduced by the amount as arrived at under sub-Section (2C)."

"Explanation: For the purposes of this section, `net worth' shall mean the aggregate of the paid-up share capital and general reserves as appearing in the books of account of the demerged company immediately before the demerger."

It is not understood why the other components of net worth have been left out. Notable omissions are the balance in share premium account and the balance in profit and loss account. Share premium often forms a substantial part of net worth, especially given the hefty premiums charged by companies of late.

At any rate, share premium as much belongs to the shareholders and, hence, forms a part of net worth as general reserves do. The omission of balance in profit and loss account is equally shocking, given the fact that companies often keep such balance without transferring more than what is necessary under the dividend rules to reserves.

Debit balance in profit and loss account has the effect of diluting the net worth, and overlooking the same can distort the figure of net worth. Let us take a concrete but hypothetical case to test the working, credibility and reliability of the above formulas. The balance sheet of the demerged company immediately before the demerger is as follows (figures in crores of rupees):

Liabilities: Share capital, Rs 500; share premium, Rs 600; general reserves, Rs 100; profit and loss account, Rs 200; liability to outsiders, Rs 600; sub-total, Rs 2,000.

Assets: Fixed assets, Rs 1,400; current assets, Rs 600; sub-total, Rs 2,000.

Assuming there are two divisions, A and B, with B being hived off, and further assuming that the net book value of assets transferred to B is exactly half of the net assets — Rs 1,400 crore, that is, Rs 2,000 crore minus Rs 600 crore, being liability to outsiders — the following would be the distribution if Mr X, for example, had purchased shares of the company at Rs 1,000 each.

Out of Rs 1,000, the cost of one share in B would be Rs 700 (the net assets taken over) divided by 600 (share capital plus general reserves) and multiplied by Rs 1,000. This would result in something absurd.

The cost of a share in B would be Rs 1,167. And what would be the leftover that is supposed to be the cost of a share in A? It would be minus Rs 167 given the fact that the aggregate must add up to Rs 1,000, period. The reason for this absurdity is not far to seek. It is elementary accounting knowledge that net worth and net assets must tally. The net assets are Rs 1,400 and the net worth as per accountant is indeed also Rs 1,400 (that is, 500 + 600 + 100 + 200).

But the formula prescribed by the above provisions has the effect of restricting the net worth in the above example to just Rs 600, thereby giving ludicrous results.

Had the income-tax law also adhered to the accountants' concept of net worth, the embarrassment would have been avoided. Let us test this proposition too in the light of the same facts and figures. Cost of a share in B would be 700 divided by 1,400 and multiplied by Rs 1,000. This works out to Rs 500 leaving Rs 500 as cost of share of A which is as it should be.

(The author is a Delhi-based chartered accountant.)

More Stories on : Taxation | Mergers & Acquisitions

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
ON A NEW TRACK

Finer points in a ship's final journey

A formula that needs fixing up

Will the Budget provide relief to sick companies?

Missing planes and tanks

Pulling its weight for the economy

Lalu on a new corridor