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Court sanction to corporate reorganisation: tax considerations

Rupesh Jain & Gautam Chopra  |  New Delhi 

Corporate reorganisations are effected to restructure business primarily to give more operational flexibility to the management, attain operational synergies, with a view to carrying on business more efficiently and profitably, to use resources of the enterprise optimally and sometimes also as a tool to achieve family settlements. Sections 391-394 of the Act, 1956 regulate the reorganisation of The scope of the sections is very wide and covers a vast array of business reorganisations including mergers, demergers, amalgamation, sale of undertakings and debt restructuring.

The scheme of business reorganisation is subject to approval by shareholders and subsequent sanction by the jurisdictional High Court. The Courts generally consider the objections of creditors, members and any other party having, in the opinion of the Court, a locus standi in the matter prior to granting approval to the scheme of reorganisation. The Supreme Court, in a landmark case (Miheer H. Mafatlal v Ltd), laid down the guidelines for the Courts to follow while considering such schemes and observed that apart from considering the objections of creditors and/or members, the Court must also consider that the proposed scheme of compromise and arrangement should not be violative of any provision of law and should not be contrary to public policy. In the past, courts have rejected a scheme when it was found to be mala fide and motivated primarily to defeat the claims of creditors (Bhagwan Singh & Sons Pvt. Ltd. v Kalwati). Courts have also, in the past, rejected the schemes because the same were considered unfair and unworkable.

However, in what is probably the first ruling of its kind, the Gujarat High Court, in the case of Gujarat Ltd [Company petition no.183 of 2009 (Guj)], declined to sanction the scheme of demerger filed by the petitioner on the ground that it was designed to evade tax.

In this case, the transferor, Gujarat Ltd, (“the petitioner company”) filed a petition under section 391 to 394 of the Act, 1956, for demerger to transfer its ‘Passive Infrastructure Assets’ (essentially comprising the mobile telecommunication towers) to Infrastructure Ltd (“transferee”), free of liabilities and encumbrances. The corresponding liabilities were not to be transferred. No consideration was payable by the transferee nor were any shares to be allotted to the members of the transferor. Post de-merger, the transferee was to be made a substantially owned company of a new company to be formed by all or some of the shareholders of the transferee. Thereafter, the transferee was to be amalgamated/ merged into Indus Towers Ltd. Since demerger and amalgamation are tax-neutral under tax laws subject to fulfillment of prescribed conditions, the effect of the scheme was transfer of passive infrastructure assets to Indus Towers Ltd. without payment of any taxes.

At the time of filing the petition, certain income tax demands were outstanding against the petitioner company. The application was opposed by the Income-tax department on the ground that since no consideration was involved, the transaction was invalid. It was also contended that the transaction did not fall within the ambit of sections 391 to 394 but was a simple transfer of assets between two separate entities to evade legitimate taxes which would have been payable if the transaction was effected as a simplicitor transfer.

The Court, after considering the objections of the Income Tax department, rejected the petition. In rejecting the petition, the Court made some far reaching observations. The Court observed that a gift is not contemplated under the aforesaid provisions of the Further, the Court observed that the scheme being an agreement without consideration may be void under section 25 of the Indian Contract Act, 1872.

Coming to the objections of the Income Tax Department, the Court agreed with the Department’s contention that the transferee may claim in future tax benefit under section 80IA of the Income-Tax Act, 1961 (“IT Act”) once again on same block of assets on which the transferor had already claimed the benefit under that section, treating the passive infrastructure assets as an undertaking eligible for the aforesaid benefit. The Court also held that the scheme appeared to be a camouflage to circumvent the mandatory provisions of the IT Act and may be held to be void under section 281 of the IT Act (which requires a no objection certificate to be obtained before transfer of assets, in certain cases). The Court agreed with the contention of the Income Tax department that the transaction could be a “conduit” to avoid capital gains because had it been entered into directly with Indus Towers, tax exemption, available to eligible demergers, would not have been available and tax of about Rs 3,500 crore may have been payable. Demerger under the IT Act, it may be noted is tax neutral and does not give rise to any capital gains tax either in the hands of the transferor or the shareholders of the transferor.

It was also held that the transaction sought to avoid stamp duty because if it had been entered into as a sale to Indus Towers, stamp duty at the rate of 6% would have been payable whereas in case of a demerger stamp duty at the rate of 1% is payable. Further, the Court observed that no VAT was payable on the movable assets transferred under the scheme if the same was sanctioned under section 391 of the Companies Act, which otherwise would have been payable. Considering the totality of circumstances and the objections of the Income Tax department, the scheme could not be sanctioned since in view of the Court it was void in law and designed to avoid tax.

While it is well recognised that tax laws themselves provide for tax-neutral corporate reorganisations subject to conditions, this ruling highlights that Courts may not be inclined to sanction schemes which having regard to provisions of various tax statutes, give an impression as if they are designed to avoid tax. Therefore, companies would have to consider tax provisions carefully while drafting the corporate reorganisation schemes to ensure that the same are strictly in compliance thereof and that the same have sufficient commercial/business justification.

Rupesh Jain is a Partner and Gautam Chopra is a Senior Associate at law firm Vaish Associates

First Published: Wed, April 13 2011. 14:14 IST