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India High Court Rejects Demerger on Grounds of Tax Evasion

India
19 Jan 2011

The provisions relating to corporate mergers are contained in sections 391 to 396A of the Companies Act, 1956 ("Co Act"), which also deals with compromises or other Corporate arrangements. Such Corporate mergers or arrangements take effect once they are sanctioned by the appropriate High Court under section 394 of the Co Act. In this important ruling, which can be said to be a first of its kind, the High Court of Gujarat recently refused to sanction a Scheme of Demerger after it noted that the scheme would result in tax evasion. The ruling was in the case of a large Telecom Company, wherein the Court observed that there was no business justification for the proposed Scheme and alleged that it would have resulted in evasion of taxes and stamp duties, if it was approved by the High Court. Taxand India analyses the ruling and the effect this will have on companies looking to apply a demerger scheme to their business.

The transferor company proposed a Scheme of Demerger to transfer its 'Passive Infrastructure Assets' ("PIAs") to a group company ("Transferee"), free of liabilities and encumbrances. Under the scheme, no consideration was to be paid by the Transferee. After the demerger, the Transferee company was to be merged with an independent telecommunication tower company ("Tower Company"). As per the standard procedure, the Court directed the companies to issue public advertisements of the proposed demerger in leading newspapers. The income tax department responded to the advertisements and filed its objections to the proposed demerger on the ground that the scheme, if approved, would result in tax evasion.

The Court observed that that the proposed demerger was not a mere internal restructuring as ultimately the PIAs were to be transferred by merger with the Tower Company, which was an independent company and in that case, the criterion of the 'same persons carrying on the same business' would not be met. It further noted that in the absence of any consideration, which was a basic requirement under the contract law, the scheme would not qualify as an arrangement. The Court further observed that the agreement was a forced one and not a voluntary action and hence, it would not satisfy the condition for 'gift' under the Transfer of Property Act.

On the issue of tax evasion, the Court observed that the transferee company was a shell / paper company, being an intermediate vehicle for transferring PIAs from the transferor and ultimately to Tower Company with the sole purpose of tax evasion. It noted that if the PIAs were directly sold to Tower Company, the transaction would have attracted capital gains tax computed on market value apart from levy of stamp duties and Value Added taxes. The Court also noted that if the scheme was approved, the transferee would be in a position to claim tax holiday on the profits derived from the same block of assets, which were used by the transferor earlier to claim the tax benefits. Further, it noted that the transferor, who was under the Minimum Alternate Tax regime sought to artificially reduce its book profits by writing off the assets and depressing its taxable income. It also noted that the transferee company would also have claimed depreciation on the PIA, thereby resulting in double deduction for tax purposes. It also noted that the approval by the Court would have led to the circumvention of section 281 of the Income-tax Act, 1961, which required taxpayers to seek a prior approval from the tax authorities before transferring assets. In the background of these observations, the Court accepted the objections raised by the income tax department and refused to sanction the scheme of demerger.


Taxand's Take


While it was never in question that a scheme of merger or demerger should also pass the test of not being designed for tax evasion, some of the specific observations of the Court would add to the debate on the fine line between tax evasion and tax avoidance. Recent reports indicate that the Tax Department is closely examining several cross-border merger deals for possible tax evasion, coming on the heels of the high profile proceedings in the case of Telecom Giant Vodafone's acquisition of Hutch in India. This latest ruling (re)emphasises the significance of ensuring economic substance in corporate restructurings. With the General Anti Avoidance Rule ("GAAR") provisions poised to enter the statute book with the enactment of the Direct Taxes Code, the ruling highlights the already vigilant and aggressive approach of the Revenue. Taxpayers need to ensure thorough design of restructuring plans to stand the best chance of surviving objections and/or questioning by the tax authorities, before being approved by the Courts.

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