We are familiar with the joy of a child offered a chocolate, only to be crushed when it reaches out to take it. The child realises that it would get the prize only after fulfilling certain unpalatable conditions.Yashwant Sinha has offered corporate India tax benefits for re-organisation through demergers. They will discover that this tantalising offer is beset with many pitfalls. Sinha had stated: "What the minister for petroleum gives, the minister of finance takes away". It appears that bureaucrats have taken away what the finance minister has given.
The idea behind granting tax benefits for corporate restructuring and reorganisation was to assist Indian enterprises in these difficult times. They are forced to restructure in response to the economic transition from a centrally controlled structure to being market-driven.
Consequently core competency and focused operations are today's buzz words. This calls for both exiting from non-core activities initiated during the license control raj andconsolidate scales in core activities to match international standards. Any divestiture of non-core activities would involve implications of capital gains tax and management of unabsorbed allowances. Hence the need to offer sops to business.
The budget introduces a concept of demerger, defined in the new sub-section 19AA of section 2. The phrase demerger appears to be adopted to represent divestiture or spin-offs. The definition restricts de-merger to a transfer pursuant to a scheme of arrangement under section 391 to 394 of the Companies Act.
This mandates a court intervention, mutually workable divestiture would also have to go through lengthy court procedures to avail of tax benefits. The logic of mandating such court intervention is not clear. Transfer must result in all the property of the undertaking and liabilities relatable to the undertaking becoming the liability of the resulting company.
The resulting company should issue shares on a proportionate basis in consideration for the demerger. Theshareholders of not less than three-fourths in value of the shares in the demerged company should become shareholders of the resulting company. The transfer of the undertaking is on the basis of a going concern and the demerger is in accordance with conditions if any, notified under sub-section 5 of section 72 A.
The requirement of the resulting company having to take over all liabilities relatable to the undertaking could in itself make the provision a non-starter. In a divestiture or in arrangements for reorganisation, the buyer would not be interested in being burdened with liabilities. If the value of the undertaking under demerger is less than the liabilities to be taken over, reverse consideration would have to flow. No business enterprise would be willing to pay any amount in addition to transferring the undertaking.
It the unit is not performing well, the buyer would also expect that the seller should settle with lenders. Compulsory transfer of liabilities would defeat these objectives and hencemight scare away potential buyers. To make matters worse, liabilities relatable to the undertaking are defined to include:
(a) the liabilities which arise out of the activities or operations of the undertaking;(b) the specific loans or borrowings (including debentures) raised, incurred and utilised solely for the activities or operations of the undertaking; and(c) in cases, other than those referred to in clause (a) or clause (b), so much of the amounts of general or multipurpose borrowings, if any, of the demerged company as stand in the same proportion which the value of the assets transferred in a demerger bears to the total value of the assets of such demerged company immediately before the demerger.This could creatre difficulties in case the company has a consolidated working capital facility. By virtue of clause (c), liability attributed could be more than what is warranted by the operations. No buyer would concede to take over such superimposed liabilities.
Hence it may benecessary to carry out an elaborate capital restructuring exercise, before effecting the demerger. It should, however be possible to combine such restructuring and demerger as a composite proposal under section 391 application to court. In such eventuality it is advisable that the date of takeover be set at a future date after the restructuring is complete.
The transfer of assets complying to the definition of demerger will not attract capital gains tax. These are provided in section 47, sub-clause (vi b) (vi c) and (vi d). Clause (vi c) specifically provides for exclusion of capital gains tax in the case of transfer of shares held in an Indian company by a demerging foreign company to a resulting foreign company. Further, unabsorbed losses and depreciation of the demerged company will be transferred to the resulting company. If the losses are depreciation are clearly not identifiable with the undertaking they will be transferred in proportion to the asset transferred. This is a major tax incentive andshould normally have propelled tax-driven deals. Considering the other implications, it may not take off as anticipated.
The capital gains exemption necessarily mandates that in the hands of the resulting entity, the actual cost of assets shall be taken to be the same as it would be in the hands of the demerging company. However such actual cost shall not exceed the written down value. There is apparently a confusion in the clause (explantion 7A newly inserted in section 43).
The concept of actual cost and written down value are essentially different. The determination of written value for income tax and accounts are also different. The determination of written value for a group of assets for income tax purposes could pose yet another complication. Ever since the `group of assets' concept was introduced, individual written value of assets are not be maintained. On sale of an asset, the entire sale consideration is deducted from the written down value. What would be the written down value for the purposeof de-merger?
It appears that de-mergers have a long way to take off. Until the horizon is clear, it is too far fetched to except any increased activity on this front, due to tax breaks.
The author is a Mumbai-based chartered accountant. His email address is rlakshman@vsnl.com
Copyright © 1999 Indian Express Newspapers (Bombay) Ltd.
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