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Set-off of Losses Following Demerger Disallowed by Indian Tax Tribunal

Sept. 1, 2022, 7:00 AM

Section 72A of India’s Income Tax Act 1961 is a beneficial provision which allows a taxpayer to carry forward and set off accumulated losses and unabsorbed depreciation pursuant to an amalgamation or demerger, subject to satisfying certain conditions. While section 72A(2) prescribes specific conditions which need to be fulfilled before such set-off can be claimed in respect of amalgamations, no specific guidelines have been issued in the case of demergers.

Section 72A(4) permits accumulated losses and unabsorbed depreciation directly relatable to the undertaking (and a prescribed portion of accumulated losses and unabsorbed depreciation not directly related to the undertaking) that is being transferred to the resulting company under a demerger to be carried forward and set off by the resulting company. Section 72A(5) empowers the Central Government to issue guidelines to ensure that the demerger is for genuine business purposes. However, no such guidelines have been issued. As a result, there is lack of clarity on whether this benefit is prima facie available to companies pursuant to demergers or if certain conditions need to be satisfied prior to claiming such benefit.

The Indian Revenue Authorities have often attempted to deny such benefit to taxpayers by arguing that the demerger was structured for the sole purpose of seeking a tax benefit or for tax evasion. Recently, a similar issue arose before the Pune Income Tax Appellate Tribunal in the case of Cummins Sales & Services Ltd where the tribunal clarified the scope of section 72A(4) to demerger schemes that had been approved by the jurisdictional High Court.

Background

The taxpayer was an Indian company engaged in the business of selling and servicing diesel engines and related equipment. It acquired an undertaking from its wholly owned subsidiary pursuant to a scheme of demerger, which had been duly approved by the Bombay High Court. Subsequent to the demerger, the taxpayer filed an income tax return and claimed, per section 72A(4), set-off of certain unabsorbed depreciation losses and carried forward business losses that were related to the demerged undertaking.

During assessment, the tax officer noticed that the assets of the demerged undertaking were held for sale. The officer accordingly took the view that there was no intention on the part of the taxpayer to continue with the business of the demerged undertaking, which defeated the purpose behind the enactment of section 72A(4).

The officer was also of the opinion that the conditions set out in section 72A(2), which had to be satisfied before an accumulated loss could be set-off in the case of an amalgamation, were also clearly applicable in the case of a demerger. Accordingly, the officer denied the taxpayer’s set-off claim on the grounds that the demerger was not carried out for genuine business purposes, as required by section 72A(5).

The taxpayer appealed to the Commissioner of Income-tax (Appeals), the first appellate authority for income tax cases in India. The Commissioner held that once a demerger has been approved by the jurisdictional High Court, it was not within the jurisdiction of the tax officer to question the motive behind the demerger. Further, the Commissioner observed that, in the absence of any notification by the Central Government under section 72A(5) providing such conditions it considered necessary to ensure that a demerger is for genuine business purposes, the officer could not deploy his own test to determine the genuineness of the demerger. Thus, the Commissioner reversed the tax officer’s decision to disallow the set-off of the taxpayer’s losses.

The Indian Revenue Authorities appealed against the Commissioner’s order.

Tribunal’s Ruling

The tribunal noted that while it is a settled position of law that once a demerger has been approved by the jurisdictional High Court it cannot be revisited by any statutory authority, set-off of losses was not allowed ipso facto in respect of all demergers/amalgamations under the Income Tax Act. Section 72A prescribed specific conditions under which set-off of brought forward losses is allowed in cases of demergers/amalgamations.

The tribunal further noted that the Bombay High Court, while approving the demerger, had not considered the issue of set-off of losses for the taxpayer. Just because a demerger/amalgamation had been approved by the jurisdictional High Court, it did not automatically entitle a taxpayer to avail itself of the tax benefit of setting-off its brought forward business losses.

The Pune tribunal then proceeded to discuss the scheme of section 72A holistically. It noted that while specific guidelines were available in the case of an amalgamation (including, inter alia, a requirement for the amalgamated company to continuously hold at least three-fourths of the assets of the amalgamating company for a period of five years after amalgamation), no such guidelines had been issued for demergers despite section 72A(5) empowering the Central Government to issue guidelines to ensure that demergers were undertaken for genuine business purposes.

In order to understand the scope of section 72A, the tribunal then looked into the intent of the legislature when inserting this provision.

The tribunal noted that, in the context of amalgamations, it had previously been held by the Delhi High Court in IEL Ltd v Union of India [1992] 195 ITR 232 (Delhi) and the Bombay High Court in Ballarpur Industries Ltd v Commissioner of Income Tax [2017] 398 ITR 145 (Bombay) that the benefit of section 72A cannot be claimed where the sole purpose of the amalgamation was to benefit from brought-forward losses.

Further, the Supreme Court in Commissioner of Income Tax v Mahindra & Mahindra Ltd [1983] 144 ITR 225 (SC) had also held that the purpose of enacting section 72A was to promote the revival of sick undertakings, which may not otherwise be financially viable prior to amalgamation. Reliance was also placed on the memorandum explaining the provisions of Finance (No 2) Bill 1977, which similarly highlighted the intent of the legislature to insert section 72A to revive sick units.

On reading the complete text of section 72A, the tribunal held that the provisions regarding demergers (i.e., section 72A(4) read with 72A(5)) were inserted with the same objective as the provisions governing amalgamations (i.e., section 72A(1) read with 72A(2)). Thus, the benefit of set-off of losses could not be allowed when the sole purpose of the demerger was to obtain a benefit under section 72A(4).

The tribunal observed that the financial statements of the taxpayer reflected that the assets of the demerged undertaking were held for sale. Further, it had not carried on any business of the demerged undertaking after the approval of the demerger by the Bombay High Court. Accordingly, it agreed with the contention of the Indian Revenue Authorities that the taxpayer had no intention to carry on the business of the demerged undertaking.

Thus, the tribunal held that the demerger was undertaken with the objective of the taxpayer availing itself of the benefit of set-off of losses under the Income Tax Act and it accordingly rejected the taxpayer’s claim to carry forward and set-off its losses under section 72A(4).

Significant Takeaways

The Pune tribunal has asserted that the provisions of section 72A of the Income Tax Act can be invoked by the Indian Revenue Authorities to protect its interest, even after the scheme of merger or demerger has been approved by the relevant court.

Recently, the Chandigarh bench of the National Company Law Tribunal in In the matter of scheme of amalgamation of Panasonic India Private Ltd and Panasonic Life Solutions India Private Ltd CP (CAA) No. 8.Chd/Hry/2021 adopted a similar view to the Pune tribunal and held that the sanction of a scheme at the approval stage did not automatically entitle a taxpayer to tax benefits.

While the decision of the Pune tribunal provides clarity in respect of the application of section 72A, it has raised concerns for taxpayers looking to undertake business restructurings in India. It means that a scheme, which has already been sanctioned by the jurisdictional High Court, is open to increased scrutiny from the Indian Revenue Authorities.

Further, it is relevant to note that while the provisions of section 72A clearly stipulate the conditions for carrying forward and setting-off losses in the case of an amalgamation, the absence of specific guidelines in the context of demergers leaves open a wide array of possibilities for the Indian Revenue Authorities to question genuine demerger transactions at the assessment/reassessment stage. This ruling, in effect, may lead to the Authorities attempting to deny benefits available under section 72A(4) by relying on conditions provided under section 72A(2) (such as conditions pertaining to continuity of business).

However, the real impact of the Pune tribunal ruling will be determined on the specific facts of each transaction and the considerations brought before the National Company Law Tribunal or High Court when they decide whether to approve a scheme of demerger/amalgamation. Taxpayers should thus ensure that they have adequate material on record to justify the demerger; that it was taken due to commercial expediency for the continued growth/existence of the business. They should also be mindful of their conduct after the approval of the scheme and ensure that they do not undertake any sale of business assets which may signify an intention not to continue with the demerged business.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Kunal Savani is a partner, Bipluv Jhingan is a principal associate, and Lakshya Gupta is an associate with Cyril Amarchand Mangaldas, Mumbai, India.

The authors may be contacted at: kunal.savani@cyrilshroff.com, bipluv.jhingan@cyrilshroff.com and lakshya.gupta@cyrilshroff.com