Rajasthan HC’s Landmark ruling: Pre-existing undertaking a pre-requisite for demerger

The Companies Act 1956 permits corporate restructuring by way of mergers, demergers etc. with the prior approval of the High Court. The High Court in the court process issues notices to the Regional Director representing the Ministry of Corporate affairs and the Regional Director files his observations to the High Court.

In a recent case, Rajasthan High Court heard the scheme of demerger of Uma Enterprises Private Limited [LSI-954-HC-2016-(RAJ)]. The Income Tax Act 1961 has specific provisions governing such demergers and provides exemption from payment of income tax on transfer of business undertakings if certain conditions are satisfied. One of the conditions for a tax exempt demerger is that the business should satisfy the test of an undertaking and the same has to be transferred as a going concern.

Similarly the stamp duty laws (in certain states) have exemptions/ concessions from payment of stamp duty in the case of merger / demerger.

In the given case the Regional Director opposed the sanctioning of the scheme of demerger and submitted that the demerger scheme was a sham to transfer the company\'s land to third parties circumventing liability towards capital gains under the Income-tax Act, 1961 and stamp duty under the Rajasthan Stamp Act, 1998.

The Regional Director contended that the Company did not carry out any separate real estate business at any point of time as there was there was no turnover, income or expenditure from the said business and that such land was not recorded as a current asset in the books of accounts. The Regional Director further contended that the share-holders were proposed to be allotted compulsorily redeemable preference shares and not equity shares thus separating them from the ownership in the resultant companies.

The Company contended that the demerger was in compliance with all operative laws and that the Company is free in law to arrange its affairs to minimize its tax burden. The Company further contended that it had incurred certain capital expenditure on levelling of the land and that the memorandum of the Company was amended in 2010 permitting the Company to do real estate business.

The High Court observed that issue of compulsorily redeemable preference shares indicated that the proposed transaction is a plain vanilla transfer of land and not a corporate restructuring as one of the requirements of restructuring is that the existing share-holders continue to own and manage the resulting company by means of equity interest and that in the given case the preference shareholders would not have management rights in the resulting companies.

The High Court held that the scheme of demerger appeared to be only a device for avoidance of obligation towards capital gains tax and stamp duty and sanctioning the same would be against public interest on account of loss of revenue to the government.

The transfer of a business undertaking has always been a matter of litigation under the provisions of the Income Tax Act and the benefits of demerger provisions were given in cases where the separate business entity was established.

The above ruling has stressed the importance of a preexisting undertaking as a pre –requisite for demerger.