Tax Implications on Demerger of Company under IT Act

Nikhil Mogha

01 Jun, 2024

The demerger of a company simply means splitting of company into two or more parts. Any compromise or arrangement is defined under the Companies Act 2013, however, the said act is silent on demerger. Hence, the general meaning of demerger of the company can be termed as a kind of corporate restructuring whereby the company decides to part with one of its business activities to operate it under a distinct entity. A demerger can also occur by transferring a business to a new business in lieu of which the existing shareholders are issued new shares.

The National company law tribunal approves the scheme of the demerger, wherein all the liabilities, assets, and shareholders are transferred to the transferee company. Hence, the scheme of the demerger is a transfer wherein there is a capital gain on the side of the transferee company and capital loss on the side of the Transferor Company. This capital gain and loss would attract tax implications, which the company shall adjudicate carefully. Henceforth, the present article will discuss in detail the tax implications on demerger of the company from both sides.

What Is The Meaning Of Demerger Under The Income Tax Act 1961?

Before understanding the tax implications on demerger of a company under the IT act, it is imperative to first understand the meaning of demerger and demerged company. The demerger is defined under Secretion 2(19AA) of the Incomes Tax Act 1961. It means a transfer of demerged company or its undertaking into a resulting company.

According to Section 2(19AAA), a “demerged Company” is a company whose undertaking is transferred to the resulting company under the demerger.

Moreover, the act states that the demerger shall be accorded as a transfer if it is performed in such a manner that:

1. All the property of the demerged company becomes the property of the resulting company immediately before the demerger.
2. All the liabilities of the demerged company become the resulting company’s liabilities immediately before the demerger.
3. All the liabilities and properties of the undertaking are valued at the book value of the account.
4. The resulting company issues its shares in proportion to the shareholders of the demerged company.
5. The shareholders holding at least 3/4^th in value of shares of the demerged company will become the shareholders of the resulting company by virtue of the demerger.
6. The transfer of the undertaking shall be on a going concern basis.

What Are The Tax Reliefs Available To Demerged Companies?

The tax implications on demerger in the case of a demerged company are defined under section 47 of the Income tax act. It states that transactions not regarded as transfers will not attract any tax liabilities under the IT act. Henceforth, certain transfers are exempted from the tax under the scheme of demerger.

1. Transfer to Indian Company: As per Section-47(vib) of the IT act, any transfer of a capital asset of the demerged company to the resulting Indian company in a scheme of the demerger is not regarded as transfer, and hence the tax implications on demerger for such transfer is an exemption of tax liability on capital gains.
2. Transfer to foreign Company: As per Section-47 (VIC) of the IT act, any transfer of capital assets, being the shares held in the Indian company, by the demerged foreign company to the resulting foreign company in a scheme of the demerger is not regarded as transfer, and hence the tax implications on demerger for such transfer is an exemption of tax liability on capital gains, provided that:
   • The shareholders of the demerged foreign company remain a shareholder of the resulting foreign company, provided they hold at least 3/4^th of the value of shares in a demerged foreign company.
   • The transfer does not attract any tax on capital gains in the country of demerged foreign company.
3. Transfer to shareholder of the Demerged company: As per Section 47 (vid) of the IT act, any issue or transfer of shares by the resulting company to the shareholders of the demerged company in a scheme of the demerger is not regarded as a transfer, and hence the tax implications on demerger for such transfer is an exemption of tax liability on capital gains provided that the said transfer or issue is made in place of consideration for demerger of the undertaking.

What Are The Tax Reliefs Available To The Resulting Company?

The tax implications for the resulting company are enumerated in a different section of the IT Act.

1. Depreciation on transferred assets: As per Section-32 (1) of the act, the deduction is allowed in case of depreciation of the assets. Further, tax implications on demerger are enumerated under the fifth proviso of section 32(1). It specifically states that the aggregate deduction allowed in place of depreciation to the demerged company and the resultant company shall not exceed the deduction calculated at the prescribed rates in any previous year. Moreover, such deduction shall be shared between the demerged and the resulting company according to the ratio of number of days the asset is used.
2. Deductions on the expenditure of Patent rights and Copyrights:  As per Section 35A (1) of the IT act, a deduction is allowed in case of expenditure on acquiring patent rights or copyrights. Further, in a scheme of demerger, the deduction is allowed when a demerged company sells or transfers the rights to the resulting Indian company provided:
   • Section 35A (3) and (4) would not apply to a demerged company.
   • All the provisions of Section 35A would apply to the resulting company.
3. Deduction for expenditure on Know-how: As per Section 35AB, the term “know-how” means any industrial information or technique that is likely to aid in manufacturing or processing goods. Henceforth, any lump sum expenditure on the know-how is allowed a deduction under Section 35AB (1). The tax implications on demerger under the said section are that the resulting company is eligible for the same deduction and residual period as would have been allowed to the demerged company under Section 35AB (2).
4. Deduction for Certain expenses: As per Section 35D (1), the deduction is allowed if any expenditure in respect of the preparation of a feasibility report, project report market survey or engineering services and legal charges for drafting an agreement. Further, under Section 35D (5A), where an undertaking of the Indian Company is transferred to another company in a scheme of demerger, the following tax implications on demerger will be attracted:
   • No deduction will be allowed to Demerged Company under this section
   • The resulting company can claim a deduction according to the provisions of this section.
5. Deduction for Amortisation expenses on Demerger: As per Section35DD, a deduction is allowed to an assessee being an Indian company for the amount incurred by the company in lieu of demerger of an undertaking. Further, the tax implication on demerger is the deduction of 1/5^th of the amount for the 5 successive years.
6. Deductions in profits and gains from industrial undertakings: As per Section 80-IA of the IT act, where an undertaking is transferred to an Indian Company in a scheme of demerger, a deduction is allowed on the profits and gains earned from the industrial undertakings. Further, the following tax implications on demerger will be attracted:
   • No deduction is allowed under the section to the demerged company for the previous year in which the demerger takes place
   • The resulting company can claim a deduction according to the provisions of this section

What Is the Computation Method of the Actual Cost, EDV and Carry Forward & Set-off?

1. Computation of actual cost of the transferred Capital Asset: The tax implications on demerger for computation of the actual cost of the transferred asset are defined under Explanation 7A of Section 43 (1). It state states the actual cost of the transferred asset will be the same as it would have been before the demerger and used by the demerged company for its own business. However, the value of the transferred asset shall not be more than the WDV (Written Down value) of such assets in the hands of demerged company.
2. Computation of WDV of the block of Assets: The tax implications on demerger for computation of the actual cost of the transferred asset are defined underExplanation 2A and 2B of Section 43(6) (ii). It states that if the assets are transferred to the resulting company in a scheme of demerger, the written down value of the asset shall be computed as:
   • For the Demerged Company: WDV of the block of assets of Demerged Company, immediately preceding the previous year – WDV of assets transferred t the resulting company
   • For the Resulting Company: WDV of assets transferred of the demerged company immediately before the arrangement of a demerger.
3. Carry forward and Set off of accumulated loss and Unabsorbed Depreciation: As per section 72A (4), the accumulated loss and unabsorbed depreciation of the demerged company are allowed to be carried forward and set off subject to conditions :
   • Where the loss or unabsorbed depreciation directly relates to the undertaking transferred, then the carry forward and set off is allowed in the hands of the resulting company.
   • Where the loss or unabsorbed depreciation is not directly related to the undertaking transferred, then such loss or deprecation shall be apportioned between the demerged company and the resulting company in the same proportion as if the demerged company retained it and the carry forward and set off will be allowed to both demerged and resulting company.

Conclusion

The demerger of the company is a type of corporate restructuring in which the company decides to divide its operations and form a new entity. From the above provisions, we can conclude that the tax implications on demerger are tax-free in the hands of the demerged company. However, there are some tax implications in the hands of the resulting company. Further, there will be no capital gains when there is the transfer of assets by the demerged company to the resulting company. On the other hand, the resulting company is allowed deductions and tax relief on transferred assets, expenditures and various expenses.

Read Our Article: Legal Analysis of Demerger in Corporate