[Opinion] Understanding the Tax Implications of Corporate Demergers – Case Study of Reliance Industries Ltd.

CA V K Subramani – [2023] 152 taxmann.com 556 (Article)

Business reorganization has become a buzzword with rapid economic advancement across the globe. The geographical barriers have become history because of the advancement of technology which has compressed the world and distance. Presently, the practice of discharging the assigned duties from remote is widely accepted and has become a routine. The mobility of competent persons from one place to another physically has been dispensed with, at least in the lower and middle level management. Organisations have to evolve and survive in the changing scenario and only such organizations who have adopted and embraced changes could survive and succeed. It is in this background, we come across instances of amalgamations, mergers and demergers.

One of the prominent methods of achieving better operational efficiency and increased profitability is by demerger which was resorted to recently by the corporate conglomerate Reliance Industries Ltd when it decided to hive off Reliance Strategic Investment Ltd (RSIL). Post hived off RSIL would be rechristened as Jio Financial Services Ltd (JFSL). However, the expression RSIL is used in this write up.

In consideration for hiving off RSIL by RIL, each of the shareholder of RIL would become eligible for 1 equity share of RSIL for each of the shares held in RIL. The shareholders of RIL need not shell out any money by way of payment for getting the shares of RSIL. It is in this background, the income-tax implication of such demerger and also the future tax liability of the shareholders who hold shares of both RIL and RSIL are discussed in this write up.

Legal provisions

(i) Meaning of demerger: Section 2(19AA) defines the term ‘demerger’ which is the exclusive domain applicable for corporate entities only and which could not be used by other forms of organisations. However, just to deflect, in the case of ‘slump sale’ defined in section 2(42C) it is applicable to all forms of organisations, be it individual, firm, LLP or company. Prima facie, demerger does not attract income-tax and whereas ‘slump sale’ is chargeable to tax under the head ‘capital gains’

(ii) Compliance requirement: The fundamental requirement for such tax neutral demerger is that such demerger must be in accordance with the scheme of arrangement contained under the Companies Act, 2013 (contained in sections 230 to 232). The resulting company must be eligible for taking over all the assets and liabilities of the undertaking transferred by the demerged company held immediately before demerger and which become the property of the resulting company by virtue of demerger. Similarly, all the liabilities relatable to the undertaking transferred by the demerged company must become liabilities of the resulting company by virtue of demerger. Further three-fourth of the shareholders of the demerged company must become shareholders of the resulting company and other attendant conditions of demerger contained in section 2(19AA) are to be satisfied and those conditions have not been discussed in this write up since they are procedural in nature.

(iii) Meaning of the term ‘transfer’: It is defined in section 2(47) inclusively and covers sale, exchange, relinquishment of the asset or extinguishment of any rights therein or compulsory acquisition thereof under any law. When shareholder of a demerged company receives shares from the resulting company there is decrease in asset (shown as investment) of the demerged company as the shares of resulting company are allotted to the shareholders. The demerged company also knocks off asset on demerger in return for allotment of shares from the resulting company to its shareholders.

(iv) For transferor – transaction not to be regarded as ‘transfer’: Section 47(vib) says any transfer in a demerger, of a capital asset by the demerged company to the resulting company is not to be regarded as ‘transfer’ if the resulting company is an Indian company.

(v) For shareholders of demerged company – transaction not to be regarded as ‘transfer’: As per section 47(vid) any transfer or issue of shares by the resulting company, in a scheme of demerger to the shareholders of the demerged company is not to be regarded as ‘transfer’ if the transfer is made in consideration of demerger of the undertaking.

(vi) Period of holding: Section 2(42A) defines the term ‘short-term capital asset’. When shares in an Indian company become the property of the assessee in consideration of demerger, the period for which the shares were held in the demerged company would also be included. If the shares in the demerged company were held for more than 12 months then any share issued as a result of demerger by the resulting company would automatically become long-term capital asset on the date of allotment in the hands of the shareholders of the demerged company.

(vii) Cost of acquisition – for resulting company: As per section 49 where the capital asset became the property of the assessee as per section 47(vib) or section 47(vid) the cost of acquisition of the asset shall be deemed to be the cost for which the previous owner of the property acquired it. Thus, when a demerged company transfers assets to a resulting company in a scheme of demerger, the cost of acquisition of the capital asset for the resulting company would be the same as that applicable for the demerged company.
One may take note of the proviso to section 2(19AA) (iii) inserted by the Finance (No.2) Act,2019 w.e.f.1st April, 2020 which says that the demerger would be tax neutral even if the resulting company records the value of the property and liabilities of the undertaking at a value different from the value appearing in the books of account of the demerged company, immediately before demerger, provided such variation is in compliance with the Indian Accounting Standards specified in Annexure to the Companies (Indian Accounting Standard) Rules, 2015. Thus, if the values vary in the books of resulting company but those are permissible as per Indian Accounting Standard Rules, 2015 the transaction of demerger would continue to be tax neutral.

(viii) Cost of acquisition for shareholders of demerged and resulting company: When a shareholder of a demerged company receives shares of resulting company the cost of acquisition of shares of the resulting company shall be computed with reference to the cost of acquisition of shares held in demerged company. As per section 49(2C) the cost of acquisition of the shares in the resulting company shall be the amount which bears to the cost of acquisition of shares held by the assessee in the demerged company the same proportion as the net book value of the assets transferred in a demerger bears to the net worth of the demerged company immediately before demerger.

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