There are multiple reasons for corporate restructuring through mergers or amalgamations. Companies might want to merge in order to save operational costs, to grow and diversify or to gain financial strength owing to the larger size of merged assets. However, one thing that no entrepreneur will dispute in today’s era of globalization is that mergers and acquisitions are the best bet to survive and effectively compete with the global companies. The tax concessions available in the case of merger or amalgamation support and second the market trend. These concessions play a particularly significant role in the merger of a sick company with a financially sound company.
This bulletin seeks to analyze the tax benefits to amalgamating as well as amalgamated companies in case of a merger or amalgamation. The benefits ensure that a merger does not attract additional tax liabilities or result in the withdrawal of existing relief and concessions available to the merging entity.
1. What constitutes Amalgamation?
The term amalgamation has a specific meaning under the Income Tax Act, 1961 (“ITA”).1 It means merger of one or more companies with another company, or the merger of two or more companies to form one company such that2 (1) all the property of the amalgamating company vests in the amalgamated company, (2) all the liabilities of the amalgamating company become the liabilities of the amalgamated company, and (3) at least three fourth of the shareholders of the amalgamating company become shareholders of the amalgamated company.
The ITA specifically excludes3 from the scope of amalgamation, any transaction involving (1) merger of a company into another company by sale of assets of the former, and (2) receipt of assets of a company being wound up, by another company pursuant to the order of the liquidator in the winding-up proceedings. The transfer of assets and liabilities of the amalgamating company to the amalgamated company should be in terms of the scheme of amalgamation.
The procedure for effecting a merger or amalgamation of companies is defined under the Companies Act, 1956 (“Act”).4 The Act does not define the terms merger or amalgamation. As per the Act, both the amalgamating and amalgamated companies have to submit the scheme of amalgamation to the High Court for its approval, after the shareholders and creditors of the respective companies approve the scheme. Amalgamation of companies becomes effective upon sanction of the scheme of amalgamation by the High Court.
2. Capital gains tax exemption
Profits or gains arising out of the transfer of a capital asset attract capital gains tax.5 Accordingly, any gain to the amalgamating company on transfer of assets to the amalgamated company should be chargeable to capital gains tax. However, ITA provides exemptions from capital gains tax to the amalgamating company as well as its shareholders.
2.1 Capital gains tax exemption for an amalgamating company
The Supreme Court has made it clear that with the extension of the meaning of the term transfer to extinguishment of rights6 amalgamation has to be treated as a transfer of assets or shares (as the case may be), except in the cases expressly stated under the ITA.7 The provisions of ITA expressly state that any transfer of assets by the amalgamating company to the amalgamated company pursuant to a scheme of amalgamation will not be considered as a transfer for the purpose of capital gains tax.8
Further, the ITA provides that any transfer of shares of an Indian company between two foreign companies in pursuance of the scheme of amalgamation will not be regarded as transfer for the purpose of levy of capital gains tax. This is subject to the condition that (i) at least 25% of the shareholders of the amalgamating foreign company are shareholders in the amalgamated foreign company, and (ii) such transfer does not attract capital gain tax in the country where the amalgamating company is incorporated.9
It may be noted that the capital gains tax exemption is not available in case of a merger of an Indian company with a foreign company, as the aforesaid provisions require that the amalgamated company should be an Indian company.
2.2 Capital gains tax exemption to the shareholders
Allotment of shares in the amalgamated company to a shareholder in consideration for the shares held in the amalgamating company is not treated as transfer for capital gains tax purposes.10 The Supreme Court rejected the contention that shareholders receive shares in the amalgamated company in exchange of the shares held in the amalgamating company and since the definition of transfer under the ITA, includes exchange, capital gains tax should be payable on the allotment of shares in amalgamated company. It was clarified by the court that possession of shares in amalgamating company was only a qualifying condition for allotment of shares in the amalgamated company and it cannot be said that any exchange of shares is taking place.11 Further, in order to avail the aforesaid exemption the shareholder of the amalgamating company should be allotted only shares in the amalgamated company and nothing more. Therefore, in a case where in addition to the shares in the amalgamated company, a person was also allotted bonds or debentures of the amalgamated company, it was held that the exemption from payment of capital gains tax will not be available.12 The basic difference between a share and a bond/debenture is that unlike a share that represents a part of the share capital of a company, a bond/debenture is a debt instrument and its holder becomes the creditor of the company.
2.3 Transfer of shares post amalgamation
Tax on capital gains will be charged when the shares allotted to the shareholders of the amalgamating company in the amalgamated company, are transferred to a third party. In order to calculate the capital gains in such a case, the cost of acquisition of shares13 in the amalgamated company will be same as the cost at which the shares were acquired in the amalgamating company or the market value of shares as on the notified date (presently, April 1, 1981) at the option of the tax payer.14 ITA provides that the market value of shares on the notified date can be treated as the cost of acquisition of shares in the amalgamated company only if the shares became a property of the tax payer before the notified date.15 In this regard, it is not necessary that the shares in the amalgamated company are allotted to the shareholder on a date before the notified date. It is sufficient if the shareholder acquired the shares in the amalgamating company before the notified date.
In a case before the Madras High Court, the tax payer acquired the shares in the amalgamating company before the notified date. However, the shares in the amalgamated company were allotted after the notified date. The High Court rejected the contention of the income tax department that since the shares in the amalgamated company did not exist on the notified date; the tax payer should not be allowed to treat the cost of acquisition of shares as the market value. The Court held that the allotment of share in the amalgamated company in lieu of the shares in the amalgamating company is not a transfer. The shares in the amalgamating company cannot be treated as a new asset, distinct and separate from the shares held in the amalgamating company. The tax payer was allowed to consider the market value of shares on the notified date as the cost of acquisition of shares.16
Similarly, the cost of acquisition of any capital asset acquired in terms of the scheme of amalgamation will be the cost at which the amalgamating company acquired it, to which the cost of any improvement brought about to the asset by the amalgamating company or the amalgamated company will be added. Here also the amalgamated company has an option to consider the value of assets as on the specified date, provided the capital asset becomes the property of the amalgamating company before the specified date.17
Therefore, though there is no tax on capital gains in case of transfer of property from the amalgamating company to the amalgamated company, in terms of the scheme of amalgamation, when the
latter transfers such property or assets, it will be subject to tax on capital gains based on the cost at which the amalgamating company acquired the assets or property.
3. Deductions or allowances to the amalgamated company
ITA defines various expenses that are allowed as a deduction against the profits chargeable to tax. On amalgamation, the amalgamating company ceases to exist and the amalgamated company carries out its business. Various provisions of the ITA ensure that the deductions and allowances available to the amalgamating companies are also available to the amalgamated company, to the extent not claimed by the former. The significant ones are discussed below.
3.1 Expenditure on scientific research and acquisition of patent rights
Any expenditure of a capital nature incurred on scientific research relating to business of the taxpayer is allowed as a deduction.18 If the amalgamating company transfers to the amalgamated company, any asset representing capital expenditure on scientific research, the amalgamated company is entitled to the aforesaid deduction, in the same manner as that of the amalgamating company, as if no transfer of asset had taken place.19
Intellectual property rights such as patent and copyright are amongst the most significant assets of any business unit and a company makes considerable investment in acquiring them. The expenses incurred for acquiring patent rights utilized for the business of the tax payer are specifically allowed as a deduction from the profits chargeable to tax. Upon amalgamation, deductions as regards capital expenditure on acquisition of patent rights are available to the amalgamated company in the same way they were available to the amalgamating company.20 Again, to avail the aforesaid deductions, amalgamated company should be an Indian company.
3.2 Expenditure on Know-how
A lump sum consideration paid by a taxpayer for acquiring any know-how for the purpose of its business is allowed as a deduction by spreading it over six years, namely, the year in which lump sum consideration is paid and five immediately succeeding years. Upon amalgamation of a company entitled to such a deduction, the amalgamated company can avail the deduction to the same extent (for the residual period) as would have been allowed to the amalgamating company, had such amalgamation not taken place.21
3.3 Amortization of preliminary expenses
ITA allows the amortization of certain preliminary expenses22 incurred by an Indian company before the commencement of business or for setting up a new industrial unit. The amortization is allowed against the profits of the company in ten equal installments over a period of ten years. The preliminary expenses that are not amortized by the amalgamating company as on the date of amalgamation are allowed as a deduction to the amalgamated company against the profits chargeable to tax.
3.4 Amortization of amalgamation expenses
ITA allows amortization of expenses incurred in respect of amalgamation. An Indian company that incurs any expenditure wholly and exclusively for the purpose of amalgamation is allowed a deduction of an amount equal to one-fifth of such expenditure for five successive years from the year in which amalgamation takes place.23
4. Carry forward of losses and depreciation allowance
By far the most significant benefit in case of amalgamation of companies is the carry forward of unabsorbed losses of the amalgamating company to the amalgamated company, particularly, in the case of a merger of a sick company with a profitable one. Tax benefits in the form of provision for carry forward of losses and unabsorbed depreciation ensure that the companies have an incentive to revive the business of a financially non-viable undertaking by merging such an undertaking with itself.
The rule regarding set-off and carry forward of losses is that business loss incurred in one business is available to be set-off against the income from another business in the same year. If such other business income is not sufficient to absorb, then, such unabsorbed loss can be set-off against any other income from another source. If after such adjustment also, accumulated loss remains, then it is allowed to be carried forward to be set-off against income in the following years, subject to a maximum of eight years.
Normally, unabsorbed depreciation allowance and business losses can be carried forward and set-off against the business profits of subsequent years only by the person who had incurred those losses. However, ITA carves out exceptions in case of amalgamation of companies and provides that where a company owning an industrial undertaking has amalgamated, its accumulated loss and the unabsorbed depreciation shall be deemed to be the loss, or as the case may be, the allowance for depreciation of the amalgamated company and all the provisions of the ITA relating to carry forward of losses and allowance for depreciation shall apply accordingly. In order to qualify for the aforesaid benefit the amalgamating company as well as the amalgamated company should satisfy the following conditions:24
- The amalgamating company must own an industrial undertaking or must be a banking company.25 The definition of Industrial Undertaking is restrictive and includes only an undertaking engaged in (1) manufacture of goods and software, (2) business of generating and distributing electricity, (3) providing telecom services, (4) mining, and (5) construction of ships and aircrafts.26
- The amalgamating company must be engaged in a business in which the losses accumulate or depreciation remains unabsorbed for a period of three or more years.
- As on the date of amalgamation, the amalgamating company continuously held 75% of the fixed assets held by it two years prior to the date of amalgamation.
- The amalgamated company must hold at least 75% of the fixed assets of the amalgamating company for a continuous period of 5 years from the date of amalgamation.
- The amalgamated company must carry on the business of the amalgamating company for a period of 5 years from the date of amalgamation.
- The amalgamated company must fulfill certain conditions to ensure the revival of business of the amalgamating company, notably achieving a level of production of at least 50% of the installed capacity within four years of amalgamation and must continue to maintain the same till the end of five years from the amalgamation. Further, upon achieving the aforesaid level of production the amalgamated company is required to submit to the assessing officer a certificate verified by a chartered accountant, stating the particulars of production as well as the return of income.27
The benefit of carry forward and set-off of unabsorbed losses and depreciation allowance will be available from the financial year in which the amalgamation takes place. However, if in any year the amalgamated company does not comply with the aforesaid conditions, any set-off of loss or allowance of depreciation allowed to the amalgamated company in any previous years will be treated as the income of the amalgamated company chargeable to tax in such year.
The conditions to be satisfied in order to claim the benefit of carry forward of losses and unabsorbed depreciation allowance are restrictive in nature, especially, the condition to be satisfied by the amalgamated company regarding continuing the loss making business for five years and owning 75% of the fixed assets for five years from the date of amalgamation. Further, at present this exemption is available to companies in certain sectors only, such as, manufacturing, telecom, software, shipping, hotels etc. and does not cover the booming service sector as a whole. Moreover, the condition of achieving a particular level of production as per the installed capacity is irrelevant, in sectors such as software where no manufacturing or processing is carried out as it is difficult to determine and compare the level of production with the capacity installed for such production.
The tax sops in a merger deal are many and quite often act as a motive for merger of companies. The underlying principle is that tax benefits should be limited to transfer of business as a going concern and not to transfer of specific assets, which would amount to the sale of assets and not business reorganization. There is an exemption from the payment of capital gains tax on transfer of assets and shares pursuant to the scheme of amalgamation. The amalgamated company continues to enjoy the benefit of various deductions and allowances available to the amalgamating company, to the extent not claimed by the latter. Last but not the least, the unabsorbed depreciation of the amalgamating company can be carried forward and set-off against the business income of the amalgamated company. This acts as an incentive for healthy companies to merge sick industrial units with themselves. Presently, the scope of exemption regarding carry forward of losses is narrow and does not apply to the service sector as a whole. Suitable amendments are required in the ITA to cover the service sector as a whole, as this sector is growing at an intense pace and any tax benefit in a merger deal would loose its meaning if the service sector is left out.
1 Section 2(1B) of the ITA.
2 The company or companies which so merge are known as amalgamating companies and the company with which they merge or which is formed as a result of a merger is known as amalgamated company.
3 Section 2(1B) of the ITA.
4 Section 391-394 of the Act.
5 Section 45 of the ITA.
6 The definition of transfer in section 2(47) of ITA includes extinguishment of any rights.
7 CIT, Cochin v. Mrs. Grace Collis and Ors. AIR 2001 SC 1133. This decision of the Supreme Court settled the controversy as to whether amalgamation involves a transfer within the meaning of ITA.
8 Section 47(vi) of the ITA. 9Section 47(via) of the ITA. 10 Section 47(viii) of the ITA. 11 Supra, 7
12 CIT v. Gautam Sarabhai Trust (1988) 173 ITR 216 (GUJ). Similar view has been taken by the Karnataka and Calcutta High Court in
CIT v. Master Raghuveer Trust, (1985) 151 ITR 368 and Shaw Wallace and Co v. CIT (1979) 119 ITR 399 (Cal) respectively.
13 For the purpose of computing capital gains, cost of acquisition of an asset means the value at which the tax payer acquired the asset.
14 Section 49(2) read with 55(2)(b).
15 Section 55(2)(b)(i).
16 Madura Coats Limited v. CIT, (2005) 279 ITR 493 (Bom).
17 Section 55(2)(b) and 49(1)(iii)(e).
18 Section 35(1) of ITA.
19 Section 35(5) of ITA.
20 Section 35A(6) of ITA.
21 Section 35AB(3) of ITA.
22The preliminary expenses include expenditure for (1) preparation of project/feasibility report, (2) conducting any market survey or any other survey necessary for business, (3) engineering service related to the business of the person claiming deduction, (4) legal charges for drafting articles and memorandum of association of the company.
23 Section 35DD of ITA.
24 These conditions are stated under section 72A of ITA and Rule 9C of the Income Tax Rules, 1962
25 The benefit of carry forward and set-off of business losses is also available to companies owning a ship or a hotel, in addition to the companies owning an industrial undertaking.
26 Section 72A(7)(aa) of ITA.
27 Rule 9C of Income Tax Rules, 1962.