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Tax Implications on Demerger
Demerger means the transfer of one or more undertakings to any resulting company by a demerged company in pursuant to a scheme of arrangement that fulfils the following conditions:
- All the property and liability of the undertaking “immediately before demerger” becomes the property and liability of the resulting company.
- All the property/liabilities are transferred at book value i.e. without considering the effect due to revaluation.
- The resulting company issues shares to the shareholders of demerged company on a proportionate basis, obviously this condition is not applicable where resulting company is a shareholder of the demerged company.
- Shareholders holding minimum 75% of the value of shares of demerged company become shareholders of the resulting company (other than shares already held therein immediately before the demerger by, or by a nominee for, the resulting company or its subsidiary).
- The transfer of an undertaking is on a going concern.
Tax Implications in hands of Shareholders
- It is very clear that the shareholders are bound to roll over their asset by exchanging the asset of one company by other, so accordingly capital gain tax shall arise in hands of shareholders. However by virtue of Section 47 of the Income Tax Act there will be no Capital Gain charge ability on this transaction.
- Resulting company may distribute the assets of the company to the shareholder, and accordingly one may think it to be dividend u/s 2(22). But this interpretation of law is incorrect since the definition explicitly asks that dividend shall not include “(v) any distribution of shares pursuant to a demerger by the resulting company to the shareholders of the demerged company (whether or not there is a reduction of capital in the demerged company).
- The period of holding of shares of resulting company shall consider even the period of holding of shares of demerged company.
- The Cost Of Acquisition (COA) shall be as follows:
- Of shares of Resulting company.
COA of shares of demerged Company * Net book Value of asset transferred
Net Worth of demerged company immediately before demerger.
Of shares of Demerged company.
COA of original shares in demerged company
Less: COA of shares in resulting company.
Tax Implications in hands of Resulting Company
- The actual cost of the assets transferred to the resulting company shall be the WDV of the assets in hand to demerged company.
- The preliminary expenses, expenditure for voluntary retirement scheme that are not allowed as deduction shall be allowed as deduction to the resulting company for the balance number of years.
- In the year of demerger the total depreciation that shall be allowed to both the companies as if demerger has not taken place shall be the maximum amount of depreciation allowable to both of them taken together.
The loss/ unabsorbed depreciation of the undertaking transferred shall be carried forward by the resulting company. Such loss shall be allowed for the balance number of years.
- The expense of demerger shall be allowed as deduction for a period of 5 successive assessment years.
- If bad debts of demerged company are recovered by resulting company, it will not be taxable in hands of resulting company. However any other benefit derived example any other expense recovered shall be taxable. Please note, although the recovery will not be taxable the Bad Debts of demerged entity shall be allowed as deduction
- If the undertaking transferred are eligible for deduction of Sections 10AA/80IB/80IC/80IE the deduction in the year of demerger shall be allowed to resulting company and not to demerged company.
Tax Implications in hands of Demerged Company
- Again here when demerged company passes the assets to resulting company capital gain tax shall arise in hands of resulting company. However by virtue of Section 47 of the Income Tax Act there will be no Capital Gain charge ability on this transaction.
- On transfer of assets the WDV of the assets shall be reduced in hands of demerged company since is added to the block of resulting company as discussed above.
To conclude, I would say that demerger is a process in which there is no kind of double taxation. If the income is taxable in hands of one company it will not be taxable with another company. The benefit of one shall be carried forward by another with only exception of Section 80IA.