In an upsetting ruling, the Hyderabad ITAT in Vertex Projects LLP[1] has held that even in a court approved merger, the resulting company will have to pay taxes if the assets of the merging companies were transferred to it for less than fair market value.
The anti-avoidance provisions were inserted into Section 56 of the Income tax Act, 1961 (“IT Act”), to prevent transactions undertaken to evade taxes. These provisions are intended for transactions wherein assets/ properties are transferred at less than their fair market value.
Mergers and demergers are generally kept out of the ambit of these anti-abuse provisions since they are tax neutral transactions, i.e. Section 47 of the IT Act specifically exempts mergers and demergers from the levy of any capital gains tax. Further, the exemption list provided under Section 56 of the IT Act exempts various transactions contemplated in mergers and demergers.
The ITAT, however, looked at the exemptions listed in a theoretical manner. It appeared to have disregarded the legislative intent and held that one of the transactions forming a part of the merger scheme was not specifically mentioned in the exemption list provided under Section 56(2)(viia) of the IT Act, and accordingly held that a particular transaction in a merger would be falling within the ambit of Section 56(2)(viia) of the IT Act.
The merger generally consists of following transactions:
- Transfer of assets and liabilities by the transferor company to the resulting transferee company;
- Transfer/ extinguishment of shares of the transferor company; and
- Issuance of shares of resulting transferee company to the shareholders of the transferor company.
All the abovementioned transactions have been specifically exempted from the levy of capital gains tax by virtue of various clauses forming a part of Section 47 of the IT Act. The exemption list provided in Section 56(2)(viia) refers to the said clauses of Section 47 to state that such transactions shall be out of its ambit as well. However, a specific clause of Section 47, dealing with the transfer of assets of the transferor company was not mentioned in the said exemption list of Section 56(2)(viia).
Hence, the ITAT proceeded to hold that the transfer of assets by the transferor company in a merger scheme would be governed by Section 56(2)(viia) since the said transaction was not mentioned in the exemption list. Therefore, the ITAT had held that the assets of the transferor company (consisting shares of other companies) ought to have been transferred at fair market value.
In our view, the ITAT’s literal interpretation of the provisions appears to completely disregard the legislative intent behind the insertion of the anti-abuse provisions. In a tax neutral merger, there cannot be any question of undervaluation of assets since the shareholders of the transferor company would become shareholders of the resulting transferee company, thereby resulting in no change in the ultimate ownership of assets. As per the facts of the case before the ITAT, the shareholders of the transferor company were also the shareholders of the resulting transferee company and the shareholding ratio in both the companies were also the same. Therefore, the shareholding percentage of shareholders in the resulting transferee company before and after the merger continued to be identical. Hence, it cannot be stated that the intention of the parties was to abuse tax provisions to avoid taxes. Accordingly, anti-abuse provisions should not have been invoked when there was no intention to avoid taxes. The CBDT in its Circular[2] had specifically stated that Section 56(2)(viia) was introduced as an anti-abuse provision.
Even otherwise, the ITAT ought to have at least appreciated the fact that the legislature while replacing Section 56(2)(viia) with Section 56(2)(x) w.e.f 2017 had specifically included the transfer of assets by the transferor in the merger scheme under the exemption list. Therefore, the ITAT should have appreciated that the legislative intent behind Section 56(2)(viia) was never to tax the transfer of assets in a merger scheme.
Since Section 56(2)(viia) is no longer applicable, it would be reasonable to expect that similar taxes would not be levied on transactions that are governed by Section 56(2)(x). However, it would be worthwhile for parties to consider transferring assets vis-à-vis issuance of shares under the merger/ demerger scheme at fair market value even for internal business reorganisation to avoid any additional scrutiny by tax officers. The scrutiny trigger point in this case was that the assets (i.e. shares of other companies) were transferred at face value. The parties could have avoided further examination by the tax department if they had undertaken the merger at fair market value, especially since such an exercise would not have resulted in any additional taxes.
[1] TS-224-ITAT-2023(Hyd)
[2] Circular No.1 of 2011