Tax on Demerger

As per section 391 to 394 of the Companies Act, 1956 there is no proper definition of demerger. Demerger simply means the splitting of the existing company into two or more resultant company.

The Income-tax Act, 1961 provides the tax reliefs to the demerged company, the shareholders of the demerged company, who are issued and allotted shares in the resulting company in the exchange for the shares held by them in the demerged company and the resulting company which emerges as a result of a demerger.

Tax Benefits Available to Demerged Company:

1.Tax on Capital Gain is not attracted:As per section 47 (vib) of the Income Tax Act, the transfer of any capital asset by the demerged company to the resulting company will not be regarded as transfer for the purpose of capital gain.

2. Tax relief to Foreign Demerged Company: As per section 47 (vic), where a foreign company holds any shares in an Indian company and transfer the same to resulting company in the course of demerger, such transfer will not be regarded as “Transfer” for the purpose of capital gain, if following conditions are satisfied:

  • 75% of the shareholders of demerged foreign company continue to remain shareholders of the resulting foreign company.
  • Capital gains tax is not attracted on the demerged foreign company in the country of its incorporation and S. 391 to S. 394 of the Companies Act will not be applicable.

Tax Benefits To The Shareholders Of The Demerged Company:

1. Dividend:  Section 2(22) has been amended by inserting a new clause (v) to provide that no dividend income shall arise in the hands of shareholders of demerged company on demerger.

2. Capital Gains: As per section 47 (vide), any transfer or issue of shares by the resulting company to the shareholders of the demerged company, in scheme of demerger, is not regarded as “Transfer” for the purpose of Capital Gains.

The tax implication will only arise when either the shares of RIL or the shares of the new Resulting Companies are sold.

But  When Shares are sold its tax implication will be as follows:

When the shares of any of the companies are sold, it would give rise to capital gains tax liability. The three issues that arise are:

  • Whether the new shares (in the Resulting Companies) are long-term assets or short-term.
  • Indexation of the capital gains.
  • Cost of acquisition of the various shares after the demerger transaction

a)  To find out whether or not shares in the Resulting Companies are long-term or not, the holding period of the shares (in the demerged company) will be included in the period of holding of the new shares (in the resultant company).

b)  The indexation will start from the date of allotment of the new shares and not from the date of acquisition of shares. Relevance of indexation is only for working out the capital gain amount if the same has to be set-off against capital loss. However, as explained further on, for most shareholders, there will be no need of this.

c)  To calculate capital gains when the shares are sold, a vital piece of information is the cost of acquisition. Your original cost of acquisition of shares will change now on account of the demerger. Plus there will be a new cost accorded to the new shares of the Resulting Companies. The Income Tax Act specifies a complicated formula that takes into account the proportion of the net worth of RIL vis a vis the book value of the businesses transferred to arrive at the new costs of acquisition.

Tax Benefits Available To Resulting Company:

1.  Expenses by an Indian company incurred after 1-4-1999 for amalgamation or demerger of an undertaking (Sec 35DD), shall be amortized 1/5th each year starting from the year in which amalgamation or demerger takes place.

2.  Depreciation shall be apportioned between the demerged company and the resulting company in the ratio of number of days for which the assets were used by them.

3.  The accumulated losses and unabsorbed depreciation in a demerger shall be allowed to be carried forward by the resulting company

4.  Benefits available for demerger are also extended to authorities or boards set up by Central or State Government.

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