Budget 2018 dodges on amalgamation path of tax avoidance
By CA Anjali Kukreja, RN Marwah & Co LLP Chartered Accountants
Tax law before Budget 2018 amendment: Provisions of section 115-O of the Income Tax Act, 1961(„Act‟) provide for application of Dividend Distribution Tax („DDT‟) @ 15% (plus applicable surcharge and cess) on the amount of dividend (declared distributed or paid by a domestic company). Further, provisions of section 115-Q provide that the expression dividend for the purpose of section 115-O would include deemed dividend under section 2(22)[sub-clauses (a),(b),(c) and (d)] of the Act.
Section 2(22)(d) provides that dividend includes any distribution to its shareholders by a company on the reduction of its capital, to the extent to which the company possesses accumulated profits, whether such accumulated profits have been capitalized or not. As per Explanation 2 to section 2(22), the expression "accumulated profits" in sub-clause (d), shall include all profits of the company up to the date of distribution or payment.
On a combined reading of the above provisions of the Act, a domestic company is required to pay DDT of 15% (plus surcharge and cess) on the amount paid to its shareholder on reduction of its share capital to the extent of its accumulated profits.
Strategy to avoid payment of DDT on payment to shareholders on capital reduction
In order to avoid DDT, certain unlisted companies, mainly multinationals resort to Purchase Methodi of Amalgamation wherein a profit-making company with huge Accumulated Profits is amalgamated with a company having significantly lower profits or even losses. Fixed Assets (including huge bank and cash) of the amalgamating company are transferred to the amalgamated company. Accumulated profits of the amalgamating (transferor) company are not recorded/accounted for in the books of the amalgamated company [as in the purchase method of amalgamation, accumulated profits / losses of the amalgamating company lose their identity].
After amalgamation, amalgamated company reduces capitalii by:-
i. Cancelling paid up share capital against accumulated losses; and
ii. Distribution of cash to the shareholders for paying off any paid-up share capital which is in excess of the wants of the company
On this distribution of cash on capital reduction, the company circumvents payment of DDT u/s 2(22)(d), as the DDT is applicable on distribution of cash only to the extent of accumulated profits, and the amalgamated company usually does not have any accumulated profits.
Amendment made in Budget 2018
Extract of Finance Bill 2018 (covering the amendment) is reproduced below:-
In section 2 of the Income-tax Act,–– (a) in clause (22), after Explanation 2, the following Explanation shall be inserted, namely:–– ―Explanation 2A.–– In the case of an amalgamated company, the accumulated profits, whether capitalized or not, or loss, as the case may be, shall be increased by the accumulated profits, whether capitalized or not, of the amalgamating company on the date of amalgamation.
Controversy to interpretation of the amendment
Following two views on interpretation of the amendment is reproduced below:-
View 1: Cases where amalgamating company has accumulated losses, then, it will not be recorded in the books of amalgamated company. Only in cases where amalgamating company has accumulated profits, then, it will be added to the accumulated profits or losses of the amalgamated company.
View 2: Accumulated Profits or accumulated losses (as the case may be) of the amalgamating company would be recorded in the books of the amalgamated company. Omission of the expression “or losses, as the case may be” in the context of the amalgamating company is not deliberate.
Analysis of View 1 vs. View 2 (Interpretation of amendment)
Rule of Literal Interpretation
Literal reading of the exact words of the amendment:-
- in the case of an amalgamated company, accumulated profits .., or losses, as the case
- ― "shall be increased by",
- ― "the accumulated profits" of the amalgamating company
Exact interpretation to mean that:-
- Amalgamated company can either have accumulated profits /loss ; and
- Accumulated profit/loss of amalgamated company to be increased by accumulated profits of the amalgamating company
A bare reading of the plain language suggests that, only in the cases where the amalgamating company has huge accumulated profits, such accumulated profits would be added to the accumulated profits/losses of the amalgamated company.
Language clearly uses the expression “accumulated profits or losses as the case may be” for the amalgamated company whereas it uses the expression “increased by accumulated profits of the amalgamating company”. It is evident that the use of the word “losses” for the amalgamated company and its omission for the amalgamating company is conscious and intended.
Rule of Mischief
The language of the memorandum is quite self-explanatory. The language of the memorandum explains that the intent of the law for introducing this amendment is to prevent abusive arrangements for tax avoidance through amalgamation route. Relevant extract of the explanatory memorandum to Finance Bill 2018 is reproduced below for the ease of your reference:-
Instances have come to light whereby companies are resorting to abusive arrangements in order to escape liability of paying tax on distributed profits. Under such arrangements, companies with large accumulated profits adopt the amalgamation route to reduce capital and circumvent the provisions of subclause (d) of clause (22) of section 2 of the Act. With a view to preventing such abusive arrangements and similar other abusive arrangements, it is proposed to insert a new Explanation 2A in clause (22) of section 2 of the Act to widen the scope of the term ‗accumulated profits‘ so as to provide that in the case of an amalgamated company, accumulated profits, whether capitalized or not, or losses as the case may be, shall be increased by the accumulated profits of the amalgamating company, whether capitalized or not, on the date of amalgamation.
The law aims to target mis-use of the amalgamation arrangement wherein the amalgamating company has huge accumulated profits and the intention of amalgamation is to do away with such huge accumulated profits in order to avoid tax on reduction of capital by the amalgamated company (after taking amalgamation effect).
A vice-versa arrangement i.e. wherein the amalgamating company has huge accumulated losses and the amalgamated company has huge accumulated profits is not intended to be covered by this amendment for following reasons –
(a) Intent of the amendment is not to switch places between amalgamating company and the amalgamated company. I.e. the idea is not to reverse the abusive arrangement, so that now the amalgamating company is a loss making company and the amalgamated company is a profit making company. This would mean that post amalgamation, by virtue of the amendment (interpretation under View 2), the amalgamated company may record losses (due to addition of huge accumulated losses to the profits of the company). On applying this interpretation, we come back to square one, as the amalgamated company on reduction of its capital may now be able to circumvent provisions of section 2(22) (d) of the Act. This interpretation (under view 2) renders the amendment as ineffective. The interpretation under view 2 would also amount to tax benefit on account of set off of business losses of the amalgamating company in the current year (i.e. year of amalgamation).
This also reminds me the intent behind introduction of section 72A (provisions relating to carry forward and set off of accumulated loss and unabsorbed depreciation allowance in amalgamation or demerger, etc.) was to prevent tax avoidance under an amalgamation arrangement where the amalgamating company was a lossmaking company and the intention of amalgamation was to avoid tax payment by the profit making amalgamated company, after amalgamation, by taking carry forward & set off business losses and unabsorbed depreciation.
(b) If the amalgamating company is a loss making company and amalgamation is aimed at genuine revival of business under due commercial considerations, then, interpretation under view 1, allows the amalgamating company to leave behind the losses. After amalgamation, if the amalgamated company is a profit making company, then, it would be in better position to raise money from investors or arranging credit/loan for funding as well as reviving of its business operations.
i An amalgamation arrangement can be strategized in a way that results in circumventing section 2(22)(d) of the Act.
Planning of the type of amalgamation:
An amalgamation arrangement can be executed either by Purchase Method or by Pooling of Interest Method.
Under Purchase Method
Assets and liabilities are selectively purchased by the amalgamated company at agreed values.
Accounting treatment: In order to close books of accounts of the amalgamating company, all assets, liabilities and reserves are transferred to a realization account.
Also, the Assets and liabilities being taken over by the amalgamated company are passed through realization account at their agreed values.
Realization income (profit/loss) is passed to the equity shareholders of the amalgamating company.
Under Pooling of Interest Method
There is a line by line addition of books of accounts of amalgamating company with the books of accounts of the amalgamated company. i.e. All assets and liabilities of the amalgamating company are taken as it is at existing book values as per the books of the amalgamating company.
ii A reference may be made to Section 66 of the Companies Act 2013, which deals with reduction of share capital. It states that subject to prescribed conditions of the companies act 2013, a company can reduce the share capital in any manner and in particular, may—
(a) extinguish or reduce the liability on any of its shares in respect of the share capital not paid-up; or
(b) either with or without extinguishing or reducing liability on any of its shares,—
i. cancel any paid-up share capital which is lost or is unrepresented by available assets; or
ii. pay off any paid-up share capital which is in excess of the wants of the company, alter its memorandum by reducing the amount of its share capital and of its shares accordingly
Anjali KukrejaR.N. MARWAH & CO. LLP, New Delhi, India
T: +91 114 319 20 00; F: +91 114 319 20 21
R.N. Marwah & Co. LLP is a CA firm that was established in 1946 by Late Mr. R.N. Marwah. Its head office is located in at Janpath, New Delhi (India). Four major service divisions of the firm are Audit & business advisory services, tax & regulatory services, legal & company law services and consultancy services. It has been serving huge international and domestic clientele since last 70 years.
Published: April 2018 l Photo: Curioso Photography - Fotolia.com