A demerger sanctioned by the NCLT is not automatically tax-neutral. The Income-tax Act, 1961 grants neutrality only where the transaction satisfies every condition of Section 2(19AA). The Ahmedabad ITAT's ruling in Reckitt Benckiser Healthcare India Pvt. Ltd. v. DCIT is the clearest recent illustration of the consequences that follow when a single condition fails: the transaction is recharacterised as a taxable transfer of capital assets under Section 45, and the issuance of shares is treated as a deemed dividend under Section 2(22).
Condition One: Transfer Pursuant to a Scheme
The transfer must be pursuant to a scheme of arrangement under Sections 230 to 232 of the Companies Act, 2013. A fast-track demerger under Section 233 does not satisfy this condition, because the Income-tax Act's definition does not extend to the Section 233 route. A company that chooses the fast-track route for speed may find that it has forfeited tax neutrality.
Condition Two: All Property of the Undertaking
All the property of the undertaking, including movable and immovable assets, must become the property of the resulting company. The Ahmedabad ITAT found that the taxpayer had selectively transferred only certain assets while retaining similarly placed investments in other subsidiaries. The "all property" condition is not satisfied by a transfer of the core operating assets; the undertaking must move as a whole.
Condition Three: All Liabilities of the Undertaking
All the liabilities of the undertaking must become the liabilities of the resulting company. The Ahmedabad ITAT held that the failure to transfer liabilities violates Section 2(19AA). In Reckitt Benckiser, the Treasury Undertaking's liabilities were reduced to nil on the ground that they pertained to different divisions, without any corresponding adjustment to the assets. The Tribunal treated this as a selective transfer that did not satisfy the statutory condition.
Condition Four: Transfer as a Going Concern
The undertaking must be transferred as a going concern. The assets and liabilities must move together, and the resulting company must be capable of continuing the business. A transfer of assets without the business, or a transfer that strips the undertaking of its operating coherence, does not qualify.
Condition Five: Proportionate Issuance of Shares
The resulting company must issue its shares to the shareholders of the demerged company on a proportionate basis. The share exchange ratio must reflect the relative value of the undertaking, and the issuance must be to all the shareholders of the demerged company in proportion to their shareholding. A selective issuance, or an issuance that is not proportionate, breaches the condition.
Condition Six: The Three-Fourths Shareholder Test
Shareholders holding at least three-fourths in value of the shares of the demerged company must become shareholders of the resulting company. The test is computed on the value of the shares, not on the number of shareholders. A demerger that leaves more than one-fourth in value of the demerged company's shareholders outside the resulting company does not satisfy the condition.
The Consequence of Failure
The consequence is not merely the denial of the exemption. The transaction is treated as a transfer of capital assets, and the demerged company is liable to capital gains tax. The resulting company may be liable to tax on the receipt of the assets, and the shareholders may be liable to tax on the deemed dividend. The tax cost can be far greater than the procedural savings of a defective demerger.
A company that is planning a demerger must conduct the Section 2(19AA) analysis before the scheme is drafted, not after the NCLT has sanctioned it. The checklist is not a formality; it is the condition of tax neutrality.
Call to Action
Anuj Desai & Associates advises companies on the Section 2(19AA) compliance for demergers—from the structuring of the undertaking and the transfer of liabilities to the proportionate issuance of shares and the three-fourths shareholder test. If your demerger involves a partial transfer or a complex liability structure, we can help you avoid the tax-neutrality trap.
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