A demerger is the transfer of one or more undertakings from a demerged company to a resulting company. The Companies Act, 2013 permits a demerger through the NCLT scheme route, and the Income-tax Act, 1961 grants tax neutrality where the conditions of Section 2(19AA) are satisfied. The tax neutrality is not automatic; it is conditional, and the conditions are exacting.
The Definition of 'Undertaking'
Section 2(19AA) defines a demerger as the transfer, pursuant to a scheme of arrangement, of one or more undertakings from the demerged company to a resulting company. The term "undertaking" is not defined in the Income-tax Act in exhaustive terms, but it is understood to mean a business unit that is capable of being operated independently and that generates revenue. The undertaking must be transferred as a going concern, with all its assets and liabilities.
The requirement that all the property and liabilities of the undertaking be transferred is a condition of tax neutrality. A demerger that transfers only the assets and not the liabilities is not a tax-neutral demerger; it is a transfer that may attract capital gains tax.
The Conditions for Tax Neutrality
Section 2(19AA) prescribes several conditions. The transfer must be pursuant to a scheme of arrangement. All the property of the undertaking must become the property of the resulting company. All the liabilities of the undertaking must become the liabilities of the resulting company. The resulting company must issue its shares to the shareholders of the demerged company on a proportionate basis. The shareholders of the demerged company must hold at least three-fourths in value of the shares of the resulting company, except where the resulting company is a listed company.
The conditions are cumulative. A demerger that satisfies some but not all of the conditions is not a tax-neutral demerger. The consequence is that the transfer is treated as a taxable transfer, and the demerged company may be liable to capital gains tax.
The Fast-Track Demerger Trap
The Companies Act, 2013 permits a fast-track demerger under Section 233, which is approved by the Regional Director rather than the NCLT. The Income-tax Act, however, recognises only the NCLT route for tax neutrality. The Income-tax Act's definition of demerger refers to a scheme under Sections 391 to 394 of the Companies Act, 1956, and the corresponding provisions of the 2013 Act. The fast-track route is not a scheme under Sections 230 to 232; it is a scheme under Section 233. The tax neutrality of a fast-track demerger is therefore uncertain.
A company that opts for the fast-track route to avoid the NCLT process may find that it has saved time but lost the tax neutrality. The trap is not in the Companies Act; it is in the interaction between the Companies Act and the Income-tax Act.
A tax-neutral demerger requires a scheme that satisfies every condition of Section 2(19AA), a valuation that supports the proportionate issuance of shares, and a tax analysis that anticipates the interaction between the scheme route and the tax statute.
Call to Action
Anuj Desai & Associates advises companies on the structuring of demergers—from the definition of the undertaking and the Section 2(19AA) conditions to the choice between the NCLT route and the fast-track route and the tax neutrality analysis. If you are planning a demerger, we can help you avoid the tax traps.
📧 office@anujdesaiassociates.com
📞 9619456656
🌐 https://anujdesaiassociates.com
🔗 linkedin.com/in/ca-anuj-desai-122547230
Article 83