Tax Hotline August 06, 2012

Tax-Free reorganisation not per se a Colourable device, says Bombay High Court

In the recent case of In re: AVM Capital Services (P.) Ltd.1, the Bombay High Court (“Bombay HC”) was required to consider the permissibility of a reorganisation of group companies in India, in the context of which it has examined key issues relating to tax avoidance and reorganisation transactions.

Background

The case revolved around the merger of five companies AVM Capital Services Private Limited (ACPL); Chevy Capital Services Private Limited (CCSPL); PM Capital Services Private Limited (PCSPL); Pranit Trading Private Limited (PTPL); and Viramrut Trading Private Limited (VTPL) (the “Transferor Companies”) that sought to be merged as per the merger scheme (“Scheme”) with Unichem Laboratories Limited (ULL) (the “Transferee Company”). All shareholders approved the Scheme, with the exception of one shareholder of the Transferee Company, Mr. Shailesh Mehta (“the Objector”) who held 0.001% of the total share capital, who submitted that the Scheme was intended at avoiding capital gains tax and should not be permissible.

Arguments

The Objector’s primary points of argument were as follows: 

  • Had the shares of the Transferor Companies directly been transferred to the promoters of the Transferee Company, this would have resulted in capital gains tax for the sellers on a secondary sale of shares. It was submitted that by undertaking the reorganization as a merger instead of stock sale, the transferors would avoid capital gains tax, on account of which the merger should be considered a colourable device. It was therefore submitted that the merger should not be approved by the Bombay HC on account of rulings such as McDowell and Company Limited v. Commercial Tax Officer2 and the judgment of the Gujarat High Court in In Re: Wood Polymer Limited.3
  • In relying upon McDowell, the Objector contended that the ruling in the case of Union of India and Anr., v. Azadi Bachao Andolan and Anr (“Azadi Bachao”)4 was per incuriam in light of McDowell and not good law. The Objector relied upon rulings by the Authority for Advance Rulings (“AAR”) such as In Re: Groupe Industrial Marcel Dassault5 in support of this proposition. 

In comparison, it was argued by the Transferee Company that the merger would help in consolidating and streamlining the promoter holding in the Transferee Company. Most importantly, the Transferee Company clarified that there was no divestment or gain of capital sought by the Transferor/Transferee companies or its Promoters, on account of which the question of avoidance of capital gains should not arise. With respect to the validity of Azadi Bachao, it was argued that the Supreme Court in the case of Vodaphone International Holdings6 had confirmed the validity of Azadi Bachao and that the AAR did not have the authority to hold a Supreme Court ruling incorrect. It was further contended that the ruling of Wood Polymer was no longer valid in light of the Vodafone judgment. The Transferee Company also relied upon schemes of amalgamation between Tata Services Limited and Tatanet services Limited7 and Balkrishna Industries Limited and Balkrishna Paper Mills Limited and Balkrishna Synthetics Limited8 which were approved by the Bombay HC on similar facts.

Decision

The Bombay HC approved the Scheme and held in favour of the Transferee Company. In doing so it reiterated the validity of the Azadi Bachao ruling, as confirmed by the Supreme Court in the case of Vodafone. Importantly, the Bombay HC examined the Wood Polymer ruling in the specific context of granting approval to merger transactions which may result in a tax benefit, and distinguished Wood Polymer from the instant case on the basis that Wood Polymer there was a clear use of company law provisions in a sole attempt to avoid tax. Reliance was also placed by the Bombay HC on the subsequent ruling of the Gujarat High Court in Union of India v. Ambalal Sarabhai Enterprises Ltd which considered Wood Polymer and approved a scheme irrespective of the fact that it resulted in tax benefits.9 Importantly, the Bombay HC also placed reliance upon the case of Jindal Iron & Steel Company Limited v. ACIT (“JISCO”)10 and held that the income tax department could not be impleaded into the case as the revenue authorities had no role of intervention in a case being heard under Section 391-394 of the Companies Act, 1956.

Analysis

In the context of corporate reorganisations which are accorded tax benefits under the income tax provisions, the issue is often raised as to whether the approval of the merger scheme should be contingent on any tax avoidance motive of the merging entities. Courts have grappled with the issue of whether it is the tax avoidance motive which compels the merger, or the merger which results in tax benefits under the income tax provisions, as well as the issue of whether this sequencing should be a determinative factor. An additional issue also arises as to whether, when the reorganization is accorded court approval as per the corporate processes in India, after considering the role of tax avoidance motive in the reorganization, whether the income tax authorities should then be permitted to re-examine the same transaction on the basis of tax avoidance. This case casts some clarity on the manner in which to interpret important case law on the concept of avoidance (McDowell, Azadi Bachao, Vodafone) as well as key cases on tax free reorganisations in India (such as Wood Polymer and Ambalal Sarabhai). This should go a long way in providing certainty to taxpayers who undertake consolidation of group operations / tax free reorganisations in India.


Prasad Subramanyan & Shreya Rao
You can direct your queries or comments to the authors


1 [2012] 23 Taxmann.com 222 (Bombay), Co. Scheme Petition Nos. 670-675 of 2011, Co. Summons for Direction Nos. 598 to 603 of 2011 (“Judgment”).

2 [1977] 154 ITR 148 (SC).

3 [1977] 109 ITR 177 (Guj).

4 [2004] 10 SCC 1 (SC).

5 AAR No. 846/847 of 2009.

6 [2012] 341 ITR 1.

7 Company Petition No. 758 of 2005 r/w Company Application No. 540 of 2005 (Bom.)

8 Company Petition No. 713 of 2007 connected with Company Application No. 771 of 2007 (Bom).

9 [1984] 147 ITR 294 (Guj).

10 Company Application No. 76 of 2004.


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