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Bumps on the merger route

L. V. Srinivasan

TODAY, the buzzword across industries around the globe is `restructuring'. In India, too, several companies are entering into mergers to become globally competitive. Thanks to the economic liberalisation, the Government has offered opportunities for business combinations in India, and the number of companies taking the merger route is increasing.

The Income-Tax Act provides significant tax benefits through Section 72A, as per which the unabsorbed losses and depreciation of the merging company will be available to the merged company for set off against the profits of the merged company. The significant changes in Section 72A reflects a shift in Government thinking. Earlier, financial non-viability and public interest were the basic requirements for tax relief. In addition to removing these, the merger provisions have been made simpler.

The following are the salient provisions of the Section:

  • The merging company should own an industrial undertaking or a ship; and

  • The merged company should i) hold continuously for a minimum of five years from the date of merger, at least three-fourths the book value of fixed assets of the merging company acquired in a scheme of merger; ii) continue the business of the merging company for at least five years from the date of merger; and iii) fulfil such other conditions as may be prescribed to ensure the revival of the merging company's business, or that the merger is for genuine business purpose (Section 72A(2)). If any of these conditions are not complied with, the set off of loss/depreciation made in any previous year(s) prior to the year of non-compliance shall be deemed to be the income of the merged company for the year in which such non-compliance took place (Section 72A(3)). Following the amendments to Section 72A by the Finance Act, 1999, certain anomalies such as value of assets to be held by the merged company emerged. Though these were corrected, some ambiguities still remain. In a scheme where more than one company merges into an existing one, the following issues crop up: If Section 72A(2) conditions are violated, what is the extent of losses (set off in any previous year) that would be deemed as the income of the merged company? Should it be restricted to the losses of only that particular company where non-compliance of the conditions occurs? Or, can the I-T Department argue to the contrary and invoke Section 72A(3) in relation to the accumulated losses of all the companies that had moved into the merged company?

    The following example should throw more light on the situation: Companies A, B and C merge into Company D. The accumulated losses of the merging companies are assumed at Rs 25, 15, and 20 respectively. Thus, the total accumulated losses available for set-off to Company D is Rs 60. Suppose Company D sets off Rs 35 in the first two years, and, in the third year, Section 72A(2) is violated in respect of erstwhile Company B. Then, will the entire Rs 35 that was set off in the earlier years be added as income in the hands of Company D? Or, will it be restricted to only Rs 15 (the loss of Company B), which will be added as income of Company D? Logically, the losses of Company B should only be deemed as income.

    In case it is agreed that the loss set-off should be treated as income only to the extent of the loss of the particular merging company, then what is the mechanism to identify that the set-off utilised pertains to a particular merging company? In other words, in the example, there is no basis to contend that, of the Rs 35 that was set off, Rs 15 should be attributed to Company B? Is it not possible for Company D to contend that the loss of Rs 30 that was set off pertained only to Companies A and C and, in which case, there is no violation of Section 72A(2)? Clearly, Section 72A(3) does not envisage the merger of two or more companies. Further, the section talks of set-off losses to be treated as income in the year of violation.

    What about unabsorbed losses after set-off? Can they be carried forward and set-off in subsequent years? Though there is no specific answer, it may be reasonable to assume that in the absence of anything to the contrary, the carry forward to subsequent years should be available. Assuming that the merging companies, which are in diverse businesses, decide to discontinue any or more products and yet continue in the same line of business, there is the practical handicap of complying with Rule 9C of the Income Tax Rules, as per which a production level of at least 50 per cent of the installed capacity of the said undertaking should be achieved before the end of four years from the date of merger and continue to maintain the said minimum production till the end of five years from the date of merger. The condition should be dumped. The term `business' is of a wide connotation and may involve more than one line of activity. The fact that an activity is dropped does not necessarily give rise to an assertion that the business has been discontinued. When such a product or activity is dropped, though there is no discontinuation of business, it may vitiate the condition regarding achieving a minimum level of installed capacity. Both these conditions are contrary to each other. Rule 9C should, therefore, be removed.

    At present, the merger route is adopted not only by manufacturing companies but also the service sector. Unfortunately, Section 72A is applicable only to industrial undertakings despite the service sector contributing nearly 50 per cent of GDP. Like Section 72A, Section 79, too, has outlived its utility. The section provides if in a closely-held company there is a majority change in shareholding, all unabsorbed losses lapse in the year of change. The original intent of Section 79, according to the Mathai Committee, was to prevent a person from acquiring the shares of loss-making companies and then commence profitable business through such companies. That this has lost relevance is testified by the recent amendments to the I-T provisions on amalgamations, mergers and de-mergers. Therefore, Section 79 should either be scrapped or amended to allow the benefit of carry-forward loss — for instance, continuation of the earlier business prior to change of shareholding for a minimum period.

    Further, the exceptions to Section 79 currently cover only amalgamation and demerger of a foreign company. However, it is possible that a foreign company may be acquired by another foreign company and, as a fallout, there could be a change in shareholding in the closely-held Indian company. It is suggested that such situations are also covered under the exceptions to Section 79.

    In sum, the amended Section 72A is still at a nascent stage, and, before controversies and litigations arise, the Government, in the forthcoming Budget, would do well to address the untackled issues (primarily arising out of non-compliance with the conditions laid down in the section), enlarge the scope of the section to cover the service sector, and have a relook at the very need for Section 79.

    (The author is Director, Treasury and Taxation, Alstom Ltd. The views are personal.)

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