Dec 15, 2021

Demergers and the ‘Undertaking’ Test

The IT Act provides for tax-neutrality of demergers subject to satisfaction of certain conditions. One of the key conditions for a transfer to qualify as a ‘demerger’ in terms of Section 2(19AA) of the IT Act is that it should entail the transfer of an ‘undertaking’ on a going concern basis. As per Explanation 1 to Section 2(19AA) of the IT Act, ‘undertaking’ will include any part of an undertaking, or a unit or division of an undertaking or a business activity taken as a whole, but does not include individual assets or liabilities or any combination thereof not constituting a business activity.

The IT Act does not prescribe any specific test to determine as to what would qualify as an ‘undertaking’ for the purposes of Section 2(19AA) of the IT Act and, in particular, whether holding of investments can also qualify as an undertaking. The Supreme Court[1], while interpreting the meaning of the term business of ‘holding of investments’, has observed that it refers to real, substantial and systematic or organised course of activity of investment carried on by an assessee for a set purpose such as earning profits. However, the determination on whether, in a particular case, the proposed transfer in a demerger would satisfy the ‘undertaking’ test, would need to be evaluated independently on the specific facts of each case.

Where the tax authorities challenge the demerger on account of being a transfer of specified assets and liabilities not qualifying as an ‘undertaking’, there could be potential tax consequences for the parties involved, including the demerged company and its shareholders.

In this context, the recent litigation in case of Grasim Industries is worth noting. Grasim Industries had entered into a composite scheme of arrangement with certain group companies, where under, amongst others it was proposed that Grasim would demerge its ‘financial services business’ into another company by way of a demerger. This scheme was sanctioned by the Ahmedabad bench of the National Company Law Tribunal (‘NCLT’). However, the tax authorities, on review of the scheme, came to the conclusion that what was transferred pursuant to the demerger was primarily Grasim’s minority interest in an investee company. Accordingly, the AO denied the tax-neutrality benefits to such transfer and raised a demand on Grasim towards dividend distribution tax and interest under Sections 115O/115Q read with Section 2(22)(a) of the IT Act on the alleged deemed dividend distribution of accumulated profits in the course of a demerger transaction. The Commissioner of Income-tax (Appeals) upheld the assessment order, while providing some adjustment in the valuation of the shares, thereby reducing the tax demand. The matter is currently pending before the Tribunal.[2]

Subsequently, it seems that the tax authorities also passed a Draft Order raising a capital gains tax demand in the hands of Grasim Industries by taking the value of shares issued by the resulting company to the shareholders of the demerged company as a consideration for transfer of assets by the demerged company.[3]

Therefore, it is important to carefully evaluate whether the subject matter of transfer in a proposed demerger satisfies the prescribed conditions under the IT Act, in particular, the ‘undertaking’ test, failing which the same may result in long-drawn tax litigation and/ or tax consequences for the parties to such demerger.


[1]  Commissioner of Income Tax, Gujarat v. Distributors (Baroda) P. Ltd, [1972] 83 ITR 377 (Supreme Court).

[2]  For details see, Grasim Industries Limited v. DCIT, order dated April 12, 2021 in SA No. 48/Mum/2021 in ITA No. 1935/Mum/20 (ITAT Mumbai).

[3]  As per intimation, dated October 1, 2021, filed by Grasim Industries with the Bombay Stock Exchange.  We understand that the quantum appeal is, as on date, pending disposal by the Tribunal.




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