ITAT Denies Tax-neutral Demerger; Adopts Strict View Of “Resulting Company”

BACKGROUND

• The Mumbai ITAT, in the context of the Sterling Holidays / Thomas Cook group restructuring, examined the tax neutrality of a demerger involving a nonconventional structure.
• The transaction involved:
  • Transfer of an undertaking from Sterling Holiday Resorts (India) Ltd (SHRIL) to Thomas Cook Insurance Services (India) Ltd (TCISL), a wholly-owned subsidiary of Thomas Cook (India) Ltd (TCIL), a listed company; and
  • Subsequent merger of the remaining undertaking of SHRIL into TCIL.

FACTS

• Pursuant to the scheme of arrangement within the Sterling Holiday Resorts (India) Ltd – Thomas Cook (India) Ltd group:
  • SHRIL transferred its resorts and time-share undertaking to TCISL;
  • In consideration of the demerger, shares were issued by TCIL, and not by TCISL, directly to the shareholders of SHRIL.
• The demerged undertaking of SHRIL carried accumulated business losses and unabsorbed depreciation of approximately INR 240 Crores. SHRIL contended that the transaction qualified as a valid demerger and, consequently, TCISL would be entitled to carry forward the losses of the demerged undertaking under Section 72A(4) of the Act.
• The tax authorities disputed this position on the ground that the statutory conditions for a demerger were not satisfied, particularly the requirement that shares must be issued by the “resulting company” as understood under the Income-tax Act.

ITAT’S RULING

• The Tribunal rejected the position taken SHRIL and held that:
  • The requirement that the “resulting company” must issue shares to the shareholders of the demerged company was not fulfilled;
  • The entity receiving the undertaking and the entity issuing shares must be the same; and
  • A holding company cannot be regarded as issuing shares on behalf of its subsidiary.
• Accordingly, the transaction was held not to qualify as a tax-neutral demerger, resulting in denial of carry forward of substantial accumulated business losses and unabsorbed depreciation under Section 72A(4).
• The Tribunal also rooted its conclusion in the settled principle that tax statutes must be interpreted strictly, leaving limited scope for purposive or equitable construction where the statutory language is viewed as plain.

WHERE THE RULING RAISES CONCERNS

• The decision proceeds on a strict construction of the statutory framework governing demergers, particularly in relation to the identification of the “resulting company” and the requirement of share issuance.
• In this context, the definition of a “resulting company” under the Income-tax Act assumes significance. The provision adopts an inclusive formulation, referring to one or more companies to which the undertaking is transferred, including a wholly owned subsidiary thereof. Read in the context of group reorganisations, this formulation suggests that the statutory framework does not necessarily envisage a single-entity implementation of all elements of a demerger

• Against this backdrop, the issuance of shares by the holding company — while the undertaking vests in its wholly owned subsidiary — may be commercially justified as part of the overall implementation of the scheme; however, the Tribunal observed that the statutory framework does not accommodate such bifurcation between the entity receiving the undertaking and the entity issuing shares.
• The decision, however, adopts a strict, form-driven interpretation of the demerger provisions, which raises several issues:
  • Narrow reading of the statutory definition of “resulting company” – The ruling rejects a broader reading of the inclusive wording in the definition of “resulting company” that could have permitted vesting of the undertaking and issuance of consideration across different entities within the same group structure.
  • Rigid interpretation of the share issuance requirement – The Tribunal’s conclusion effectively mandates identity between the entity receiving the undertaking and the entity issuing shares. This leaves limited room for alternative structuring of consideration within a group, even where the end shareholders receive shares as contemplated under the scheme.
  • Limited accommodation for multi-tier group structures – While the ruling treats the provisions as unambiguous, it offers limited practical accommodation for modern group reorganisations where implementation may involve both a holding company and its wholly owned subsidiary.

AURTUS COMMENTS

• The ITAT’s decision reflects a constrained interpretation of the demerger provisions, particularly in the context of modern group structures.
• Given the divergence from commonly implemented structuring models and the limited reasoning on key aspects of the statutory definition, the ruling is likely to be subject to further judicial scrutiny. In the interim, the potential exposure arising from this interpretation should be evaluated while considering similar structuring options.

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