Mumbai: In a ruling that carries significant implications for corporate restructuring transactions, the Mumbai bench of the Income Tax Appellate Tribunal (ITAT) recently held that a resulting company in a demerger cannot claim the carry-forward of accumulated losses and unabsorbed depreciation if the consideration shares are issued by the holding company rather than the subsidiary that actually receives the business—a structuring choice increasingly common in group reorganisations, but one that tax tribunals are now signalling comes with a real cost.

The appellate tribunal partly allowed an appeal by Sterling Holiday Resorts Ltd (formerly Thomas Cook Insurance Services India Ltd), granting relief on several tax disallowances while dismissing the tax department's cross-appeal for the 2015-16 assessment year.

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In this case, the division bench of Vice President Saktijit Dey and Accountant Member Prabhash Shankar denied the company's claim to carry forward losses and unabsorbed depreciation aggregating Rs 240.15 crore, even as it granted relief to the assessee on a separate ESOP-related issue.

Many organisations have traditionally used demergers before undertaking mergers and acquisitions (M&A) or as part of internal restructuring, sometimes before opting for an initial public offering (IPO). Tax experts say the ruling means such companies will be required to revisit these structures and analyse their tax implications.

"A demerger has long been used by corporates as a tax-efficient mechanism to reorganise businesses. The ruling is likely to create uncertainty for such restructuring arrangements and may require businesses to re-evaluate the manner in which future demergers are structured," said Bhavin Vora, Partner, Price Waterhouse & Co LLP.

The ITAT examined whether a business restructuring can qualify as a tax-neutral demerger when the business is transferred to a new company, but the shares are issued by that company's parent (holding) company instead. The key question before the Tribunal was whether this structure still meets the statutory conditions for a tax-free demerger.

The tribunal examined whether the transaction remains tax-neutral even though the shares are issued by a different company within the same group.

"The Mumbai ITAT has held that where the business is transferred to a wholly owned subsidiary, the issuance of shares by its holding company would not satisfy the statutory conditions for a tax-neutral demerger under the Income-tax Act. The ruling is significant, as similar structures have been adopted in practice, often to meet commercial and business objectives," added Vora.

Tax experts said the core issue before the Tribunal was whether a parent company and its wholly owned subsidiary could together be treated as the "resulting company" in a demerger. This would allow the parent company to issue shares to the demerged company's shareholders, even though the business itself was transferred to the subsidiary.

In this case, the business undertaking (or its underlying assets) was transferred to the subsidiary, while the parent company issued the shares. The Tribunal held that the conditions for a tax-neutral demerger were not met because the company receiving the business did not issue the shares itself. As a result, the tax benefits relating to the carry-forward and set-off of accumulated losses and unabsorbed depreciation were denied.

The genesis of the dispute lies in the Bombay High Court's approval of a scheme of arrangement involving three entities: Sterling Holiday Resorts India Ltd (the demerged company), Thomas Cook (India) Ltd (the listed holding company), and the assessee, then known as Thomas Cook Insurance Services India Ltd, a wholly owned subsidiary of Thomas Cook India.

Under the approved scheme, the resorts and timeshare undertaking of Sterling Holiday Resorts India was demerged into the assessee company on a going-concern basis. However, in consideration for the demerger, Thomas Cook India, the parent, issued shares to the shareholders of the demerged company, rather than the assessee subsidiary that had actually received the undertaking.

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The revenue department took the view that this arrangement fell foul of Section 2(19AA), read with Section 2(41A), of the Income-tax Act, which govern the definitions of a tax-neutral "demerger" and a "resulting company". Both provisions require that the entity receiving the demerged undertaking must itself issue shares to the shareholders of the demerged company. Since the assessee had not done so, the Assessing Officer (AO) disallowed the carry-forward of losses, a position that was later upheld by the Commissioner of Income Tax (Appeals).