The Indian Income Tax Department (“ITD”) has been closely scrutinising the internal business restructuring of companies to weed out any unwarranted tax incentives or benefits that may be claimed by the taxpayer. This has sometimes resulted in prolonged tax litigation, with no end in sight. The ongoing dispute between the ITD and Grasim Industries Limited (“GIL”) is one such example.
In 2016, GIL entered into a composite scheme of arrangements with Aditya Birla Nuvo Limited (“ABNL”) and Aditya Birla Capital Limited (“ABCL”) and their respective shareholders under Sections 391 to 394 of the Companies Act, 1956. As per the scheme, ABNL would merge with GIL and subsequently, the Financial Services Business division (“Financial Division”) would be demerged into ABCL. As part of the scheme, GIL would issue shares to the shareholders of ABNL while ABCL would issue shares to GIL. The scheme became effective in July 2017.
The ITD alleged that the demerger does not satisfy the undertaking test laid down in Explanation 1 to Section 2(19AA) of the Income tax Act, 1961 (“IT Act”) on the ground that the Financial Division was merely a combination of certain assets and liabilities. The ITD imputed the market value of the ABCL shares that were issued as demerger consideration to be dividends in the hands of shareholders of GIL under Section 2(22)(a) of the IT Act. The reasoning of the ITD is as follows:
(i) Vide the demerger of Financial Division, GIL essentially transferred 9.77% shares of its subsidiary, Aditya Birla Finance Limited (“ABFL”), to ABCL and the remaining 90.23% shares were already held by ABCL.
(ii) This transaction can only be considered as a transfer of certain combination of assets and liabilities but cannot be said to be satisfying the undertaking test laid down in Explanation 1 to Section 2(19AA) of the IT Act. Therefore, provisions related to deemed dividend should be invoked.
(iii) For the purposes of quantification of dividend in the hands of GIL shareholders, the ITD adopted the opening price of ABCL shares on the first day of listing as the fair market value of such shares. Accordingly, an amount of INR 24,037 crore was considered as dividends in the hands of GIL shareholders.
On this basis, the ITD passed an order that GIL ought to have paid dividend distribution tax (“DDT”) as per Section 115-O of the IT Act. The order was upheld by the Commissioner of Income Tax (Appeals)). However, it reduced the fair market value of shares on the reasoning that market price of listed shares tend to fluctuate on a day-to-day basis and therefore, the same cannot be taken as a base to compute dividends for the purposes of Section 2(22)(a) of the IT Act. Accordingly, the CIT(A) reduced the alleged dividends amount from INR 24,037 crore to INR 13,380 crore. The case is currently pending before the Income Tax Appellate Tribunal (“ITAT”)). GIL had also simultaneously filed a stay application before the ITAT, which was disposed-off partially in favour GIL wherein it was held that stay would be granted upon payment of 20% of the disputed demand.
Our views on the matter
Without going into whether an investment arm is an undertaking under Section 2(19AA) of the IT Act, this article examines the stand of the ITD that if the demerger entity does not satisfy the undertaking test, the demerger consideration amounts to deemed dividend distribution under Section 2(22)(a) of the IT Act.
Section 2(22)(a) of the IT Act inter alia states that any distribution of accumulated profits by the company would be considered as a deemed dividend, if such distribution entails release of any of its assets to the shareholders.
The ITD has alleged that the fair market value of ABCL shares is deemed dividends in the hands of GIL shareholders because GIL had indirectly transferred the demerger consideration it ought to have received (upon the transfer of its assets to ABCL) to its shareholders. It has, however, disregarded the aspects relating to accumulated profits.
The Supreme Court has consistently held that tax statutes should be given a strict and literal interpretation. Section 2(22)(a) of the IT Act is attracted where accumulated profits are distributed to the shareholders. Explanation clause 2 to Section 2(22)(a) defines “accumulated profits” to mean all the profits of the company up to the date of distribution. Further, in the case of Urmila Ramesh, the Supreme Court held that the expression “accumulated profits” means the profits which are capable of being accumulated in the hands of the company. It further held that only accumulated profits that the company distributes to its shareholders be considered as dividends. Generally, the profits earned by the company by undertaking its business activities is construed as profits and when such profits are accumulated over a period of time (as retained earnings), the same would be considered as accumulated profits.
In the instant case, admittedly, the accumulated profits of GIL were not distributed to its shareholders. Instead, shares of ABCL were issued to the GIL shareholders in exchange for the Financial Division received from GIL. The Financial Division cannot be considered as accumulated profits of GIL. Therefore, the shares of ABCL issued to the shareholders of GIL cannot be considered as dividends.
Moreover, even if the Financial Division is to be acquired by GIL from the profits accumulated by it, the said profits will be capitalised in the books of ABCL and will be considered as capital contribution by GIL shareholders in ABCL and not as dividends distributed by GIL to its shareholders.
Based on the above, the stand taken by the ITD appears to be ill-conceived. Sections 47(vib) and 47(vid) of the IT Act inter alia provides exemption from capital gains taxes if the demerger satisfies all the conditions mentioned in Section 2(19AA) of the IT Act. Section 47(vib) provides that capital gains taxes would not be levied on the demerged company for transferring the assets to resulting company. Section 47(vid) of the IT Act provides that capital gains taxes would not be levied on the resulting company for issuance (or transfer) of shares by the resulting company to the shareholders of demerged company.
Therefore, as a corollary, it can be stated that in cases where the conditions prescribed under Section 2(19AA) of the IT Act have not been satisfied, the ITD could invoke capital gains related provisions under the IT Act.
Lastly, the methodology adopted by the ITD in determining the value of dividends is also not clear as neither the methodology adopted by the ITD nor the one adopted by the CIT(A) have been prescribed under the IT Act.
It appears that the ITD has issued a subsequent order against GIL by imposing capital gains tax on this very same transaction and raised a tax demand of INR 8,334 crore against GIL. That could be a subject matter of a separate blog.
 Order of ITAT in (i) SA No 48/Mum/2021 in ITA No. 1935/Mum/20 Assessment year: 2018-19 dated April 12, 2021 and (ii) SA No 226/Mum/2020 in ITA No. 1935/Mum/20 Assessment year: 2018-19 dated December 18, 2020; The order of Bombay High Court in (i) Writ Petition No. 3367 of 2019 dated January 20, 2021 and (ii) Writ Petition No. 1405 of 2019 dated October 01, 2019
 https://www.grasim.com/Upload/PDF/NCLT-order-scheme.pdf section
 Innamuri Gopalam and Maddala Nagendrudu v State of A.P 14 STC 742(SC), C.I.T. v B. M. Kharwar 72 ITR 603 (SC)
 CIT v. Urmila Ramesh 230 ITR 422