Introduction

Companies may enter the scheme of arrangement (variation of rights with its shareholders/creditors) for various business reasons. Said event is also known as business reorganization, restructuring or reconstruction. The demerger is one such form. The company may demerge a certain division(s) or product line(s) to an existing company or a new company. It, therefore, alters the rights of the existing shareholders/creditors vis-à-vis the transferor company as they also assume rights in the transferee company. The demerger is undertaken to focus more on the core business as an independent company or to unlock the value of the division(s) by way of a separate listing or separate funding. Whatever may be the objective, for professionals it is imperative to understand the implications that may arise under the GST laws on account of the demerger. In the present paper, we shall first briefly discuss the meaning of the term ‘demerger’ and then discuss various issues with possible views thereon.

Meaning

The term ‘demerger’ has not been defined in the GST laws or Company Laws. The general meaning of the said term implies the transfer of an undertaking on a going concern basis by an existing company (referred to as ‘demerged company’ in the present paper) to a transferee company (existing or newly formed) (referred to as ‘resulting company’ in the present paper). Income Tax Act, 1961 defines the term ‘demerger’ u/s 2(19AA) to mean the transfer pursuant to a scheme of arrangement under sections 230 to 232 of the Companies Act, 2013 by a demerged company of its one or more undertakings to any resulting company subject to the stipulated conditions. The key conditions stipulate that all the property as well as liabilities of the undertaking should be transferred on a going concern basis. We can therefore assert that the demerger involves the transfer of an undertaking on a going concern basis.

Demerger process

The following activities are required to be performed to affect a demerger: 

  • Filing of the Scheme of Arrangement – The scheme of arrangement contains the terms of the demerger. An application along with the stipulated documents is required to be filed before the NCLT seeking an order of conveying a meeting for approving the said scheme.
  • Meeting of members/creditors – A meeting is required to be held as per the provisions of the law and the directions of NCLT. The minutes of the meeting are required to be recorded with the facts of the votes cast in favour or against the motion for accepting the scheme. The motion is required to be approved by the majority of the members/creditors provided the vote in person/proxy represents members/creditors holding 3/4th in value of the said total members/creditors.
  • Petition and Sanction of the scheme – The chairman of the meeting is to report the result to NCLT. If the scheme is approved in the said meeting, a second petition must be submitted to NCLT seeking approval of the scheme. After hearing the objections, the NCLT will pass an order approving the demerger with or without modifications.
  • Filing with the ROC – The NCLT order is required to be filed with ROC within 30 days from the receipt of the same.

One may also appreciate the concept of ‘appointed date’ and ‘effective date’. The appointed date (Sec. 232(6) of the Companies Act, 2013) is the date indicated in the scheme from which the said scheme shall come into force. The effective date (Sec. 232(5)) is the date on which a copy of the NCLT order sanctioning the scheme is filed with the ROC.

With the aforesaid brief context, let us now deal with issues that may arise under the GST laws.

Demerger – GST Implications

Levy of tax on demerger

An issue may arise as to whether GST can be levied on the transfer of the undertaking by way of the demerger. Sr. No. 2 of Notification No. 12/2017-CT (Rate) dt. 28.06.2017 issued in exercise of powers granted by Sec. 11(1) of the CGST Act, 2017 grants exemption from tax to the services by way of transfer of a going concern, as a whole or an independent part thereof. The term ‘going concern’ implies a running business (comprising all the assets, liabilities, employees, goodwill, contracts, etc.) which is capable and intended to be run independently by the transferee. It is distinguished from a mere transfer of assets. Further, it may be the entire business which has been transferred or an independent part of the business capable of separate operation. It may also be noted that the said exemption presumes that the transfer of a going concern is a ‘service’. It is so because the said transfer does not merely entail a transfer of goods. It can therefore be contended that the transfer of the undertaking by way of the demerger cannot be brought to tax.

One may also consider whether recourse to the aforesaid exemption is actually required in the case of the demerger. This is so because Sec. 9(1) of the CGST Act, 2017 r/w Sec. 7(1)(a) of the said Act provides for the levy of tax on all forms of supply of goods or services or both made for a consideration by a person in the course or furtherance of business. Only if the demerger is found to be covered by the said charging provisions that the recourse to the exemption may be found necessary. The existence of an exemption cannot imply the charge of tax otherwise (Associated Cement Companies Ltd vs State Of Bihar 2004 (7) SCC 642). The levy is attracted only to the supply made ‘in the course or furtherance of business’. The term ‘business’ has been defined u/s 2(17)(a)/(b) to include any trade, commerce, etc. and any activity or transaction in connection with or incidental or ancillary to such trade, commerce, etc. Therefore, the activity leading to the cessation of business qua the transferor cannot be said to have been undertaken in the course or furtherance of business. One may also consider that Sec. 2(17)(d) includes the supply or acquisition of goods including capital goods and services in connection with the commencement or closure of business. The same applies qua the ‘supply’ in connection with the closure. Therefore, it cannot apply to the transfer of business itself.

One may also note that Sec. 7(1)(c) read with Sr. No. 1 of Schedule I cannot apply to the situation of a demerger since the said provisions apply to the permanent transfer or disposal of business assets as opposed to the situation of a demerger which entails the transfer of the undertaking as a going concern. On the same ground, one can also say that Sr. No. 4 of Schedule II cannot apply to demerger.

Therefore, it can be contended that since the demerger is not covered by the charging provisions (and hence not a ‘supply’) recourse to the exemption notification is not warranted.

One may consider the following judicial rulings on the given issue:

  • Deputy Commissioner v. K. Behanan Thomas [1977] 39 STC 325 (Mad.) – Held that the proceeds from the transfer of business cannot be said to be proceeds made in the course of business. Further, it was held that such proceeds also cannot be said to be in connection with or incidental or ancillary to the business. Hence it was held that the question of claiming exemption under Rule 6(d) (which granted a deduction to the proceeds from the transfer of business) arises only if such proceeds are part of the turnover. Since the proceeds from the sale of the business cannot be part of the turnover, the question of exemption shall not arise. It was also held that it is not necessary that the assessee must entirely go out of business post sale or that such business must have a separate registration. Sale proceeds of a branch which is an independent unit by itself would qualify as a sale of a business.
  • Zacharia v. State of Kerala [1977] 39 STC 221 (Ker.) – Held that the mere fact that the seller had undertaken to settle liabilities which had accrued prior to the sale of the business would not by itself show that the seller had not transferred the business as a whole. So long as there is nothing to suggest that any part of the assets was retained by the seller or any amounts standing to the credit of the business were taken over by the seller, it cannot be suggested that the business as a whole was not transferred.
  • Monsanto Chemicals of India (P.) Ltd. v. State of Tamil Nadu [1982] 51 STC 278 (Mad.) – Held that a person may carry on several lines of business and each line of business would be a unit of business by itself.
  • Coromandal Fertilisers Limited v. State of A.P. 1998 (6) ALT 730 (AP) (Full Bench on reference) – Held that the transfer of an entire business undertaking together with the moveable properties, even if it involves the sale of goods, cannot be regarded as a sale in the course of business by the dealer as the seller intends to put an end to the business.
  • Paradise Food Court v. State of Telangana 2017-VIL-238 (AP) – Held that even the amendment in the definition of ‘business’ by including ‘any transaction in connection with or incidental or ancillary to the commencement or closure of such trade, commerce, manufacture, adventure or concern’ cannot override the ratio of Coromandal Fertilisers supra and hence the transfer of business in entirety cannot come within the charging provisions unless the charging section makes even the transfer of a business as a whole chargeable to tax or if the definition of the word ‘sale” does not use the expression ‘in the course of trade or business’. Also held that the provisions restricting the input tax credit attributable to the transfer of business reiterate that the transfer of business is not liable to tax. Also held that mentioning all the assets of the business individually with their value in the Schedule cannot lead to the levy of tax as the transaction continues to be of the transfer of a business as a going concern.
  • Triune Projects Pvt. Ltd v. DCIT [TS-6237-HC-2016 (Del)] – Held in the context of Income Tax that leaving out defunct or superfluous assets of an undertaking will not vitiate slump sale as there is common and commercial sense behind such decisions (the principle should also apply to indirect taxation).

ITC qua the demerger

Sec. 16(1) of the CGST Act, 2017 permits the availment of the ITC on the inward supplies used in the course or furtherance of business. On the other hand, Sec. 17(2) of the CGST Act, 2017 restricts ITC attributable to exempt supplies. If the view is entertained that the transfer of business by way of the demerger is not a supply (as it is not in the course or furtherance of business), the ITC related to the said transaction will not be admissible u/s 16(1) as it permits ITC only on supplies used in the course or furtherance of business. If the view is entertained that the transfer of business by way of the demerger is exempt from tax (vide Sr. No. 2 of NN 12/2017 – CT (Rate)), then the ITC attributable to the said exempt supply gets restricted u/s 17(2).

Hence it appears that the ITC in respect of the expenditure incurred exclusively on the demerger may not be available. One may however consider the possibility (fact-based) of attributing the given expenditure as common in nature (to facilitate the demerger as well as to facilitate the remaining business qua the transferor outlining the benefit of the demerger on the remaining business) and apply Sec. 17(1) of the CGST Act, 2017 (ITC restricted for non-business) r/w Rule 42(1)(j) for reversing 5% of the common ITC.

Registration

Sec. 22(4) of the CGST Act, 2017 carves a special provision overriding the general provisions in respect of registration to provide that in a case of transfer pursuant to sanction of a scheme or an arrangement for amalgamation or, as the case may be, the demerger of two or more companies pursuant to an order of a High Court, Tribunal or otherwise, the transferee shall be liable to be registered, with effect from the date on which the Registrar of Companies issues a certificate of incorporation giving effect to such order. This is so given the peculiar nature of the transaction that the transfer comes into effect from the date of filing of the scheme with the ROC. The resulting is therefore required to apply for registration u/s 25(1) within 30 days from such date. Further as per Sec. 85(2) of the CGST Act, 2017 in case of a demerger to a resulting company which is already in existence and registered under GST, an amendment in the registration certificate for including the details of the transferred business will be required.

Transfer of ITC

Sec. 18(3) of the CGST Act, 2017 provides that the registered person shall be allowed to transfer the input tax credits (ITC) which remain unutilized in his electronic credit ledger in the case of demerger amongst other types of transfer. Rule 41 of the CGST Rules, 2017 contains the mechanism for the said transfer. It may be noted that the law does not permit the transfer of the balance available in the electronic cash ledger. This as such should not pose an issue since the demerged entity can always claim a refund of the excess cash balance.

Now the first issue is whether it is mandatory for the demerged company to transfer the ITC if the balance is available. Sec. 18(3) uses the expression ‘should be allowed to transfer’. Rule 41(1) also provides that the registered person shall furnish the stipulated details on the GSTN portal in FORM GST ITC-02 along with a request for transfer. Hence it can be contended that it shall not be mandatory for the demerged company to seek a transfer. However, if the transfer is envisaged, the same shall be undertaken as per the mechanism prescribed in Rule 41.

The next issue relates to the way the transferable ITC is determined. Proviso to Rule 41(1) provides that in the case of a demerger the ITC balance shall be apportioned in the ratio of the value of assets of the new units as specified in the demerger scheme. CBIC has issued Circular No. 133/03/2020-GST dt. 23-3-2020 clarifying various aspects related to Rule 41 as under (in the context of demerger):

  • that the value of assets is to be taken at the State level (at the level of a distinct person) and not at the all-India level.
  • that the transferor is required to file FORM GST ITC-02 only in those States where both transferor and transferee are registered.
  • that the ratio of the assets shall be applied to the total amount of unutilized ITC and hence is not required to be applied separately in respect of each head of ITC (CGST/SGST/IGST).
  • that once the allowable ITC is determined with respect to the total unutilized ITC, the transferor shall be at liberty to determine the amount to be transferred under each tax head (IGST, CGST, SGST/UTGST) within this total amount, subject to the availability of balance in the specific heads. Further, the said formula shall also be applicable for apportionment of Cess between the transferor and transferee.
  • that the apportionment formula shall be applied on the ITC balance of the transferor as available in the electronic credit ledger on the date of filing of FORM GST ITC-02 by the transferor.
  • that the ratio of the value of assets should be taken as on the “appointed date of the demerger.”

There is also a requirement under Rule 41(2) to submit a copy of a certificate issued by a practising chartered accountant or cost accountant certifying that the demerger has been done with a specific provision for the transfer of liabilities.

An issue may arise in a situation where the demerged company and the resulting company are in different States. The law does not restrict the transfer of the unutilized ITC in such situations however the aforesaid Circular as well as GSTN portal permits the transfer only if both entities are in the same State. This might have been done to avoid the transfer of the SGST balance from one State to another State. However, the said reason does not justify restricting the transfer of balance available under CGST and IGST head. It is a settled law that a Circular cannot override the express provisions of the law. Hence it can be contended that the balance available in CGST/IGST should be allowed to be transferred to the resulting company in another State.

An issue may also arise with respect to the expression “value of assets” used in Rule 41(1). The Explanation clarifies that the “value of assets” means the value of the entire assets of the business, whether or not input tax credit has been availed thereon. Whether the assets that are outside the purview of GST (such as cash/bank balances, investments, receivables, etc.) are also required to be considered for the determination of the transferable ITC? Whether the assets (such as deferred tax, building leases, etc.) which are created only to comply with the requirement of the Accounting Standards are also required to be considered? It may be noted that the question of availment of ITC never arises on such assets as they are not leviable to the tax. The expression ‘entire assets’ used in the Explanation suggests that the ratio of all the assets between the demerged company and the resulting company is required to be taken irrespective of whether GST is leviable on such assets or not. The expression ‘whether or not input tax credit has been availed thereon’ can be said to only suggest that availment of ITC shall be an irrelevant factor for the determination of the value of the assets. Hence a view can be taken that even the value of assets outside the ambit of GST is required to be considered for the determination of the transferable ITC.

Availment of ITC post the effective date

Issues may arise as regards the availment of the ITC post the effective date of transfer in respect of the inward supplies which have been received prior to the said date. Illustrative situations can be:

  • Mismatch with GSTR 2B

Sec. 16(2)(aa) of the CGST Act, 2017 r/w Rule 36(4) of the CGST Rules, 2017 restricts the availment of the ITC until the same is reflected in GSTR 2B. A situation may arise wherein the demerged company may not have been able to avail of the ITC in respect of the supplies attributed to the transferred undertaking since it has not been reflected in GSTR 2B before the effective date of transfer. Can the said demerged company still avail of the ITC post the effective date? It can be contended that all the conditions stipulated u/s 16 r/w Rule 36 barring the condition related to reflection in GSTR 2B stood satisfied at the end of the demerged company before the effective date. Further, the law does not deny the ITC to the demerged company in respect of supplies received by it before the effective date on the ground of reflection of the said otherwise eligible ITC in GSTR 2B after the effective date. Hence a view can be taken that the demerged company can avail of such ITC.

  • 180 days condition

A situation may arise wherein the demerged company has reversed the ITC under the second proviso to Sec. 16(2) of the CGST Act, 2017 on account of failure to pay the vendor within a period of 180 days in respect of the supplies related to the transferred business and the outstanding liabilities are now settled by the resulting company as it assumes all the liabilities pertaining to the transferred business. Who shall then be entitled to re-avail the ITC? The third proviso to Sec. 16(2) provides that the recipient shall be entitled to avail of the ITC on payment made by him of the outstanding amount. Sec. 2(93) defines the term ‘recipient’ to include a person who is liable to pay the consideration. It can therefore be contended that the expression ‘payment by him’ in the said third proviso should also include the payment by the resulting company after assuming the liabilities with the approval of NCLT as this leads to the satisfaction of the original debt. It can therefore be contended that it is the demerged company who was the recipient at the time of the receipt of the inward supply and hence it is the said company who shall be entitled to re-avail the ITC on payment by the resulting company.

  • Goods in transit

Who shall be entitled to avail of the ITC in respect of goods in transit qua the transferred business? The issue arises since the receipt of the goods does not take place before the effective date. We have already seen earlier that the condition of reflection of ITC in GSTR 2B after the effective date cannot lead to the denial of the ITC to the demerged company. Now an Explanation to Sec. 16(2)(b) provides that it shall be deemed that the registered person has received the goods where the goods are delivered by the supplier to the recipient or any other person on the direction of such registered person whether acting as an agent or otherwise. It can therefore be contended that the goods in question have been delivered to the resulting company on the direction of the demerged company (as it is this company who files the scheme of arrangement). Hence it can be contended that the demerged company is in receipt of the goods that have been delivered to the resulting company and hence shall be eligible to avail of the ITC.

Reversal of the ITC

A situation may arise wherein the demerged company transfers capital goods on which it has availed the entire ITC and subsequently paid the pro-rata ITC (owing to common use for taxable/exempt supplies) for certain months as per Sec. 17(2) of the CGST Act, 2017 r/w Rule 43 of the CGST Rules, 2017. If on the effective date, the period of 60 months (useful life as per Rule 43) has not elapsed, whether the resulting company is liable to pay the amount under Rule 43 for the balance of months? The harmonious reading of clauses (h) and (i) of Rule 43(1) entails that the obligation of subsequent payment rests only with the person who has claimed the ITC. Hence it can be contended that the resulting company in absence of any claim of ITC cannot be burdened with the obligation under Rule 43. One may consider the ratio of the decision in the case of Saraswati Industrial Syndicate v. CIT (1990) Supp (1) SCR 332 (SC). Sec. 41(1) of the Income Tax Act, 1961 deemed as income the remission of trading liability at the hands of the assessee who had claimed the same as expenditure in previous years. In the said context it was held that the given provisions are attracted only if the identity of the assessee in the previous year and subsequent year remains the same and hence it was held that the amalgamated company cannot be made liable to tax on remission of trading liability since the claim of expenditure was made prior to amalgamation by the amalgamating company.

Credit notes and debit notes

An issue may arise as regards which entity can issue tax credit/debit notes post the effective date in respect of supplies made before the said date. Sec. 34(1) of the CGST Act, 2017 permits the registered person who has made the supply to issue the tax credit notes. Similar provisions exist for debit notes. The said provisions, therefore, permit only the registered person who has made the supply to issue the tax credit/debit notes. It may also be noted that the issuance of the tax credit/debit notes only alters the transaction value of the supply already made and does not result in an independent supply. Hence it can be contended that it is only the demerged company which had made the supply before the effective date that can issue the tax credit/debit notes.

Demands and Recovery

Sec. 85(1) of the CGST Act, 2017 provides that in case of the transfer of business in whole or in part, the transferor, as well as the transferee, shall be jointly and severally liable wholly or to the extent of the transfer to pay the tax, interest or any penalty due from the transferor upto the time of transfer irrespective of whether such liability has been determined before the date of transfer and remains unpaid or the liability has been determined thereafter. Since Sec. 85(1) supra covers all forms of transfer (by using the expression ‘in any other manner whatsoever’), even the demerger of business which entails the transfer of an undertaking from the demerged company to the resulting company shall be covered within its ambit. It may be noted that in absence of such provisions, the transferee cannot be made liable to pay tax on supplies effected by the transferor (DCTO vs. Sha Sukhraj Peerajee 1967 SCR (3) 661 (SC)).

Sec. 85(2) of the CGST Act, 2017 provides that the transferee shall be liable to pay the tax on the supply effected by him with effect from the date of such transfer and the registered shall apply for the amendment of the certificate of registration. We have also seen earlier in the context of coming into existence of a new resulting company that u/s 22(4) of the CGST Act, 2017 the said resulting company shall be liable to register with effect from the date on which the ROC issues a certificate of incorporation.

An issue may arise as to whether the show-cause notice and the adjudication thereof can be undertaken directly against the resulting company in respect of the liability upto the time of transfer. It may be noted that Sec. 85(1) supra fixes joint and several liability in respect of the tax, interest and penalty ‘due’ from the transferor (i.e., the demerged company). Further Sec. 73(1) or 74(1) of the CGST Act, 2017 permits the issuance of the SCN on the ‘person chargeable with tax’ or ‘to whom the refund has erroneously been made’ or ‘who has wrongly availed or utilised input tax credit’. Hence Sec. 85(1) are recovery provisions and the demands for the liabilities upto the time of transfer are required to be determined only against the demerged company. It is only on non-recovery of the same that the recovery can be initiated against the resulting company.

Another issue may arise as regards the liability on the supplies made between the appointed date and the effective date. As stated earlier, although the scheme of arrangement comes into effect from the effective date (ROC filing), the same at times is made applicable from an earlier appointed date. In other words, the benefits, as well as liabilities from the appointed date, stands accrued to the resulting company. Sec. 85(2) of the CGST Act, 2017 provides that the transferee shall be liable to pay the tax from the date of transfer. Sec. 22(4) also provides for modalities for seeking the registration from the effective date. Hence a harmonious construction entails that the resulting company shall be liable to pay the tax on the supplies effected on and after the effective date.

Another issue may arise in a situation wherein a certain time elapses between the effective date and the actual date from which the resulting company can start issuing the tax invoices in its name. This could be due to the time needed to obtain approvals under other laws (post the issuance of the certificate of incorporation by ROC). During the said time span, the resulting company may continue to use the identity of the demerged company for operational purposes. In such a situation, one may consider putting an appropriate clause in the scheme of arrangement providing for the extension of the effective date to complete various compliances with the laws. It can therefore be contended that the approval granted by NCLT to the said scheme is required to be read into Sec. 85(2) of the CGST Act, 2017 to determine the date from such the resulting company shall be liable to pay the tax. One may also refer to the decision in the case of L and T Hydrocarbon Engineering Ltd. v. UOI (SCA No. 11308 of 2019) (Guj.) wherein it has been held that demand of the excise duty again from the successor entity on which excise duty had already been deposited by the transferor cannot be sustained. It was also held that the Central excise department is bound by the Order of the High Court approving the scheme of the demerger and that duty paid by the transferor ought to have been adjusted against the duty, if any, payable by the transferee. The Court also observed that this may not be a problem peculiar to the central excise law alone as such disputes can equally arise under the GST laws also.

Conclusion

A perusal of the above discussion indicates that several issues shall arise under GST in the context of the demerger. One is required to understand the same and accordingly guide the trade to ensure compliance. Proper study and care shall certainly add value to the trade and industry.

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