Capital Gains, Deemed Dividend and Cost of Acquisition of Assets

Capital Gains, Cost of Acquisition
and Deemed Dividend
Presented by:
Prashant Kapoor
Content
1
2
3
Background
Case Studies – Capital Gains and Cost of
Acquisition
Case Studies – Deemed Dividend
4
Appendices
1

1 Background
2
Capital Gains, Cost of Acquisition and Deemed Dividend
Amalgamation / Demerger
Tax Neutral Amalgamation / Demerger
Where an Amalgamation / Demerger is compliant with conditions prescribed under the Income-tax Act, 1961 (“ITA”):
CAPITAL GAINS EXEMPT in the hands of:
- Amalgamating / Demerged Company; and
- Shareholders of Amalgamating / Demerged Company.
COST OF ACQUISITION OF SHARES ISSUED in case of:
- Amalgamation: Equal to original cost of shares in Amalgamating Company; and
- Demerger: Cost of acquisition of shares in Demerged Company allocated proportionately for Demerged and Resulting
company.
COST OF ACQUISITION OF ASSETS for AMALGAMATED / RESULTING COMPANY:
Block of assets
- Amalgamation: WDV of the block of assets of Amalgamating Company for the immediately preceding previous year as
reduced by the amount of depreciation actually allowed in the said previous year.
- Demerger: WDV of the block of assets of resulting company shall be WDV of transferred assets of demerged company
immediately before the demerger.
Other Assets
- Cost to the amalgamating / Demerged company.
DEEMED DIVIDEND:
- Not applicable on issue of shares in case of Demerger.
3

2
Case Studies –
Capital Gains & Cost of Acquisition
4
Capital Gains and Cost of Acquisition of shares
Case Study – I
Cost of
Acquisition is
Rs.10 per share
1
Demerger of
Division X into
A Ltd
Shareholders
100%
A Ltd
100%
B Ltd
Division X Division Y
2
3
Payment to
shareholder on
Capital
reduction
Capital
Reduction by B
Ltd
Transaction 1:
Demerger of Division X (comprising of substantial part of
business of B Ltd– 85%-90%) of B Ltd into A Ltd
No shares issued on demerger
(Difference between the net assets and consideration adjusted
against reserves of B Ltd)
Transaction 2:
In next financial year, B Ltd proposed to carry out capital
reduction u/s 100-104 of the Companies Act ,
1956 through cancellation of its shares
Pay out of Re.1 per share to shareholders i.e. A Ltd.
Demerger would be tax neutral since non compliance of conditions is due to impossibility of law
Cost of acquisition of shares of B Ltd in the hands of A Ltd would be Rs.10
5

Cost of Acquisition of shares in Demerged Company
Case Study – II
Split Balance Sheet of B Ltd prior to Demerger
A Ltd
100%
Division
X
B Ltd
Division
Y
2
Issue of
shares to A
Ltd
Demerger of
Division Y into
C Ltd
C Ltd
* Original Cost of Acquisition of Shares in Demerged
Company = Rs 8,00,000
1
Particulars
Sources of Funds Division X Division Y Total
Share Capital - 800,000 800,000
General Reserve - 200,000 200,000
Profit and Loss Account 250,000 (1,050,000) (800,000)
Total 250,000 (50,000) 200,000
Application of Funds
Amount (in Rs)
Fixed Assets -
Gross Block 300,000 1,200,000 1,500,000
Less: Accumulated Depreciation 150,000 1,100,000 1,250,000
Net Block 150,000 100,000 250,000
Current Assets 150,000 150,000 300,000
Less: Current Liabilities - 350,000 350,000
Net Current Assets 150,000 (200,000) (50,000)
Total 300,000 (100,000) 200,000
6
Cost of Acquisition of shares in Demerged Company
Case Study – II
Cost of acquisition of shares in Resulting Company 1 = Cost of shares in Demerged Company x (Net Book Value of
Assets transferred / Net Worth of Demerged Company pre-demerger).
Net worth 2 = Paid up share capital (SC) plus General Reserves (GR) as appearing in the books of account of Demerged
Company prior to demerger.
Possible interpretations of terms “Net Book Value of Assets” and “Net Worth”
Particulars Option 1 Option 2 Option 3 Option 4
Meaning
Net Book Value of Assets
Net Worth
BV of Assets -
BV of Liabilities
SC + GR -
Losses
BV of Assets -
BV of Liabilities
SC + GR
BV of Assets -
Depreciation
SC + GR -
Losses
BV of Assets -
Depreciation
SC + GR
Value
Net Book Value of Assets (100,000) (100,000) 250,000 250,000
Net Worth (50,000) 10,000,000 (50,000) 1,000,000
COA of Shares of Resulting Company 1,600,000 (8,000) (4,000,000) 200,000
* Original Cost of Acquisition of Shares in Demerged Company = Rs 8,00,000
Option 4 is correct interpretation
1. Section 49(2C) of ITA
2. Explanation to Section 49(2E) of ITA
7

Non-Tax Neutral Merger – Capital Gains and Depreciation on Goodwill
Case Study – III
PROMOTERS HOLDING 60% EQUITY IN C LTD INTEND TO DIVEST COMPLETELY AT FAIR VALUE
OPTION 1: DIRECT SALE OF SHARES TO B LTD
B Ltd
2
Payment of cash
consideration
Promoters
1
Sale of shares
of C Ltd to B Ltd
60%
C Ltd
Public
40%
Sale of shares taxable as Capital Gains.
Shares of C Ltd would be recorded in the books of B
Ltd as Investment, which is not a depreciable asset.
ALTERNATE OPTION TO CONSIDER DEPRECIATION
ON GOODWILL
2
Payment of cash
consideration to
shareholders
Promoters
60%
Public
40%
Step 1: Merger of C Ltd with B Ltd for cash consideration
Step 2: B Ltd based on purchase price allocation records
difference between consideration & fair value of
assets taken over as Goodwill
B Ltd
1
Merger of C
Ltd with B Ltd
C Ltd
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3 Case Studies – Deemed Dividend
9

Deemed Dividend under Section 2(22) of the ITA
Key Aspects
POWERFUL TAX TOOL FOR REVENUE
Definition of dividend under section 2(22) of the ITA is an “Inclusive” definition – with specific exclusions
provided.
Extension of connotation of the word “Dividend” to comprise distributions or payments which may not be
necessarily considered as dividend under the Companies Act, 1956.
Clause (a) Clause (b)
Clause (c) Clause (d)
Clause (e)
Release of all or
part of assets
Refers to the
distribution of
accumulated
profits, whether
capitalized or not
Distribution of
debentures
bonus shares,
etc.
Distribution to the
extent of
accumulated
profits, whether
capitalized or not
Distribution
liquidation
on
Distribution to the
extent of
accumulated
profits before
liquidation,
whether
capitalized or not
Distribution on
reduction of
capital,
Distribution to the
extent of
accumulated
profits, whether
capitalized or not
Payment by way of
loans/advances
Distribution to the
extent of
accumulated
profits
Applicable
closely
companies
to
held
10
Deemed Dividend under Section 2(22) of the ITA
Case Study – I
AMALGAMATION OF WHOLLY OWNED SUBSIDIARY (‘WOS’)
Merger
Holding Company
1 100%
Shareholders
100%
2
Cancellation of
Investments in
Subsidiary
Step 1: Merger of Subsidiary into Holding Company
No shares issued
Step 2: Cancellation of Investments by Holding
Company
Subsidiary
No implications u/ s 2(22)
11

Deemed Dividend under Section 2(22) of the ITA
Case Study – II
NON-TAX NEUTRAL DEMERGER
Shareholders
100%
Company X
1
Div A Div B Demerger of Division
B into Co. B
Co. X has
accumulated
profits
2
Payment of cash
as demerger
consideration
Company Y
Step I: Demerger of Division B of Co. X into Co. Y
through a court approved Scheme of
Arrangement
Step II: Co. Y discharges demerger consideration by
paying cash to shareholders of Co. X
Payment to shareholders considered as deemed dividend u/s 2(22)(a)
12
Thank You

4 Appendices
14
Appendix :: 1
Section 2(19AA) (iv) & Extract of Circular No. 5-P dated October 9, 1967
Section 2(19AA) - Amendment made by Finance Act, 2012
“2(19AA) “demerger” in relation to companies ………….. In such a manner that –
(i) to (iii)
(iv) the resulting company issues, in consideration of the demerger, its shares to the shareholders of the demerged company
on a proportionate basis except where the resulting company itself is a shareholder of the demerger company”.
Extract of Circular No. 5-P dated October 9, 1967
“…..it has been provided that in applying the said condition (viz., that shareholders holding not less than 9/10th in value of
the shares in the amalgamating company should become shareholders of the amalgamated company by virtue of the
amalgamation), the shares in the amalgamating company held by the amalgamated company or its nominees or subsidiaries
immediately before the amalgamation, will not be taken into account.
15

Appendix :: 2
Relevant Extract of Section 49
Section 49(2C)
“The cost of acquisition of the shares in the resulting company shall be the amount which bears to the cost of acquisition of
shares held by the assessee in the demerged company the same proportion as the net book value of the assets transferred
in a demerger bears to the net worth of the demerged company immediately before such demerger.”
Section 49(2D)
“The cost of acquisition of the original shares held by the shareholder in the demerged company shall be deemed to have
been reduced by the amount as so arrived at under sub-section (2C).”
16
Appendix :: 3
Supreme Court Ruling - Smifs Securities Ltd
Relevant Extract of Ruling
“Explanation 3(b) to Section 32(1) of the Act, states that the expression 'asset' shall mean an intangible asset, being knowhow,
patents, copyrights, trademarks, licences, franchises or any other business or commercial rights of similar nature. A
reading of the words 'any other business or commercial rights of similar nature' in clause (b) of Explanation 3 of Section
32(1) of the Act, indicates that goodwill would fall under the expression 'any other business or commercial right of a similar
nature'. The principle of ejusdem generis would strictly apply while interpreting the said expression which finds place in the
Explanation 3(b).”
17

Appendix :: 4
Relevant extracts of Section 2(22)
“2(22) "dividend" includes—
(a) any distribution by a company of accumulated profits, whether capitalized or not, if such distribution entails the release by
the company to its shareholders of all or any part of the assets of the company;
(b) any distribution to its shareholders by a company of debentures, debenture-stock, or deposit certificates in any form,
whether with or without interest, and any distribution to its preference shareholders of shares by way of bonus, to the extent
to which the company possesses accumulated profits, whether capitalized or not ;
(c) any distribution made to the shareholders of a company on its liquidation, to the extent to which the distribution is
attributable to the accumulated profits of the company immediately before its liquidation, whether capitalized or not ;
(d) any distribution to its shareholders by a company on the reduction of its capital, to the extent to which the company
possesses accumulated profits which arose after the end of the previous year ending next before the 1st day of April, 1933,
whether such accumulated profits have been capitalized or not;
(e) any payment by a company, not being a company in which the public are substantially interested, of any sum (whether as
representing a part of the assets of the company or otherwise) made after the 31st day of May, 1987, by way of advance or
loan to a shareholder, being a person who is the beneficial owner of shares (not being shares entitled to a fixed rate of
dividend whether with or without a right to participate in profits) holding not less than ten per cent of the voting power, or to
any concern in which such shareholder is a member or a partner and in which he has a substantial interest (hereafter in this
clause referred to as the said concern) or any payment by any such company on behalf, or for the individual benefit, of any
such shareholder, to the extent to which the company in either case possesses accumulated profits….”
“…but "dividend" does not include - ….
…. (v) any distribution of shares pursuant to a demerger by the resulting company to the shareholders of the demerged
company (whether or not there is a reduction of capital in the demerged company).”
18