India: Delhi High Court* Holds "Income-Diversion" Principle To Be Inapplicable In Case Of Receipt Of Consideration Directly By The Shareholders Of The Transferor Entity Under Court Approved Scheme Of Arrangement

Facts and background of the case:

• The assessee, a limited company incorporated under the provision of the Companies Act, 1956, was engaged in the business of manufacture of television sets and components and had started Panasonic Division in technical collaboration with foreign company M for the manufacture of colour television sets in India. Later the assessee decided to restructure and reorganize the company by spin off of the Panasonic Division to company M under Court approved scheme of arrangement under sections 391-394 of the Companies Act, 1956. The High Court accorded permission to the scheme.
• The total consideration agreed to be paid by company M had been fixed at ₹50.12 crores. As per the scheme of arrangement, the shareholders of the assessee were entitled to claim as a right from company M, two equity shares of ₹10 each credited as fully paid.
• In the income tax return filed by the assessee, the total consideration in respect of sale of Panasonic Division was shown as ₹32.48 crores and the same did not include the sum of ₹17.64 crores, being the value of the shares allotted by the transferee-company M to shareholders of the transferor company.
• The assessing officer was of the view that the company diverted part of its income to the shareholders in terms of the scheme of arrangement and concluded that - (i) total sale consideration which accrued in the hands of the assessee was ₹50.12 crores on which the assessee was liable to pay tax on capital gains, and (ii) shares worth ₹17.64 crores given to shareholders were nothing but application of income.
• On appeal, the CIT(A) confirmed the order of the assessing officer.
• On second appeal, the Tribunal reversed the order of the CIT(A) and held that there was diversion of receipt at the very source itself and, therefore, shares worth ₹17.64 crores issued to shareholders of the assessee by company M could not be considered as part of consideration received by the assessee for purpose of computing capital gains.
• The Tribunal further observed that the shareholders of the assessee had acquired the right to receive the shares of the transferee-company M by virtue of the Court approved scheme of arrangement which had binding effect; accordingly, the value of the shares issued to the shareholders of the assessee could not be said to be income arising to the assessee, the same having been diverted at the very source itself.

Decision of the High Court:

• On an appeal filed by the Revenue, the High Court, referring to the decision of the Supreme Court in the case of Bacha F. Gazdar¹, held that since title in the Panasonic Division vested with the assessee and not its shareholders, who were separate and distinct legal entities, the assessee (being the transferor) would be entitled to the entire consideration for sale of the Panasonic Division and the fact that, at its instance, part of the consideration was diverted to the shareholders would not absolve the assessee from recognizing the entire consideration.²
• Following the "look at" approach enunciated by the Supreme Court in the case of Vodafone, to ascertain taxability of the transaction, the Court held that in an instrument effecting sale of assets, where the owner calls upon the buyer to pay part consideration to third party, undisputedly, the seller is entitled to the entire consideration for sale. Accordingly, equating the word "entitlement" to "accruing" as used in section 48 of the Income tax Act, the Court held that the value of shares issued to the shareholders should be taken into account for purpose of computation of capital gains in the hands of the seller, in terms of that section.
• Rejecting the Tribunal's view that the shareholders acquired right to receive shares under a Court approved binding scheme and that there was diversion of income at source, the Court referred to the decision of the apex³ Court in Sitaldas Tirathdas to observe that the nature of obligation is a decisive fact to determine whether there is diversion of income or not. Applying that test, the Court noted that in the case in question, the assessee had in the scheme of arrangement proposed that the total sales consideration of ₹50.12 crores be discharged in the above manner and hence voluntarily diverted part of the income which belonged to the assessee, to its shareholders.
• Since the Revenue was not seeking to compute capital gains on any hypothetical basis, the entire consideration for transfer of the Panasonic Division (including the value of shares issued to the shareholders of the assessee) was held to be real income accruing in the hands of the assessee.

VA Comments:

• The High Court, by holding that the entire consideration (including the value of shares issued to the shareholders of the assessee) to be taxable in the hands of the assessee has infact, considered the issuance of shares by M to the shareholders of the assessee under the Court approved scheme of arrangement as a two-step transaction, viz, constructive receipt of shares of M by the assessee and thereafter transfer of the said shares by the assessee to its shareholders.
• The issues which arise for consideration are (i) applicability of the said decision to a case where the consideration payable to the transferor is not split in the aforesaid manner but shares to the shareholders of the transferor company are additionally issued by the transferee, (ii) taxability of the second leg of the transaction, viz, transfer of shares (of M) by the assessee to its shareholders – to whether the same would be considered as deemed distribution of assets by the assessee to its shareholders falling within the purview of section 2(22)(a) of the Income tax Act?
• The aforesaid decision of the High Court has opened a pandora's box which would result in uncertainty as to the correct tax treatment in similar cases, both in the hands of the transferor company and its shareholders till such time the issue is settled by a higher forum.

Footnotes

* CIT vs. M/s Salora International Ltd. ITA 12/2003; judgement dated 13.05.2016

1. Bacha F. Guzdar vs. CIT : 27 ITR 1 (SC)

2. Vodafone International Holdings B.V. vs. Union of India : 341 ITR 1 (SC)

3. CIT vs. Sitaldas Tirathdas : 41 ITR 367 (SC)

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