Vinesh Kriplani & Rohan Umranikar

Background

In a couple of recent decisions, the Mumbai bench of the Income-tax Appellate Tribunal (ITAT) has held that the transaction in question was a slump exchange.  Since the Income Tax Act 1961 (ITA) does not prescribe a mechanism to compute the cost of acquisition of the transferred undertaking in a slump exchange, the computation machinery fails and gains arising in such a transaction cannot be subjected to capital gains tax.

These decisions reignite the debate on taxability of slump exchange (distinguished from slump sale) transactions.  

The controversy

As per section 2(42C) of the ITA, “slump sale” means the transfer of one or more undertakings as a result of a sale for a lump sum consideration without values being assigned to the individual assets and liabilities in such sales.  The ITA provides a mechanism to compute the cost of acquisition of the transferred undertaking in section 50B.  It was never in doubt that transfer of a business undertaking triggered capital gains for the seller; however, the Hon’ble Supreme Court (SC) has held that before section 50B was inserted in the ITA, the charge of capital gains tax failed in case of transfer of a business undertaking since there was no computation mechanism prescribed in the ITA.  Section 50B was inserted to cure this lacuna.

A question arises as to whether the computation mechanism prescribed in section 50B can be applied to transactions resulting in transfer of an undertaking as a result of “exchange” (say for consideration in the form of shares of the transferee) and not as a result of “sale”.

It may be noted that the expression “transfer” in relation to a capital asset has been defined in the ITA in an inclusive manner; it specifically includes, inter-alia, sale, exchange or relinquishment of any asset.  Thus, the ITA itself has specifically referred to both the terms “sale” as well as “exchange” while defining “transfer” and hence, it can be said that the legislature itself makes a distinction between the two terms.  Transfer of capital asset could be in several forms; but the legislature, while defining slump sale, has thought it fit to include only transfer by way of sale and not any other mode of transfer.

The expression “sale” has not been defined in the ITA and hence, the definition of the term “sale” as appearing in Section 54 of the Transfer of Property Act, 1882 and section 4 of the Sale of Goods Act, 1930 may need to be looked into.  Under the Transfer of Property Act, the expression “sale” has been defined as a transfer of ownership in exchange for a price paid or promised or part paid and part promised.  Under the Sale of Goods Act, sale has been defined as contract, whereby the seller transfers or agrees to transfer the property in goods to the buyer for a price.  Section 2(10) of the Sale of Goods Act defines “price” to mean the money consideration for a sale of goods.

The term “exchange” is also not defined in the ITA.  The SC has held that where consideration in a transaction is other than money, it would be a case of “exchange” and not “sale”.  

Courts have held that where the transferor of an undertaking receives consideration in kind (say in the form of shares/ debentures of the transferee or any investment/ asset held by the transferee) and not in monetary form, the transaction is in the nature of an exchange and such transactions do not qualify as “slump sale” under the ITA.  Consequently, such transactions cannot be subjected to capital gains tax. The Bombay High Court has been very emphatic while concluding that no larger question or wider controversy needs to be decided and this issue does not raise any substantial question of law. The recent Mumbai ITAT decisions also follow this judicial view. The Courts have rejected the argument advanced by the Revenue that this treatment is not in the spirit of the law.  

Cost carry over in a slump exchange

While the transferor will not be subjected to capital gains tax on the transfer of the undertaking, it may not result in just a deferral of the tax liability but a permanent benefit to the extent of the fair value of the undertaking transferred.  To add to this, the transferee may also be allowed a higher tax cost base for the assets received pursuant to the transaction.

The transferor is likely to argue that the assets received in exchange have a tax cost base equivalent to their fair value and hence, in case of a subsequent transfer of these assets, the gains arising, if any, from this base should only be subjected to tax.  The transferee is also likely to argue that the assets (tax depreciable assets, stock-in-trade, other capital assets) have been acquired by it at their fair value and hence, enjoy a stepped-up tax cost base in its hands in the absence of any provision in the ITA deeming the cost to be the same.  

The generally acknowledged principle of tax neutrality through carry over of cost from the transferor to the transferee may not apply inspite of the transaction not giving rise to any tax in the hands of the transferor.

Has the dust settled?

With the emphatic ruling of the Bombay High Court and the judicial trend thereafter, the balance seems to be in favour of the taxpayer.  However, whether a particular transaction qualifies as a slump “exchange” or a slump “sale” is very fact specific and depends significantly on the underlying documentation and commercial understanding of the parties.

The SC has succinctly explained the difference between a sale and an exchange as follows:

“Where the person carrying on the business transfers the assets to a company in consideration of allotment of shares, it would be a case of exchange and not of sale, and the true nature of the transaction will not be altered, because of stamp duty or other reasons the value of the assets transferred is shown as equivalent to the face value of the shares allotted.  A person carrying on business may agree with a company floated by him that the assets belonging to him shall be transferred to the company for a certain money consideration and that in satisfaction of the liability to pay that money consideration, shares of a certain face value shall be allotted to the transferor. In that case there are in truth two transactions, one a transaction of sale and the other a contract under which the shares are accepted in satisfaction of the liability to pay the price… it is necessary to precisely determine the facts and to ascertain in which of the different categories the transaction falls”.

Are all court schemes immune from taxation?

In most of the judicial precedents of slump exchange transactions, the transfer of undertaking has happened through a scheme of arrangement.  An interesting dimension is whether the transaction would be outside the purview of slump sale taxation given that it is through a court scheme or whether it still needs to qualify as an “exchange”.

In the case of Avaya Global, placing reliance on certain decisions in the context of a different provision of the Act, the transferor argued that transfers pursuant to court schemes are by operation of law and do not qualify as a “sale” and hence, the computation mechanism prescribed for slump sale transactions cannot be applied.  The taxpayer also argued that the transaction was in the nature of a slump exchange. Mumbai ITAT seems to have upheld both the arguments of the taxpayer.

However, this argument has been brushed aside by the Delhi High Court in a subsequent decision.  In the case decided by the Delhi High Court, the taxpayer transferred a business undertaking pursuant to a court scheme and received monetary consideration from the transferee.  The High Court held that the transaction was in the nature of a “sale” and hence, was subject to capital gains tax.

Thus, transfer through a court scheme which does not qualify as an “exchange” may not be immune from capital gains tax.

Can slump exchange be a panacea for restructurings?

Traditionally, restructurings have been in the form of tax neutral mergers and demergers.  Slump exchange may emerge as a more tax efficient mode to spin-off business undertakings in internal group restructurings as well as external transactions.  

With the advent of General Anti-Avoidance Rule (GAAR), taxpayers need to be cautious while considering a slump exchange transaction.  Taxpayer’s commercial rationale for receiving consideration in kind and not in monetary terms will play a critical role to mitigate consequences under GAAR.  An advance ruling could be sought in suitable cases in order to achieve tax certainty.

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