Lately, the income tax authorities have been actively objecting to schemes of arrangement initiated under sections 391 to 394 of the Companies Act, 1956 on the ground that the schemes are intended to avoid applicable taxes. Such objections are usually raised when the scheme is presented for sanction of the High Court. This scenario has been played out last week in a decision of the Gujarat High Court in Vodafone Essar Gujarat Limited v. Department of Income Tax.
The scheme involved the demerger of the passive infrastructure assets of several telecom companies into a single transferee company. Both the transferor companies and the transferee company were part of the same group, with all of them being wholly owned subsidiaries of one of them. Since the companies were located in several states, the scheme required the approval of different High Courts. While the High Courts of Bombay, Calcutta, Madras and Delhi approved the scheme, a single judge of the Gujarat High Court rejected the scheme on the ground that the transaction did not fall within the scope of “arrangement” within the provisions of the Companies Act as the transaction was considered to be a gift due to the lack of consideration. The court found the existence of a number of other grounds to reject the scheme, primarily because the transaction would result in a loss to the revenue.
Although similar arguments were placed by the income tax authorities before the Delhi High Court, the scheme was nevertheless sanctioned with powers reserved to the income tax authorities to determine tax liability on the scheme. We have previously discussed these contrasting approaches between the Gujarat and Delhi High Courts in a previous post.
Unsurprisingly, the company appealed against the decision of the single judge of the Gujarat High Court, which was reversed last week by a division bench. After carefully considering the law pertaining to the ability of the income tax department to successfully challenge a scheme of arrangement on the ground of tax avoidance, the court came to its own conclusion on the relevant issues.
First, on the threshold question whether the income tax authority has the locus standi to challenge a scheme before the court, there was no doubt about that because the income tax authority is in the nature of a creditor of the company, and is entitled to examine the scheme from the purview of any tax liability arising from that.
Second, the court’s role in approving a scheme of arrangement was considered, and that includes an examination of whether the provisions of the scheme were structured so as to be against public policy or contrary to the provisions of applicable law.
Third, the expression “arrangement” in sections 391 to 394 is of wide import, and cannot be interpreted narrowly. In that sense, it cannot be said that a scheme that is in the nature of a gift cannot amount to an “arrangement” for the purposes of these provisions.
Fourth, while examining the scheme, the court cannot conduct a close examination of its terms such as the nature and extent of the consideration involved in the transaction, which was among group companies. As far as the role of the court is concerned, it was observed:
In our view, while examining the Scheme each and every objection of a third party cannot be considered by carrying out microscopic examination. It is also required to be noted that it is not necessary that consideration is always a monetary consideration. In such type of cases wherein the reconstruction involves give and take and mutual/reciprocal promises and obligations, which can be said to be consideration for each other and it cannot be said that there is absolutely no consideration so far as Scheme of Arrangement is concerned. The Court is required to see whether the Scheme in question is for the benefit of shareholders and whether it is framed with the sole object of avoidance of the Scheme is avoidance of tax or it is against the public policy. Even otherwise, when various High Courts have sanctioned the identical Schemes, even on the principles of parity and judicial comity, in our view, consent is required to be given to the Scheme in question.
Fifth, the role of the tax authority to object to the scheme is fairly narrow and courts will generally be slow in rejecting a scheme on account of issues pertaining to tax. Here, it was observed:
... it is required to be noted that even if the ultimate effect of the Scheme may result into some tax benefit or even if it is framed with an object of saving tax or it may result into tax avoidance, it cannot be said that the only object of the Scheme is tax avoidance. Considering the various clauses of the Scheme it is not possible for us to come to a conclusion that the Scheme is floated with the sole object of tax avoidance. In its commercial wisdom if the Company has decided to have a particular arrangement by which there may be even benefit of saving income-tax or other taxes, that itself cannot be a ground for coming to the conclusion that the sole object of framing the Scheme is to defraud the Income Tax Department or other taxing authorities.
In sum, the division bench of the Gujarat High Court appears to have adopted a similar stance as the other courts that sanctioned the scheme, particularly the Delhi High Court which considered similar objections from the income tax department. The ultimate outcome seems to be that while the income tax department may have limited powers to prevent the implementation of the scheme itself, courts have generally recognised powers to the department to subsequently open the issue of taxability of the scheme and the consequences arising from that. Therefore, from a structuring and implementation standpoint, while companies may now be able to undertake and successfully proceed with various types of schemes of arrangement, the impact of taxation may be felt only subsequently when the department examine the taxation issues.
There seems to be a pattern emerging now on cases involving challenges of schemes by the tax authorities or others (on taxation grounds). A somewhat similar approach was adopted in two other cases recently, In re: AVM Capital Services (P.) Ltd. and In re Indo Rama Textile Ltd.
In the AVM Capital case, a scheme of amalgamation was challenged on the ground that it amounted to avoidance of capital gains tax, and hence that the scheme ought not to be sanctioned. However, the Bombay High Court, after extensively considering the case law on tax avoidance and schemes of arrangement, proceeded to sanction the scheme.In the Indo Rama Textile case, a scheme of demerger was sanctioned by the court although there was no allocation of common assets and liabilities among the different undertakings. This was on the ground that the transferred assets and liabilities themselves constituted an undertaking that is capable of carrying on business in an uninterrupted manner. In that case, the court clearly stated that a scheme of demerger may be sanctioned by the court under sections 391 to 394 of the Companies Act although the scheme may not satisfy the requirements of a qualifying demerger under section 2(19AA) of the Income Tax Act.