SC ruling casts a tax shadow on merger share-swap deals

Mumbai: Corporate mergers and amalgamations can trigger tax liabilities for shareholders who are not viewed as long-term investors in the erstwhile, amalgamating companies.

Such shareholders who receive shares of the acquiring company under a share-swap arrangement can come under the taxman's scrutiny even if they do not sell the shares to realise gains. It is sufficient for tax officials to conclude that the shareholders hold the securities as 'stock-in-trade' and could exit at the next available opportunity.

This, in essence, is the import of a recent Supreme Court ruling that is feared to spur litigation, as investors and traders - who have no say in merger decisions - are likely to resist paying tax on 'notional gains' arising from the involuntary receipt of shares.


Significantly, the difference in value between the shares received and those surrendered would be taxed as 'business income', rather than 'capital gains', which are subject to a lower tax rate.

The court held that where shares of an amalgamating company (the old entity), held as stock-in-trade, are substituted with shares of the amalgamated company (the new entity) pursuant to a scheme of amalgamation, and such shares are realisable in money and capable of definite valuation, the substitution results in taxable business income under Section 28 of the Income-Tax Act.

The distinction between a 'capital asset' and 'stock-in-trade' lies in the intention behind holding them: a capital asset is regarded as a long-term holding, while stock-in-trade is meant for immediate sale in the ordinary course of business. Based on circulars issued by the Central Board of Direct Taxes, assessing officers examine the holding period and frequency of past transactions to determine whether securities held by an assessee constitute 'stock-in-trade' or a 'capital asset'. However, subjectivity often creeps into this assessment, resulting in tax disputes.

The apex court verdict relates to appeals by OP Jindal group investment companies that held shares in Jindal Ferro Alloys Limited (JFAL), which was merged into Jindal Strips Limited in 1996. In 2000, the assessing officer treated the JFAL shares held by the group investment companies as stock-in-trade.

The Supreme Court rejected the argument that the receipt of shares in the amalgamated company does not amount to either a 'sale' or an 'exchange' since the amalgamating company stands dissolved and its shares cease to exist. While the ruling pertains to an 'amalgamation' of two companies, the Income-Tax Department is expected to extend the principle to merger transactions while raising tax demands.

According to Ashish Karundia, founder of CA firm Ashish Karundia & Co, "The ruling is likely to have significant implications for family offices, banks, local financial institutions, Category-III AIFs and HNIs engaged in securities trading - particularly where separate trading and investment portfolios are maintained. The decision reiterates the distinction between capital and business assets, clarifying the principle that where business assets are not subject to the rigours of law, such as deemed valuation rules, capital gains benefits are unavailable. It may, however, lead to litigation over valuation in amalgamation-related transfers, an issue not directly settled by earlier Supreme Court rulings."

"Crucially, the judgment holds that tax liability arises on receipt of shares, thereby accelerating taxation, unlike other non-cash transactions where tax is deferred, such as the conversion of capital assets into stock-in-trade," he said.

In buttressing its view, the Supreme Court observed that if amalgamations involving trading stock were insulated from tax through judicial interpretation, it would create an easy avenue for tax evasion. Enterprises could set up shell entities, warehouse trading stock or unrealised profits, and then amalgamate them to convert such gains into new shares without subjecting the commercial profits to tax, the court said. Similarly, losses could be engineered and shifted across entities to depress taxable income, the bench noted.