- Timir Baran Chatterjee
Sr. Executive Vice President (Corporate Affairs & Legal) & Company Secretary
DIC India Limited (formerly Coates of India Limited)
10 Jan, 2010

The Gujarat High Court has recently rejected the plea of telecom giant Vodafone Essar Gujarat Limited (VEGL) seeking sanction for its scheme of demerger and transferring its property to another company, Vodafone Essar Infrastructure Limited (VEIL). The decision likely to impact conventional M&A structures.

Mergers and demergers in India are Court  mediated processes requring the concerend companies to file a schme of arrangement before a High Court, in accordance with the provisions of the Companies Act, 1956. The scheme would have to relate to the reconstruction or amalgamation of the companies. While approving the scheme, the High Court is entitlted to look into the scheme to find out whether the affairs of the company have been conducted in a manner that is not prejudicial to public interest or the interests of its shareholders.

Background

The  subject demerger scheme was a consolidated scheme by seven Vodafone companies transferring their passive infrastructure assets (PIA) to VEIL out of which only one Transferor company is situated in Gujarat.  The  approximate market value of the cumulative assets of all seven transferor companies sought to be transferred under the scheme is to the tune of Rs. 15,000 crores. As per the scheme of demerger, the PIA of the Transferor Companies shall vest in and become the right, property and assets of the Transferee Company without any encumbrances for "Nil" consideration. Post merger, VEIL was sought to be merged into Indus Towers Limited, an existing joint venture company which is already promoted by Bharti Group, Aditya Birla Telecom Group and Vodafone Essar Group to provide passive infrastructure services to telecom service providers.

Why there is objection?

Pursuant to Court's direction VEGL issued a public notice stating its intention to demerge its PIA to VEIL. In reply to the same, the Income Tax Department filed their objections  challenging the substance and purpose of the scheme and claimed various taxes were sought to be evaded and hence the scheme is opposed to public interest. The Department  observed  that it was a device for avoiding tax and do not have the necessary ingredients of a valid scheme of arrangement. The material contentions of the Tax Authority, inter alia  were as under:

(a) The scheme, if passed would enable Transferee company to claim benefit u/s 80IA, on the same assets on which VEGL has already claimed the same benefit and exhausted;

(b) Since assets are transferred at NIL value without corresponding liability, the Transferor company i.e. VEGL would continue to charge interest and other liabilities with respect to the said assets in its hand. This would reduce the taxable profit in the hands of the VEGL. However, the inflated profit shown in the books of Transferee Company would be eligible for tax benefits in view of deduction u/s 80IA and accordingly there will be a loss of revenue;

(c) VEGL has substantial amount of tax liability and in the event its assets are transferred without valid consideration, there will be a significant dilution of assets in the hands of VEGL and the Department may find it difficult to recover the dues in case attachment proceedings are necessitated;

(d) The scheme is neither an "arrangement" nor a "compromise" since there is no "give" and "take" which is a pre-requisite for a scheme to qualify as an arrangement;

(e) The scheme is essentially a "Gift" which was not covered under the object clause of the Memorandum of Association of VEGL;

(f) The scheme was without any consideration. Any agreement without consideration is considered to be void under the provisions of the Indian Contract Act, 1872.

The Income tax department had filed its objection to the sanctioning of the scheme stating the above major reasons  It was contended that such transaction of gift was beyond the scope of the provision of section 391 of Companies Act, 1956 and was nothing but a devise to evade taxes of crores of rupees (including income tax and stamp duty). They  further contended that court's approval was sought for the same in a garb of a demerger scheme. It was also informed that the approximate market value of the cumulative assets of all seven transferor companies sought to be transferred under the scheme was to the tune of Rs. 15,000 crore, which would entail an evasion of stamp duty of approximately Rs. 900 crore at the existing rate of stamp duty in Gujarat and the income tax evasion through the device would be in the region of Rs. 3,500 crore.

Gujarat High Court's Decision

The High Court accepted the tax department's contentions to the proposed demerger and refused to sanction the scheme. Considering that an "arrangement" essentially involves some sort of "give" and "take", the Court also held that a demerger of assets for zero consideration would not qualify as an arrangement. Further, in the absence of valid consideration, the transfer of assets would not even qualify as a valid contract. It was also observed that Charter documents (i.e. MOA) of the Transferor company did not authorize it to gift  the assets to the Transferee company and hence the High Court could not legitimize such transfer as a scheme of arrangement. The High Court also observed that the scheme allowed the Transferor to avoid tax which would otherwise get triggered if it directly sold the assets to the joint venture company for a consideration. The High Court refused to sanction the scheme on the basis that it was solely designed to evade tax and was against public interests.

Uncertainity prevails

The Gujarat High Court's decision is likely to have a significant impact on M&As in India since minimization of tax impact is one of the primary objectives of M&A. It is also not clear whether examining of tax implications is within the ambit of HC while considering Scheme of arrangement for which there is an appropriate forum. In the case of Aadi Bachao Andolan, the SC has explained the context of the McDowell's case as not limiting or restricting a taxpayer's right to arrange its affairs  legally as permitted under law so as to mitigate their tax liability. 

Present status

Gujarat High Court (HC) on 24^th December, 2010  admitted VEGL's  appeal challenging the order passed by a single judge bench dismissing the demerger  scheme for transferring the passive assets of VEGL to VEIL  However, the court rejected Vodafone's application to extend the stay ( 2 weeks) granted earlier by the single judge. We have now wait and see  the final judgement of the Division Bench.

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