Carry Forward of Losses in M&A: Identifying Beneficial Holder Upon Shareholding Change in Group Cos
[Khush is a student at NALSAR University of Law.]
Section 72 of the Income Tax Act 1961 (IT Act) provides assessees the right to carry forward their business losses for eight assessment years until the same can be set off against their business profits. Section 79 of the IT Act is an exception to this rule. It bars companies, in which the public is not substantially interested, from claiming a set-off unless persons who beneficially held shares corresponding to at least 51% voting power at the time of incurring the losses continue to hold shares corresponding to at least 51% voting power when the set-off is claimed. Section 79 is an anti-abuse provision that was introduced with the intent of preventing companies from acquiring loss-incurring companies for the sole purpose of reducing their tax liability. The threshold of 51% of voting power with the shareholder when the loss was incurred and when the set-off is claimed ensures that the assessee does not effect a change in shareholding solely for avoiding/reducing tax liability.
Uncertainty arises in cases of internal corporate reorganization where shares of a subsidiary company are transferred to another company in the same corporate group for business or commercial reasons, as to whether a set-off would be allowed in such cases. Consider a corporate group with the following structure:
Here, A is the group's ultimate holding company with two wholly owned subsidiaries, B and C. C, in turn, wholly owns D. A decides to undergo restructuring, and all shares of D held by C are transferred to B. To decide if Section 79 would apply to such a situation, it must be ascertained as to who is the beneficial holder of the shares of D. If C is the beneficial holder, then D cannot carry forward and set off its losses because C no longer holds a controlling voting power pursuant to the restructuring. However, if A is the beneficial holder by the virtue of being the ultimate holding company, then a set off can be claimed because even though the shareholding pattern has changed, A retains the controlling voting power when the set off is claimed.
Recently, the Mumbai bench of the Income-tax Appellate Tribunal (Tribunal) in Sodexo India Services Private Limited v. PCIT subscribed to the latter view and held that where beneficial shareholding of a company remains same and/or no set-off of losses have been claimed or allowed, Section 79 cannot be invoked. The applicability of Section 79 to transactions in such group structures has been a contested issue which stems from the contrary rulings of the Delhi and the Karnataka High Courts (HCs) in the cases of Yum Restaurants (India) Private Limited v. ITO (Yum Restaurants) and CIT v. AMCO Power Systems Limited (AMCO) respectively.
AMCO v/s Yum Restaurants
The Karnataka HC in AMCO subscribed to the latter view, allowing the assessee to carry forward and offset its losses. Here, the shares of the assessee were wholly owned by a company named ABL. Subsequently, ABL transferred 45% shares to APIL, a wholly owned subsidiary of ABL. Thereafter, it transferred 49% out of the 55% remaining shares to a third party named TAFE. Resultantly, ABL owned only 6% shares in the assessee. The assessee filed its returns and claimed a set off for its business losses on the ground that ABL continued to hold 51% shares and voting power (45% indirectly through its wholly owned subsidiary, APIL, and 6% directly). The court accepted this argument and observed that even though ABL controlled only 6% of shares directly, it beneficially held the remaining 45% as it controlled APIL's entire voting power by being the ultimate holding company. A change in shareholding did not lead to a change in effective voting power, and therefore, Section 79 did not apply.
However, the Delhi HC in Yum Restaurants came to the opposite conclusion. Here, the assessee belonged to the Yum Restaurants Group, whose parent company was Yum USA. Initially, Yum Asia, a wholly owned subsidiary of Yum USA, held 99.99% of the shares of the assessee. Pursuant to restructuring, the shares held by Yum Asia were transferred to Yum Singapore, another wholly owned subsidiary of Yum USA. The assessee claimed a set-off. The court rejected this claim and observed that Yum Asia and Yum Singapore were distinct entities. The corporate veil could not be pierced at the instance of the assessee on the grounds that since Yum USA was the ultimate holding company, it was the beneficial owner of the shares of the assessee. Beneficial ownership could not be presumed in such cases, especially in the absence of any arrangement/agreement laying this relationship.
It must be noted that the Delhi HC did not have the benefit of the judgment in AMCO when it was deciding Yum Restaurants as it was not placed on record before the court. Moreover, in Yum Restaurants, the court also overlooked an earlier decision of the same HC in CIT v. Select Holiday Resorts Private Limited, where the court allowed a set-off and as the assessee company was beneficially held (by way of an intermediary) by four persons of a family both on the day when the loss was incurred and when the set-off was claimed.
The contrary rulings by the Delhi and the Karnataka HCs have led different Tribunals to come to different conclusions. For instance, the Mumbai Tribunal has relied on AMCO in the cases of Wadhwa & Associates Realtors v. Assistant CIT (Wadhwa), Bechtel France SAS v. DCIT, DCIT v. Tril Roads, and BancTec TPS India (Private) Limited v. Principal Commissioner of Income-Tax. Similarly, the Ahmedabad Tribunal also relied on AMCO in CLP Power India v. DCIT (CLP Power). However, the Delhi and Mumbai Tribunals relied on Yum Restaurants in ACIT v. WSP consultants and Aramex India v. Deputy CIT, respectively, to deny the assessee the benefit of carry forward and set off.
Shareholding v/s Voting Power
The applicability of Section 79 hinges on who controls the voting power and not on the shareholding pattern. In CIT, Bombay v. Italindia Cotton Private Limited, the Supreme Court (SC) held that if the change in shareholding did not result in holding voting power of 51% or if it is established that post this change, the shares of a company carrying not less than 51% voting power in the assessee are beneficially held by the same person, it can be presumed that there is no change in control over the company. The ITAT in Wadhwa specifically took note of this distinction between 'voting power' and 'shareholding' and held that “if the intention of the legislature was to lay down the condition of shareholding, then there was no need to specify ‘voting power.’ This clearly indicates that shareholding is not the condition but exercise of ‘voting power’ is important for the purpose of section 79(a).” Therefore, one should look beyond the registered shareholder and inquire as to who controls the company's affairs and influences how voting rights are exercised.
Beneficially ‘Owned’ v/s Beneficially ‘Held’
The term ‘voting power’ is qualified by the term ‘beneficially held.’ Therefore, the question remains whether a holding company can be called the beneficial holder of shares held by its downstream subsidiaries for taxation purposes. Most judgments on Section 79 (see, for instance, the Delhi HC’s ruling in CIT vs S Net Freight India Private Limited) use the terms ‘beneficial owner’ and ‘beneficial holder’ interchangeably. The author submits that although ‘beneficial holding’ is a derivative of ‘beneficial ownership,’ it operates in a distinct sphere.
International taxation uses ‘beneficial ownership’ clauses to tackle treaty shopping. Upon satisfaction of beneficial ownership conditions, taxpayers can avail beneficial tax rates as available under international tax treaties. As per these treaties, a ‘beneficial owner’ is a person who has the right to use and enjoy the income earned by dividend, interest, royalties, and fee for technical services. The Commentary on OECD Model Tax Convention shows that beneficial ownership in international taxation is used in a very specific context for taxing certain specific incomes instead of beneficial ownership of assets. Regarding identifying the real owner of assets, the OECD does not provide any guidance and has left it open for the respective countries to provide a different and extensive meaning to the term or its variant terms.
The usage of ‘beneficially held’ instead of ‘beneficially owned’ in Section 79 is notable. In CLP Power, the ITAT observed that the word ‘held’ is more elastic than ‘owned.’ The use of 'beneficial' before ‘held’ requires the courts to go beyond the register of ownership, notwithstanding the separate and independent legal personality of the registered owner of shares. Yum Restaurants took a narrow understanding of ‘beneficially held’ and refused to lift the corporate veil. The author submits that the very wording of Section 79 indicates the authority must lift the veil of incorporation and look at the realities of the situation. In CIT v. Subhlaxmi Mills Limited, the Gujarat HC advocated for a 'substance over form' approach where the authorities must look beyond the façade of the corporate entity and see the real substance behind the transaction.
Section 79 was enacted to check a very specific mischief, i.e., preventing companies from purchasing loss-making companies and thereby avoiding tax liability by claiming a set-off. In this light, the phrase ‘beneficially held by persons who beneficially held’ should include indirect control of voting rights through a chain of holding by the same group and the embargo of Section 79 should not be extended to companies undergoing internal corporate reorganization.
Further, the court in Yum Restaurants introduced a new condition of the existence of an arrangement/agreement of ‘beneficial holding’ between the parent and the subsidiary, which is not contemplated by Section 79. It is trite law that a taxing statute must be construed strictly, and nothing is to be read in or implied. The court’s view in Yum Restaurants contradicts this settled proposition of law.
Holding structures are well recognized in corporate as well as tax laws. Although parent and subsidiary companies have distinct juristic personalities, the language and intent of Section 79 necessitate that the corporate veil is pierced by looking at the substance of the transaction over its form. A corporate group undergoing internal restructuring must not be brought under the dragnet of Section 79. Such companies should be allowed to carry forward and set off its losses notwithstanding the non-existence of material that indicates that the ultimate holding company is the beneficial holder of shares owned by its subsidiaries.