While there are merger/demerger corporate and tax laws, none exist for partnerships or LLPs
By KS Mehta
Union commerce minister Piyush Goyal initiated the production-linked incentive scheme to attract investment, finance minister Nirmala Sitharaman brought the credit facilitation and equity schemes, while MSME minister Nitin Gadkari liberalised the MSME policy, raising turnover to Rs 250 crore plus unlimited exports. But NPA levels of PSBs are predicted to be 17%. Thus, the FM must strategise both for (i) growth of healthy industries and (ii) revival of weak ones.
These recent policies can revive animal spirits to meet the twin objectives of growth and revival if certain supportive measures are taken in taxation, company law, LLP and partnership law—all within FM’s domain. Tax law for corporate mergers has existed since 1961; demerger law came in the 1990s (this author had a small role in that). It resulted in the acceleration of corporate demerger and restructuring activities, resulting in higher turnover and taxes than the undivided company earlier.
A major policy instrument can be the encouragement of mergers and demergers in corporates and partnership. While there are merger/demerger corporate and tax laws, none exist for partnerships or LLPs. Existing tax laws should be liberalised to allow issuing a mix of equity or preference shares plus debt paper against the present stipulation of only shares in mergers/demergers. The stipulation of 75% old shareholders becoming shareholders in the merged company should be reduced to 51% in mergers, with a similar reduction from 100% to 75% in a demerger. Thus, even if 25% shareholders disagree, they can be paid out. Tax laws require 100% equity issue in a demerger.
A specialised court (NCLT) approves merger/demerger schemes. A registered valuer’s report for all companies is compulsory. In listed companies, stock exchange and Sebi also conduct scrutiny. A NOC from tax authorities is also required. Hence, checks and balances are already in place.
A clarificatory amendment in the definition of a demerger is needed. A tax on income is levied under five heads—salary, property, business capital gains and other sources. A company with mainly investment activity resulting in capital gain but no business income still earns income and regularly pays dividends and taxes. But the tax authorities do not classify it as “business”, and hence, keep it out of the definition of Sec 2 (19AA). However, if you demerge the investment division, there is no tax exemption. When A-Limited demerged its investment division of Rs 1,000 crore assets earning capital gain, the ITO opined that investment is not business and hence, cannot be tax-exempt in a demerger. Any income-earning division should be considered as an Undertaking for Sec 2 (19AA). In common parlance, investment activity is also business.
Many companies have invested in subsidiaries, which need to grow faster by being spun off, while protecting the interests of the holding company’s shareholders and promoters in a demerger.
Taking over of sick companies by efficiently-run firms is an alternative turnaround strategy. If the sick firm is not listed on the bourses or ceases to be so listed due to a change in shareholding, the target firm will lose its right to carry forward its business loss. This attracts tax much faster on future profits while the old liabilities have to be paid out. Internal finance available for revival depletes. Revival period and cost becomes longer. Sec 79 should be deleted.
Tax Laws do not allow setting off losses of merging company in many situations even though it leads to a genuine turnaround. For example, if an engineering company in auto seat manufacturing business having losses is merged with a tractor company will lose its tax losses and unabsorbed depreciation, if the unit does not achieve production of auto seats of at least 50% capacity within three years.
It can’t use these facilities for making components and has to continue the loss-making business of auto-seat production. Another absurd condition is that the merged company must continue to have 75% of the same old equipment for five years. How can such a unit then absorb new technology or diversify production? The condition is to ensure employment for 50% of erstwhile labour.
The law allows only some manufacturing industries and only some services like telecom, hotels, etc, to carry forward the losses in a merger. The services sector contribute over 60% of GDP, but is mostly cut out of this exemption, even though it is high employment to investment generator. At least, think of the above measures for five years and evaluate its efficacy.
MSMEs mainly operate as partnerships. While the LLP Act provides for reorganisation, merger, or demerger of LLPs inter se, there is no such law for partnerships. The government should bring in a law for inter se merger of firms & LLP with any listed or non-listed company for quick growth/turnaround. At present, the company law requires a firm to register as a single company; then merge after waiting for five years due to tax laws. This is absurd.
Two/three firms or LLPs should be merged directly into an operating company or registered as one company. Size and speed are critical. Similarly, law for demerging one division of one or more firms or LLP, as is allowed for a company, should be permitted. Let a fast track process be taken up by the regional director of companies so that equity investments can flow in faster.
The LLP Act has laid down processes for such matters. This should be extended within this Act to cover Partnerships as well, but the power should be delegated to RD or a specialised NCLT bench.
Inexplicably, LLP law allows merger only with an unlisted company; this should be extended to listed companies, including via a demerger. All taxation laws regarding merger and demerger should be extended to partnership firms and LLPs.
A takeover financing scheme allowing healthy borrowers special loans with total moratorium up to five years for taking over or merging with weak ones should be started. Where a firm is succeeded in its business by conversion into a company, capital gains is exempted, and losses are allowed to be carried forward, subject to conditions. This should be allowed even if one division of a firm is transferred.
There are operational problems of such succession by business transfer agreement as compared to merger/demerger under a court order which is binding on all. Such reorganised firms will race for growth.
The author is Managing partner, SS Kothari Mehta & Co.