[Yarabham and Chakkapalli are students at Hidayatullah National Law University.]
On 1 February 2025, Finance Minister Nirmala Sitharaman presented the Union Budget 2025-26 introducing new procedures related to mergers and acquisitions (M&A), aiming to rationalize and simplify the process of mergers. Fast-track procedures will be introduced which will increase the scope for speedy approval of mergers and reduce the waiting time. It also proposes for the amendment of Section 72A and 72AA of Income Tax Act 1961 (ITA) to rationalize provisions related to amalgamation. There is no precise definition for merger in the ITA and used to refer the same thing as amalgamation. According to Section 2(1B) of the ITA, amalgamation refers to the merger of two or more companies to form a resulting amalgamated company.
Sections 72A and 72AA of the ITA talk about the carry forward and set-off of accumulated losses and unabsorbed depreciation of the amalgamating company (the company which is going to get merged) to be set-off against the profits of the amalgamated company (resultant company after merger) if the specified conditions are met. This amendment although aims to improve tax certainty and prevent unintended benefits to companies, it will be a major blow to the companies which genuinely consider mergers as part of their business restructuring to improve their business and diversify into new markets. This article provides a background of the new proposed amendments and discuss its implications on M&A. Eventually, it analyzes its implementation challenges and suggest some alternate solutions.
Section 72A and 72AA Saga: From Lifeline to Deadline
First, Section 72 of ITA talks about the set-off and carry forward of business losses. It provides a tax relief to the companies earning income under the head profits or gains of business or profession. Business losses arising under the same head can be used to set-off the profits arising from another business under the same head to calculate the net income or profits. If there are no net profits arising against which losses can be set-off, then the losses will be carried forward to be set-off in the next assessment year (AY). Section 72(3) provides the maximum permissible limit to be 8 years for carrying forward the losses.
However, the issue arises whether this time-limit will apply in cases where the companies undergo mergers under Sections 72A and 72AA. Do they get a fresh 8 years from the date of amalgamation or the period will end after 8 years from the year where the loss first occurred? A bare reading of the provision Section 72A(1) gives an interpretation that accumulated losses and unabsorbed depreciation of the amalgamating company will be transferred to the amalgamated company and is deemed to belong to it from the year of merger. Further, this issue was brought before the Income Tax Appellate Tribunal, Mumbai in the case of Supreme Industries Limited v. DCIT, where it established that the amalgamated company will get the right to carry forward the loss for a fresh period of 8 AYs from the previous year in which the amalgamation took place.
Hoping to prevent this evergreening of losses by amalgamations, the Government proposed to insert a new subsection (6B) to Section 72A which states that in case of any amalgamation or business reorganization which takes effect on or after 1 April 2025, the losses forming part of accumulated losses of amalgamating company shall be carried forward in the hands of amalgamated company only till the eight AYs immediately succeeding the assessment year in which the losses were first computed in the hands of the amalgamating company.
Implications of the Amendment: Bad Trade for Mergers
Amalgamations and business organizations serve as strategic levers for companies to tap into new markets and diversify their portfolio and drive innovation, despite resulting in initial losses. Hence, set-off and carry forward will incentive the companies to pursue mergers aiming at long term value creation while offsetting initial financial strains. Take the case of Vodafone and Idea merger which faced financial and non-financial challenges immediately after the merger leveraged the tax provisions to offset and carry forward the losses for a new 8 AYs, thereby enabling it to significantly transform the telecom sector and establish itself as a dominant player in the market. Moreover, companies use mergers to rescue their ailing businesses and stabilize them which often takes time to start generating profits. Removing this flexibility risks not just recovery but also transformative growth.
The amendment might prevent the companies from evergreening of losses and tax avoidance. There are cases where a profit-making corporation acquires a loss-making entity whose principal purpose is to avoid paying taxes by setting off losses against the profits and claim deductions. These so-called upstream mergers proved harmful to the revenues of the government. However, the amendment did not take into consideration the genuine losses that could be incurred during initial phase of merger and provides a one size fits all solution. The government needs to strike a balance between allowing a fresh period of carry forward of losses and preventing tax avoidance.
Improving the Mechanism: Implementation Challenges in India
Although the proposed amendment intends to prevent companies from taking advantage of fresh set off and carry forward for another 8 years, it might prove counter-productive to the growth of mergers. Implementing this amendment might throw a wrench in the deals that were concluded before the start of the 1 April 2025, hoping to benefit from the current provisions. Instead, the current provisions coupled with widely recognized practices can strike a balance between curbing deliberate avoidance of taxes and reviving ailing companies with large accumulated losses.
Instead of focusing on time period for carry forwards, ownership changes and profit capping can be used to restrict the abuse of Sections 72A and 72AA. In the United states, Section 382 of Internal Revenue Code restricts the company’s right to carry forward of losses if their shareholding pattern changes by more than 51% and restricts the profits that could be used to offset the net operating losses which is calculated by multiplying the pre-merger stock value with long-term tax-exempt rate of Internal Revenue Services without emphasizing on time period. ITA already has similar provisions for ownership change under Section 79 of ITA which only exempts startups but can introduce profit capping. Different tiers of profit capping can be introduced to allow only a certain percentage of profits to be off-set depending upon the size and turnover to provide a more nuanced approach to the problem. Also, companies could be classified into different sectors to establish sector specific rules so that companies in automobile manufacturing and infrastructure development could benefit from indefinite carry-forward of losses.
Further, the government can implement the business continuity test to ensure proper business restructurings and genuine mergers. The amalgamated company needs to continue the business of predecessor entities for a certain period (5 years in Australia, 2 years in the US, etc.). This test is effectively implemented in countries like New Zealand, Australia, the UK, etc. to discourage tax avoidance arrangements.
ITA already provides provisions related to General Anti Avoidance Rules (GAAR) in Chapter XA, empowering the tax authorities to scrutinize and invalidate transactions whose primary purpose is to avoid taxes. The court in the case of Furniss v. Dawson held that two ingredients must be satisfied to prove the non-legitimacy of any transaction. Firstly, there must not be any legitimate business purpose and secondly, it serves no purpose other than the avoidance of tax. These practices could provide a balanced approach to the evergreening of losses.
Conclusion
The proposed amendment to Sections 72A and 72AA of ITA reflects the government’s intent to curb tax avoidance through evergreening of losses by restricting carry forward of losses to the original 8 assessment years post mergers. Although this amendment addresses the issue of upstream mergers where the profit-making entities acquire loss-making companies to avail tax benefits, it might harm legitimate business restructurings and amalgamations. Nonetheless, mergers in the hope of long-term strategic gains incurs short term financial losses requires time and resources to stabilize and capitalize synergies. These rigid time caps ignore unique challenges faced by certain sectors like pharma, infrastructure and R&D heavy industries which need longer time periods to recover from initial losses and become profitable.
Instead of adopting a one size fits all solution, government should take a more nuanced approach to the problem by utilizing current provisions and incorporating internationally recognized practices. Merging the current ownership provisions with profit restrictions to offset the losses, introducing different tiers of profit offsets based on turnovers, mandating business continuity tests for 3-5 years and allowing sector-specific exemptions could address the indefinite carry forward of losses. Leveraging the current GAAR framework coupled with stricter audits could prevent abuses without dis-incentivizing genuine mergers. This approach could foster innovation and ensure economic growth while also safeguarding the revenues and achieve India’s goal of becoming a 5 trillion-dollar economy by 2027.
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