Section 115-O of the Income-tax Act (‘Act’) requires payment of dividend-distribution tax. Section 2(22) gives an inclusive definition of ‘Dividend’. As per clause (d) thereof, any distribution by a company on reduction of its share capital, to the extent to which it possesses ‘accumulated profits’ arising after the end of the previous year ending next before 1.4.1933 (whether such accumulated profits have been capitalised or not), is covered within the definition of dividend. As per Explanation 2, the expression ‘accumulated profits’ includes all profits of the company up to the date of distribution or payment referred to in clauses (a) to (e) (i.e, in the events of release of assets by the company, issue of debentures or distribution of bonus to preference shareholders, liquidation, capital reduction or loan or advance).  

Clause 3 of the Finance Bill 2018 seeks to amend section 2 of the Act. It has been proposed to insert a new Explanation to the said clause to provide that in the case of an amalgamated company, accumulated profits or loss in the hands of the amalgamated company shall be increased by the accumulated profits of the amalgamating company, whether capitalised or not, on the date of amalgamation, for the purpose of ‘Dividend’. The amendment is applicable for Assessment 2018-19 onwards.

As per Memorandum explaining provisions of Finance Bill 2018, instances have come to light of the Government whereby companies are resorting to abusive arrangements to escape liability of paying tax on distributed profits. Under such arrangements, companies with large accumulated profits adopt the amalgamation route to reduce capital and circumvent the provisions of section 2(22)(d). With a view to preventing such abusive arrangements and similar other abusive arrangements, it is proposed to insert a new Explanation 2A in section 2(22) of the Act to widen the scope of the term ‘accumulated profits’ so as to provide that in the case of an amalgamated company, accumulated profits, whether capitalised or not, or losses as the case may be, shall be increased by the accumulated profits of the amalgamating company, whether capitalized or not, on the date of amalgamation.

The above amendment comes with the objective of overruling decision of Ahmedabad Tribunal in the case of ACIT vs. Gautam Sarabhai Trust dated 20 March 2001 [TS-5102-ITAT-2001(AHMEDABAD)-O]. The Tribunal in the said case has inferred the following legal propositions amongst others:

1. Section 2(22) introduces legal fiction and would necessarily receive strict interpretation.

2. The expression ‘accumulated’ profits used in the section would be construed as commercial profits computed in accordance with principles of commercial accounting. These profits are not to be treated as equivalent to assessable income.

3. Surplus arising on amalgamation of companies would not result in revenue gain since amalgamation even if treated as an activity of purchase would not result in profit to the amalgamated company.

4. Since amalgamating company is a separate entity, profits in its balance sheet, after amalgamation cannot be treated as accumulated profits of the amalgamated company.

In the above decision, Tribunal has held that the capitalised part of share capital would not be covered under the expression 'accumulated profits or capitalised profits' for the purposes of Section 2(22)(d). While discussing the legal implications and effect of amalgamation and merger of companies, Tribunal held that merger or amalgamation is not to be construed as a transaction of purchase and even if it is a transaction of purchase, any surplus realised due to the process of amalgamation/merger could not be treated as a revenue gain. The provisions of Section 2(22)(d) introducing legal fiction by artificially extending the scope and ambit of the word ‘dividend’, would have to be construed strictly. Strictly construed accumulated profits whether capitalised or not held by the amalgamating companies which are separate independent entities, cannot by any stretch of imagination be treated as accumulated profits or capitalised profits of the amalgamated company after amalgamation.

Regarding capital reserve, the Tribunal observed that the same is in nature of book surplus which has arisen on account of various amalgamations and mergers. Given the basic principles inferred above, Tribunal concluded that such surplus is not liable to Income – tax.  

Conclusion