The Conundrum of Transferring an Undertaking

The article discusses undertakings in-depth with reference to the Income Tax Act and various judgments.
DSK Legal - Rishi Anand, Chirag Jain, Snigdha Prakash
DSK Legal - Rishi Anand, Chirag Jain, Snigdha Prakash

The dynamics of conducting a business have undergone a dramatic change in the recent past, and the same continues to be organic in nature in light of the business practices adapting to the ever-changing social and economic conditions. Entities today operate in an intricate and multifaceted manner whereby, in many cases, the same entity is responsible for managing various brands across diverse industries, and consequently, have various business segments or enterprises knit into forming one single entity. Commonly, such separate business segments comprise of their own sets of assets and liabilities, each of which would focus on a particular economic section. Owing to this, over time the practice of undertaking restructuring of corporate entities by way of selling off a portion of the entity has naturally gained immense popularity.

To this purpose, both slump sale and demerger remain popular forms of reorganization of corporate entities whereby assets and liabilities are transferred from one entity to another. The term ‘slump sale’ refers to the transfer of one or more undertakings for a lump sum consideration without values being assigned to individual assets and liabilities in such sales [Section 2(42C), Income Tax Act, 1961]. On the other hand, a ‘demerger’ pertains to a National Company Law Tribunal (NCLT) approved process of reorganizing a company’s operations by transferring one or more undertakings from the demerged company to the resulting company [Section 2(19AA), Income Tax Act].

From a reading of the above, it becomes apparent that both, slump sale as well as a demerger, are reliant upon the principle of there being a transfer of an ‘undertaking’ or ‘a part of an undertaking[Section 232(1)(b) of Companies Act, 2013], for such transfer to qualify as a demerger or slump sale. In this context, it becomes imperative to assess the four corners of an ‘undertaking’ and outline the structure within which a transfer may be perceived as the transfer of an ‘undertaking’.

Meaning of ‘Undertaking’

It may be noted that while the term ‘undertaking’ does not find a distinct meaning within the confines of the provisions of the Companies Act, 2013, the said term has been specifically defined under the Income Tax Act, 1961 (“Income Tax Act”), as follows:

An undertaking shall include any part of an undertaking, or a unit or division of an undertaking or a business activity taken as a whole, but does not include individual assets or liabilities or any combination thereof not constituting a business activity.[Explanation 1 to Section 2(19AA), Income Tax Act]

Upon a bare perusal of the aforementioned provision, it can be reasonably determined that for the purposes of transfer of an undertaking, the transfer should not be in a manner such that only individual assets or liabilities are transferred but the business as a whole and on a going concern basis is being transferred. In this context, it may be noted that the term ‘going concern’ is an accounting principle, and has been defined to mean an enterprise that is seen to be continuing for the foreseeable future, and in this regard, it is assumed that the enterprise has neither the intention nor the necessity of liquidation or of curtailing materially the scale of its operations. [Accounting Standards (AS) 1, accessible here] In other words, the accounting principle of a ‘going concern’ implies that the business of the given enterprise/ unit would continue to exist and operate for an indefinite period in the future.

Test to Determine an Undertaking

Over time, Indian courts have promulgated various tests and ingredients for the purposes of identifying whether a transfer would be construed as a transfer of an ‘undertaking’. The Supreme Court in the case of Rustom Cavasjee Cooper v. Union of India observed that the expression ‘undertaking’ means a going concern with all its rights, liabilities, and assets as distinct from the various rights and assets which compose it. To supplement this, it has been further clarified that the unit being transferred as an ‘undertaking’ should be able to separately compute profits and be in a position such that it is capable of ascertaining its income and expenditure separately.

In essence, one of the principal tests for the purposes of determining an ‘undertaking’ is to assess whether the undertaking which is being transferred includes the entirety of the business irrespective of the separate ingredients and if the same is independent of other undertakings for the purposes of its functioning and operations. In this regard, one requires to be mindful of the fact that not all assets and liabilities of a unit are required to be transferred for the same to be considered as an ‘undertaking’, so long as the core business of the unit forms part of the transfer. The expression ‘taken as a whole’ in the definition of an undertaking refers to the ‘business activity' of the unit and not the undertaking itself. In support of this understanding, the Indian courts have ordained that the transfer of an undertaking cannot be made subject to a straitjacket format since that would infringe upon the rights of the parties to negotiate with regard to transfer of assets and liabilities of the undertaking.

Therefore, the heart of such assessment lies in evaluating whether the basic structure of the unit is being transferred, and if such unit would be incapable of running the business for the foreseeable future even if the transfer of certain assets is held back. For this purpose, the Income Tax Appellate Tribunal (ITAT) has, in case of an IT company, regarded the transfer of technical know-how such as intellectual property, codes, formulae, designs, programs, etc., along with the transfer of employees and ancillary assets such computers and furniture, as the transfer of an ‘undertaking’ since the aforementioned ingredients formed the core ingredients of the business activity of the assessee, and held that by a summation of the above, the acquirer was enabled to carry on the business without relying on other independent items.

In another instance, considering whether a branch of a publishing house would have separate goodwill and if the said branch could be construed as an independent undertaking, it was held that each branch of a publishing house constituted as a separate undertaking since the branches were being transferred lock, stock, and barrel. It was further held that in such case, it was possible for each of such branch to have separate goodwill which would depend on a host of factors such as popularity, performance, circulation, peculiarities of the region, etc. Herein, the goodwill of such undertaking would form part of the transfer of the undertaking. On a similar note, the ITAT while considering the liberty awarded to the parties in deciding which assets and liabilities may form part of an undertaking, proclaimed that the intent is not to direct a businessman on how to conduct their business, and it is up to the transferee to determine the usage of the assets which form part of the undertaking. By way of the mere reason that some of the assets forming part of the transfer had not been utilized by the transferor prior to the transfer, the same cannot be said to have an effect on the merit of such unit being regarded as an undertaking.

Key Takeaway

On due consideration of the judicial precedents, it is essential for the terms and conditions of the entire arrangement between the parties to accurately reflect the intention of transferring a specific unit which entails the transfer of all necessary assets and liabilities which form part of the core business of the undertaking, and such intent should not be to merely transfer itemized assets and liabilities which do not have a relevant nexus with the core structure of the business activity.

Rishi Anand is a Partner, Chirag Jain is a Principal Associate and Snigdha Prakash is a Senior Associate at DSK Legal.

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