Introduction

The legislature has time and again introduced various income-tax benefits and incentives to encourage fresh investments and stimulate the economic growth. These incentives are generally given to new businesses in form of tax holidays, concessional tax rates or additional deductions.

In order to effectively realize said objectives and curb any abuse of the same, certain restrictions on the eligibility to claim such benefits are usually imposed. One such restriction which is provided under various provisions of the Income-tax Act, 1961 (‘IT Act’) is that the new business should ‘not be formed by splitting up, or the reconstruction, of a business already in existence’. The intent behind this restriction is to ensure that the businesses are not enabled to avail the tax benefits by mere manipulation of their existing investments without dispensing any actual capital into the economy.

Tax Benefits under Sections 80-IAC, 80JJAA and 115BAB

The allowability of tax benefits under the following provisions is subject to the restriction of the ‘businesses not being formed by splitting up or reconstruction of an existing business’:

Section 80-IAC: Tax holiday to eligible Start-ups

Section 80-IAC provides for profit-linked tax holidays to eligible startups for a period of any 3 consecutive years within 10 years from the year of their incorporation. The startups are required to be incorporated between 1 April 2016 and 31 March 2022. It is pertinent to note that the sunset date for claiming deduction under this provision has been proposed to be extended to 31 March 2023 by the Finance Bill, 2022.

Section 80JJAA: Deduction in respect of employment of new employees

Section 80JJAA allows businesses to claim an additional deduction of 90% of the additional employee cost incurred on additional employees over a period of 3 years starting from the year in which such employment is provided.

Section 115BAB: Lower tax rate for new domestic manufacturing companies

Section 115BAB provides for a lower tax rate of 15% from AY 2020-21 for new companies which are set-up and registered on or after the 1 October 2019 and commencing manufacturing or production before 31 March 2023. The sunset date for claiming deduction under this provision has also been proposed to be extended to 31 March 2024 by Finance Bill, 2022.

Meaning of Reconstruction & Splitting-up

In order to examine the restriction with respect to formation of a start-up/ business/ company imposed under the abovementioned provisions, it is pertinent to firstly understand the meaning of the terms, ‘reconstruction’ and ‘splitting-up’ of a business already in existence. Although, these terms have been used extensively under various provisions for tax benefits under the IT Act, but they have not been defined anywhere. However, there are numerous judicial pronouncements in the context of other tax benefit provisions under the IT Act wherein the Courts have interpreted the similar language employed in those provisions to deduce their meaning.

The phrase ‘reconstruction of a business already in existence’ has been interpreted as continuation of the same business in some altered form by a new entity in such a manner that the identity of the original business is not lost or abandoned.[1] The phrase ‘splitting-up of a business already in existence’ can be understood as a break-up or division of an integral part of the existing business/its assets between the old and new business.[2]

Applicability of restriction on ‘Formation’ – Contrary Rulings

As observed above, the position on the interpretation and meaning of the phrase ‘reconstruction or splitting-up of a business already in existence’, is pretty settled. However, the controversy arises with respect to the applicability of this restriction.

The usage of the term ‘formed’ raises a question as to whether the applicability of the conditions is restricted only to the year of formation of the start-up/business/company, or would it apply every year for which the tax benefit is being claimed? As per the judicial pronouncements discussed below, the position in this regard is far from settled.

There is no direct ruling on this aspect with respect to Sections 80-IAC, 80JJAA or 115BAB of the IT Act. However, identical conditions under other provisions of the IT Act have been subject to contrary views from various Courts.

Although, a couple of judgments of the Supreme Court (‘SC’) do shed light on the interpretation of this restriction, however, they fail to provide a conclusive answer to settle the controversy. In the case of Bajaj Tempo Ltd. v. CIT[3], the SC took the view that the term ‘formation’ has to be understood such that an undertaking could not have come into being without the violation of the restriction. However, the issue of whether this condition would be required to be fulfilled in subsequent years after the initial year of formation was not deliberated upon by the SC. In another judgment[4], the SC pronounced an obiter dictum to the effect that these conditions are required to be fulfilled during the initial year of the constitution of the undertaking.

The root of the controversy arises due to the divergent views emanating from the rulings of various High Courts (‘HCs’). In 1990, the Karnataka HC[5], held that the word ‘formed’ suggests that the eligibility for exemption must be tested only in the initial/ first AY and once such eligibility is satisfied in the initial year, the benefit could be availed in the succeeding years. An identical view has been subsequently laid down by various other HCs and Tribunals (‘ITAT’)[6].

On the other hand, the Gujarat HC in 1978[7], had taken a diametrically opposite view. It was held that principally such conditions are required to be fulfilled in each of the subsequent years for which the benefit is being claimed. This judgement has been followed by multiple HCs subsequently[8]. Even the Punjab & Haryana HC in 2016[9], had held in line with the Gujarat HC ruling after an extensive discussion on divergent rulings. These judgments are based on the reasoning that the object behind the insertion of beneficial provisions would be frustrated if it is held that the conditions are not required to be satisfied in subsequent years.

Thus, the dilemma with respect to the year of applicability of the restriction has continued to persist due to the contrary rulings of the HCs.

Conclusion

Keeping in mind this dichotomy in the interpretation of the condition, the taxpayers must be extremely vigilant while claiming the benefits. This is especially pertinent when the new enterprises are engaged in similar businesses which have been previously undertaken by the already existing enterprises. This is because such cases are highly prone to scrutiny by the Income-tax Department as such cases are more likely to result in reconstruction or splitting up of an existing business. Needless to mention that the fulfilment of this condition must be examined keeping in mind the objects and purposes for which a specific tax benefit provision has been inserted.

In order to avoid any protracted litigation on this front, the new entities, which are likely to be adversely impacted by the divergent views taken by the HC, may consider approaching the CBDT for necessary clarifications in this regard.

[The Authors are Senior Associate and Associate respectively, Direct Tax Team, Lakshmikumaran and Sridharan Attorneys, New Delhi]

1. [1] CIT v. Gaekwar Foam and Rubber Co. Ltd. [1959] 35 ITR 662 (Bombay HC); Textile Machinery Corporation Ltd. v. CIT [1977] 107 ITR 195 (SC); CIT v. Travancore Rayons Ltd. [1986] 50 CTR (Kerala HC) 51; Nagardas Bechardas & Bros. (P.) Ltd. v. CIT [1976] 104 ITR 255 (Gujarat HC); CIT v. Ganga Sugar Corpn. Ltd. [1973] 92 ITR 173 (Delhi HC).
2. [2] Smt. Sangita Agarwal v. CIT [2012] 18 taxmann.com 97 (Calcutta HC); T. Satish U. Pai v. CIT [1979] 1 Taxman 123 (Karnataka HC).
3. [3] [1992] 62 Taxman 480 (SC).
4. [4] DCIT v. ACE Multi Axes Systems Ltd. [2018] 400 ITR 141 (SC).
5. [5] CIT v. Nippon Electronics [1990] 181 ITR 518 (Karnataka HC).
6. [6] CIT v. Dandeli Ferro Alloys (P.) Ltd. [1995] 212 ITR 1 (Bombay HC); CIT v. Paul Bros. [1995] 216 ITR 548 (Bombay HC); Jain Udhay Hosiery (P) Ltd. v. ACIT [2004] 1 SOT 193 (Chandigarh Trib.); Aqua Plumbing (P.) Ltd. v. ACIT [2011] 46 SOT 366 (Agra Trib.).
7. [7] CIT v. Satellite Engineering Ltd. [1978] 113 ITR 208 (Gujarat HC).
8. [8] CIT v. Suessin Textile Bearing Ltd. [1982] 135 ITR 443 (Gujarat HC); CIT v. Seeyan Plywoods [1991] 190 ITR 564 (Kerala HC).
9. [9] CIT v. Micro Instruments Co. [2016] 388 ITR 46 (Punjab & Haryana HC).