Key Interpretational Issues in Tax-Neutral Demergers under the Income-Tax Act, 2025
Demergers remain one of the most widely used restructuring tools for business reorganizations in India. Under the Income-Tax Act, 2025, however, tax neutrality is available only where the transaction satisfies the conditions prescribed under Section 2(35). This is significant because several key tax benefits including exemption from capital gains under Section 70 and carry-forward of accumulated losses under Section 116(7) are available only where the transaction qualifies as a "demerger" for tax purposes.
While the statutory framework is largely settled, recent judicial developments have brought certain interpretational issues into sharper focus. Three such issues are discussed below.
Whether Preference Shares Can Be Issued in a Demerger?
Section 2(19AA)(iv) under the old Act and section 2(35) under the new Act require that “the resulting company issues, in consideration of the demerger, its shares to the shareholders of the demerged company on a proportionate basis.” The provision uses the term “shares” without distinguishing between equity and preference shares.
The provision refers simply to "shares", without distinguishing between equity and preference shares. This has raised the question of whether the issuance of preference shares would satisfy the statutory requirement.
A literal reading suggests that both equity and preference shares should qualify. However, the Revenue has traditionally viewed a tax-neutral demerger as one in which shareholders of the demerged company continue their ownership interest in the resulting company. Redeemable preference shares, in particular, may not always reflect such continuing participation.
In a welcome development, the Delhi ITAT in Bharti Airtel Ltd. v. PCIT [2025] 171 taxmann.com 754 held that issuance of preference shares satisfies the requirement under Section 2(19AA)(iv). While the decision provides comfort, taxpayers should remain mindful that the issue has not yet attained final judicial certainty.
Does the Tax Definition Cover Fast-Track Demergers?
Historically, the tax definition of "demerger" has been linked to court-approved schemes under Sections 391–394 of the Companies Act, 1956, now corresponding to Sections 230–232 of the Companies Act, 2013.
This raises an important issue for restructurings undertaken through the fast-track route under Section 233 of the Companies Act, 2013. Since Section 2(35) continues to refer only to schemes corresponding to Sections 230–232, a demerger implemented under Section 233 may technically fall outside the tax definition.
The result is an unintended mismatch; while the restructuring may be fully valid under company law, it may not qualify for tax neutrality. Until legislative clarification is provided, taxpayers adopting the fast-track route should carefully evaluate this risk.
Sterling Holiday Resorts: Strict Compliance with the Share-Issuance Requirement
In Sterling Holiday Resorts Ltd. v. DCIT (Mumbai ITAT, June 2026), the undertaking was transferred to a subsidiary. However, the shares were issued by the holdng company to the shareholders of the demerged company, rather than by the subsidiary that received the undertaking.
The Tribunal rejected the taxpayer's argument that issuance by the holding company amounted to substantial compliance. It held that Section 2(19AA) (iv) expressly requires the resulting company itself to issue shares. Since a holding company and its subsidiary are distinct legal entities, the statutory condition was not satisfied.
As a result, the transaction did not qualify as a tax-neutral demerger, leading to the denial of consequential tax benefits, including carry forward of losses.
Our Comments
Recent rulings indicate that courts and tribunals continue to adopt a strict interpretation of the statutory conditions governing tax-neutral demergers. While decisions such as Bharti Airtel provide welcome clarity on certain aspects, issues such as the treatment of fast-track demergers and the mandatory share-issuance requirements continue to present practical challenges. Given the significant tax consequences of non-compliance, these conditions should be carefully evaluated while structuring any demerger transaction.