Loophole that may allow Godrej split without attracting capital gains tax

The Godrej Group is being divided into two separate businesses, one controlled by Adi Godrej and Nadir Godrej and their descendants, and the other controlled by Jamshyd Godrej and Smita Godrej Crishna and their descendants. Lawyers say that the split may not result in any capital gains tax because it is considered a family settlement, and family settlements are exempt from capital gains tax in India. However, there could be tax implications if any companies are involved in transferring assets as part of the agreement
 

A family arrangement is a tax law provision that allows asset transfers between family members to be exempt from capital gains tax.  The Godrej family's restructuring meets the specific requirements for this tax benefit.Essentially, transferring assets within a valid family arrangement is not considered a taxable sale.

 

The split:

The Godrej family conglomerate, which has been around for 127 years, is dividing into two separate groups. Each group will control different businesses within the conglomerate.

Who gets what
 

Adi Godrej and Nadir Godrej faction: This group, likely including their descendants (children, grandchildren etc.), will oversee the publicly traded (listed) companies of the conglomerate. These include well-known names like Godrej Industries, Godrej Properties, Godrej Consumer Products, and others.

Jamshyd Godrej and Smita Crishna faction: This group will take control of Godrej & Boyce, which is an unlisted company. This means its shares are not traded on a stock exchange.

What is a family arrangement?

A family arrangement is a provision in Indian tax law that allows the transfer of assets between close family members without incurring capital gains tax. This can be a significant tax benefit, especially for high-value assets like stocks or property. However, it's important to understand the rules and limitations to avoid issues with tax authorities.

"A family arrangement entails an understanding among relatives with the aim of promoting the overall well-being of the family. This can involve resolving uncertainties or disputes regarding rights, safeguarding family assets, maintaining harmony, and preventing legal conflicts or damage to the family's reputation. Essentially, the core concept of family arrangements is to ensure that familial harmony, happiness, and prosperity are prioritized while minimizing the need for litigation. The same has been defined by the hon’ble Supreme Court in the decision of Maturi Pullaiah v. Maturi Narasimham AIR 1966 SC 1836," said Keshav Singhania, Private Client Leader, Singhania & Co. LLP.

Why a Family Settlement matters

Normally, dividing up a massive business like the Godjrej split could lead to a hefty tax bill. However, since this is considered a family settlement, it might be exempt from taxes. Here's why:

 A family settlement is an agreement between family members to avoid future disputes, settle existing disagreements, and ensure a fair division of assets while keeping things peaceful within the family.
 

The Indian law recognizes that family settlements are primarily about maintaining peace and not necessarily about making money. Because of this, the transfer of shares between family members under a valid family settlement may not attract capital gains tax, a tax levied on profits from selling assets.

What is the catch? 

While a family settlement sounds like a tax-free way to split the business, there are a few things to keep in mind:

Companies vs. individuals: If companies within the Godrej Group are directly involved in transferring assets as part of the agreement, those transfers might be taxable. The tax would be based on the difference between the current value of the asset and the original investment.

Gifts vs. settlements: While gifts between relatives are generally not taxed, the settlement needs to be genuine and have a valid purpose beyond just tax benefits. If the main reason seems to be avoiding taxes, authorities might challenge it.

Legal precedent:

The Supreme Court judgement in Kale vs Deputy Director of India (1976) is a key precedent for family arrangements like the Godrej split. This case and others have established four principles for such arrangements to be legally valid.
 

Four key Conditions:

Direct relatives: Only close family members can be involved in a family arrangement. This ensures the transfer of assets stays within the family.

Dispute Resolution (Actual or Potential): The arrangement should aim to resolve existing family disputes about assets or prevent future ones. It promotes harmony and a fair distribution of wealth.

Even without current disputes, the potential for future disagreements (like those seen in cousin succession battles) can justify the arrangement.

Mutual Sacrifice: Each party must give up something. In the Godrej case:

Adi and Nadir relinquish their stakes in the unlisted Godrej & Boyce.

Jamshyd and Smita give up control of most listed entities.

Mutual Recognition of Rights: All family members involved must acknowledge and respect the rights of others under the agreement. This ensures everyone is on the same page and avoids future challenges.

"The arrangement can be oral, but if written, registration is necessary unless it's merely a memorandum for record-keeping purposes. All parties involved must have some prior claim or interest in the property, and if one party relinquishes their claims to another, the arrangement is upheld. Even if the disputes settled are not legally binding, a fair and equitable family settlement is considered final and binding on all parties involved," said Singhania.
 

How it Works:

A formal agreement is drawn up between family members outlining the transfer of assets. This document should be clear, documented properly, and ideally stamped by a revenue authority.
 

The agreement should be based on demonstrably fair and reasonable terms, not solely benefiting one member. This could involve factors like the recipient's financial needs or contribution to the family business.

Examples:

Parents gifting shares to children: Parents can transfer appreciated shares to their children without triggering capital gains tax. This can be a way to help children build their wealth and potentially reduce the overall family tax burden when the children eventually sell the shares.

Sibling dividing inherited property: Siblings inheriting property can decide to divide it amongst themselves through a family arrangement, avoiding capital gains tax as long as the division is fair.

Limitations and Cautions:

Genuine Transaction: The arrangement must be a genuine transfer of assets, not simply a disguised sale. The purpose should be for family planning or resolving disputes, not solely for tax benefits.

Fair Market Value: The transfer of assets should be at fair market value. If the asset is undervalued for tax purposes, authorities may challenge the arrangement and impose capital gains tax.

Point to note:  Supreme Court in the case of CIT v. R. Nagaraja Rao held that, “Partition or family settlement is not transfer. When there is no transfer there is no capital gain and consequently no tax on capital gain is liable to be paid.”

"Even though, the Arrangement between the Godrej family envisages dilution of cross-company shareholdings which would involve transfer of both quoted and unquoted shares in the hands of the family members, however, the same will still be exempt from being taxed for capital gains. However, it is pertinent to note that even though the Arrangement is completely valid as per the essentials laid out in the judicial precedents, the same may become taxable if the assessee in consideration is a company or other such judicial person that is not an individual," said Singhania.