When a subsidiary merges
with its parent company, the profit element in the inter-company transactions
and the consequential tax effects need to be eliminated from the earliest
comparative period. This article explains why and how this is done.
FACTS
A parent has several
subsidiaries and is listed on Indian exchanges. One of the subsidiaries merges
with the parent. The merger order is passed by the NCLT on 30th
November, 2020 with the appointed date of 1st April, 2019. The
appointed date is relevant for tax and regulatory purposes.
Prior to 1st
April, 2019 the subsidiary had sold inventory to the parent for onward sale by
the parent. The cost of inventory was INR 80 and the subsidiary had sold it to
the parent at INR 100. At 1st April, 2019 the inventory was lying
with the parent company. The tax rate applicable for the parent and the
subsidiary is 20%.
The parent sells the
inventory to third parties at a profit in May, 2019. In June, 2019, the
subsidiary sells inventory to the parent. The cost of inventory was INR 160 and
the subsidiary had sold it to the parent at INR 200. At 30th June,
2019 the inventory remains unsold in the books of the parent company.
After the merger, the
subsidiary becomes a division of the parent company and the inventory transfer
between the division and the parent is made at cost.
In preparing the merged
financial statements, whether adjustments are made for the unrealised profits
and the consequential tax effects? If yes, how are these adjustments carried
out?
RESPONSE
Paragraph 2 of Appendix C
of Ind AS 103 Business Combinations of Entities Under Common Control
defines a common control transaction as
‘Common
control business combination means a business combination involving entities or
businesses in which all the combining entities or businesses are ultimately
controlled by the same party or parties both before and after the business
combination, and that control is not transitory.’
Paragraph 8 states as
follows
‘Business
combinations involving entities or businesses under common control shall be
accounted for using the pooling of interests method.’
Paragraph 9 states as
under:
‘The pooling of interest
method is considered to involve the following:
(i) The assets and liabilities of the combining
entities are reflected at their carrying amounts.
(ii) No adjustments are made to reflect fair values
or recognise any new assets or liabilities. The only adjustments that are made
are to harmonise accounting policies.
(iii) The financial information in the financial
statements in respect of prior periods should be restated as if the business
combination had occurred from the beginning of the preceding period in the
financial statements, irrespective of the actual date of the combination.
However, if business combination had occurred after that date, the prior period
information shall be restated only from that date.’
The following conclusions
can be drawn:
1. The transaction is a common control transaction
and is accounted for using the pooling of interests method.
2. The financial statements for prior periods are
restated from the earliest comparative period, i.e., from 1st April,
2019.
3. Adjustments are made to the financial
statements to harmonise accounting policies. Therefore, in the merged accounts
unrealised profits arising from the transaction between the parent and the
merged subsidiary should be eliminated.
4. As this is a listed entity and information
relating to comparative quarters is provided in the financial results, the
adjustments for unrealised profits are made for all comparative and current
year quarters, up to the date the merger takes place.
In the merged accounts, the
following adjustments are made with respect to the unrealised profits:
At 1st April,
2019, the following adjustment will be required to the merged numbers:
Inventory
credit 20
Deferred
tax asset debit (20% on 20) 4
Retained
earnings debit 16
The adjustment is made to
reflect the fact that when the inventory is sold to external parties, the
merged entity will not be subject to tax again on INR 20.
As the inventory is sold in
the first quarter, the following entry will be passed with respect to tax:
P&L (deferred tax line)
debit 4
Deferred tax asset credit 4
At 30th June,
2019 the following adjustment will be required:
Inventory
credit 40
Current
tax asset debit (20% on 40) 8
P&L
debit 32
Since the parent will file
a revised return for the previous financial year, the tax paid on INR 40 will
be shown as recoverable from the tax authorities, rather than as a deferred tax
asset.
The above adjustments are carried out
for all the quarterly results from 1st April 2019 up to the date of
the NCLT order, i.e. 30th November, 2020.
