On 5 April 2025, Dr Reddy’s Laboratories Ltd (DRL) informed the stock exchanges of the receipt of a show-cause notice from the tax authorities to raise a demand of Rs2,396 crore, which triggered this article.
The company has explained that the notice pertains to a possible tax issue arising due to the merger of Dr Reddy’s Holding Ltd (DRHL) with itself in April 2022.
Some background to the above-referred merger may be necessary to set the stage for further discussion.
The promoters of DRL were holding a substantial part of their investment in the company through a promoter investment vehicle, Dr Reddy’s Holding Ltd.
In order to eliminate the additional tier in the holding structure, the merger of DRHL with DRL was contemplated in 2019, for which the steps came to be initiated with the appointed date of 1 April 2019.
The rationale for the scheme clearly lays out that the intent was to eliminate the two-tier holding system that was then in place.
This was neither the first of its type nor possibly the last, where rationalising the promoters’ holding structure embroils the listed entity, triggering costs and consequences.
In this case, the scheme provided that the costs and expenses would be entirely met by the promoters and also included a clause for the indemnification of the listed entity for any possible liability arising on account of the merger.
In the context of this case, and cases of a similar nature already explained in this column, (TVS Electronics, Shriram Life, and Shriram General), the amalgamating entity typically has just the investment in the listed entity which gets extinguished on the merger.
The relevant clause in the scheme of amalgamation (SoA) covering this aspect is reproduced below.
The only asset on DRHL’s books was its investment of 41,325,300 shares in DRL. Once DRHL merged into DRL, the shares were extinguished. No asset is actually vested in DRL in terms of the merger.
However, the shareholders of DRHL were compensated by the issue of fresh shares of DRL, like to like.
The table below would explain this. Out of the total promoter holding of 26.77% in DRL, 24.83% was held by DRHL.
The manner in which the promoters’ shareholding was restructured post the merger is shown below.
The notes to the accounts for the FYE 31 March 2024 give a gist of the merger and also state that the expenses were to be borne by the promoters, and an indemnity covered the potential liabilities arising on account of the merger.
It is, however, noticed that neither in the year FY23-24, where the above note appeared nor in any of the earlier years, had the details of expenses incurred and recouped from the promoters been provided.
Since the appointed date is 1 April 2019, technically all expenses incurred for the scheme should appear in the books of DRL, the amalgamated company.
As per the scheme, DRHL was supposed to keep enough cash to defray all such expenses. Therefore, the books of the amalgamated company may actually show no expense or recoupment as there are no two entities involved post-1 April 2019.
While that is a book entry point of view, the shareholders of DRL need to know the actual cost of implementing this and the manner of recoupment of the same.
More importantly, there is no explicit note as to how the indemnity for future liabilities has been ensured.
Did DRL enter into an agreement with the promoters to this effect, or was it assumed that the mention in the scheme was good enough to enforce this? Note 2.37 shown above also misses covering this explicitly.
Certainly, the lack of these details, and the absence in the audit report of any reference to this event, which is not a routine merger in the normal course of business, but a corporate action solely to benefit the promoters, is notable.
The reason I am writing this article is to examine why tax authorities poked their nose into this scheme.
Typically, tax authorities need no added reason to stir up controversy after they were handed the ‘anti-tax avoidance’ powers.
This is the equivalent of leaving a loaded AK47 in the arms of an adolescent who doctors are treating for schizophrenia!
No corporate scheme would come out smelling of roses, and an element of tax planning is inbuilt. For the tax authorities to characterise such arrangements as ‘primarily designed for tax avoidance’ is not any more difficult than saying that Tendulkar is a better batsman than Thomas, living next door!
The cases where the promoters seek to eliminate the intermediate holding structure like in DRL, TVS-Electronics, Shriram Life and Shriram General Insurance (to name a few), carry an added risk of not complying with the definition of amalgamation under the law.
The key requirement of the definition is that all the assets should vest in the transferee company.
These cases had just a solitary asset, being the shares in the listed entity that was extinguished when the merger happened.
It would be difficult to fulfil this definition where the original investment is extinguished and fresh shares are issued.
Though the definition may not be satisfied, it is farfetched that either the amalgamating or the amalgamated company can be said to have avoided any tax.
Therefore, the tax notice issued to DRL may appear to be contestable. The promoters alone benefited, having substituted the shares in the listed entity for the ones held in the investment company.
The last word on who is liable, if at all, may take years to emerge. Meanwhile, the lawyers would have a field day. However, DRL should provide the details of the expenses incurred in the litigation and how they are recovered from the promoters. Hope the IDs who are part of the board and the auditor would not have forgotten what was written in the scheme of the merger!
(Ranganathan V is a CA and CS. He has over 44 years of experience in the corporate sector and in consultancy. For 17 years, he worked as Director and Partner in Ernst & Young LLP and three years as a senior advisor post-retirement, handling the task of building the Chennai and Hyderabad practice of E&Y in tax and regulatory space. Currently, he serves as an independent director on the board of four companies.)
