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Splitting a company to remain below threshold
February, 05th 2007

What is common between the threshold in a tax regime and a mini-skirt? The answer is that both should ideally be neither too high nor too low. With the Budget now at the doorstep, suggestions are flying about revising the threshold both in VAT and service tax. 
 
The threshold of Rs 4 lakh for service tax is already under pressure. Analysts say that it is too low. On the other hand, a threshold of Rs.10 lakh is too high. To determine the correct quantum, one has to delve into the basic proneness of small scale to remain under the threshold, if necessary by splitting itself if it exceeds the limit. 
 
In the past, such attempts at fragmentation have been detected and action taken against them to prove that one firm is a dummy of the other. Investigations have proved that often one person starts two firms just to split the turnover and to avail of the concession of small scale. They are usually dependent of each other. In some cases, raw materials are supplied to the other. In other cases financial, technical, supervisory or other help is given by one firm to the other. These cases have been contested in courts, which has led to an impressive array of case laws on the subject. 
 
Unfortunately, all the judgments are on facts. Therefore there is no fixed criterion laid down by courts. Analysing all the judgments, we find that there is unanimity to the following effect: (i) If one firm supplied raw materials to another firm to manufacture goods, which he buys back, then the other firm does not become a dummy of the buying firm provided the transaction is on a principal-to-principal basis; (ii) If one firm buys goods from another firm, who manufactures and fixes the trade name of the buyer, the buyer does not become a manufacturer or the other firm does not become a dummy of the buyer so long as the transaction is on principal-to-principal basis; (iii) The Bombay High Court has said in the case of Pilky Footwear versus U.O.I 1880(6)ELT338 (Bom) that it is not one circumstance but the cumulative effect of various circumstances which should be taken into account; and (iv) The basic principle that emerges is that one firm should not have a financial control over the other. This is the key consideration. 
 
The officers should therefore use the following principles to determine if one firm is a dummy of the other. One firm is not a dummy of the other if the following conditions are satisfied: 
 
a. There should be no financial deal between the new and old firms. No loans. No advances, credit notes etc. The new firm should borrow funds from banks independently. There should be no flow-back of funds. 
 
b. Premises have to be separate. 
 
c. There should be separate telephone and electricity connections. 
 
d. They should be separately registered companies under income tax, VAT and service tax laws. 
 
e. All the products of the new firm should not be sold to the old firm. Some should be sold to the outside market as well. 
 
f. There should be no power of attorney given by the wife to the husband. 
 
g. There should not be any control exercised by the old firm on the new firm. 
 
h. The transactions by the two firms should be transparently separate and independent. 
 
If the conditions are not satisfied, then one is a dummy of the other. But it is a hard task to succeed in a case since some of the conditions may be fulfilled. 

Sukumar Mukhopadhyay

 
 
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