Demerger - An Analysis

Definition and Meaning of Demerger:

Demerger is a form of corporate restructuring. One of the prime reasons why large corporate houses go in for demerger is to increase the role of specialisation in the particular segment. In case of  large conglomerates, demerging entities often are the departments which are growing at an impressive rate and have substantial potential.

Demerger is the converse of a merger or acquisition. It describes a form of restructure in which shareholders or unit holders in the parent company gain direct ownership of the demerged entity or the subsidiary entity. Underlying ownership of the shares of the company/ trusts that formed part of the group does not change. The company or entity that ceases to own the entity is called the demerging entity. If the parent entity holds a majority stake in the demerged entity, the resulting company is referred to as the subsidiary.[1]

Sections 391 to 394 of the Companies Act, 1956 deal, inter-alia with the reconstruction and amalgamation of companies or what is commonly referred to as “mergers”. The procedures contemplate an application by the company to the concerned High Court by way of a scheme of compromise or arrangement with its creditors or members or any class of its members. Such a Scheme is a viable option for the amalgamation of two or more Indian companies. Moreover, sections 391 to 394 of the Act envisage a “single window clearance” by providing a composite code for facilitating mergers and amalgamations which obviates the need for making multiple applications under the Act and ensures that the interested entities are not put through unnecessary and cumbersome procedures involving protracted consequences for implementing such schemes[2]

Sec 390 - Interpretation of sections 391 and 393 (Companies Act, 1956).

[In sections 391 and 393, (b) the expression "arrangement" includes a reorganisation of the share capital of the company by the consolidation of shares of different classes, or by the division of shares into shares of different classes or, by both those methods] ; and

Sub Section 19AA of Section 2 of Income Tax Act, 1961:
 

[(19AA) “demerger”, in relation to companies, means the transfer, pursuant to a scheme of arrangement under sections 391 to 394 of the Companies Act, 1956 (1 of 1956), by a demerged company of its one or more undertakings to any resulting company in such a manner that—

(i) all the property of the undertaking, being transferred by the demerged company, immediately before the demerger, becomes the property of the resulting company by virtue of the demerger;

(ii) all the liabilities relatable to the undertaking, being transferred by the demerged company, immediately before the demerger, become the liabilities of the resulting company by virtue of the demerger;

(iii) the property and the liabilities of the undertaking or undertakings being transferred by the demerged company are transferred at values appearing in its books of account immediately before the demerger;

(iv) the resulting company issues, in consideration of the demerger, its shares to the shareholders of the demerged company on a proportionate basis;

(v) the shareholders holding not less than three-fourths in value of the shares in the demerged company (other than shares already held therein immediately before the demerger, or by a nominee for, the resulting company or, its subsidiary) become share-holders of the resulting company or companies by virtue of the demerger, otherwise than as a result of the acquisition of the property or assets of the demerged company or any undertaking thereof by the resulting company;

(vi) the transfer of the undertaking is on a going concern basis;

(vii) the demerger is in accordance with the conditions, if any, notified under sub-section (5) of section 72A by the Central Government in this behalf.

Explanation 1.—For the purposes of this clause, “undertaking” shall include any part of an undertaking, or a unit or division of an undertaking or business activity taken as a whole, but does not include individual assets or liabilities or any combination thereof not constituting a business activity.

Explanation 2.—For the purposes of this clause, the liabilities referred to in sub-clause (ii), shall include—

    (a) the liabilities which arise out of the activities or operations of the undertaking;

   (b) the specific loans or borrowings (including debentures) raised, incurred and utilised solely for the activities or operations of the undertaking; and

    (c) in cases, other than those referred to in clause (a) or clause (b), so much of the amounts of general or multipurpose borrowings, if any, of the demerged company as stand in the same proportion which the value of the assets transferred in a demerger bears to the total value of the assets of such demerged company immediately before the demerger.

Explanation 3.—For determining the value of the property referred to in sub-clause (iii), any change in the value of assets consequent to their revaluation shall be ignored.

Explanation 4.—For the purposes of this clause, the splitting up or the reconstruction of any authority or a body constituted or established under a Central, State or Provincial Act, or a local authority or a public sector company, into separate authorities or bodies or local authorities or companies, as the case may be, shall be deemed to be a demerger if such split up or reconstruction fulfils 81[such conditions as may be notified in the Official Gazette82, by the Central Government];

(19AAA)    “demerged company” means the company whose undertaking is transferred, pursuant to a demerger, to a resulting company;]

Demerger of a company takes place when:[3]

1. De-merger is essentially a scheme of arrangement under Section 391 to 394 of the Companies

Act, 1956 requiring approval by;

i. majority of shareholders holding shares representing three-fourths value in meeting convened for the purpose, and;  

ii. sanction of High Court.

2. De-merger involves ‘transfer’ of one or more ‘undertakings’.
 

3. The transfer of ‘undertakings’ is by the demerged company, which is otherwise known as transferor company. The company to which the undertaking is transferred is known as resulting company which is otherwise known as ‘transferee company’.

Existing provisions relating to amalgamations of companies were rationalised and new ones relating to demerger of companies, or sale/transfer of business as a going concern through slump sales were introduced. [4]
 

In demergers, tax benefits and concessions available to any undertaking are made available to the undertaking on its transfer to the resulting company. The condition regarding continuity of the same business for the allowability of loss to an assessee under Section 72 of the Income-Tax Act, 1961 was dispensed with. The accumulated losses and unabsorbed depreciation in a demerger is allowed to be carried forward by the resulting company if these are directly relatable to the undertaking proposed to be transferred. Where it is not possible to relate these to the undertaking, such losses and depreciation will be apportioned between the demerged company and the resulting company in proportion of the assets coming to the share of each as a result of demerger. Tax benefit to such business reorganisation is limited to transfer of specific assets, which would amount to sale of assets and not business reorganisation. [5]

Demerger And Spin Off/Out:

Another term commonly associated with demerger is that of a ‘spin out’ or ‘spin off’.
 

Spin out refers to the process when a division of a company or organization becomes an independent business. The "spin-out" company takes assets, intellectual property, technology, and/or existing products from the parent organization. Shareholders of the parent company receive equivalent shares in the new company in order to compensate for the loss of equity in the original stocks; thus, as the moment of spin-off, the ownership of the original and spun-off companies are identical.[6]
 

A demerger can take place through a spin out by distributed or transferring the shares in a subsidiary holding the business to company shareholders carrying out the demerger.The demerger can also occur by transferring the relevant business to a new company or business to which then that company's shareholders are issued shares of. [7]
 

Demerger also take place through the process of ‘decartelisation’, i.e the transition of a national economy from monopoly control by groups of large businesses, known as cartels, to a free market economy.

Demerged Company and Resulting Company - Meaning of
 

According to Sub-section (19AAA) of Section 2 of the Income-tax Act, 1961, “de-merged company” means the company whose undertaking is transferred, pursuant to a de-merger, to a resulting company.

According to Sub-section (41A) of Section 2 of the Income-tax Act, 1961 “resulting company” means one or more companies (including a wholly owned subsidiary thereof) to which the undertaking of the de-merged company is transferred in a demerger and, the resulting company in consideration of such transfer of undertaking, issues shares to the shareholders of the de-merged company and includes any authority or body or local authority or public sector company or a company established, constituted or formed as a result of demerger.

The definition of ‘resulting company’ has clearly brought out three important requirements while establishing its relationship with de-merging company. They are:[8]

1. Consideration for transfer of undertaking would be by issue of shares only by resulting company. [Price Consideration]
2. Such consideration would be paid only to the shareholders of de-merged company.
3. Resulting company can also be a subsidiary company of a de-merged company.

Conclusion
 

It is now a just and proper statement to state that, demergers are a fairly common term involved with corporate restructuring nowadays. They provide an opportunity to create individual profit centres and investors in the company also benefit from the process as there is fresh valuation of the demerged entity which in turn often results in an increase in the share price. Demerger is often done with an eye to segregate, categorise and more importantly specialise a particular segment of a corporate entity.

However due to the creation of an altogether new business entity, the same requires prudence and astute decision making on the part of the investor.

The following are some of the important points and key notes that the investors must make and

take heed of in case of Demerger of a corporate restructuring:[9]

Extent of separation

First, the activities separated at the time of demerger is a critical factor. It is important to remember that the overall size of the business entity and the extent of the profits that it makes is one important factor that determines the pricing of the newly-listed shares. Also, the future potential will determine the price impact after the demerger.

Identifying benefits
 

The key role for the investor is to identify an entity where the strong or profitable business remains. And then, look for the company which has a future potential.

Trading price

Demerger can lead to some immediate gains for the investors where the price of the separate entities shoots up. Too high a rise and one should immediately opt for the sell option. It is not uncommon to find valuations touch dizzying heights after a demerger and the benefits have to be booked.

Investor interest

There is often a high interest on a particular scrip, immediately after the demerger leading to a shooting up of the scrip. Following a thumb rule where the price of the scrip vis-a-vis actual valuation gives a fair idea about the extent of overvaluation or undervaluation taking place.
 

Limitations/Hindrances in the Current Legal Provisions Relating to Demerger:

Questionable re-structuring exercises are undertaken with a view to strip parent companies of vital assets and defeat revenue. In the process, the parent company's business is reduced to the minimum and no significant assets are left from which the I-T Department can recover its dues.

The parent company becomes a shell company though styling itself as a holding company.

When the amendments were made, the Central Government was able to prescribe guidelines or conditions so as to ensure that the demergers were made for genuine business purposes. Section 281 of the I-T Act declares certain transfers to be void. But this applies where such transfers are made during the pendency of any proceeding under the Act. It also does not apply to assets not forming part of the stock-in trade of the business. It was not anticipated that the provisions would be abused not merely to take advantage of tax concessions but also to defeat legitimate tax revenues.

Asset-stripping is a favourite mechanism always used by errant taxpayers to defeat the Revenue. Such abuses have, however, not become widespread. Proper amendments should be made to the law to safeguard revenue.

The definition of demerger in Section 2 (19AA) requires fresh look. The property and liabilities of the undertaking being transferred by the demerged company, as per the definition, will be transferred at book value. Even a unit or a division or a business activity of an undertaking can be transferred. No doubt, all the property of the undertaking, including liabilities relatable to the undertaking being transferred by the demerged company, shall become the property and liabilities of the resulting company. But it is necessary to specifically lay down that demergers should not result in defeating the Revenue by way of transfer of assets.[10]
 

By Biswadeep Chakravarty

IV BSL LLB

ILS Law College