CORPORATE RESTRUCTURING - DE-MERGER

DEMERGER

Demerger is a form of corporate restructuring in which the entity's business operations are segregated into one or more components. It is the converse of a merger or acquisition.

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 new company.

Demergers can be undertaken for various business and non-business reasons, such as government intervention, by way of anti-trust law, or through decartelization.

A spin-out, also known as a spin-off or a starburst, refers to a type of corporate action where a company "splits off" sections of itself as a separate business

The common definition of spin-out is 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, at the moment of spin-off, the ownership of the original and spun-off companies are identical. However, shareholders may then buy and sell stocks from either company independently; this potentially makes investment in the companies more attractive, as potential share purchasers can invest in only the portion of the business they think will have the most growth.

The companies Act, 1956 does not contain the concept of ‘De – merger’ as such , but it does indirectly recognize it in:

(a)  Section 391/394 (as a scheme of compromise, scheme or arrangements

(b) Section 293(1)(a) (sell, lease or otherwise dispose of the whole, or substantially the whole, of the undertaking of the company, or where the company owns more than one undertaking, of the whole, or substantially the whole, of any such undertaking)

 

Modes of Demerger

1. Demerger by agreement – It may be effected by agreement where under the demerged company spins off its specific undertaking to a resulting company, formed with another names in such a manner that all the property and all the liabilities of the undertaking, being transferred by the demerged company immediately before the demerger, becomes the property and liabilities of the resulting company by virtue of demerger. The resulting company issues, in consideration of the demerger, its shares to the shareholders of the demerged company on a proportionate basis.

2. Demerger under scheme of arrangement – It requires the approval by Tribunal u/s 391 of the Companies Act.

3.  Demerger and Voluntary Winding up – A Company, which has split into several companies after division, can be wound up voluntarily pursuant to Section 484 to 498 of the Companies Act. Where a the transferor company is proposed to be, or is in course of being wound-up altogether voluntarily the liquidator of the transferor company may, with the sanction of a special resolution of that company conferring on the liquidator either a general authority or an authority in respect of any particular arrangement receive, by way of compensation or part compensation for the transfer or sale, shares, policies, or other like interest in the transferee company, for distribution among the members of the transferor company or enter into any other arrangement whereby the members of the transferor company may, in lieu of receiving cash, shares, policies, or other like interests or in addition thereto, participate in the profits of, or receive any other benefit from, the transferee company.

 

Demerger – Importance of Appointed Date

Appointed Date means the date for identification of assets and liabilities of the existing company for transfer to new company. The ‘Appointed Date’ has been taken for identification and qualification of the assets and liabilities of the existing company and new company consequent upon proposed spin off. This identification is done on the basis of the audited balance sheet of the existing company for the financial year.

Appointed date is different from ‘Effective Date’ which was the date on which all consents and approvals required under the scheme were to be obtained and transfer effected.

 

Steps to be taken for Demerger

1. Preparation of Scheme of Demerger
2. Application to Tribunal for direction to hold meetings of members/ creditors.(Section 391[1] of Companies Act )
3. Obtaining Tribunal’s order for holding meetings of members/ creditors.
4. Notice of the meetings of members/ creditors
5. Holding meeting of members and creditors
6. Reporting the result of the meeting by the Chairman to Tribunal.
7. Petition to the Tribunal for sanctioning the scheme of demerger.
8. Obtaining Order of the Tribunal sanctioning the scheme
9. Tribunal’s order on petition sanctioning the scheme of demerger – Section 394 of Companies Act

                                                    

Tax reliefs to Demerged Company

1.     Capital gains tax not attracted – According to Section 47(vib) of the Income Tax, 1961 where there is any transfer, in a demerger, of a capital asset by the demerged company to the resulting company, if the resulting company is an Indian company shall not be regarded as a transfer for the purposes of capital gains.

2.     Tax relief to a foreign demerged company - According to Section 47(vic) of the Income Tax, 1961 where there is any transfer in a demerger, of a capital asset, being a share or shares held in an Indian company, by the demerged for­eign company to the resulting foreign company, if—

(a) the shareholders holding not less than three-fourths in value of the shares of the demerged foreign company continue to remain shareholders of the resulting foreign company; and

(b) such transfer does not attract tax on capital gains in the country, in which the demerged foreign company is incorporat­ed :

Provided that the provisions of sections 391 to 394 of the Companies Act, 1956 shall not apply in case of demergers referred to in this clause, shall not be regarded as a transfer for the purposes of capital gains.

 3.     Tax relief to the Shareholders of the demerged company - According to Section 47(vid) of the Income Tax, 1961 when there is any transfer or issue of shares by the resulting company, in a scheme of demerger to the shareholders of the demerged company if the transfer or issue is made in consideration of demerger of the undertaking shall not be regarded as a transfer for the purposes of capital gains.

 

Cost of acquisition of Shares in resulting Company

=

Cost of acquisition of shares  in demerged company    x    Net Book Value of Assets transfered in demerger _______________________________________ Net worth of demerged company before demerger.

 

Tax relief to resulting company

The resulting company is eligible for tax relief if

• The demerged satisfies all the conditions laid down in Section 2(19AA) of the Income Tax  ACT, 1961
• The resulting company is an Indian company.

 

1.Depreciation on assets transferred to resulting company – Section 32(1) of the Income Tax, 1961 provides that in respect of depreciation of—

  (i) buildings, machinery, plant or furniture, being tangible assets;

 (ii) know-how, patents, copyrights, trademarks, licenses, franchises or any other business or commercial rights of similar nature, being intangible assets acquired on or after the 1st day of April, 1998,

 owned, wholly or partly, by the assessee and used for the purposes of the business or profession, the following deductions shall be allowed

 (i)  in the case of assets of an undertaking engaged in generation or generation and distribution of power, such percentage on the actual cost thereof to the assessee as may be prescribed;

(ii) in the case of any block of assets, such percentage on the written down value thereof as may be prescribed

The fifth proviso  to clause (ii) of Section 32(1) of the Income Tax, 1961 the aggregate deduction, in respect of depreciation allowable to the amalgamating company and the amalgamated company in the case of amalgamation, or to the demerged company and the resulting company in the case of demerger, as the case may be, shall not exceed in any previous year the deduction calculated at the prescribed rates as if the succession or the amalgamation or the demerger, as the case may be, had not taken place, and such deduction shall be apportioned between the predecessor and the successor, or the amalgamating company and the amalgamated company, or the demerged company and the resulting company, as the case may be, in the ratio of the number of days for which the assets were used by them.

 

2. Expenditure on acquisition of patent rights and copyrights – Section 35A (1) of the Income Tax, 1961 provides in respect of any expenditure of a capital nature incurred after the 28th day of February, 1966 but before the 1st day of April, 1998, on the acquisition of patent rights or used for the purposes of the business, there shall, subject to and in accordance with the provisions of this section, be allowed for each of the relevant previous years, a deduction equal to the appropriate fraction of the amount of such expenditure.

Section 35A (7) Where in a scheme of demerger, the demerged company sells or otherwise transfers the rights to the resulting company (being an Indian company),-

(i) the provisions of sub-sections (3) and (4) Section 35A  shall not apply in the case of the demerged company; and

(ii) the provisions of this section shall, as far as may be, apply to the resulting company as they would have applied to the demerged company, if the latter had not sold or otherwise transferred the rights.

However, if such expenditure is incurred by the demerged company 31.03.98, deduction under Section 35A is not allowed, as such expenditure will be eligible for depreciation.

 

3. Expenditure on Know –how – Section 35AB(3) of the Income Tax, 1961 provides where there is a transfer of an undertaking under a scheme of amalgamation or demerger and the amalgamating or the demerged company is entitled to a deduction under this section, then, the amalgamated company or the resulting company, as the case may be, shall be entitled to claim deduction under this section in respect of such undertaking to the same extent and in respect of the residual period as it would have been allowable to the amalgamating company or the demerged company, as the case may be, had such amalgamation or demerger not taken place.

 

4. Expenditure for obtaining licence to operate telecommunication services  -  Section 35ABB(7) of the Income Tax, 1961 provides where, in a scheme of demerger, the demerged company sells or otherwise transfers the licence to the resulting company (being an Indian company),-

(i) the provisions of sub-sections (2), (3) and (4) of Section 35ABB   shall not apply in the case of the demerged company; and

(ii) the provisions of this section shall, as far as may be, apply to the resulting company as they would have applied to the demerged company if the latter had not transferred the licence

 

5. Amortization of certain preliminary expenses  - Section 35D(5A) of the  Income Tax, 1961 provides  that where the undertaking of an India Indian company which is entitled to the deduction under sub-section (1) Section 35D of  is transferred, before the expiry of the period specified in sub-section (1), to another company in a scheme of demerger

(i)  no deduction shall be admissible under sub-section (1) in the case of the demerged company for the previous year in which the demerger takes place; and

(ii)  the provisions of this section shall, as far as may be, apply to the  resulting company, as they would have applied to the demerged company, if the demerger had not taken place

 

6. Amortization of expenditure in case of amalgamation or demerger - Section 35DD(1) of the  Income Tax, 1961 provides that where an assessee, being an Indian company, incurs any expenditure, on or after the 1st day of April, 1999, wholly and exclusively for the purposes of amalgamation or demerger of an undertaking, the assessee shall be allowed a deduction of an amount equal to one-fifth of such expenditure for each of the five successive previous years beginning with the previous year in which the amalgamation or demerger takes place.

 

7. Computation of actual cost to resulting company of capital assets transferred – Explanation 7A to Sub- section (1) of Section 43 of the  Income Tax, 1961 Where, in a demerger, any capital asset is transferred by the demerged company to the resulting company and the resulting company is an Indian company, the actual cost of the transferred capital asset to the resulting company shall be taken to be the same as it would have been if the demerged company had continued to hold the capital asset for the purpose of its own business.

However, such actual cost shall not exceed the written down value of such capital asset in the hands of demerged company.

 

8. Written down value of assets transferred to resulting company - Explanation 2A & 2B to Clause (ii) of  Sub- section (6) of Section 43 of the  Income Tax, 1961

Explanation 2A.—Where in any previous year, any asset forming part of a block of assets is transferred by a demerged company to the resulting company, then, notwithstanding anything contained in clause (1), the written down value of the block of assets of the demerged company for the immediately preceding previous year shall be reduced by the written down value of the assets transferred to the resulting company pursuant to the demerger.

Explanation 2B—Where in a previous year, any asset forming part of a block of assets is transferred by a demerged company to the resulting company, then, notwithstanding anything contained in clause (1), the written down value of the block of assets in the case of the resulting company shall be the written down value of the transferred assets of the demerged company immediately before the demerger.

 

9. Carry forward and set off of accumulated loss and unabsorbed depreciation allowance - Section 72A(4) of the  Income Tax, 1961

Notwithstanding anything contained in any other provisions of this Act, in the case of a demerger, the accumulated loss and the allowance for unabsorbed depreciation of the demerged company shall—

(a) where such loss or unabsorbed depreciation is directly relatable to the undertakings transferred to the resulting company, be allowed to be carried forward and set off in the hands of the resulting company;

 (b) where such loss or unabsorbed depreciation is not directly relatable to the undertakings transferred to the resulting company, be apportioned between the demerged company and the resulting company in the same proportion in which the assets of the undertakings have been retained by the demerged company and transferred to the resulting company, and be allowed to be carried forward and set off in the hands of the demerged company or the resulting company, as the case may be.

 

10. Deductions in respect of profits and gains from industrial undertakings or enterprises engaged in infrastructure development, etc - Section 80-IA of the  Income Tax, 1961 - Where the gross total income of an assessee includes any profits and gains derived by eligible business, there shall, in accordance with and subject to the provisions of this section, be allowed, in computing the total income of the assessee, a deduction of an amount equal to hundred per cent of the profits and gains derived from such business for ten consecutive assessment years.

Where any undertaking of an Indian company which is entitled to the deduction under this section is transferred, before the expiry of the period specified in this section, to another Indian company in a scheme of amalgamation or demerger—

(a) no deduction shall be admissible under this section to the amalgamating or the demerged company for the previous year in which the amalgamation or the demerger takes place; and

 (b) the provisions of this section shall, as far as may be, apply to the amalgamated or the resulting company as they would have applied to the amalgamating or the demerged company if the amalgamation or demerger had not taken place.

 

11. Tax on income from bonds or Global Depository Receipts purchased in foreign currency or capital gains arising from their transfer - Section 115AC(5) of the  Income Tax, 1961 provides that where the assessee acquired Global Depository Receipts or bonds in an amalgamated or resulting company by virtue of his holding Global Depository Receipts or bonds in the amalgamating or demerged company, as the case may be, in accordance with the provisions of sub-section (1) Section 115AC of the  Income Tax, 1961 of , the provisions of that sub-section shall apply to such Global Depository Receipts or bonds.