Demergers and Tax Consequences in Indian Contacts

India’s vibrant economy gives the corporates a competitive edge and encourages growth and innovation. The diverse organisational restructuring via mergers, acquisitions, demergers, etc., aid in the survival and expansion of industries in the economic scuffle as well as in the identification of profit-driven operations and unhealthy enterprises. As a result, these organisational restructurings may or may not benefit the corporate, and when a corporate restructuring fails to achieve its goals, the corporate must restructure by diversifying its business components.

The business restructuring or reorganisation may be carried out for a variety of causes and with a variety of goals in minds of the corporates. The term “Demerger” is used to describe this business restructuring or reorganisation.

What is Demerger?

A strategy in which a single business is divided into components that can function independently, be sold, or be liquidated. A ‘de-merger’ allows a huge company to separate its many parts in order to attract or avoid an acquisition, to raise funds by selling off units that are no longer part of the company’s main line, or to form independent units to handle different operations.

The Companies Act, 2013 (the “CA-2013”) governs demergers in India, however it doesn’t define the term “demerger” in any explicit way. Furthermore, Section 2 (19AA) of the Income Tax Act, 1961 (the “IT Act”), which governs the taxability of the demerger in India, defines the demerger as ‘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…’

Due to the fact that a demerger is a form of ‘compromise’ or ‘arrangement’, the CA-2013 covers this aspect under Sections 230 and 232 in India, and the Companies (Compromises, Arrangements and Amalgamations) Rules, 2016, outline the application and approval processes.

Demerger in India therefore generally refers to the transfer of a demerged company (transferor) to a new company (transferee) through a plan of ‘compromise’ or ‘arrangement’ in which all of the assets and shares are transferred to the new company.

Rationales of Demerge:

• Adjusting with the changing political as well as economic environment of the country.
• Increasing the opportunities effectively to optimize the use of the resources when the parent company is unable to do so.
• Generating resources during planning for acquisition while lacking finances or funds.
• Realizing capitals gains out of assets that are underperforming.
• Developing more profitable opportunities by restructuring financial as well as managerial resources available.
• Selling unwanted, surplus or unconnected parts of the business to get rid of the sick part of the company.

Modes of Demerger:

• By Agreement: the parent company chooses to create a subsidiary through a spin-off and consents to give the new subsidiary company all of its assets, liabilities, and stock. The contract binds the parties and requires them to abide by its terms and conditions.
• By Scheme of Arrangement: according to Section 232 of the CA-2013, the company must first alter its MOA and AOA and produce a draft scheme of arrangement that the board of directors must approve through resolution. Following the board resolution, the company must apply to the Tribunal for the sanction of the scheme of arrangement, accompanied by the relevant documentation.

Forms of Demergers:

• Spin-Off: entails the parent company creating a wholly-owned subsidiary of its own through the pro rata distribution of all the subsidiary company’s shares. Both the parent and subsidiary company are still present in the market due to this arrangement. Establishing a subsidiary company allows many companies to invest their time in other services while also giving the subsidiary company the freedom to make decisions on its own and adopt business strategies that are most appropriate for its needs.
• Split-up: separates the parent company into two or more separate entities. The parent business ceases to exist following its divisions, and its shareholders are transferred to the new firms in consultation with them. If a corporation is unable to handle multiple verticals of its business segment, it would normally demerge into separate companies and appoint board members for each. This allows the vertical company to concentrate on their area of expertise and implement the best practices.
• Split-off: offers the shareholders the option to exchange their parent company’s shares for fresh shares of the subsidiary (split company). This “tender offer” frequently includes a premium to persuade existing parent company shareholders to accept the offer. Typically, a huge corporate houses with many operations may desire to separate them.

• Equity Carve-out: establishes a subsidiary of the parent company while maintaining control over the subsidiary company’s operations. This arrangement is similar to a spin-off, except that the parent company retains control of the equity carve-out. In addition, a portion of the subsidiary company’s shares are made available to the public through public offerings.
• Divestitures: sells the parent company’s one of the segments to a third party in exchange for cash and securities. If the company intends to diversify investment methods in other commercial operations in a different area, it will typically enter into this arrangement to raise capital.

Advantages of Demerger:

• Focus: Many a time the companies are notorious for their lack of concentrated corporate operations and overseeing a wide range of operations that necessitate a variety of skills. In many situations, the businesses are defeated by competitors who have a laser-like focus on a particular line of business. Specialisation is more important in today’s corporate world and as a result, businesses must concentrate on their core capabilities. Many companies have streamlined their operations as a result of this logic, and demerger has been an important tool in the process.
• Management Accountability: As the companies are divided, each company’s management has its own financial statements. As a result, certain entities within the group cannot subsist off the earnings of others. Every company’s management is held accountable for their financial results. In addition, management has greater control over their activities. They have the authority to make their own investments and raise funds on their own behalf in the market.
• Increase Market Capitalization: Demergers are sometimes utilised to increase stock market value. Investors now have a better understanding of the operations and cash flow of a spun-off the companies. This enables them to make better investment judgements and to charge a premium for this improved information. As a result, separating components to become independent legal entities increases the group’s overall market valuation.

Demerger’s Tax Effects:

Section 47 of the IT Act defines the tax consequences of a demerged firm. It stipulates that transactions that are not considered transfers are not subject to taxation under the IT Act. Certain transfers are now tax-free under the scheme of arrangement.

• Cost of Acquisition: of the original shares, or shares of the demerged company, is allocated proportionately between the shares of the demerged company (transferor) and the shares of the resulting company (transferee) in the same ratio as the net book value of the demerged company’s assets transferred to the net worth of the demerged company prior to the demerger.
• Capital Gains: does not arise according to Section 47 of the IT Act, when the demerged company transfers assets (depreciable or non-depreciable) into the hands of either the demerged company or the resulting company. Although transfers in India are subject to transfer tax, demergers in the Indian landscape enjoy dual tax-neutrality, with both, i.e., the transfer of undertakings and the transfer of a portion of the demerged company’s shares in exchange for shares in the resulting company, as consideration, being tax-free.

Non-residents and foreign companies: as per Section 47 (vic) of the IT Act, when shares of an Indian company are transferred in a scheme of arrangement, both the demerged company and the new business are foreign corporations.

Provided-

1. shareholders owning at least 3/4 of the demerged foreign company’s shares remain shareholders of the resulting foreign company; and

2. such a transfer of shares is not subject to capital gains tax in the jurisdiction of the foreign demerged business in which it is established.

According to Section 47(vicc) of the IT Act, a foreign company may transfer shares in a scheme of arrangement only if the shares of an Indian company are substantially used to value the shares being transferred, and both the demerged company and the resulting company are foreign corporations.

Provided-

1. at least 25% of the foreign company’s owners remain shareholders of the new company;

2. the transfer should not result in capital gains in the state where the company is established.

• Capital Assets: as per Section 56(2)(x), read with Section 47 the following transfers are also exempt from income tax under the IT Act:

by the ‘demerged company’ to the resulting company being an Indian company; and

a foreign company’s shares that derive a significant portion of their value from Indian company’s shares held by the demerged company and transferred to the resulting company, both of which are foreign corporates;

Provided-

1. shareholders owning at least 3/4 of the demerged foreign company’s shares remain shareholders of the resulting foreign company; and

2. such a transfer of shares is not subject to capital gains tax in the jurisdiction of the foreign demerged business in which it is established.

• Written Down Value (WDV): with respect to the apportionment of block of assets transferred by the demerged company for:

Demerged Company: to be reduced by the value of assets transferred;

Resulting Company: to be recorded as value of assets received and added to the block of assets.

The demerged and resultant companies will split the cost of depreciation, or amortising capital assets and the same will be carried out based on the number of days that have been determined for the purpose of depreciation.

• Unabsorbed business losses:

The resulting company may carry forward and set off the transferred ‘unabsorbed business losses’ to the extent of the allowed period that is still open. In place of the demerger, it must be carried out in the same proportion that the assets were given to the resulting company. Only the amount of the retained assets after the demerger allows the demerged company to carry forward business losses.

GST:

GST may not be attracted during a demerger under a scheme of arrangement because there is no movement of goods or services. As the individual is no longer a taxable person, there would be a transfer of a going concern.

Although, Section 18 of the CGST Act, 2017 has provisions for Input Tax Credit (ITC). A registered taxable person may transfer its unused ITC to the transferor if its constitution changes as a result of a sale, demerger, merger, amalgamation, lease, or transfer of any business, according to the provisions when taken together with Rule 41 of the CGST Rules, 2017.

In the event of a demerger, ITC will be distributed in accordance with the values of the assets transferred to the resulting company and the assets retained by the demerged entity.

Stamp Duty:^[1]

In India, it is up to the states to collect the stamp duty on mergers and acquisitions. The term “conveyance” also includes a scheme of ‘amalgamation’ or ‘arrangement’ of companies within its purview, in accordance with the Stamp Duty Act, 1899 and decisions of High Courts and Tribunals.

On conveyance, or the transfer of movable or immovable property between two juridical persons, stamp duty is payable. The actual agreement that will transfer ownership of the demerged company is the scheme of arrangement.

Only the transfer of an undertaking as a whole, for which shares are granted to the shareholders as consideration, is included in the term “the scheme of arrangement.” As a result, under the applicable state stamp legislation, any scheme of arrangement involving a transfer of property (whether assets or liabilities) will be subject to stamp duty. Such stamp duty will be determined either basis the Net value of asset / property transferred; or the total consideration for the demerger transaction.

Conclusion: ‘Demerger’ of the company is a type of corporate reorganisation in which the company decides to split its operations and form a new entity. We can deduce from the foregoing rules that the tax consequences of demerger are tax-free in the hands of the demerged company, although, the resulting company may face some tax implications. Furthermore, no capital gains will be realised when assets are transferred from the demerged company to the resulting company. The resulting company, on the other hand, is eligible for deductions and tax relief on transferred assets, expenditures, and miscellaneous expenses.

Despite these limitations, corporate restructuring via demerger acts as a tool for corporates to establish their footprint on a global platform. As a result, because the formation of a new company in India has implications for its finances, taxes, and operations, the investors must make sound selections while investing in India.

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DISCLAIMER: “The information provided in this article is for general informational purposes only. While an author tries to keep the information up-to-date and correct, there are no representations or warranties, express or implied, about the completeness, accuracy, reliability, suitability, or availability of the information. Any views or interpretations described in this article are the author’s personal thoughts and do not constitute legal or other professional advice. You may discover there are other views or interpretations to accomplish the same end result.”

^[1]The Author has already dealt with topic of ‘Stamp Duty’ in his article @ https://taxguru.in/company-law/stamp-dutys-epigram-mergers-demergers.html