This article is written by Advocate Shamika Vaidya pursuing Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from Lawsikho.com. Here she has discussed demergers and five reasons why they are used.

Introduction

If Mergers are like marriages, demergers could be termed as“divorce”. In the simplest way, if a company wants to split up into multiple business entities, one of the methods is demerger, and like people have their own reasons for divorce, so do companies.

What is a demerger

• Demerger is defined under Section 2(19AA) of the Income-Tax Act, 1961. An analysis of the definition is as follow;

1. It is a Scheme of Arrangement and has to be sanctioned by the National Company Law Tribunal.
2. The property and liabilities of the undertaking that are transferred by the demerged company become the property of the resulting companies and are transferred at a value appearing in its book of accounts.
3. The resultant share issues are in proportion to the shareholdings of the demerged company and is a consideration in itself.
4. The shareholders holding not less than three-fourths (3/4th) in value of the shares of the demerged company become shareholders of the resultant company.

• Section 230 – Section 240  of the Companies Act along with the Companies (Compromise, Arrangements, and Amalgamations) Rules, 2013 state the necessary compliances and process for a demerger.
• Under a demerger, the balance sheet of the company is split up into two or more balance sheets representing the business that existed under the common balance sheet.

The aspect of Tax Neutrality

• In the matter of Indo Rama Synthetics Limited, it was held that a demerger as defined u/s  2(19AA) of the Income Tax Act is only for the sake of determining whether a demerger is tax neutral or not, despite the arrangement not fulfilling the conditions as contemplated by the IT Act it is qualified to be a demerger.

Uma Enterprises Private Limited

• In the matter of Uma Enterprises Private Limited, the Regional Director opposed the sanctioning of the scheme of arrangement, submitting that the scheme was a sham to transfer the company’s land to third parties and to avoid capital gains and stamp duty.   

The submissions of the Regional Director were as follows:

1. The Company did not carry out any separate real estate business, this was evident from the fact that there was no turnover, income or expenditure from the real estate business.
2. The shareholders were proposed to be allotted compulsorily redeemable preference shares which implied of separating them from the ownership in the resultant companies.

The company contended that;

1. The Company is free in law to arrange its affairs to evade taxes.
2. The Company had incurred certain capital expenditure on leveling of the land and that the memorandum of the Company was amended in 2010 permitting the Company to do real estate business.

The High Court observed that;

1. With regards to the issuance of compulsorily redeemable preference shares, it implies that the proposed transaction is a plain vanilla transfer of land.
2. One of the requirements of the demerger is the continuance of the existing shareholders in the new entity which was absent in this case.
3. The High Court held that the scheme only appeared to be a device for the avoidance of capital gains tax and stamp duty and did not sanction the scheme.

1. To conclude, if the tax authorities are of the view that the whole scheme is to avoid tax liabilities it may put forward an objection and further NCLT may even reject the scheme.
2. If a scheme does not fulfill the conditions put forward in the Income Tax Act it does not mean that the arrangement is not a demerger.

Structured Demerger

• As specified by the Income Tax Act, a demerger requires ratification by the shareholders representing 75% of the paid-up capital of the company.
• It leaves the company with 25% percent scope apart from the proportional shareholding by the shareholders of the demerged company.
• The company demerged in a way that the parent company can hold up to 25% of the remaining share capital it is known as Structured Demerger.

Plain Vanilla and Composite Demerger

• The resultant company can be either be demerged into a new company, or it can get demerge into an existing company.
• Transfer of business through demergers to a new entity is known as plain vanilla demerger and when the transfer of business through demerger is in an already existing company then it is known as Composite Demerger.

How is a Demerger different from Hive-off and Spinoff

• Terms like Hive-off and Split off are often confused with a demerger,
• Hive-off is not statutorily defined and is a generic corporate finance term. A demerger is a special form of hive off specifically envisaged under the IT Act for providing tax neutrality. In other words, Hive offs that fulfill condition prescribed under the IT Act are demergers.
• Under a spin-off, shareholders of the parent companies are offered direct holding in the subsidiary and the parent company ceases to hold any shares in the new entity. Whereas, in a demerger, shareholders of the parent company receive shares in the demerged entity based on their holdings in the parent company( pro-rata basis).

Why do companies demerge?

To focus on the core business

• Undertakings in the companies attend distinct levels of growth and demand peculiar human resources, investments, and other resources.
• Having said that, few undertakings of the company are its core business and the company is recognized as well as derives most of its income from them.
• In order to unlock the true potential of such undertaking, companies consider demerger as one of the ways.
• Companies demerge the units which form the core business or the potential units which it proposes to focus from the rest of its business.
• The demerged businesses derive the benefit of focused leadership which in turn is helping to streamline the business.
• One such example is of RCOM, who demerged its non-core assets to form Reliance Property Limited, this step was taken to divest the non-core assets and to focus on the core assets.

When a unit is Loss-making

• When a unit is loss-making in the company, it erodes the valuation of the company. Especially, if the company is a public listed company it has a direct effect on the shares of the company.
• Even if a single unit is a loss-making it is reflected in the annual reports of the company which in turn can affect the prospective investment of the company.
• Companies, therefore, choose the route of demerger and separate the loss-making unit. It not only serves the purpose of maintaining the valuation of the company but also caters to the need of specialized attention to the loss-making unit.
• Pursuant to the demerger, the company could do any of the following;

1. Transfer the demerged company to the interested buyers through slump sale.
2. Find a strategic partner.
3. Find private equity funds to infuse capital.

• The tyre division of Kesoram Industries was a loss-making unit for years, it was planned to be demerged from the main business as to find a strategic partner for it. This had instantly reflected with the companies shares that climbed to 9.5% on the announcement. (Read the full story here)
• CESC Ltd planned to demerge by splitting into four units that is power, generation, distribution, retail, and other ventures. The retail division incurred losses for a  and the company did not want the valuation to get affected. A demerger opens up the possibility for other units to get a better valuation. (Readfullstoryhere)

When a wing is Self Sufficient

• If any of the undertakings of the company depicts incredible growth in a short period, the company can demerge that segment to add expertise and focus strategy to unlock its potential.
• With an intention to get an undertaking listed through back door listing (explained below), companies demerge them.

• Marico Ltd demerged the skin care business, as it had grown considerably and was becoming an important vertical for group interests distinct from the core business of the Marico that is FMCG. One of the main reasons for the demerger was for raising investment. The shareholding pattern of the former was mirrored in the later.

 To create value for shareholders

• Shareholders receive shares in the demerged companies on the basis of their holdings in the parent company. For example, If A holds 10 shares in PQR Ltd., then based on the valuation he may receive 3 shares in the demerged entity for every share that he holds in the parent company.
• Thus, shareholders benefit by holding shares in two entities and can participate separately as well as collectively in the growth of the demerged entities.
• Over the past few years, companies that have been listed after the demerger from the parent companies have created handsome returns for their investors.
• One such example is of Crompton Greaves, which demerged its consumer product business into a separate company Crompton Greaves Consumer Electrical. The result of demerger was a return of 57% since its record date on March 16, 2016.

If the company is debt-laden

• As a part of the corporate resolution process under the Insolvency and Bankruptcy Code, debt structuring of the debtor company that takes place and Demerger can be a part of it.
• Jindal Stainless Limited as a part of its restructuring demerged its three undertakings that is the domestic steel, power and international steel business to leverage idle capacity and in streamlining operations.
• The proposed demerger created a possibility to distribute the debt which is 8,580 crore. It is also beneficial for the three companies to raise funds independently. Therefore the burden of debt is distributed amongst four entities by way of a demerger. (Read Full Story Here)

Listing of the subsequent company

• Pursuant to the Scheme of Arrangement, the company can be listed by complying with the concerned regulations stated in the Securities Contract (Regulation) Rules.
• Notwithstanding this, it has to be specifically mentioned in the Scheme that the resultant company intends to get listed.
• The company can get listed without following the cumbersome procedure of Initial Public Offering, by merely applying to the Securities Exchange Board of India.
• Demerger is a good way of getting a good performing undertaking of a business listed without going through the long route of Initial Public Offering.

Stamp duty

• Stamp duty imposition differs according to the different states. Let us take an instance of the Demerger is happening in the State of Karnataka.
• Article 20(4)(ii) of the Schedule of the Karnataka Stamp Act states the stamp duty in case of demerger to be three percent (3%) on the market value of the property of the transferor company located within the state of Karnataka and transferred to the resulting company.
• An amount equal to one percent (1%) of the aggregate value of shares issued or allocated to the resulting company and in addition the amount of consideration if any paid for such demerger whichever is higher.

Tax implications

• As mentioned earlier, if a demerger satisfies the conditions laid down by the IT Act then the whole demerger transaction is tax neutral.
• By the virtue of Section 47(vib) of the Income Tax Act, any transfer in a demerger of a capital asset by the demerged company to the resulting Indian company is not regarded as a transfer and therefore does not attract capital gains tax.

• Section 2(22)(v) of the Income Tax Act states that any distribution of shares pursuant to a demerger by the resulting company to the shareholders of the demerged company is not considered as the dividend.

• By the virtue of Section 72A loss and unabsorbed depreciation of the demerged company can be carried forward by the resulting company in case it is directly related to the undertakings transferred in the demerger.

Conclusion

Demerger is proving to be an effective means for corporate restructuring and companies like 1) NRB Industrial Bearings 2) Orient Cement 3) Star Ferro 4) Cement 5) Marico Kaya 6) Welspun Enterprise 7) Gulf Oil Lubricants are leading performing demerged stocks which have benefited the shareholders as well as the company.

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