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This article is written by Bhumika Saishri Panigrahi who is pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions)  from Lawsikho.

Introduction

Demergers could be described as “divorce” if mergers are like marriages. If a company wants to split up into numerous commercial organisations, one of the procedures is demerger, and just like people, companies have their own reasons for divorce. 

A demerger is a type of corporate reorganisation in which a company’s business operations are separated into one or more components. It is the  polar opposite of a merger or acquisition. 

A demerger is the separation or disjoining of one or more units of a company in order to form a new firm that is independent of the original. The following definition of demerger is taken from the Income Tax Act of 1961, section 2 (19AA). 

“Demerger” refers to the transfer of a demerged company’s one or more undertakings to any resulting company pursuant to a scheme of arrangement under sections 391 to 394 of the Companies Act, 1956 (1 of 1956). 

Demerger is a type of corporate restructuring in which companies merge in order to increase specialisation. Because of the numerous advantages it provides, businesses have begun to use demerger. 

A demerger enables a corporation to extend its operations in a methodical and orderly manner. It enables a division or unit to develop as a distinct and focused entity, boosting efficiency and effectiveness. It benefits shareholders by giving them more possibilities to participate in the applicant company’s management, operations, decision-making process, and profits, as well as the resulting company’s earnings. 

Causes that lead to demergers 

To concentrate on the core business

  • Companies have different levels of growth, which necessitates different human resources, capital, and other resources. However, a number of the company’s ventures are its primary business, and the corporation is well-known for them, as well as the source of the majority of its revenue.
  • Companies view demerger as one of the strategies to harness the true potential of such a project.
  • Companies separate the units that make up their main business or the potential units on which they want to focus from the rest of their operations.
  • Focused leadership is a benefit of the demerged company, which helps to streamline the operation. 
  • RCOM, for example, demerged its non-core assets to form Reliance Property Limited in order to dispose the non-core assets and concentrate on the core assets. 

Company debt

  • Debt structuring of the debtor firm takes place as part of the corporate resolution procedure under the Insolvency and Bankruptcy Code, and Demerger might be a component of it.
  • Jindal Stainless Limited demerged its three businesses, domestic steel, power, and international steel, as part of its restructuring to utilise idle capacity and streamline operations.
  • The proposed demerger opened up the potential of redistributing the debt, which now stands at Rs 8,580 crore. It’s also advantageous for the three companies to raise financing on their own. As a result of the demerger, the debt load is spread across four businesses. 

To increase shareholder value

  • Shareholders obtain shares in the demerged entities based on their parent company ownership. For example, if A owns 10 shares in PQR Ltd., he may receive 3 shares in the demerged corporation for every share he owns in the parent company, based on the valuation.
  • As a result, shareholders gain from owning shares in two companies and can participate in the demerged companies’ growth both individually and collectively.
  • Investors have reaped substantial profits from companies that were listed after demergers from their parent companies in recent years. 
  • Crompton Greaves, for example, demerged its consumer goods division as Crompton Greaves Consumer Electrical, a separate company. Since its record date on March 16, 2016, the stock has returned 57 percent as a result of the demerger. 

When a unit is losing money

  • When a company’s unit is losing money, it lowers the company’s valuation. It has a direct impact on the company’s shares, especially if it is a publicly listed company.
  • Even if a single unit is losing money, it is reflected in the company’s yearly reports, which might influence future investment decisions.

As a result, companies opt for a demerger and split the loss-making segment. It not only serves to maintain the company’s valuation, but it also meets the requirement for specialised attention to the loss-making business.

The company could perform any of the following as a result of the demerger:

  1. Through a slump sale, transfer the demerged company to potential buyers.
  2. Make contact with a strategic partner.
  3. To infuse capital, look for private equity funds.
  • For years, Kesoram Industries’ tyre section has been a loss-making subsidiary, and it was expected to be demerged from the main firm in order to locate a strategic partner for it. This was immediately reflected in the company’s stock, which jumped 9.5 percent after the news.

Methods of demerger 

Demerger by agreement

The demerged company spins off its specific undertaking to a resulting company, formed under a different name, in such a way that all of the undertaking’s property and liabilities, which were transferred by the demerged company immediately before the demerger, become the property and liabilities of the resulting company by virtue of the agreement. In exchange for the demerger, the resulting business distributes its shares proportionately to the demerged company’s owners. 

Demerger pursuant to a scheme of arrangement

This requires Tribunal permission under Section 391 of the Companies Act. 

Voluntary Demerger and Demerger Winding up

Under Sections 484 to 498 of the Companies Act, a company that has split into many companies after division can be wound up voluntarily. The company that is being wound up may transfer or sell all or part of its operations to another company in this case. 

With the approval of a special resolution of the transferor company, the liquidator may receive shares, policies, or other similar interests in the transferee company as compensation or part compensation for the transfer or sale, for distribution among the transferor company’s members or for any other purpose. 

Steps of demerger

  1. Preparation of a Demerger Scheme
  2. Application to the Tribunal for a directive to hold member/creditor meetings (Section 391[1] of Companies Act )
  3. Obtaining a Tribunal order to host member/creditor meetings.
  4. Notice of members’/creditors’ meetings
  5. Organizing a meeting of creditors and members
  6. The Chairman will report the meeting’s outcome to the Tribunal.
  7. Petition to the Tribunal for approval of the demerger proposal.
  8. Obtaining a Tribunal Order authorising the scheme.
  9. Order of the Tribunal approving the demerger scheme – Section 394 of the Companies Act, 2013.

Stamp Duty

  • Stamp duties are imposed differently in various states. Take, for example, the demerger that is currently taking place in the state of Karnataka.
  • The stamp duty in the case of a demerger is three percent (3%) on the market value of the transferor firm’s property located within the state of Karnataka and transferred to the resulting company, according to Article 20(4)(ii) of the Schedule of the Karnataka Stamp Act.
  • Amount equal to one percent (1%) of the total value of shares issued or allotted to the new business, plus the amount of consideration paid for such demerger, whichever is greater. 

Tax reliefs to a demerged company 

No capital gains tax

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

Tax relief to a demerged foreign company

According to Section 47(vic) of the Income Tax Act of 1961, if the demerged foreign company transfers a capital asset, such as a share or shares held in an Indian firm, to the resulting foreign company in a demerger, if—

(a) Shareholders who own at least three-quarters of the value of the demerged foreign business’s shares continue to own shares in the resulting foreign company; and

(b) In the country where the demerged foreign firm is incorporated, such a transfer is not subject to capital gains tax: 

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

Tax relief for demerged company shareholders

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

Tax relief to resulting company 

The resulting company qualifies for tax reduction, if the demerged meets all of the requirements set forth in Section 2(19AA) of the Income Tax Act of 1961 if the resulting corporation is based in India. 

Conclusion

Demerger would allow corporations to raise investment and focus more on core business while also strengthening shareholder value. The Companies Act, Income Tax Act, SEBI, and Stamp Duties all apply to demergers. The demerger should have a clear purpose and should prioritise the interests of the shareholders. 

In many cases, demergers have proven to be effective, and many parties have profited. Consider the demerger of Reliance Industries Ltd in August 2005. Reliance Industries’ shareholders profited in a variety of ways, including the fact that they may now directly participate in the company’s operations and unlock significant value, and they would also get dividends.  


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