Demerger - An Analysis

By Biswadeep Chakravarty IV BSL LLB ILS Law College

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 schemes2

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

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. Demerger An Indian Legal Perspective - Dipen Chatterjee, Advocate, APJ-SLG Law Offices, New Delhi . Procedural Compliances Relating to De-merger/ Reconstruction of Companies in India- S. Dhanapal, Partner, Damodaran & Dhanapal Associates, Company Secretaries, Chennai.

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 a 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 subclause (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 subclause (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;] Thus, the following points may be considered to analyse the concept of Demerger, from a legal standpoint:3

De-merger would fall within the ambit of 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 the High Court. De-merger would necessarily involve transfer of one or more undertakings. The transfer of undertakings is by the demerged company, which is otherwise known as transferor company.While the company to which the undertaking is transferred is known as the resulting company or the transferee company. Following rapid industrialisation and subsequent globalisation and liberalisation (New Economic Policy, 1991), existing provisions relating to amalgamations of companies were rationalised and 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 conferred upon 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 scheme of demerger, may be carried forward by the resulting company if the same are in a direct relation to the undertaking proposed to be transferred. Where it would not be possible to relate the aforementioned losses to the
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. companies act, 1956 [section 391-394] . Getaways in the demerger route - T. C. A. Ramanujam, The Business Line, Jan 17, 2004 (http://www.thehindubusinessline.in/2004/01/17/stories/2004011700100900.htm)

undertaking, the same may 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. Pertinent to note here would be that, tax benefit to such business reorganisation however, is limited to a 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 would take the 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. 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. 6 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, demerged 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:7 1. Consideration for transfer of undertaking would be by issue of shares only by resulting company, i.e the price consideration.
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. Ibid. . Bryer, Lanning G. (2002). "Intellectual property assets in mergers and acquisitions". John Wiley and Sons. pp. 12.2 12.3 . Demerger An Indian Legal Perspective - Dipen Chatterjee, Advocate, APJ-SLG Law Offices, New Delhi

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. Judicial Decisions: In HCL Ltd., In Re and HCL-Hewlett Packard, In re,8 the Court was asked to decide upon the issue of the effective date in the case of a demerger. The scheme of arrangement provided for an appointment date and an effective date. As per the definition in the scheme the effective date was the .later of the date on which all the assents and approvals referred to in Part VI were obtained and/or the date on which the certified copy of order of the High Court sanctioning the scheme was obtained is filed with the Registrar of Companies. The Central Government had made an observation on the scheme when it came up before the Delhi High Court for approval. It observed that the appointed date under the scheme was fixed at July1, 1990 when, in fact, the company itself was incorporated on May 15,1991. This meant that the transfer had come into effect even prior to the date on which the transferee company had been incorporated under the Companies Act, 1956. Relying on the submissions on behalf of the transferor and transferee companies the Court concluded that the effective date was to be distinguished from the appointed date. The appointed date, in the instant case, was the date taken for the identification and quantification of assets and liabilities of the company proposed to be spun-off. This identification is done on the basis of the audited balance sheet of the demerging company for the financial year ending. The appointed date is relevant for the purpose of determining the share valuation and share exchange rate, which the existing company would offer to its shareholders after the bifurcation. In the instant case, the effective date was the date on which, as per the scheme, the sanction of the High Court was to be filed with the Registrar of Companies. However, the Court failed to address the issue as to the date on which the scheme of demerger is to have effect if no date was specified in the scheme of demerger itself9. In Re EITA India Ltd,10 the scheme of amalgamation was objected to by the Central Government on the following grounds: (a) that the transferee company did not carry on the business as was being done by the transferor companies; (b) that the memorandum and articles of association of some of the transferor companies did not permit amalgamation and there was no such clause therein ; (c) that fixation of share ratio was unjust and unfair.
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. (1994) 80 Com. Cas. 228 (Del.). . P.S. Kaicker, Merger of Sick Industrial Companies and Reverse Mergers: Perspectives and problems, 27 Chartered Secretary 1149 (1997). . (1996) 4 Comp LJ 346 (Cal).

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The Calcutta High Court in the instant case opined that:

Where all statutory formalities have been complied with and the scheme is fair and reasonable and there is no fraud involved, then the court would sanction it. The onus lies heavily on those who oppose the sanction of the scheme to show that the scheme is unfair or fraudulent. The power to amalgamate is a statutory power, given to a company under Section 391 and hence the objection that the transferor and transferee company did not carry on the same business, could not be sustained. Power to amalgamate is a statutory power and it may be exercised notwithstanding the fact that the memorandum and articles of association of a particular company may not contain an express power to amalgamate. If the ratio of exchange has been fixed by experienced and reputed firm of chartered accountants, then, in the absence of any charge of fraud against them, the court will accept such ratio of exchange. Where the majority of shareholders has accepted the share exchange ratio, there is no reason why their business decision should be interfered with.

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 folowing points must however be considered both from an investors as well as a legal point point of view:11

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

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. Demergers: A great way to get richer by Arnav Pandya in New Delhi

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: However, the current scenario does not suffer from its share of drawbacks. Corporate entities often tend to manupilate and use the loopholes, of which there are plenty, to abuse the system of laws and regulations regarding Demerger. Immediate and prudent amendments (inter alia through rules and nitfications) by the Government must be put in place to prevnt the same. 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 28112 of the I-T Act declares certain transfers to be
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. Section 281 - CERTAIN TRANSFERS TO BE VOID (1) Where, during the pendency of any proceedings under this Act or after the completion thereof, but before the service of notice under rule 2 of the Second Schedule, any assessee creates a charge on, or parts with the possession (by way of sale, mortgage, gift, exchange or any other mode of transfer whatsoever) of, any of his assets in favour of any other person, such charge or transfer shall be void as against any claim in respect of any tax or any other sum payable by the assessee as a result of the completion of the said proceeding or otherwise :
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Provided that such charge or transfer shall not be void if it is made

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(i) For adequate consideration and without notice of the pendency of such proceeding or, as the case may be, without notice of such tax or other sum payable by the assessee; or (ii) With the previous permission of the Assessing Officer.

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(2) This section applies to cases where the amount of tax or other sum payable or likely to be payable exceeds five thousand rupees and the assets charged or transferred exceed ten thousand rupees in value. Explanation : In this section, "assets" means land, building, machinery, plant, shares, securities and fixed deposits in banks, to the extent to which any of the assets aforesaid does not form part of the stock-in-trade of the business of the assessee.

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)13 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.14

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. supra . Getaways in the demerger route - T. C. A. Ramanujam, The Business Line, Jan 17, 2004