Demergers in India is undertaken to separate a business unit from a business structure, for reasons such as focusing on core operations or unlocking value for shareholders.
Introduction to Demergers in India
According to Section 2(19AA) of the Income Tax Act, 1961, demergers refer to a form of corporate restructuring wherein:
- One or more business undertakings of a corporate entity (referred to as the ‘transferor’ or demerged company) are transferred to either-
- A new corporate entity; or, (transferee or resulting company)
- An existing corporate entity (transferee or resulting company).
- The remaining businesses of the company continues to vest in the first corporate entity, which is the transferor of the business.
Demergers, in India, can take place via an agreement between the parties. Let us explore how demergers take place in the Indian landscape.
What is an undertaking?
An undertaking refers to a unit or part of a business activity taken as a whole and does not include individual assets or liabilities, that are not engaged in a business activity.
The resulting company, in consideration of such demerger, issues its shares (or any other instrument or cash- see detailed discussion and conditions) to the shareholders of the demerged company on a proportionate basis. This is done to ensure such a transaction is recorded as a tax-neutral demerger. While conducting a demerger one must keep in mind the various tax implications associated with it.
As per, Section 2(19AA) of the Income Tax Act, 1961 the key ingredients involved in a demerger are as follows:
- Transfer of all assets of the undertakings of transferor company to the recipient company at Book Value as recorded by the demerged company;
- Transfer of all liabilities of the undertakings of the demerged company to the recipient company at Book Value (as recorded by the demerged company);
An exception has been carved out where the above-mentioned requirements need not be fulfilled if the resulting company is recording the value of the assets and liabilities in compliance of Ind AS even if the Book Value recorded by the demerged company is different.
- Shareholders of the demerged company who hold at least 3/4th shares in value of the demerged company, become shareholders of the resulting company.
- The transfer of the undertaking shall be on, going concern basis.
The tax authorities can ensure that the undertakings are being transferred on a going concern basis, by confirming whether there has been a transfer of assets, integral to the operations of the undertaking transferred, such as machinery, labour, manpower, managing workforce, etc.
- The demerger shall be in accordance with the various regulations prescribed for such an arrangement between the companies and their shareholders.
Regulations to be followed while conducting Demergers in India.
To ensure proper regulation and oversight of demergers in India, regulatory authorities have issued guidelines which have to be adhered by the transacting parties while drafting a scheme of arrangement for a demerger. Relevant provisions of the below mentioned legislations regulate the legal environment of a demerger:
- Companies Act, 2013;
- IFRS/Accounting Standards;
- Indian Stamp Act, 1899;
- Securities and Exchange Board of India Regulations (SEBI Regulations)
- Income Tax Act, 1961
- Exchange Control;
- Overseas Tax Legislations;
- Competition Act, 2002 and CCI Regulations;
- Foreign Direct Investments Indirect Tax.
Furthermore, the companies must also seek approval for the demerger from the shareholders, creditors, and the National Company Law Tribunal (NCLT).
Implications of Demergers: A Brief Overview
Income Tax Implications
According to the Income Tax Act, 1961 a ‘demerger’ refers to the transfer of one or more undertakings from the demerged company to the resulting company. As consideration for the demerger, shares are issued by the resulting company on a pro-rata basis.
Cost of Acquisition of shares
The cost of acquisition of the original shares i.e., shares of the demerged company are proportionately attributed between the shares of the demerged company and the shares of the resulting company (transferee) in the same proportion as the net book value of assets of the demerged company transferred to the net worth of the demerged company before the demerger took place. The formula is given below:
No Capital Gains
As per Section 47 of the Income Tax Act, 1961, no capital gains arise on transfer of assets by the demerged company (depreciable or non- depreciable) in 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 and both, i.e., the transfer of undertakings, and the transfer of part value of shares of the demerged company, in exchange of the shares of the resulting company, as consideration, are exempt from tax.
Furthermore, following transactions shall not be regarded as transfer for the purpose of attracting capital gains tax in respect of non-residents and foreign companies: –
- Where there is a transfer of shares of an Indian company in a scheme of demerger, wherein both the demerged company as well as the resulting company are foreign companies – Section 47 (vic);
Provided-
- i) shareholders holding at least 3/4th shares of the demerged foreign company continue to remain shareholders of the resulting foreign company, and;
- ii) such transfer of shares does not attract capital gains tax in the jurisdiction of the foreign demerged company in which it is incorporated.
- Where the shares being transferred, in a scheme of demerger by a foreign company, is drawing its substantial value from shares of an Indian company in a scheme of demerger, wherein both the demerged company as well as the resulting company are foreign companies– Section 47(vicc).
Provided-
(a) 25% or more of the shareholders of the demerged foreign remain shareholders of the resulting company;
(b) The transfer should not attract capital gains in the State where it is incorporated.
Provisions of Section 230 to 232 of the Companies Act, 2013 shall not apply in the case of such demergers.
Furthermore, as per Section 56(2)(x), read with Section 47 the following transfers are also exempt from income tax under the Income Tax Act, 1961:
- Transfer of capital assets by the demerged company to the resulting company, wherein the resulting company is an Indian company.
- Transfer of capital assets, being shares of a foreign company, which draws a substantial value from shares of an Indian company, held by the demerged company to the resulting company, wherein both the demerged and resulting companies are foreign companies;
Provided-
- shareholders holding 3/4th or more shares of the demerged company and it remain shareholders of the resulting company, and;
- such transfer of shares does not attract capital gains tax in the jurisdiction of the foreign demerged company.
WDV of Block of Assets
With respect to the apportionment of Written Down Value (WDV) of block of assets transferred by the demerged company, computed as under:
For Demerged Company: WDV to be reduced by the value of assets transferred;
For Resulting Company: WDV to be recorded as value of assets received and added to the block of assets
Depreciation i.e., amortization of capital assets shall be apportioned between the demerged and resulting companies. This shall be done on the basis of number of days, calculated for the purpose of depreciation.
Carry Forward and Set off of Transferred Unabsorbed Business Losses
Transferred Unabsorbed Business Losses may be carried forward and set off by the resulting company up to the extent of the permissible period that has not yet expired. It is to be done in the same proportion in which the assets had been transferred to the resulting company, in lieu of the demerger. The demerged company can carry forward business losses only to the extent of the assets which it has retained post-demerger.
Expenditure incurred during demerger
Any expenditure incurred by the transacting parties shall be tax deductible in five equal instalments. It shall start from the year of demerger.
Note: A step-up in the value of the assets is not allowed in the book of accounts. Neither it is allowed for the purposes of calculating tax. This means that no change in the value of assets shall be allowed after revaluation of the undertaking(s).
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Indirect Tax Implications
In India, the concept of indirect tax is governed by the Goods and Services Act, 2017. It is a tax that is applicable on supply of Goods or Services or both in the course of furtherance of business. During a demerger there is no transfer of goods or services. GST, i.e., Goods and Services Tax, may not be attracted under a scheme of arrangement. It would amount to transfer of business as a going concern, due to person ceasing to be a taxable person.
However, Section 18 of the CGST Act, 2017, enshrines provisions of Input Tax Credit (ITC). Read along with Rule 41 of the CGST Rules, 2017, the provisions stipulate that in case of change of constitution of a registered taxable person under the Act due to sale, demerger, merger, amalgamation, lease or transfer of any business, then the registered person can transfer its unutilized ITC to the transferor.
In case of demergers, the ITC shall be apportioned in the ratio of the value of assets transferred to the resulting company and assets retained of the undertaking by the demerged company.
Stamp Duty Implications
Levy and collection of stamp duty on Mergers and Acquisitions in India is a subject matter of the states. (By virtue of List II, Entry 63- State List and List III, Entry 44- Concurrent List in Schedule VII of the Constitution.
As per the definition given in the Stamp Duty Act, 1899 and relying on decisions passed by High Courts and Tribunals, the term ‘conveyance’ shall also include within its scope, “a scheme of amalgamation or reconstruction of companies”.
Stamp duty is chargeable on conveyance i.e., transfer of movable or immovable property between two juridical persons. The scheme of arrangement shall be the instrument itself under which the going concern will be transferred. Point to note: assets and liabilities cannot be transferred individually. Rather ‘the scheme of arrangement’ includes only transfer of an undertaking as a whole, against which shares are issued to the shareholders as consideration.
Thus, any scheme of arrangement involving a transfer of property (whether assets or liabilities) shall attract stamp duty under the relevant state Act. Such stamp duty shall be calculated on either the:
- Net value of property transferred or;
- On the consideration of the transaction of demerger (in the absence of a specific entry concerning such transfer).
Conclusion
The Indian landscape with its dynamic economy provides a competitive battleground and stimulates growth and innovation. Various schemes of arrangement such as mergers, acquisitions, demergers, etc. help industries survive and grow in the economy. These arrangements help corporate entities to get a fresh evaluation and identify profit intensive operations and its sick undertakings. However, the formation of a new entity also requires astute decision-making on the part of the investor because it results in financial, tax and business implications for the companies.
With the rise and fall of empires around the world, corporations are looking to strengthen their roots in their economies and expand their operations to new markets. However, despite the challenges, corporate restructuring acts as instruments for business leaders to establish their presence on a global level.
