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Subject : Business Reorganisation
Month-Year : May 2000
Author/s : Nitesh Kr. More
Jai Narayan Gupta

Chartered Accountants
Topic : Demerger
Article Details :

Why has Govt. introduced the concept of 'Demerger' ?
In 1991, the then Finance Minister started the liberalisation of economy which has been carried on by successive Finance Ministers. One of the things he had introduced was to allow foreign investors to bring their capital in India and invest it in different areas. Now, Govern-ment of India has brought out the concept of demerger to tax to neutralise demerger, if it takes place by fulfilling the prescribed conditions. Perhaps, the govt. has been pressed by these investors to bring out such thing so that the Indian partner may get demerged from his foreign partner and the foreign partner may take back his investment. I personally feel that it is the main reason for the introduction of the concept of demerger. In other words, it is the main cause for tax neutra-lisation of demerger.

Demerger — Definition :
When one company, say X Ltd. having 10 undertakings, transfers one or more of its undertakings to a new company, say Y Ltd., it is a case of demerger. X Ltd. is the demerged company and Y Ltd. is the resulting company.

Reasons for demerger :
It is difficult to list out the reasons which give effect to demerger because reasons may differ from time to time, company to company, country to country and even industry to industry within the country. However, researchers have specified some reasons for demerger as noted below :

(1) Corporate attempt to adjust to changing economic and political environment of the country;
(2) Strategy to enable others to exploit opportunity effectively to optimise returns when the parent company is unable to do so;
(3) To correct the previous investment decisions where the company moved into the operational field having no expertise or experience to run the show on a profitable basis;
(4) To help finance an acquisition;
(5) To realise capital gains from the assets acquired at the time when they were under performing and now no better performance, capital gain can be realised;
(6) To make financial and managerial resources available for developing other more profitable opportunities;
(7) Selling unwanted and surplus or unconnected parts in the business as a restructuring strategy to get rid of sick part of the company.

The above list of reasons for sell out is not exhaustive or conclu-sive as more reasons could be added depending upon the numerous influences emanating from political, economic, social and international backgrounds. One thing remains crystal clear that the objective underlying divestitures or sell offs in the corporate world is to ensure resource mobility essential to effective operations of an enterprise and moving these resources from less-valued uses to higher-valued uses.

Effect of demerger :
(i) Tax neutrality of the assets transferred to resulting company.
(ii) To extend the benefit of carry forward of loss or depreciation relating to transferred undertaking to resulting company.
(iii) To extend the benefits like S. 80IA, S. 80IB, etc. to the split off unit.
(iv) To allow the expenditure incurred for demerger.
(v) Tax neutrality of the demerger for the shareholders of demerged company.

Applicability :
(i) Companies incorporated under the Companies Act, 1956
(ii) Any authority or a body constituted or established under a Central, State or Provincial Act
(iii) A local authority
(iv) A public sector company
(v) A foreign company
(vi) Any institution, association or body assessed as company or declared by the CBDT as a company.

Conditions of demerger (S. 19AA) :
Conditions :

(i) The transfer is pursuant to a scheme of arrangement u/s.391 to u/s.394 of the Companies Act, 1956.
(ii) Transfer of all the assets/ liabilities of one or more undertakings by a demerged company to any resulting company at book value on going concern basis, otherwise than by way of acquisition.
(iii) The resulting company issues shares to the shareholders of demerged com-pany on proportionate basis.
(iv) Shareholders holding at least 75% of the share capital become shareholders of resulting company.
(v) In accordance with the conditions notified u/s.72A(5) by the Central govt.
(vi) Transfer should be with reference to transfer of a business activity and not any individual assets or liabilities or any combination thereof.
(vii) Apart from specific liabilities relating to a business, general liabilities are to be apportioned in the ratio of assets relating to each business.
(viii) Revaluation of assets will be ignored.
(ix) Reconstruction of any body, authority.
(x) In case the conditions are discontinued to be complied with, the set off of loss or depreciation made in any earlier years in the hands of the amalgamated company shall be deemed to be the income of the amalgamated company taxable for the year in which there is non-compliance.
(xi) In case of demerger, accumulated loss and unabsorbed depreciation of demerged company shall be allowed to be carried forward and set off in the hands of the resulting company to the extent of :
(a) if such loss/depreciation is directly relatable to transferred undertaking — 100%
(b) if such loss/depreciation is not directly relatable to transferred undertaking, that proportion which the assets of the undertaking transferred bear to the total assets of the demerged company
(xii) Where a firm or proprietary concern is succeeded by a company fulfilling the conditions of S. 47(xiii) or S. 47(xiv), the unabsorbed loss/depreciation shall be deemed to be the loss/ depreciation of the successor company for the year in which reorganisation is effected. In case any of the conditions are not continued to be fulfilled in any of the years after such reorganisation, the set off of loss or depreciation shall be in case of the year in which conditions are discontinued to be fulfilled.
(xiii) Accumulated loss relates to the head 'Profits or gains of business or profession (other than speculation business)' only.

Definition of demerged company (S. 19AAA) :
Demerged company means a company whose undertaking is transferred pursuant to a de-merger to a resulting company.

Definition of resulting company (S. 2[41A]) :
Resulting company means one or more companies to which the undertaking of the demerged company is transferred in consi-deration of issue of its shares to the shareholders of the demerged company.

Taxation of shareholders in demerged company :
(i) Dividend : S. 2(22) has been amended by inserting a new clause (v) to provide that no dividend income shall arise in the hands of shareholders of demerged company on demerger.
(ii) Capital gains : A new clause (vid) in S. 47 has been inserted to provide that no capital gains shall arise to shareholders of the demerged company on account of receipt of any shares from the resulting company.

Tax benefits to resulting company :
(i) Expenses incurred for the purpose of amalgamation or demerger shall be allowed @20% every year from the year in which the demerger takes place.
(ii) Depreciation shall be apportioned between the demerged company and the resulting company in the ratio of number of days for which the assets were used by them.
(iii) The accumulated losses and unabsorbed depreciation in a demerger shall be allowed to be carried forward by the resulting company.
(iv) Benefits available for demerger are also extended to authorities or boards set up by Central or State Govt.

Note : There is no lock in period for demergers like in case of amalgamation.

Comments :
Sub clause (iv) in S. 2(19AA) provides that the consideration should consist only of shares in the resulting company and composite consideration in the form of shares and cash or shares and debentures, etc. are not covered for availing of the exemption.

Courts' view :
(a) Gujarat High Court, in CIT v. Gautam Sarabhani Trust, (1988) 173 ITR 216 held that exemption u/s.47 will not be available if there is composite consideration.
(b) Madras High Court, in CIT v. MCTM Corporation Pvt. Ltd., (1996) 221 ITR 524 held that exemption u/s.47 shall be available even if composite consideration is given.

Suggestion :
(i) It is suggested that suitable amendments may be made to ensure that even if the resulting company issues composite consideration it would come within the scope of the definition of demerger. The difficulties arising in the case of odd lots should also be taken care of.
(ii) Further, it is suggested that the consideration received in the form of cash may be required to be invested in approved securities with a suitable lock in period.

Transaction not to be regarded as transfer
(S. 47 [vib], [vic], [vid]) :

Conditions :
(i) Resulting company is an Indian company.
(ii) Transfer of shares in an Indian company held by the demerged foreign company to resulting foreign company if
— 75% of the shareholders of demerged foreign company continue to remain shareholders of the resulting foreign company.
— Capital gains tax is not attracted on the demerged foreign company in the country of its incorporation and S. 391 to S. 394 of the Companies Act will not be applicable.
(iii) transfer or issue of shares by the resulting company to the shareholders of the demerged company.

Amortisation of expenditure in case of amalgamation or demerger (S. 35DD) :
Expenses by an Indian company incurred after 1-4-1999 for amal-gamation or demerger of an undertaking, shall be amortised @20% each year starting from the year in which amalgamation or demerger takes place.

Cost of shares acquired in the scheme of demerger (S. 49) :
(i) Cost of acquisition of shares in the resulting company shall be the proportion of the cost in the demerged company in the assets transferred bears to the net worth of the demerged company. (S. 49[2C]).
(ii) The cost of acquisition of shares in the demerged company shall be reduced by the proportion being the ratio which the net book value of the assets transferred bears to the net worth of the demerged company. (S. 49[2D]).


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