(This article was originally published on Taxsutra: https://www.taxsutra.com/dt/experts-corner/acquisition-through-demerger-listing)
Background
In an earlier article, various commercial, regulatory, and tax considerations in relation to acquisition of an unlisted company by a listed company, partially through upfront cash consideration on sale of equity shares, followed by merger of such target company into the listed company and issuance of listed equity shares to the sellers were discussed.
This article seeks to discuss various aspects of an acquisition structured as an all-equity deal, whereby, an identified business of a listed company is acquired by an unlisted company (unrelated to the listed company) through a demerger in lieu of which the acquirer unlisted company issues equity shares to the shareholders of the listed company, and in turn, in the process of such acquisition through demerger, such acquirer unlisted company becomes listed.
Key Mechanics
In the context of the above background, pursuant to a Scheme of Arrangement u/s 230-232 of the Companies Act, 2013 (“Scheme”), an identified business of a listed company would be demerged from the said listed company, and would then be transferred to and vest upon the unlisted company. As consideration for such demerger, the unlisted company would issue equity shares to the shareholders of the listed company, which would constitute both promoters and public shareholders of the listed company.
Given that this would be a demerger from a listed company to an unlisted company, the unlisted company would become automatically listed, without an IPO, and subject to certain conditions laid down in the SEBI Master Circular on Schemes of Arrangement dated 23 November 2021 (“SEBI Circular”). In terms of approvals, this Scheme would require approval of the boards of both companies, audit committee and independent directors’ approval of the listed company, SEBI/ stock exchange approval, NCLT approval, shareholders/ creditors approval, and the approval of Regional Director, and other regulatory authorities.
Key Commercial Considerations
In the above-mentioned structure, there are two key commercial considerations from the perspective of the unlisted company, and the listed company, captured as under:
1. From the perspective of the listed company, if the division sought to be demerged is not core to the listed company, or say, the said risk-reward profile of the said division does not fit into the overall strategic vision of the management of the listed company, or say, the unlisted company genuinely ascribes attractive valuation for acquisition of the said division, then the listed company may consider divestment of the identified division through a demerger.
The shareholders of the listed company would, in turn, enjoy any equity upside once the unlisted company becomes listed. On the flip side, given the enormous gap of around 10-11 months from the date of definitive documents being entered into till the listing of the unlisted company, or if the price discovery of the unlisted company, post listing, is tepid due to market factors, then the shareholders of the listed company may not benefit from such demerger.
2. From the perspective of the unlisted company, subject to compliance with the conditions of the SEBI Circular, such acquisition through demerger from the unlisted company results in automatic listing of the unlisted company, without going through the rigours of an IPO process. Consequently, the consolidated value of unlisted company comprising of its existing business and the newly acquired business can be discovered upon listing of such unlisted company.
Further, if there are any institutional investors in the said unlisted company, this demerger would also provide such investors an exit route post listing, subject to certain lock in conditions.
Key SEBI Considerations
Before delving into the tax and other considerations, the following deals with the key conditions laid down under the SEBI Circular with respect to a demerger, especially a demerger which involves listing of an unlisted company pursuant a demerger:
1. Majority of Minority Approval: One key condition is that the approval of public shareholders of a listed company would be required, if the equity holding of such public shareholders is diluted by more than 5% in the combined entity (i.e., the unlisted company), post demerger. Such demerger would be considered as approved only if majority of the votes cast by the public shareholders of the listed company are in favour of the demerger.
2. Post Scheme Shareholding: The Qualified Institutional Buyers (i.e., QIBs, such as FPIs, NBFCs, etc.) of the unlisted company and the public shareholders of the listed company should constitute at least 25% of the total equity base post demerger on a fully diluted basis. Therefore, if the valuation of unlisted company is significantly higher than the valuation of the identified business being demerged, and if the unlisted company does not have significant QIBs, then this condition may be difficult to be satisfied.
3. Public Shareholding Post Demerger: In addition to the above, since the unlisted company is getting listed, the public shareholders of the listed company should hold at least 25% of the post scheme capital of the combined entity.
This is reduced to 10% if the valuation of the combined entity is at least INR 1600 Cr, out of which public shareholders hold shares equivalent to INR 400 Cr, and subject to the said 10% being brought back to 25% within 1 year.
4. Lock in Conditions: 20% of the entire paid-up capital of the unlisted company (prior to the demerger) would be locked in for a period of 3 years, and the balance would be locked in for a period of 1 year. There would not be any lock in for new shares issued to the shareholders of the listed company as consideration for the demerger.
5. Promoter Declassification: If the promoters of the listed company are not envisaged to manage or control or participate in the administration of the unlisted company, then it is possible for the Scheme to provide that such promoters of the listed company would be declassified as promoters and be re-classified as public shareholders of the combined entity post listing.
However, irrespective of such promoter being treated as public shareholders, the above-mentioned conditions in point 2 and 3 will have to be satisfied independently.
Key Tax Considerations
Having dealt with the regulatory parameters, it would be imperative to understand the tax implications in the hands of the listed company, as the transferor/ demerged company, the unlisted company, as the transferee/ resulting company, and shareholders of the listed company.
1. From the perspective of the listed company, as the transferor, if the identified undertaking constitutes a business, and not merely a group of assets or liabilities constituting a business, and if such undertaking/ business is transferred on a going concern basis (i.e., the unlisted entity would continue to operate such business post demerger), then the transaction should be considered as tax neutral from the perspective of the listed company.
2. Similarly, from the perspective of the unlisted company, as the transferee company, the demerger (i.e., receipt of the undertaking with all its assets and liabilities) should be considered as tax neutral.
If there are any tax losses or unabsorbed depreciation attributable to the demerged undertaking, such losses would also be vested with the unlisted company for the remainder of the 8 years (in case of business losses), even if the transferred undertaking does not constitute an “industrial undertaking” (which includes manufacturing business, amongst others) as is required to be satisfied in case of merger.
3. From the perspective of the shareholders of the listed company, while the receipt of new shares should not be taxable, there are certain issues in relation to the cost and manner of acquisition of such new shares issued pursuant to demerger.
a. Firstly, the cost of acquisition will be split basis the net book value of the assets transferred as a proportion to the net worth of the demerged company. A question arises in case as to what would be the split cost of acquisition if the net book value of assets transferred is negative.
In such a scenario, the cost of acquisition of shares of the unlisted company issued may be considered as NIL. Conversely, if the net worth of the demerged company, is negative, then the cost of acquisition of the demerged company may be considered as NIL.
b. Secondly, if the shares of the listed company were acquired prior to 31 January 2018, then the total deemed cost in the hands of the shareholders would be the current market price prevailing on 31 January 2018 (assuming that the original cost was lower than the current market price on 31 January 2018).
However, since the new shares issued by the unlisted company were not “acquired” prior to 31 January 2018, would the split of cost of acquisition be basis the said grandfathered cost? Logically, it should be, since the cost of acquisition and the period of holding relates back to the cost and date of the original acquisition. An express clarification in this regard is warranted.
c. Lastly, from the perspective of investors from Mauritius, Cyprus, or Singapore, the relevant DTAAs only provide for grandfathering of capital gains, if the shares were acquired prior to 1 April 2017.
Therefore, even if the original shares may have been acquired prior to 1 April 2017, since, technically, the new shares would be issued post 1 April 2017, it may not be considered as having been “acquired” prior to 1 April 2017.
Again, an express clarification since the period of holding relates back to the original date of acquisition, the date of acquisition of new shares should also relate back to the date of original acquisition under the relevant DTAAs is warranted.
Key IndAS Aspects
From an IndAS perspective, the said demerger should be accounted under the acquisition method of accounting in the books of the unlisted company, whereby the assets (including previously unrecognized intangibles (say, brand, customer lists, etc., and which may or may not be subject to amortization depending on whether their determinable useful life) and liabilities of the identified undertaking, would be recorded at fair values, the consideration issue would be recorded at fair value, and the difference would be recorded as residual goodwill.
From a tax perspective, such specifically recognised intangibles may be subject to amortisation, whereas the residual goodwill will not be.
From the perspective of the listed company, since this would not be a common control transaction, such demerger would be recorded as “deemed dividend distribution” by the listed company to its shareholders, in relation to the new shares issued.
Irrespective of the accounting being treated as deemed dividend distribution, it should not impact the tax neutrality of the demerger.
Summing Up
As can be seen from the above, while a demerger of an undertaking of a listed company to an unlisted company may appear to be straight forward, depending on the exact facts, such a demerger would warrant a detailed analysis of various tax, accounting, and regulatory aspects, including valuation aspects tied to the said regulations. Further, fiscal costs such as stamp duty, which is dependent on the stamp duty laws of the state, could have major ramifications on the intended deal. Lastly, approvals from sector specific authorities could further complicate the deal, and may impact the overall timelines.