(First published on Linkedin)
Demerger has multiple nuances before it can be considered as a “tax neutral demerger”:
1. Undertaking v/s Shares: For a demerger to be tax neutral, what is demerged should be an undertaking i.e., a business activity, rather than a mesh of individual assets. This poses risk if what is sought to be demerged are shares of a subsidiary; while doing business through a subsidiary may be required due to commercial or regulatory reasons, lack of clarity on whether such strategic investments qualify as a business undertaking poses significant risk vis-à-vis a tax neutral demerger.
2. Liabilities Must Follow: The definition requires both assets and liabilities to be demerged – only transferring assets may not quality as an “Undertaking”. Attributable liabilities, direct and proportionate, should also be demerged, as held by various cases previously.
3. Proportionate Share Issuance: Shares should be issued proportionately to shareholders of the demerged company. While any type (equity/preference) is permitted, mixed issuance must be proportionate based on fair market value.
4. Substance in Residual Entity: Demerger of the entire business must leave behind sizeable assets or operations. Otherwise, it may be construed as a disguised merger and carry forward losses u/s 72A may be questioned.
5. Going Concern Caveat: Extending the above, the undertaking must continue post-demerger; if it is divested soon after, tax neutrality may be questioned, especially in a case where losses are sought to be carried forward.
6. Resulting Company Flexibility: Shares can be issued by a 100% holding company, even if the undertaking is transferred to a subsidiary. This becomes relevant for structures involving share issuance by listed companies, or by foreign holding companies, where the undertaking is transferred to their subsidiaries.
7. No Valuation in Mirror Demergers: In mirror-image demergers (full or partial), since the overall value does not change, valuation becomes irrelevant; hence, capital structuring and public float decisions (for listed companies) gain importance.
8. Family Arrangements: Similarly, in demergers involving family settlements, valuation often takes a backseat versus the family consensus.
9. Part Undertakings: Even part of a business, if independently viable, may be treated as a business undertaking.
10. Intangibles Recognition: For non-common control demergers under IndAS, intangibles can be recorded and amortized under Section 32 (except goodwill).
11. Employees should Move: An undertaking without people may not be considered as a business. Hence, transferring key employees is important to establish the existence of an operational business.
12. IT Bill, 2025 – Fast Track Excluded?: The draft Bill refers only to sections 230-232 of the Companies Act. Exclusion of fast-track demergers under section 233 could cast doubt on the tax neutrality.