Recently, an interesting scheme of arrangement has been filed by Wholly Owned Subsidiary (‘WOS’), Holding Company, and Resulting Company which deals with the amalgamation of WOS, a 100% subsidiary of Holding Company, into Holding Company itself and a demerger of the renewable energy business of Holding Company into Resulting Company. Ultimately, upon demerger, Resulting Company is intended to be a parallel company with a mirror image shareholding as that of Holding Company; thereafter, Resulting Company would be listed on the stock exchanges without going through the stringent process of an IPO.
Certain details of the scheme
The scheme has 6 parts. The two operative parts are Part II which deals with the amalgamation of WOS into Holding Company, and Part III which deals with the transfer and vesting of the demerged undertaking (i.e. the Renewable Energy Business, which, inter alia, includes business of generation and sale of wind energy and providing services or Erection, Procurement and Commissioning (EPC) of wind farms) from Holding Company to Resulting Company.
The “Appointed date” in relation to Part II (Merger) has been defined as 1st April 2020 and appointed date in relation to Part III (Demerger) has been defined as 1st July 2020.
The scheme provides for a sequence that Part II relating to the merger shall be deemed to have taken effect prior to Part III of the scheme, and then only, Part III shall be deemed to have taken effect. The reason appears to the that the business which is going into Holding Company from WOS is the same business which is getting dropped down into the subsidiary. However, given that there are two appointed dates (i.e. 1 April 2020 for the merger of WOS into Holding Company and 1 July 2020 for the demerger of the Renewable Energy Business, the demerger would, presumably, include the Renewable Energy business which would be vested with Holding Company upon merger of WOS with itself with retrospective effect from 1 April 2020 and would also include the business deemed to be carried out by Holding Company from 1 April 2020 to 30 June 2020.A direct merger of the two subsidiaries would not have achieved the listing which seems to be desired as a part of unlocking value. Given that the residual Holding Company would continue to be a mere holding company for strategic investments in various companies (since it had demerged its chemicals business in the prior year), it could be considered as a Core Investment Company under the RBI NBFC Regulations.
In so far as the accounting treatment is concerned, the first one is a common control transaction and therefore, would be accounted for accordingly as per the Pooling of Interests method prescribed under Appendix C to IndAS 103. In relation to the second one, also it is a common control transaction and would be accounted accordingly.
Lastly, it is interesting to note that the Scheme also provides for consolidation of authorised share capital upon merger (which is typical in all merger schemes); however, the Scheme further provides for split of the consolidated authorised share capital between the demerged company (i.e. Holding Company) and the resulting company (i.e. Resulting Company) upon demerger.
Approvals
The Scheme would require obviously the consent of the NCLT (and other authorities such as stock exchanges and SEBI, Regional Direction, Registrar of Companies, Official Liquidator, etc.), but it is also provided that the Scheme would need to be approved by the public shareholders of Holding Company under Para I(A)(9) of the SEBI Circular dated 10 March 2017. As per the said para,, a scheme is required to be approved by majority vote of public shareholders who are voting (through e-voting) in certain limited circumstances such as issuance of additional shares to the promoters, scheme involving companies which were previously acquired from the promoters, etc. However, typically, since a merger of a wholly owned subsidiary with its 100% holding company and thereafter, demerger resulting in a mirror image demerger does not impact the interest of the public shareholders, such a scheme should not require approval of the public shareholders. Therefore, it is peculiar that the scheme provides for an approval of the public shareholders, which, presumably, could be as a result of shares of WOS (either in part of in full) being acquired by Holding Company previously.
Tax issues
The scheme has been stated to be tax neutral in so far as merger is concerned, vis-à-vis Section 2(1B) and in accordance with Section 2(19AA) of the Income-tax Act, 1961 (“ITA”). The operating conditions of the two relevant sections are broadly as follows:
In so far as amalgamation is concerned, all the properties and liabilities of the amalgamated company would become properties and liabilities of the amalgamated company. Also, shareholders holding not less than 3/4th in value of the shares in the amalgamating company become shareholders of the amalgamated company; there is a carve out in this section for a holding company which obviously cannot satisfy this condition because the shares would be cancelled.
In relation to demerger u/s 2(19AA) there are various conditions, including that the property and liabilities being transferred by the demerged company become the property and liabilities of the resulting company and that they are transferred at book value (except where required otherwise under IAS). Additionally, the resulting company should issue, in consideration of the demerger, shares to the shareholders of the demerged company on a proportionate basis and that the shareholders holding not less than 3/4th value of the shares of the demerged company become shareholders of the resulting company by virtue of the demerger.
In so far as the merger of WOS into Holding Company is concerned, the condition seems clearly satisfied. Of course, the merger is “momentary”, in the sense that the there is a demerger after 3 months from the appointed date of the merger, where the scheme provides that the conditions would be satisfied. The drop down of the former WOS undertaking into Resulting Company would result in shares being issued to the shareholders of Holding Company, in the same proportion as that of Holding Company, which is intended to satisfy the condition of the shareholders holding not less than 3/4th in value of the shares in the demerged company becoming shareholders of the resulting company.
One of the issues that arises is relating to the grandfathering of cost for shares acquired by shareholding (including promoters) on or before 31st January 2018. Whilst section 55(2)(ac) of the ITA talks of shares acquired on or before 31st January 2018 and does not expressly deal with merger or demerger, it is logical that the grandfathering should apply to the new shares also, because they are nothing but a split up of the shares of Holding Company.
Given that the resulting company would not have been technically listed on 31st January 2018, the issue will be how is the grandfathered value of the resulting company to be computed, and one would think that it would be a split in the same proportion as that being adopted for the purpose of working out the cost of a resultant company in normal situations also; in relation to a demerger, this is provided in Section 49(2C) i.e. the cost of shares in the resulting company shall be in the same proportion as the net book value of the demerged assets to total net-worth. In any case, it is important for CBDT to come up with a Circular on this aspect; yet various representations have been made, but unfortunately, such a circular has not been issued.
The other rationale to first merge WOS into Holding Company and thereafter, demerge the Renewable Energy Business from Holding Company into Resulting Company is the concept of “undertaking” u/s 2(19AA). In order for a demerger to be tax neutral, one of the conditions is that what should be demerged is an “undertaking” which is a set of assets and liabilities constituting a business activity. A demerger of pure investments in WOS by Holding Company to Resulting Company may not be considered as an “undertaking” (further, it would also mean that Resulting Company would become a pure holding company, listed on stock exchanges, without any operations and therefore, may not unlock value for shareholders). Incidentally, from a business perspective, it should not matter if a company carries on business through itself or through its investee companies and therefore, the definition of “undertaking” should be enlarged to include business carried on by a company through its investee companies as well, in addition to business carried on directly; several representations have been made to the CBDT and one wishes that a clarification is issued by CBDT in the interest of avoiding confusion.
1. Accounting for the merger and the demergerAccounting upon demerger in the books of Holding Company i.e. the Demerged Company
The only standard prescribing for accounting in the books of the Demerged Company upon demerger is Appendix A to IndAS 10, which, basically, deems the demerger as a non-cash distribution of assets of the company to its shareholders and therefore, records the demerger as a “dividend distribution” in its books, whereby the assets and liabilities so demerged are recorded as a debit to the statement of profit and loss after restating the said assets and liabilities at fair values.
However, this standard does not apply to demergers which are under common control. Therefore, typically, schemes prescribe a particular method of accounting in detail. In the present case, it is provided that the book value of assets and liabilities would be reduced in the books of Holding Company. Further, the reserves, except Capital Redemption Reserve, would be transferred in proportion of the net assets transferred to Resulting Company and the net assets retained in the books of Holding Company. Lastly, the Scheme provides that the difference shall be adjusted against the general reserve/ retained earnings and excess, if any, shall be adjusted to the Business Combination Adjustment Reserve Account.
2. Accounting upon demerger in the books of Resulting Company i.e. the Resulting Company
Given that this is a common control business combination, the Resulting Company would record all the assets, liabilities and reserves at existing carrying amounts, record share capital issued at nominal value and ultimately, record the difference between the share capital issued and assets, liabilities and reserves taken over as capital reserve.
Summing up
There are various dimensions to this scheme. Firstly, the concept of a merger and a demerger, but with two different appointed dates. Obviously, a very important dimension is that of the intended automatic listing of the resulting company which seems to have been the key driver of the scheme. Thirdly, the tax issues articulated above are interesting and of course, the need for a CBDT circular to make matters completely beyond doubt. Fourthly, accounting for business combinations itself has varied aspects and therefore, one needs to be cognizant of how the balance sheet would look ultimately upon merger/ demerger. This is a good example of interconnect between commercial imperatives, regulations, tax and accounting aspects.