(Originally Published on Taxsutra: https://www.taxsutra.com/dt/experts-corner/understanding-disjointed-demerger-tax-accounting-and-regulatory-perspective)
Typically, in a deal scenario, the acquirer would want to acquire the acquired business to be housed where the main business of the acquirer is housed. However, in certain peculiar cases, the acquirer may want to house the acquired business in a separate entity other than the main entity of the acquirer; at the same time, however, the acquirer may want value consolidation on account of the new business so acquired with the main entity, and therefore, may intend to acquire it in a wholly owned subsidiary of the main entity.
Few illustrations where the acquirer may want to acquirer a new business in say, a wholly owned subsidiary of the main entity are cases, where the new business is not entirely related to the acquirer’s main business, or where the economic or synergistic benefits of the acquirer may accrue in a period subsequent to the acquisition, or where the acquired business may need to be housed separately for regulatory reasons (typically, in case of regulated sectors such as infrastructure, financial services, etc.), or where the acquired business could be subject to a joint venture in the foreseeable future.
Notwithstanding the acquirer’s objectives, if the deal does not envisage discharge of consideration in the form of cash and it envisages an all-stock deal as consideration for the acquisition, then the seller may insist on receipt of shares of the acquirer’s main entity, especially if the acquirer’s main entity is a listed company. For the seller, receipt of shares of a listed company, even though the business is acquired by a wholly owned subsidiary of the said listed company, may be warranted to ensure liquidity to the seller.
In the context of the above, this article seeks to explore various tax, regulatory and accounting implications of a Disjointed Demerger.
Contemplated Steps in relation to the acquisition envisaged above:
For ease of understanding, the following diagram captures the intended acquisition/ divestment structure:
Steps in relation to the above:
1. The Seller Company would demerge (under a Scheme of Arrangement u/s 230-232 of the Companies Act, 2013) its business to a Wholly Owned Subsidiary (“WOS”) of a Listed Company; and
2. As consideration, the Listed Company (and not its WOS) would issue its shares to the shareholders of the Seller Company.
Whether such demerger tax neutral under the Income-tax Act, 1961 (“ITA”)?
In a plain vanilla demerger, the seller company would demerge its business to the acquirer entity (Listed Company, in the above case) and thereafter, as consideration, the Listed Company would issue its shares (either in the form of equity shares or preference shares or a combination of both) to the shareholders of the seller company.
The above, mentioned demerger should fall within the definition of a “demerger” u/s 2(19AA) of the ITA and therefore, subject to certain other conditionalities such as what is being demerged should constitute an “undertaking” or a business, shareholders of the seller company (i.e. the demerged company) should be issued shares in proportion to their shareholding and that 3/4th in value of shareholders of the demerged company should become shareholders in the acquirer company (i.e. the Resulting Company), such a demerger should be considered as tax neutral. Consequently, there should not be any capital gains tax implications in the hands of the demerged company or its shareholders[1] or the deemed recipient tax in the hands of the resulting company[2].
However, in case of the demerger presently being envisaged, one key question is – when the demerger of an undertaking is to a WOS of the Listed Company, while the shares are being issued by the Listed Company (and not the WOS), whether such a demerger would be considered as a “demerger” as defined u/s 2(19AA) of the ITA and therefore, be tax neutral?
In relation to the above, the relevant conditionalities of a tax neutral demerger are that the undertaking should have been demerged to a “resulting company” and the “resulting company” should have issued shares to the shareholders of the demerged company. Therefore, the definition of a resulting company is critical. Section 2(41A) of the ITA defines a resulting company, inter alia, to include a company and its wholly owned subsidiaries, to which the undertaking of the demerged company is transferred on demerger, and as consideration, the Resulting Company issues shares to the shareholders of the demerged company.
On a conjoint reading of the above, it becomes apparent that the resulting company is not only the company to which the undertaking of the demerged company is demerged, but also its 100% holding company which may issue shares to the shareholders of the demerged company, since the definition of the resulting company includes a company and its wholly owned subsidiaries.
In the light of the above, given that while the WOS would be vested with the Undertaking, and the Listed Company would be issuing shares, since the Listed Company would be a 100% holding company of the WOS, both the Listed Company and its WOS should be considered as resulting companies and therefore, the said demerger should fall within the definition of “demerger” u/s 2(19AA) of the ITA. Consequently, the said demerger should be considered as tax neutral for the demerged company, its shareholders and the resulting companies.
One key tax consequence, especially in the current times, would be whether it would be the WOS or the Listed Company which would be eligible to carry forward the tax losses and unabsorbed depreciation (if any) of the demerged undertaking. Logically, since the undertaking is being vested with the WOS and not the listed company, it should be the WOS (and not the Listed Company) which should be eligible for carry forward of tax losses/ unabsorbed depreciation of the demerged undertaking u/s 72A(4) of the ITA.
Lastly, given that the Listed Company has, effectively, issued shares on behalf of its WOS (and its would be recorded as “deemed equity contribution” in the books of WOS – see accounting implications below), one could rationally argue that the WOS has, in substance, discharged the purchase consideration against acquisition of net assets of the demerged undertaking, and therefore, goodwill, if any, arising as a result of this acquisition, should be eligible for depreciation u/s 32 of the ITA basis the decision of the Supreme Court in the case of Smifs Securities Ltd.[3][4]
Accounting Implications
1. Accounting upon demerger in the books of Demerged Company
a. If IndAS is applicable to the Demerged Company, then the only standard prescribing for accounting in the books of the Demerged Company upon demerger is Appendix A to IndAS 10.
b. This standard 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.
c. However, in cases where IndAS is not applicable to the Demerged Company, then, under IGAAP, it may be provided that the book value of assets and liabilities would be reduced in the books of demerged company and would be adjusted against the existing reserves (such as capital reserves, securities premium, general reserves, balance in profit or loss account, etc.) of the demerged company, or it could also be provided that the net debit on account of demerger of asset and liabilities could be recorded as a Restructuring Reserve (albeit with a debit balance) in the books of the demerged company.
2. Accounting upon demerger in the books of the Wholly Owned Subsidiary i.e. the Resulting Company upon which the undertaking is vested
a. One of the basic tenets of Ind-AS 103 is “acquisition accounting” in case of an acquisition of business or entity from an unrelated seller (who is not ultimately controlled by the same persons controlling the acquirer) (“Third-party Acquisitions”). This method of accounting is basically a fair value accounting in case of a Third-party Acquisition which is undertaken either by way of whether by way of a merger or demerger.
b. Therefore, in case of a demerger between two unrelated parties, the acquirer would record (as is the present case) assets/ liabilities at their respective “fair values” in its books.
c. However, since the WOS of the Listed Company would not issue any shares, the question is that where would be consequent credit entry be recorded in the books of the WOS? Such credit could be recorded as a deemed equity contribution by the holding company (i.e. the Listed Company) to the WOS at the fair value of shares issued by the Listed Company to the shareholders of the demerged company.
d. The difference, if any, between the fair value of the net assets recorded and the fair value of deemed equity contribution would be recorded as goodwill, or capital reserve, as the case may be.
3. Accounting upon demerger in the books of the Listed Company i.e. the Resulting Company which issues shares
a. In the books of the Listed Company, while the shares being issued to the shareholders of the listed company could be recorded at fair values (split into face value and securities premium), the key question is what would the corresponding debit entry be recorded as?
b. Since the Listed Company would, effectively, effectively discharge the onus of issuing shares as consideration on behalf of its WOS, such debit entry would be recorded as an additional investment in WOS in the books of the Listed Company.
Approvals
This demerger, undertaken through a Scheme of Arrangement u/s 230-232 of the Companies Act, 2013, would require obviously the consent of the NCLT (and other authorities such as stock exchanges and SEBI, Regional Director, Registrar of Companies, Official Liquidator, etc.).
Further, if the NCLT so directs, this would also require consent of the shareholders and creditors who are present and voting (including e-voting) at the NCLT-convened meeting representing majority in number and 3/4th in value; moreover, at such NCLT-convened meeting all the shareholders, either promoters or public shareholders would be able to vote. Furthermore, since this would be a scheme of arrangement with an unrelated party (where no entity of the promoter group would be involved), no separate approval of the public shareholders under the SEBI Circular[5] should be required.
FEMA Implications
Typically, no RBI/ government approval is required[6] for any scheme of merger/ demerger in relation to the shares issued to the non-resident shareholders, if the scheme is approved by the NCLT, if the business being demerged is under automatic sector and the transferee company issues shares to the shareholders of the demerged company.
Therefore, one question that may arise is where the “transferee company” is different from the company which issues the shares, whether any RBI/ government approval would be required? Under FEMA, the term “transferee company” is not defined and therefore, as per the literal interpretation, the transferee company would be the company to which the undertaking is vested upon (i.e. WOS of the Listed Company, in the present case).
However, on a substantive interpretation, where the transferee company are treated as both the Listed Company and its WOS, just as in case of the Income-tax Act, 1961, one may interpret that the shares being issued by the Listed Company, are also shares which are being issued by the transferee company and therefore, no RBI/ government approval should be required. In this regard, a government/ RBI clarification to this effect, to align FEMA with the tax laws, would be welcome.
Summing up
There are various dimensions to this scheme; however, the key interesting dimension is that aspect of tax neutrality, especially since the “resulting company” being vested with the undertaking is different than the “resulting company” issuing the shares; yet, at the same time, for tax purposes, both the companies (i.e. the Listed Company and its WOS) are treated as “resulting companies” for the purposes of determining whether the demerger is as per the definition provided u/s 2(19AA) of the ITA.
Further, accounting for business combinations itself has varied aspects and therefore, one needs to be cognizant of how the balance sheet would look ultimately upon demerger since there are various deeming fictions which come into play where there is a “disjointed demerger”.
This is a good example of interconnect between commercial imperatives, tax, accounting and regulatory aspects.
[1] Under section 47(vib) and section 47(vid)
[2] Under section 56(2)(x)
[3] [2012] (SC) CIT v. Smifs Securities Ltd. / [TS-639-SC-2012-O]
[4] [TS-546-ITAT-2020(Ahd)] (Ahd) Urmin Marketing P. Ltd. v. DCIT
[5] Para I(A)(9) of the SEBI Circular dated 10 March 2017
[6] Regulation 19 of FEM (Non-Debt Instrument) Rules, 2019