DEMERGER

 It is a business strategy in which a single business is broken into components, either to

operate on their own, to be sold or to be dissolved.

 A demerger allows a large company, such as a conglomerate, to split off its various
brands to invite or prevent an acquisition.

 To raise capital by selling off components that are no longer part of the business's
core product line, or

 To create separate legal entities to handle different operations.

 Demerger is an arrangement whereby some part/undertaking of one company is

transferred to another company which operates completely separate from the original
company.

 Shareholders of the original company are usually given an equivalent stake of

ownership in the new company.

 Demerger under Section 2(19AA) of the Income tax Act, 1961.

 Reliance Industries demerged to Reliance Industries and Reliance Communications

Ventures Ltd. Reliance Energy Ventures Ltd, Reliance Capital Ventures Ltd, Reliance
Natural Resources Ltd.

The Rationale of Successful Demerger is that: Sum of the separate entities is greater than the
combined entity.

• 1. Improve Valuation

• 2. Focus on Core Business

• 3. Attract Investors

• 4. Family Settlement

• 5. business interest and to curb losses

• 6. the desire to perform better and strengthen efficiency

• 7. wastage and competition.

It is a business strategy in which a single business is broken into components, either to
operate on their own, to be sold or to be dissolved. A demerger allows a large company, such
as a conglomerate, to split off its various brands to invite or prevent an acquisition, to raise
capital by selling off components that are no longer part of the business's core product line, or
to create separate legal entities to handle different operations.

Demerger is an arrangement whereby some part / undertaking of one company is transferred

to another company which operates completely separate from the original company.
Shareholders of the original company are usually given an equivalent stake of ownership in
the new company.

The contracts relating to the demerged undertaking would get automatically transferred to the
resulting company, unless the underlying contract has stipulated specific restrictions. A
demerged company is said to be one whose undertakings are transferred to the other
company, and the company to which the undertakings are transferred is called the resulting
company. It is a process of reorganizing a corporate structure whereby a capital stock of a
division or subsidiary of corporation or of a newly affiliated company is transferred to the
stakeholders of existing company.

Demerger under Section 2(19AA) of the Income tax Act, 1961 means the transfer, pursuant
to a scheme of arrangement under section 230 to 232 of the Act, by a demerged company of
its one or more undertakings to the resulting company in such a manner that:-

(i) All the property of the undertaking, being transferred by the demerged company,
immediately before the demerger, becomes the property of the resulting company
by virtue of demerger;
(ii) All the liabilities relatable to the undertaking, being transferred by the demerged
company, immediately before the demerger, become the liabilities of the resulting
company by virtue of the demerger;
(iii) The property and the liabilities of the undertaking or undertakings, being
transferred by the demerged company are transferred at values appearing in its
books of account immediately before the demerger;
(iv) The resulting company issues, in consideration of the demerger, its shares to the
shareholders of the demerged company on a proportionate basis except where the
resulting company itself is a shareholder of the demerged company;
 (v) The shareholders holding not less than three-fourth in value of shares in the
demerged company (other than shares already held therein immediately before the
demerger, or by a nominee for, the resulting company or, its subsidiary) become
shareholders of the resulting company or companies by virtue of the demerger;
otherwise than as a result of the acquisition of the property or assets of the
demerged or any undertaking thereof by the resulting company;
(vi) the transfer of the undertaking is on a going concern basis
(vii) Demerger in accordance with the conditions notified under Section 72A(5) of
Income Tax Act, 1961.

“Undertaking” includes any part of an undertaking, or a unit or division of an undertaking or

a business activity taken as a whole, but does not include individual assets or liabilities or any
combination thereof not constituting a business activity.

“Liabilities” referred to in sub-clause (ii), shall include:

(a) the liabilities which arise out of the activities or operations of the undertaking;

(b) the specific loans or borrowings (including debentures) raised, incurred and utilised solely
for the activities or operations of the undertaking; and

(c) in cases, other than those referred to in clause (a) or clause (b), so much of the amounts of
general or multipurpose borrowings, if any, of the demerged company as stand in the same
proportion which the value of the assets transferred in a demerger bears to the total value of
the assets of such demerged company immediately before the demerger.

As per provisions of Section 72A(4) of Income Tax Act, 1961, in the case of a demerger, the
accumulated loss and the allowance for unabsorbed depreciation of the demerged company
shall

(a) where such loss or unabsorbed depreciation is directly relatable to the undertakings
transferred to the resulting company, be allowed to be carried forward and set-off in the
hands of the resulting company;

(b) where such loss or unabsorbed depreciation is not directly relatable to the undertakings
transferred to the resulting company, be apportioned between the demerged company and the
resulting company in the same proportion in which the assets of the undertakings have been
retained by the demerged company and transferred to the resulting company, and be allowed
to be carried forward and set-off in the hands of the demerged company or the resulting
company, as the case may be.

Types of Demerger

1.Divestiture: Divestiture means selling or disposal of assets of the company or any of its
business undertakings/divisions, usually for cash (or for a combination of cash and debt). It is
explained in detail in further.

Divestiture means selling or disposal of assets of the company or any of its business
undertakings/ divisions, usually for cash (or for a combination of cash and debt) and not
against equity shares to achieve a desired objective, such as greater liquidity or reduced debt
burden. Divestiture is normally used to mobilize resources for core business or businesses of
the company by realizing value of non-core business assets.

For example: XYZ Ltd. is the parent of a food company, a car company, and a clothing
company. If XYZ Ltd. wishes to go out of the car business, it may divest the business by
selling it to another company, exchanging it for another asset, or closing down the car
company.

Reasons for Divestitures

 Huge divisional losses

 Continuous negative cash flows from a particular division
 Difficulty in integrating the business within the company
 Unable to meet the competition
 Better alternatives of investment
 Lack of technological upgradations due to non-affordability
 Lack of integration between the divisions
 Legal pressures

2. Spin-offs: The shares of the new entity are distributed to the shareholders of the parent
company on a pro-rata basis. The parent company also retains ownership in the spun-off
entity. Spin-offs have two approaches that can be followed. In the first approach, the
company distributes all the shares of the new entity to its existing shareholders on a pro rata
basis. This leads to the creation of two different companies holding the same proportions of
equity as compared to the single company existing previously. The second approach is the
floatation of a new entity with its equity being held by the parent company. The parent
company later sells the assets of the spun off company to another company.

Spin-offs: A spin-off occurs when a subsidiary becomes an independent entity. The parent
firm distributes shares of the subsidiary to its shareholders through a stock dividend. Since
this transaction is a dividend distribution, no cash is generated. Thus, spin-offs are unlikely to
be used when a firm needs to finance growth or deals. Like the carve-out, the subsidiary
becomes a separate legal entity with a distinct management and board. Like carve-outs, spin-
offs are usually about separating a healthy operation. In most cases, spin-offs unlock hidden
shareholder value. For the parent company, it sharpens management focus. For the spinoff
company, management doesn’t have to compete for the parent’s attention and capital. Once
they are set free, managers can explore new opportunities. Investors, however, should beware
of throw-away subsidiaries the parent created to separate legal liability or to off-load debt.
Once spin-off shares are issued to parent company shareholders, some shareholders may be
tempted to quickly dump these shares on the market, depressing the share valuation.

3. Splits/divisions: Splits involve dividing the company into two or more parts with an aim
to maximize profitability by removing stagnant units from the mainstream business. Splits
can be of two types, Split-ups and Split-offs. Split-ups: It is a process of reorganizing a
corporate structure whereby all the capital stock and assets are exchanged for those of two or
more newly established companies resulting in the liquidation of the parent corporation.
Split-offs: It is a process of reorganizing a corporate structure whereby the capital stock of a
division or subsidiary of corporation or of a newly affiliated company is transferred to the
stakeholders of the parent corporation in exchange for part of the stock of the latter. Some of
the shareholders in the parent company are given shares in a division of the parent company
which is split off in exchange for their shares in the parent company.

In the case of split-off, a new company is created in order to takeover the operations of an
existing division or unit of a company. A portion of the existing shareholders of the company
obtains stocks in the subsidiary (i.e., the new company) in exchange for stocks of the parent
company. As a result, the equity base of the parent company is reduced representing the
downsizing of the firm. Thus, shareholding of the new entity (i.e., subsidiary) does not imply
the shareholding of the parent company. In the case of a slit-off, there is no question of cash
inflow to the parent company.
4. Split Ups: In the case of a split-up, the entire company is broken up in series of spinoffs.
As a result, the parent company no longer exists and only the new off springs continue to
survive. A split-up basically involves the creation of a new class of stock for each of the
parent’s operating subsidiaries, paying current subsidiaries a dividend of each new class of
stock, and then dissolving the parent company Stockholders in the new companies may be
different as shareholders in the parent company may exchange their stock for stock in one or
more of the spin-offs. Restructuring of Andhra Pradesh State Electricity Board (APSEB) is a
good example of split-off. The power generating division and the transmission and
distribution division of APSEB was transferred to two different companies namely
APGENCo and APTRANACo respectively. As a result of such split-up the APSEB ceased to
exist

5. Equity Carve-Outs: Equity carve-outs are referred to a percentage of shares of the

subsidiary company being issued to the public. This method leads to a separation of the assets
of the parent company and the subsidiary entity. Equity carve outs result in publicly trading
the shares of the subsidiary entity.

6.SLUMP SALE The transfer of the undertaking concerned as going concern is called
“Slump sale”. Slump sale is one of the methods that are widely used in India for corporate
restructuring where the company sells its undertaking. The main reasons of slump sale are
generally undertaken in India due to following reasons:

• It helps the business to improve its poor performance.

• It helps to strengthen financial position of the company.

• It eliminates the negative synergy and facilitates strategic investment.

• It helps to seek tax and regulatory advantage associated with it.

Section 2 (42C) of the Income Tax Act, 1961, recognizes ‘Slump-sale’ as a transfer of an
‘undertaking’ i.e. a part or a unit or a division of a company, which constitutes a business
activity when taken as a whole. It is a transfer of one or more undertakings as a result of sale
for a lump sum consideration, without values being assigned to the individual assets and
liabilities in such sale. Sale includes transfer of an asset from one person to another for some
consideration, where consideration can be in kind or cash.

‘Undertaking’ shall include any part of an undertaking or a unit or division of an undertaking

or a business activity taken as a whole, but does not include individual assets or liabilities or
any combination thereof not constituting a business activity.

The term ‘sale’ is not defined in the Income Tax Act, 1961. The term “Sale” is defined in the
Section 4 of the Sales of Goods Act, 1930. Sale is a contract whereby the seller transfers the
property in goods to a buyer for a price.

In CIT v R.R. Ramkrishna Pillai (66 ITR 725), the Supreme Court made the clear distinction
between sale and exchange. In this case, the assessee was carrying on the business and had
transferred the assets of the business to a company in consideration for the allotment of the
shares of that company. The issue was whether it was exchange or sale because on that basis
the transaction will be identified as slump sale. The Supreme Court held that where the assets
are transferred for money consideration and the liability of consideration so determined is
discharged by any mode whether money or other assets then the said transaction is sale.

In that case, there are in truth two transactions, one transaction of sale and the other of
contract under which the shares are allotted in satisfaction of the liability to pay the price.
However where the assets are transferred for a consideration of another asset other than
money the said transaction is exchange. On the basis of this distinction the Supreme Court
held that transfer of assets in consideration for the allotment of shares of that company is
‘exchange’ and not sale.

The Act does not define a slump sale but has included in its ambit slump sale by way of
section 180(1) and provides for the procedure and approval required for selling, leasing or
disposing of the whole or substantially whole of the undertaking of the company or where the
company owns more than one undertaking, of the whole or substantially the whole of any
such undertakings.

“Undertaking” means an undertaking in which the investment of the company exceeds twenty
per cent. of its net worth as per the audited balance sheet of the preceding financial year or an
undertaking which generates twenty per cent. of the total income of the company during the
previous financial year.
“Substantially the whole of the undertaking” in any financial year shall mean twenty per cent.
or more of the value of the undertaking as per the audited balance sheet of the preceding
financial year.

7. Hiving off

• A process wherein an existing company sells a particular division to reduce

unproductive expenditure.

• It helps entity to reap the benefits of core competencies, competitive advantage and
optimum capacity.

• Example : Hiving off of the yarn division of Modern Woollens to Modern threads, Dr
Reddy’s Sun Pharma, Ranbaxy and Nicholas Piramal hiving off their R&D divisions.

• A hive up is a reorganization within a group of companies whereby the assets and
business of a subsidiary are transferred up into the parent company.

• Hive off can be opted by any businesses having more than one business segments,
which can be effectively run independently.

• In the hiving-off, the business or the undertaking is sold and transferred by the
company to the buyer at a pre-determined price, under an agreement between the
seller and the buyer.

• This agreement is usually called ‘Business Transfer or Assignment Agreement