Demerger, also known as spin-off, is a corporate restructuring strategy where a company transfers one or more of its undertakings to another company. In a demerger, the assets, liabilities, and operations of the division or subsidiary are divided and distributed among the newly formed entities or existing companies. This article provides an overview of demerger under the Companies Act, 2013, and the Companies (Compromises, Arrangements and Amalgamations) Rules, 2016.

Legal and Regulatory Framework –

Demergers are subject to various legal and regulatory requirements, including approval from shareholders, creditors, and regulatory authorities. Companies must comply with company law provisions, securities regulations, and taxation laws governing demergers.

What is Demerger?

Demerger is a process where a company divides its business into separate entities, resulting in the creation of a new company or companies. 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. This can be done for various reasons, such as:

– To focus on core business activities

– To unlock shareholder value

– To improve management efficiency

– To reduce debt

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.

Reasons for Demerger

These are some of the common reasons why companies undergo demerger. The specific reasons may vary depending on the company’s circumstances and goals.

1. Unlocking Shareholder Value: Demerger can unlock shareholder value by separating high-growth businesses from low-growth or non-core businesses

2. Improved Management Focus: Demerger allows management to focus on core businesses, leading to improved efficiency and competitiveness.

3. Reducing Debt: Demerger can help reduce debt by separating debt-laden businesses from healthier ones

4. Enhancing Growth Opportunities: Demerger can create new growth opportunities for the separated businesses, as they can pursue independent strategies.

5. Improving Operational Efficiency: Demerger can lead to improved operational efficiency, as the separated businesses can optimize their operations independently.

6. Reducing Complexity: Demerger can simplify complex corporate structures, making it easier for investors to understand the business.

7. Creating Pure-Play Companies: Demerger can create pure-play companies, which can attract investors seeking exposure to specific industries or sectors.

8. Mitigating Risk: Demerger can help mitigate risk by separating high-risk businesses from lower-risk ones.

9. Compliance with Regulatory Requirements: Demerger may be necessary to comply with regulatory requirements, such as separating banking and non-banking businesses.

10. Strategic Reorientation: Demerger can be a strategic move to reorient the business, focus on core competencies, and exit non-core businesses.

Types of Demerger

The word demerger has got statutory recognition in the Income Tax Act, 1961. As per Income Tax Act, 1961 demerger in relation to companies, means the transfer, pursuant to a scheme of arrangement under Companies Act, 2013 by a demerged company of its one or more undertakings to any resulting company subject to conditions specified. As per various court decisions AS-14 -Accounting for Amalgamations is not applicable to demergers. There are four 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) 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.

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.

There are two approaches in which Spin offs may be conducted.

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.

A company may also separate a business unit into its own entity if it has been looking for a buyer to acquire it but failed to find one. For example, the offers to purchase the unit may be unattractive, and the parent company might realize that it can provide more value to its shareholders by spinning off that unit.

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.

4. 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.

Challenges and Risks:

1. Complexity: Demerger can be a complex and time-consuming process, requiring significant resources and expertise

2. Regulatory Approvals: Obtaining regulatory approvals can be challenging, especially if the demerger involves multiple jurisdictions

3. Stakeholder Management: Managing stakeholder expectations, including those of shareholders, employees, and customers, can be difficult.

4. Valuation: Valuing the businesses to be demerged can be challenging, and disagreements may arise between parties.

5. Integration/ Separation: Integrating or separating systems, processes, and infrastructure can be complex and time-consuming.

6. Execution Risks: Demergers involve complex legal, financial, and operational processes, and failure to execute effectively can result in disruptions, delays, or cost overruns.

7. Value Leakage: The value created through the demerger may be eroded by transaction costs, tax liabilities, or adverse market reactions.

Process of Demerger

The demerger process involves the following steps:

Company PQR is a conglomerate with diverse business operations, including a pharmaceutical division and a real estate division. The company decides to demerge its real estate division into a separate entity called Company A, which will be a standalone real estate company.

1. Planning and Announcement: Company PQR’s management identifies the real estate division as a separate entity with its own growth potential. The decision to demerge the division is made, and the company announces its plans to shareholders and stakeholders.

2. Valuation and Asset Allocation: The real estate division’s assets, liabilities, and operations are evaluated and valued. The valuation determines the distribution of assets and liabilities between the parent company (Company PQR) and the new entity (Company A). This may involve conducting a separate business valuation for the real estate division.

3. Legal and Regulatory Requirements: Company PQR complies with legal and regulatory requirements specific to the jurisdiction where the demerger is taking place. This may involve obtaining approvals from shareholders, regulatory authorities, and other relevant parties.

4. Implementation: The demerger is executed by transferring the identified assets, liabilities, and operations of the real estate division from Company PQR to Company A. This could involve transferring property titles, contracts, employees, and other necessary arrangements to ensure the smooth functioning of the new entity.

5. Shareholder Allocation: Company PQR determines how the shares of the newly formed entity (Company A) will be allocated among its existing shareholders. This can be done through a share swap ratio, where shareholders receive shares of the new entity in proportion to their holdings in the parent company.

6. Independent Operations: After the demerger, Company A operates as an independent real estate company, having its own management, board of directors, financials, and strategic direction. Company A can raise funds, make investments, and pursue growth opportunities specific to its real estate business

A demerger allows the parent company to focus on its core operations, while the demerged entity can operate autonomously and pursue its own growth strategies. It can unlock value by creating separate entities with specialized expertise and clearer market positioning.

Taxation aspect- carry forward and set off of accumulated loss and unabsorbed depreciation allowance

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.

Demergers can have significant tax implications for both the parent company and the spun-off entities. Tax considerations include capital gains tax, stamp duty, transfer pricing, and tax consolidation rules. Companies must carefully plan the demerger structure to optimize tax outcomes.