Mergers and Acquisitions Law

Transcription

1 READING MATERIAL Mergers and Acquisitions Law UNIT 3 Legal Framework Governing De- Mergers

2 MERGERS AND ACQUISITIONS LAW 2 So far in this Programme, we have learnt about the legal framework governing mergers and amalgamations in India. We have discussed the elements of a merger and the procedure for implementation of a merger process in India. In this Unit, we shall discuss the law in relation to de- mergers in India. By the end of this Unit, you will have a working understanding of how a de- merger operates in India. Let us begin by understanding the meaning of a de- merger. Simply put, a de- merger is the opposite of a merger. Illustration: Say Company Ace merges into Preliance Group Limited, with the resultant entity being Preliance Group Limited. Company Ace ceases to exist. In other words, all of Company Ace is consolidated into Preliance Group Limited. In a de- merger, only a part of the business of Preliance Group Limited (transferor or de- merging company) is split off or divided and then transferred to Company Ace (transferee or de- merged company). After the de- merger, both Company Ace and Preliance Group Limited continue to exist, though the transferred undertaking(s) are now a part of Company Ace. A de- merger is, essentially, a business strategy in which any one business is divided and split into different components. These components then either operate under a separate entity, or are sold. Companies often opt for a de- merger due to the ease with which it allows them to split off or break down their various divisions, by either transferring those divisions that are no longer part of the main business, or incorporating fresh legal entities for varying businesses. i An important characteristic of every de- merger is the transfer of an undertaking. What exactly is an undertaking? An undertaking is not defined in the Companies Act, 1956 ( Companies Act ). It has only been

3 MERGERS AND ACQUISITIONS LAW 3 defined in the Explanation to Section 2(19AA) of the Income Tax Act, 1961 ( Tax Act ). The definition, according to the Tax Act, is that an undertaking includes any part of an undertaking, or a unit or division of an undertaking or business activity taken as a whole, but excludes individual assets or liabilities or any combination thereof, not constituting a business activity. From this definition we can see that, in order to constitute an undertaking for the purpose of a de- merger, the transferred component or part of the business must be capable of functioning as a separate business unit or a business activity on its own. In other words, an undertaking is that part of the business that can function independently and separately as a business on its own. Let us also keep in mind that an undertaking consists of both assets and liabilities together and is always transferred along with all the assets and liabilities to the transferee company. Illustration: Preliance Group Limited is one of India's largest conglomerates, owned by one of the richest families, the Shahs. The group spans various businesses: infrastructure, retail, energy, telecom, and financial services. All these divisions work independently and are capable of running without depending on each other. Each division also has its own assets and liabilities. Preliance Group Limited transfers its retail division to Company Buy. This is a de- merger since the retail division is an undertaking, that is, a part of the businessness that can function independently. Now that you have an understanding of what a de- merger is let us learn about the legal framework governing de- mergers. As you go through this Unit, you will note that the process for a de- merger is identical to that of a merger. Also, similar to a merger, a de- merger, is not defined under the Companies Act. However, every de- merger scheme must be approved by the High Court under Sections of Companies Act. Given the

4 MERGERS AND ACQUISITIONS LAW 4 similarity in processes, this Unit will only contain an overview of the steps involved in a de- merger process. The detailed procedure for implementing a merger process that we discussed in the previous Unit is applicable in context of de- mergers as well. Process of a De- merger Before implementing a de- merger, both the transferor and transferee companies must be permitted by their memorandum of association to enter into a scheme of arrangement or de- merger. If such a provision does not exist, the memorandum of association of the companies will need to be amended before implementing a scheme. A de- merger scheme is filed under Sections of the Companies Act with the High Court within whose jurisdiction the registered office of the companies is situated. As we studied in the earlier part of the Programme, the Companies (Second Amendment) Act, 2002 proposed the constitution of a new tribunal called the National Company Law Tribunal ( Tribunal ). This Tribunal is expected to be a forum where company law cases and company restructurings are fast tracked. The power of the High Court to approve restructurings under Sections of the Companies Act has also been transferred to this Tribunal. However, the provisions relating to this Tribunal have not yet been notified and the power continues to lie with the High Court of a particular state. Once these provisions are notified, the power will be transferred to the Tribunal and the High Courts will no longer have the authority to approve reconstructions under Sections of the Companies Act. ii It is important to note that a de- merger scheme is also considered as an arrangement or a compromise between a company and its creditors or between a company and its members. iii A de- merger typically affects the net worth of the company and generally has an effect on its business as a whole. Therefore the consent of creditors and

5 MERGERS AND ACQUISITIONS LAW 5 shareholders is imperative as their interests are directly affected. In the de- merger process, the board of directors of the respective companies first approve the de- merger scheme. After such approval the scheme is filed with the High Court. The High Court directs that a meeting of the creditors, or class of creditors, or members, or class of members, of the transferor and transferee companies be convened. In these meetings it is necessary that the scheme be approved by a majority in number representing three- fourths in value of the creditors, or class of creditors, or members, or class of members, present and voting, whether in person or through proxies, if proxies are permitted. Additional consents are required from suppliers, lenders and other third parties, if any contracts provide that consent must be taken before the company undertakes a de- merger. Approval will be required from employees and workmen depending upon the provisions of the employment statutes. The employment law provisions have been discussed in the later part of the Programme. The High Court also directs that the scheme be filed with the Regional Director and the Official Liquidator who give their comments on the scheme. Once the company obtains all approvals, the High Court tests the scheme on the grounds that is fair and reasonable and complies with all statutory provisions. As long as adequate information in relation to the scheme has been provided to the shareholders, the scheme is fair, equitable, not unjust, not contrary to public policy, and does not violate any law, the court will approve the scheme. At this stage, you will appreciate that in terms of processes, approvals, and the testing by the High Court, a de- merger process follows the same course as a merger scheme as we have studied in the previous Unit.

6 MERGERS AND ACQUISITIONS LAW 6 Once a scheme is sanctioned, the scheme becomes effective, upon filing the order with the Registrar of Companies and the companies can commence with its implementation. The primary benefit of the court approval providing a single window clearance continues in case of de- merger. Just like we saw in the case of a merger, a single window clearance means that companies do not need to obtain specific approvals or exemptions from various state authorities for transfer of property, land and assets. The transfer and vesting of business and assets of the transferor company is automatic unless prior approval of an authority is required before sanctioning the scheme. Please however note that in many cases, licences and approvals granted under other applicable by- laws do not vest automatically in the transferee company. The court approval in these cases is only of persuasive value and not binding. Further, as discussed in the earlier part of the Programme, stamp duty is chargeable on the Court Order sanctioning the scheme. The amount of stamp duty is calculated based on the states where the registered offices of the transferor and the transferee companies are located. We shall learn about the law in relation to stamp duty in the subsequent parts of this Programme. Before moving forward, let us glance through two concepts that we learnt about in the context of a merger. These are the concept of an appointed date and the concept of an effective date that is present in every de- merger scheme. To recall, the effective date is the date on which the transferee company files the order of the High Court with the Registrar of Companies. Once the order is filed, the demerger becomes effective from the appointed date. The appointed date is the cut off date from which assets and liabilities of the transferor company are transferred and vested with the transferee company. iv

7 MERGERS AND ACQUISITIONS LAW 7 Taxation provisions In the earlier part of this Unit, we examined the company law provisions in relation to a de- merger. Let us examine the taxation provisions governing a de- merger. Often, companies structure de- merger scheme primarily to obtain taxation benefits as outlined below. In order for a de- merger to be tax efficient the scheme must fall within the scope of Section 2 (19AA) of the Tax Act. This section defines a de- merger and lays down the following conditions that must be fulfilled for a de- merger to be tax neutral. These are that: All the property and liabilities that are relatable to the transferred undertaking, become the property and liabilities of the resulting company through the demerger. This means that if certain assets or liabilities (relatable to the undertaking) are left behind in the transferor company, the de- merger is not a tax efficient de- merger. Illustration: Preliance Group Limited is de- merging an undertaking into Company Bake. There are 100 assets that are related to the undertaking. Only 99 of the assets are transferred to Company Bake. Since all the assets have not been transferred, this will not fulfil the condition specified above. Hence the de- merger will not be tax efficient. All the property and liabilities are to be valued at their book value, that is, the value appearing in the books of accounts immediately prior to the de- merger. Illustration: In the previous example, 100 assets belonged to the transferred undertaking. One of the assets is a property at Delhi. Immediately before the de- merger, the property was valued in the books of accounts at 3.5 crore. This will be its book value. At the time of the de- merger, the property must be transferred at 3.5 crore to satisfy this condition.

8 MERGERS AND ACQUISITIONS LAW 8 The resulting company issues, in consideration of the de- merger, its shares to the shareholders of the demerged company or transferee company on a proportionate basis. Illustration: In our earlier example, an undertaking of Preliance Group Limited is de- merging into Company Bake. As consideration for the de- merger, Company Bake is issuing shares to the shareholders of Preliance Group Limited, the de- merged entity. Therefore, the shareholders of Preliance Group Limited shall be shareholders in Company Bake. Shareholders holding not less than three- fourths in value of the shares (other than shares already held immediately before the demerger, or by a nominee for, the resulting company or, its subsidiary) in the demerged company are shareholders of the resulting company or companies by virtue of the demerger. Illustration: StartMeUp Pvt. Ltd. has 3 shareholders and a total of 100 shares. Each share is worth Rupees 10. Hence, the value of all the shares will be Rupees Amar holds 40 shares, Ranjeet holds 35 shares, and Kamal holds 25 shares. Amar and Ranjeet together hold 75 shares, which are worth Rupees 750. In other words, Amar and Ranjeet together hold shares that are equivalent to three fourths in value of the shares of StartMeUp Pvt. Ltd., the de- merged entity. If both Amar and Ranjeet are shareholders in Company A, the resulting company this will be a tax efficient de- merger. The transfer of the undertaking is on a going concern basis. This means that the undertaking being transferred must not be at the brink of winding up or collapse. It should be an undertaking that is capable of running smoothly in the future. v

9 MERGERS AND ACQUISITIONS LAW 9 In order to avail of the benefits under the Tax Act, a de- merger must fulfil the conditions mentioned above. If the conditions mentioned above are not fulfilled, the de- merger will continue to be valid under the Companies Act, though the tax benefits shall be inapplicable. Let us look at the tax benefits that would be available under the Tax Act. The permission to carry forward accumulated losses and unabsorbed depreciation (outlined in Section 72A of the Tax Act) is one of the main benefits available. Let us understand these concepts better. Under the Tax Act a company is permitted to set off its total losses in a particular year, against the profits for that year. vi If a company does not have sufficient profits or income in a year, the part of the loss that is not set off against the income is called accumulated loss. Such loss can be carried forward to next year and adjusted in that year. Illustration: Company Ace has losses to the tune of Rupees Twenty crore in Its profits for that year are Rupees Ten crore. Rupees Ten crore is the accumulated loss that can be carried forward to the next year. Depreciation is essentially a decrease in the value of fixed assets over a period of time. This decrease is usually given a specific value by the auditors of a company. According to the Tax Act, every company is allowed to set off its total depreciation against its income in a particular year. vii If a company does not have sufficient profits or income in a year, the part of the depreciation that is not set off against the income is called unabsorbed depreciation. Such unabsorbed depreciation is carried forward to next year and adjusted in that year. viii Illustration: StartMeUp Pvt. Ltd. has an income of Rupees Ten lakh. Its depreciation amounts to Rupees Nine lakh.

10 MERGERS AND ACQUISITIONS LAW 10 StartMeUp Pvt. Ltd. sets off its depreciation of Rupees Nine lakh against its income of Rupees Ten lakh. It will pay income tax only on Rupees One lakh. Now, let us assume that its depreciation is Rupees Eleven lakh. This means that StartMeUp Pvt. Ltd. will only be able to set off depreciation upto Rupees Ten lakh in this year. Rupees One lakh is carried forward to the next year and set off against next year s income. This is unabsorbed depreciation. Please note these illustrations only explain the general concepts of unabsorbed depreciation and accumulated losses. Rules and regulations and specific procedures prescribed by the Tax Act to claim such exemptions must be followed at all times. In a de- merger, the transferee company is permitted to set off accumulated losses or unabsorbed depreciation of the transferred undertaking against its own income, if such loss or depreciation is directly connected to the transferred undertaking. If only a portion of loss is connected to the undertaking then only that portion of the loss is set off. ix Illustration: Preliance Group Limited (transferor company) has de- merged its undertaking into Company Ace (transferee company). The unabsorbed depreciation for Preliance Group Limited s undertaking is Rupees One lakh and the accumulated losses are Rupees Fifty thousand. Company Ace sets off Rupees One lakh (unabsorbed depreciation) and Rupees Fifty thousand (accumulated losses) against its own profit of Rupees Two lakh. Additionally, Section 47 of the Tax Act states that there is no incidence of income tax by way of capital gains on the transferor company in relation to transfer of a capital asset in a de- merger. To recall from the earlier part of this Programme, capital gains is a gain from sale of a capital asset. This gain is typically taxed, though it is exempt in case of a de- merger.

11 MERGERS AND ACQUISITIONS LAW 11 Illustration: Preliance Group Limited has de- merged its undertaking into Company A. Apart from the other assets and liabilities, the undertaking comprises of one piece of machinery. The machinery is valued at Rupees Twelve lakh. The original purchase price of the machinery was Rupees Ten lakh. Rupees Two lakh is the capital gain in the hands of Preliance Group Limited. Normally, Preliance Group Limited is taxed for this gain. In case of a de- merger, Preliance Group Limited is exempt from this tax burden. Another benefit available to a de- merger under Section 47 of the Tax Act is that the issue or transfer of shares by the transferee company to the shareholders of the transferor company as part of the de- merger scheme is exempt from tax. Illustration: Preliance Group Limited has de- merged its undertaking into Company Ace. As consideration for the de- merger, Company Ace has issued shares to the shareholders of Preliance Group Limited. This issue of shares is not taxed. At this stage, you should spend some time to look through the provisions of the Companies Bill, 2011, in relation to mergers and de- mergers. For instance, the Companies Bill, 2011 has proposed that all schemes of arrangement (mergers and de- mergers) shall be accompanied by details regarding valuation of the transferor undertaking and the manner of arriving at the value of shares in the transferee company. No scheme must be approved or implemented in a manner, which does not comply with the currently prevailing accounting standards. Such a provision will be useful as on many occasions schemes are stuck in courts on the grounds of valuation. Often shareholders and valuers do not agree with each other. By suggesting that a scheme should carry with it a valuation, there is an attempt to ensure that well

12 MERGERS AND ACQUISITIONS LAW 12 reasoned valuation reports that are capable of justification are placed before the courts. Also, changes have been suggested in relation to who has a right to object to an arrangement scheme. The Companies Bill, 2011 suggests a threshold of ten percent of shareholding for placing any objection. Though one can argue that this provision is aimed at reducing frivolous litigation, it is possible that this provision is against the interest of minority shareholders and creditors. x the legal framework governing mergers and de- mergers in India from a company law and income tax perspective. In the next Unit, we shall move on to examining the concept and the legal framework governing acquisitions in India. For a useful overview of the Companies Bill, 2011 in relation to mergers and de- mergers read the article titled Restructuring restrictions specifically targeted, availble on mylaw.net at ted/. Through this Unit, we have understood the concept of a de- merger and the manner in which a de- merger is implemented in India. We have completed our study of

13 MERGERS AND ACQUISITIONS LAW 13 Suggested Reading Books S.Ramanujam, Mergers et al Issues, Implications and Case Law in Corporate Restructuring (Lexis Nexis Butterworths Wadhwa Nagpur) at Raju Patel, Handbook on Merger and Acquisition Management (Cyber Tech, 2012) at Articles Taxation aspects of demerger in India, LexVidhi, accessed at details/taxation- aspects- of- demerger- in- india- 46.html. Aju John, Restructuring restrictions specifically targeted, accessed on mylaw.net at targeted/. i Investopedia.com, De- merger definition, accessed at ii FE Bureaus, SC clears National Company Law Tribunal, The Financial Express, May 12, 2012 accessed at clears- national- company- law- tribunal/617523/. iii Section 391 of the Companies Act, iv Raju Patel, Handbook on Merger and Acquisition Management (Cyber Tech, 2012) at v Accounting Explained, Going Concern definition, accessed at &ved=0cduqfjac&url=http%3a%2f%2faccountingexplained.com%2ffinancia l%2fprinciples%2fgoing- concern&ei=qcliunm9oiltrqe0moew&usg=afqjcnfbqc9crmjpqohz_prbm6i 64K70YQ. vi Section 72A(5b) of the Tax Act. vii Pradip Kapasi and Gautam Nayak, Unabsorbed depreciation- Rules for carry forward, BCA Journal, January 2006, accessed at viii Kapasi and Nayak, Unabsorbed depreciation- Rules for carry forward. ix Biswadeep Chakravarty, Demerger- An Analysis, Lawyers Club India, accessed at An- Analysis asp#.UEMbTESs6Lk. xaju John, Restructuring restrictions specifically targeted, accessed on mylaw.net at