presentation on corporate demerger & divestment-for circulation

August 17, 2007 S-Global Consulting / [email protected]

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A Case Study onCorporate Demerger

& Divestment


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Issues(1) Advise on financial and other strategic issues relating to

Demerger(2) The process of demerger(3) Drafting of the Joint Venture Agreement(4) Formation of JVC & commencement of operations.(5) Conversion of a company into a wholly owned subsidiary

(WOS)(6) Drafting of Stock Purchase Agreement(7) Issues relating to :

(1) Sales Tax / (2) Income Tax / (3) Stamp Duty /(4) FEMA-RBI and (5) Accounting treatment


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1.Financial and strategicissues relating to

Demerger for both Piaggio and Greaves


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1.Financial and strategic issues relating to Demerger

• Piaggio1. Entry in Indian Market2. Ready to use manufacturing

facilities3. Partner with understanding of

Indian Market4. Ready marketing set up5. Other infrastructure6. Influential partner7. Recovery of initial investment by

Technical Know how fees and supply of Plant & Equipment

• Greaves1. Stop bleeding2. Profitable sale of the plant3. Partnership with

international major4. Good investment

opportunity5. Revenue from sharing of

infrastructure6. Assured customer for the

engine supplies


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Approaches to Demerger1. Process of Demerger under

Section 293 (1)(a), referred as Slump Sale

2. Spinning off of one or more of the undertakings into another company. (Section 391-394), referred as Demerger.


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2. Process of Slump Sale under Section 293 (1)(a)


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2. Process of Slump Sale under Section 293 (1)(a)

1. In principle decision to demerge2. Due Diligence3. Valuation of the Unit4. Board of Directors’ Decision 5. Agreement with the Buyer (JVC)6. Approval from the Financial Institutions7. Shareholders approval U/S 293(1)(a) of the Companies Act,

19568. Execution of Sale Deed and receipt of consideration.9. Removal of the unit from the Books.

P.S.: Inform SEBI /stock Exchanges


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Definition of Slump Sale

• It means transfer of one or more undertakings as a result of the sale for a lump sum consideration without values being assigned to the individual assets and liabilities in such sale.


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Characteristics of Slump Sale Transactions

1. Approval of shareholders required.2. Undertaking is sold as a package of assets and

liabilities3. Buyer identifiable4. The Buyer wishes to retain control on the

Equity pattern of new entity.5. The new entity has a different shareholding

pattern.


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Characteristics of Slump Sale Transactions

6. The entire undertaking is sold as a going concern on as is where is basis.

7. All the fixed / currents assets and liabilities pertaining to the undertaking are transferred.

8. All the employees of the undertaking are offered option to be transferred

9. All the licenses, permits , registrations, approvals etc are transferred in the name of the Transferee company.


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3. Drafting of Joint Venture Agreement


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3. Drafting of Joint Venture Agreement

8. General representation and warranties

9. Term and termination10. Rights on termination11. Confidentiality12. General provisions such

as assignments13. Non compete clause

1. Shareholding pattern2. Future Financing

pattern3. Management of JVC4. Restriction on

Transfer of shares5. Deadlock Resolution6. Activities 7. Pre-closing

covenants


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4. Formation of JVC & commencement of operations

1. Actions by Foreign partner2. Actions by the Indian Partner3. Actions by the JVC


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1. Actions by Foreign partner1. Approval from the Board of Piaggio2. RBI Approval - Automatic Route:

1. Annexure A• Industries where 100% FDI is allowed

2. Annexure B• Industries where FDI is allowed with Sectoral

caps3. Press Note 18


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2.Actions by the Indian Partner / JVC1. Indian Partner:

– Application to ROC – Receive Incorporation Certificate – Pay equity subscription– Receive Consideration from the JVC– Handover the Unit to the JVC

2. JVC:– Hold first Board Meeting for initial matters

• Appointment of Auditors• Open Bank Account• Appoint Directors• Allot shares and Issue Share Certificates

– Pay consideration for Auto Unit– Acquire the Auto Unit – Commence operations– Transfer of MIDC Land– Tripartite Agreement with SICOM


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5. Conversion of a company into a Wholly Owned

Subsidiary (WOS)


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What is a Wholly Owned Subsidiary

(WOS)?


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Conversion of a company into a wholly owned subsidiary (WOS)

1. Actions by the two partners:1. Valuation of the JVC Share:

Report from Chartered Accountants2. Closing date fixation3. Stock Purchase Agreement4. Escrow Account Agreement


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Why Escrow Account?


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How does Escrow Account work?


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2. Actions by the selling partner (Greaves):1. Board’s approval2. Inform SEBI /stock Exchanges3. Obtain RBI’s Approval


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3. Actions by the acquiring partner (Piaggio):

1. Board Approval to acquire the shares from Greaves

2. SIA Approval


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4. BODM-I of JVC:– Amendment of Articles

• Name change• Provision relating to Quorum

– Resolution for name change– Convening of EOGM for the above

on the same day.


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5. Closing– Nominees of Selling partner (Greaves)

resign– Consideration is paid by the Buyer

(Piaggio) to Seller through a mandate to the Bank

– S T D is handed over by the Seller to the Buyer


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6. BOD - II of JVC:– Resignation of the Nominees of the

Selling partner (Greaves) accepted– The Share Transfer endorsed in favour

of the Acquiring partner (Piaggio)– Reconstitution of Board by the Piaggio

India Pvt. Ltd.


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6.Drafting of the Stock Purchase

Agreement


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6. Drafting of the Stock Purchase Agreement

1. Price of the share2. Duties and obligations of the Buyer (Piaggio)3. Duties and obligations of the Seller

(Greaves)4. Closing date5. Closing covenants6. Other incidental clauses


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7. Issues relating to:1. Sales Tax 2. Income Tax 3. Stamp Duty 4. FEMA-RBI and 5. Accounting treatment


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1. Sales Tax• The entire undertaking is sold as a going

concern on as is where is basis.• It is a slump sale.• Slump Sale was exempt from Sales Tax.• Sales Tax now has been replaced by

VAT.


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2. Income Tax• Was it a Slump Sale or• Demerger under Section 391-394 of the

Companies Act?


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Computation of Income Tax

liability in case of a Business


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Illustration on computation of provision for Income Tax

34%Corporate Tax rate65Brought forward business loss75Depreciation under the Income Tax Act40Depreciation under the Companies Act

400Profit Before TaxAmountParticulars

From the information given below of XYZ Ltd., compute its tax liability. All amounts are Rs. In Lakhs.


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Income Tax provisions in case

of Slump Sale


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Definition of Slump Sale

• Provisions relating to Slump Sale were introduced by the Finance Act, 1999.

• It means transfer of one or more undertakings as a result of the sale for a lump sum consideration without values being assigned to the individual assets and liabilities in such sale.

• If value of an asset or liability is determined for the sole purpose of payment of stamp duty, registration fees or other similar taxes or fees, that should not be regarded as assignment of values to individual assets and liabilities.


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Question• In case an undertaking is transferred against

the allotment of shares in the acquiring company and not against cash payment, would such a transaction qualify as a Slump Sale under the Act?.


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What is the cashflow impact on the Transferor company in case of Slump

Sale and Demerger?


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Chargeability of Slump Sale under Income Tax

• Any profit arising from the Slump Sale shall be chargeable as capital gains.

• It shall be deemed to be the income of the PY in which the transaction takes place.– PY , AY , Actg Y , FY

• Benefit of Indexation is not allowed.• If the undertaking is owned and held by the

assessee for not more than 36 months, it shall be treated as short-term capital asset.


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Undertaking defined for Slump Sale [(Section 2(42C)]

• Undertaking is defined to include any part of an undertaking or a unit or division of an undertaking or a business activity as a whole, but does not include individual assets or liabilities or any combination thereof not constituting business activity.

• Implication?


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“Net Worth” for Slump Sale

• Net worth shall be the aggregate value of total assets of the undertaking or division as appearing in its books of account.

• In case of depreciable assets , WDV shall be taken and in case of other assets, book value shall be taken.

• What are the assets that will be taken at Book Value?


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Obligations of the Transferor assessee

• Who is transferor in the given case?• Shall furnish in the prescribed form along with

the Return of Income a report from a Chartered Accountant indicating the computation of net worth and certifying that the same has been computed in accordance with the provisions of the Act.


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Auditor’s Certificate in Form No.3CEA (Rule 6H)

• The Auditors of the Assessee shall provide a Certificate in Form No.3CEA relating to the computation of capital gain in case of slump sale.

• This certificate needs to be filed along with the Return of Income in accordance with the provisions of Section 139 of the Act.


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Income Tax provisions in case of a Slump Sale

• The Transferor company (Greaves) to account for capital gains from the sale of the unit and pay tax thereon.

• What should be the effect on the Transferee company (JVC)?.

• Unabsorbed depreciation and brought forward losses relating to the undertaking not transferred under Slump Sale.


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What is unabsorbed Depreciation and

Unabsorbed Loss and how to compute it?


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3. Stamp Duty

• The transfer is liable for stamp duty under the Bombay Stamps Act.

• Get the Sale Deed adjudicated and pay the Stamp Duty so assessed.– What is adjudication?

• Purchase Deed signed between JVC and Greaves was submitted to the Stamps Collector’s Office for adjudication and

• Stamp Duty was paid accordingly @ applicable rate i.e. 5%.


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4. SIA - FEMA - RBI

• Specific Approval from SIA required in case the transfer of shares is to a non resident from a Resident.

• In this case, Greaves , a Resident transferred shares to Piaggio, a non-Resident, hence approval of SIA was obtained.

• Approval from RBI required. Reason? • Definition of a Resident under FEMA is different

from that given under the Income Tax Act.


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5. Accounting Treatment

• What are the Accounting Standards?• Is there any Accounting Standard applicable to

Demerger ?• AS 14 applicable in respect of Amalgamations.


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Accounting Treatment by Greaves and JVC

• Transferor (Greaves) to remove the assets and liabilities from its Books and account for the consideration received by passing a Journal Entry.– What should be the Journal Entry?

• Transferee (JVC) to take the assets and liabilities on record in its books and reduce the bank balance by the amount of consideration paid to Greaves by passing a Journal Entry.– What should be the Journal Entry?

• Value of the net assets received was Rs. 28.0 crore and the price paid was Rs. 32.0 crore. How would you account for the difference?


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When Goodwill is recorded in the Books?

• Sunil Bharti identifies one unit of a company for purchase.• Value of the net assets of the Unit is Rs. 800 cr., but the

transferor company has asked for a consideration of Rs. 1000 cr.

• Considering the synergy these assets have with the current operations of Sunil Bharti’s Company, he agrees to pay Rs. 1000 cr for the assets whose fair market value is Rs. 800 cr.

• Assuming Sunil Bharti has funded the acquisition in the Debt Equity Ratio of 1:1, how will the Balance sheet of Sunil Bharti will look like after the acquisition?


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What if the same assets would have been bought at Rs. 700

crores, how the Balance Sheet of Sunil Bharti would look like .


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DemergerSpinning off of one or more of the undertakings into another company. (Section 391-394).


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Section 391-394 Route1. Besides shareholders’, approval from the High

Court / NCLT also necessary2. Creation of a new entity for focus and control3. Division of family business4. Shareholding pattern remains the same in the

new entity.


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Demerged / Resulting company

•Reliance Communications•Reliance Infrastructure•Reliance Natural Gas

Reliance Industries

Ultratech Cement Ltd.L & T Ltd.

Resulting companyDemerged company


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Demerger under Section 391-394

Pre-demerger situation

Reliance

RefineryDiv.

TelecomDiv.

CapitalDiv.

InfrastructureDiv.


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Post -demerger situationRIL

RelianceCommunication

RelianceInfrastructure

Reliance NaturalGas


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Demerger – Process u/s 391-384

• In principle approval to the Proposal by the Board of Directors of the Company.

• Enabling provision in the Memorandum /Articles• Incorporation of the Resulting company • Board Meeting of both companies• Notice to SEBI and Stock Exchanges• Presentation and approval to the scheme of demerger

by the Boards• Application to the High Courts for directions


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Demerger – Process u/s 391-384

• Actions as per the High Court directions– Convene Shareholders’ Meeting– Convene Creditors meeting– Release Notice in Paper

• File affidavits with the high courts confirming fulfillment of the HC directives

• HC to direct for filing of the demerger petition • File demerger petition


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Demerger – Process u/s 391-384• HC to direct :

– Fix the date of hearing– Notice to be given in the newspapers

• Release Notice in the papers• Hearing Takes place, HC passes the order• Stamping of the Order if applicable / Adjudication• File the Order with the ROC• The Demerger becomes effective with filing of the

High Court Order with ROC.• Initiate consequent steps


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Income Tax provisions of Demerger – under the Income Tax Act, 1961


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Definition of Demerger – Section 2(19AA) of IT Act, 1961

• Demerger is defined as the transfer of one or more of its undertaking by the demerged company pursuant to a scheme of arrangement u/s 391 to 394 of the Companies Act, 1956 to any resulting company in such manner that:

a) All the properties and liabilities of the undertaking which is being transferred become the properties and liabilities of the resulting company.

b) properties and liabilities of the undertaking being transferred by the demerged company are transferred at their book values immediately before the demerger.


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Definition of Demerger – Section 2(19AA)

c) In consideration of the demerger, the resulting company issues shares to the shareholders of the demerged company on a proportionate basis.

d) The transfer of the undertaking is on a going concern basis.


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Undertaking would mean..

• An 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.


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Liability shall mean the followinga) Those which arise out of the activities or operations

of the undertakingb) The specific loans or borrowings (including

debentures) raised, incurred and utilised solely for the activities or operations of the undertakings.

– A loan from IDBI for exclusively financing the assets of the resulting undertaking.

c) So much of the general purpose or multipurpose borrowings 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 the demerged company immediately before the merger.


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Liability – Examples

a) A Term Loan of Rs. 500 cr. was taken from FIs for financing the assets of the undertaking transferred to the Resulting company. FIs have a pari passu first charge on these assets of the undertaking. Carrying amount of these assets on the effective date is Rs. 300 cr where the amount of loan outstanding on that is Rs. 250 cr..

b) Comment on the transferability of the assets and liabilities in this case?.


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Liability – Examples a) The demerged company had availed working capital facility of

Rs. 400 cr. from a consortium of bankers for financing the working capital of the entire demerged company including the resulting company.

b) Total working capital of the demerged company was Rs. 800 cr. Out of which the resulting company accounted for Rs. 200 cr.

c) On the date of the demerger the entire WC facility was utilised by the demerged company. The resulting company’s share in such utilisation was in the proportion of its WC to the WC of the demerged company as a whole.

d) How much of the Working Capital loan and the Current Assets would be transferred in this case to the Resulting Company?.


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Accounting Treatment in case

of Demerger


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Accounting in case of Demerger involves the following

• Removal of assets and liabilities from the Balance Sheet of the Demerged Company.

• Adjustment to the General Reserves amount of the Demerged company.

• Accounting of the assets and liabilities by the Resulting company in its Balance Sheet

• Issuance of fresh share capital by the Resulting company and accounting for the same in its books.


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88007000180088001100700

800500300Creditors

1000600400Bank Borrowings

58005000800Current Assets3000Term Loans

3000General Reserves

300020001000Fixed Assets1000Share

Capital

TotalDemerged Co.

Resulting Co.TotalDemerged

Co.Resulting

Co.

AmountAssetsAmountLiabilities

Balance Sheet of XYZ Ltd.

From the above table, determine the ratio in which shares will be issued by the Resulting company to the shareholders of the Demerged Company


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Determine the amount by which the General Reserves of the Demerged Company

will reduce.


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Exemptions and benefits• A demerger transaction fulfilling the conditions of Section

2(19AA) is free from capital gains tax both with respect to:1. The transfer of assets and

• No CG Tax on the Demerged Entity2. Issue of shares to the shareholders

– No CG Tax on the new shares issued by the Resulting Company • Section 2(22) of the Act has been amended to provide that

the issue of shares directly to the shareholders pursuant to the demerger of an undertaking will not constitute deemed dividend.

• Implication?


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Exemptions and benefits: Accumulated losses and depreciation

• Accumulated losses and depreciation relatable to the undertaking being transferred in a scheme of demerger is allowed to be carried forward and set off in the hands of the Resulting Company.

– DEMCO had accumulated losses and depreciation of Rs. 100 cr. in respect of its one of the undertakings namely RESCO on the date of Demerger. RESCO will be allowed to set of such Accumulated losses and depreciation of Rs. 100 cr. from its future earnings.


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Exemptions and benefits: Accumulated losses and depreciation

• The Act provides for the apportionment of the Accumulated losses and depreciation between the demerged company and the resulting company in the same proportion in which the value of the assets have been transferred.

• When will it happen?


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Exemptions and benefits: depreciation• Depreciable assets base for tax purposes in the hands of the

resulting company would be tax written down value in the hands of the demerged company.

– Tax Written Down Value of the assets being transferred to the RESCO on the date of demerger is Rs. 350 cr. This will become depreciable assets base in the hands of RESCO upon the demerger.

• The tax depreciable assets base for the demerged company will be reduced by the tax written value of the assets transferred in the demerger process.

– The tax depreciable assets base of the DEMCO prior to demerger was Rs. 1000 cr. Out of this, Rs. 350 cr has been transferred to the RESCO. The tax depreciable assets base of the DEMCO now stands reduced to Rs. 650 cr.


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Cost of acquisition of shares in the resulting company

• How will you determine the cost of acquisition of shares in the resulting company since the shareholder does pay a dime?.


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What is the difference in tax treatment in case of Slump Sale and Demerger?


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presentation on corporate demerger & divestment-for circulation

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