Synopsis
Following the rapid ushering in of the Companies Act, 2013, MCA has also started issuing draft rules. The author highlights the glaring lacunae in the Draft Rules for Accounting for Demerger, which require the accounting to be undertaken in accordance with the current provisions under Income Tax governing demergers, instead of acceptable accounting principles.
This article deals with the issues relating to accounting for demerger, as a result of the draft rules under the Companies Act 2013. The said rules are not yet final.
As per the draft rules, “demerger” in relation to companies means transfer, pursuant to scheme of arrangement by a ‘demerged company’ of its one or more undertakings to any ‘resulting company’ in such a manner as provided in section 2(19AA) of the Income Tax Act, 1961, subject to fulfilling the conditions stipulated in section 2(19AA) of the Income Tax Act and shares have been allotted by the ‘resulting company’ to the shareholders of the ‘demerged company’ against the transfer of assets and liabilities.
As per section 2 (19AA) of the Income-tax Act, “demerger” in relation to companies, means the transfer, pursuant to a scheme of arrangement under the Companies Act, 1956, by a demerged company of its one or more undertakings to any 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 the 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 threefourths in value of the 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 share-holders 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 company or any undertaking thereof by the resulting company;
vi. the transfer of the undertaking is on a going concern basis;
vii. the demerger is in accordance with the conditions, if any, notified u/s.s. (5) of section 72A by the Central Government in this behalf.
Explanation 1—For the purposes of this clause, “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.
Explanation 2—For the purposes of this clause, the 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.
Explanation 3—For determining the value of the property referred to in sub-clause (iii), any change in the value of assets consequent to their revaluation shall be ignored.
Explanation 4—For the purposes of this clause, the splitting up or the reconstruction of any authority or a body constituted or established under a Central, State or Provincial Act, or a local authority or a public sector company, into separate authorities or bodies or local authorities or companies, as the case may be, shall be deemed to be a demerger if such split up or reconstruction fulfils such conditions as may be notified in the Official Gazette, by the Central Government.
Accounting for demerger under the draft rules issued under Companies Act 2013
The draft rules recognise that accounting standards issued under the Companies Accounting Standard Rules do not contain any standard for demergers. Till such time an accounting standard is prescribed for the purpose of ‘demerger’, the accounting treatment shall be in accordance with the conditions stipulated in section 2(19AA) of the Income Tax Act, 1961 and
(i) in the books of the ‘demerged company’:-
(a) assets and liabilities shall be transferred at the same value appearing in the books, without considering any revaluation or writing off of assets carried out during the preceding two financial years; and
(b) the difference between the value of assets and liabilities shall be credited to capital reserve or debited to goodwill.
(ii) in the books of ‘resulting company’:-
(a) assets and liabilities of ‘demerged company’ transferred shall be recorded at the same value appearing in the books of the ‘demerged company’ without considering any revaluation or writing off of assets carried out during the preceding two financial years;
(b) shares issued shall be credited to the share capital account; and
(c) the excess or deficit, if any, remaining after recording the aforesaid entries shall be credited to capital reserve or debited to goodwill as the case may be.
Provided that a certificate from a chartered accountant is submitted to the Tribunal to the effect that both ‘demerged company’ and ‘resulting company’ have complied with conditions as above and accounting treatment prescribed in this rule.
Author’s Analysis
First, the draft rules are designed to ensure compliance with section 2(19AA). In the author’s view, accounting treatment should be governed by Indian GAAP, Ind-AS/IFRS or generally acceptable accounting practices; rather than, the provisions of the Income- tax Act. The requirement to record demergers at book values in accordance with section 2(19AA) may not gel well with the requirements of generally acceptable accounting practices. For example, under IFRS/Ind-AS, distribution to shareholders is recorded at fair value, whereas under the draft rules the same is recorded at book value. This anomaly should be rectified through a collaborative effort of the Institute of Chartered Accountants (ICAI), the Ministry of Corporate Affairs (MCA) and the Central Board of Direct Taxes (CBDT). However it appears that this may not be as easy as it appears. Many issues need to be first resolved, such as, the strategy with respect to, implementation of Ind-AS/ IFRS, continuation of Indian GAAP for some entities, implementation of Tax Accounting Standards, implementation of the IFRS SME standard, etc needs to be finalised. Right now, this whole area is a maelstrom and the Government and the ICAI should provide a clear roadmap, before complicating this space any further.
Second, the draft rules and section 2(19AA) of the Income-tax Act assumes a very simple scenario of demerger. In practice, demerger may involve many structuring complexities. The draft rules therefore are very elementary. They focus on the accounting that is required in a narrow situation where the demerger is in accordance with section 2(19AA) of the Income-tax Act.
Third, the draft rules on accounting of demerger is applicable only when the demerger is in accordance with section 2(19AA) of the Income-tax Act. These accounting rules are not applicable when the demerger is not in accordance with section 2(19AA). For example, a company demerging one of its undertaking may be doing so, to unlock value rather than obtaining tax benefits under section 2(19AA). For such demerger, the prescribed draft accounting rules are not applicable. Thus, as an example, the resulting company could account for the assets and liabilities taken over at fair value rather than on the basis of book values as prescribed in the draft rules.Fourth, in the books of the demerged company when the transfer to a resulting company is a net liability, the draft rules require the corresponding credit to be given to capital reserves. This accounting seems appropriate, as it could be argued that the shareholders are taking over the net liability, and hence this is a contribution by the shareholders to the company. When the transfer to a resulting company is a net asset, the draft rules require the corresponding debit to be given to goodwill. This seems completely ridiculous as distribution of net assets to shareholders cannot under any circumstances result in goodwill for the demerged company. Rather it is a distribution by the demerged company of the net assets to the shareholders, and hence the debit should be made to general reserves. This mistake should be corrected in the final rules. Fifth, in the books of the resulting company, the net assets/liabilities taken over are recorded at book values. This is designed to comply with the requirements of section 2(19AA). As already indicated, the accounting in statutory books should not be guided by the requirements of the Income-tax Act. In practice, the resulting company may want to record the said transfer at fair value, to capture the business valuation. Whilst for tax computation purposes, he net assets may be recorded at book values; it is inappropriate for the Income-tax Act to suggest the accounting to be done in statutory books.Lastly, in the resulting company there is no requirement in respect of how share capital is valued. Thus the securities premium, goodwill and capital reserves can be flexibly determined by ascribing a desired value to the share capital. This is certainly not an appropriate approach from an accounting point of view.
In conclusion, the author believes that some immediate correction is required in the draft accounting rules as suggested in this article. In the long term, accounting should be driven by sound accounting practices and not by income-tax requirements. In this regard, ICAI, CBDT and the MCA should collaborate and establish a clear roadmap for the future.
