Demerger
is a business reorganisation where one or more business unit is hived off into
a separate entity. There could be a number of reasons why a demerger is done;
for example, to unlock the value in a business, to focus on a particular
business or to seek external participation in the transferor or resulting
company. It involves separation of business, unlike an amalgamation, which
entails consolidation or merger of businesses.
Demerger
is generally achieved through a scheme of compromise or arrangement in a court
process u/s. 391 to 394 of the Companies act, 1956. The demerged company
(transfer or company, referred to as TCO in this article) transfers a business
unit on a going concern basis to a resulting company (transferee company
referred to as RCO in this article).
In
order to become a tax neutral or tax compliant scheme, the demerger should be
compliant with section 2(19AA) of the income-tax act, which, inter alia,
requires that the demerger should be pursuant to a scheme u/s. 391 to 394 of
the Companies act, 1956 and that the
transfer of assets and liabilities should take place at the book values of the
transferor company by ignoring revaluation, if
any. The tax neutrality provisions
provide neutrality to all parties
concerned, viz., the transferor company, the transferee company and the
shareholders of the transferor and transferee company. From the transferor
company perspective, there will be no capital gains on the transfer. Further
there will be no deemed divided nor dividend distribution tax with respect to
the distribution to the shareholders. The shareholders of the transferor
company too will not have to bear the incidence of capital gains tax.
Appendix
a Distribution of Non-cash Assets to Owners of Ind AS 10 Events after the
Reporting Period deals with accounting for distribution of assets other than
cash (non cash assets) as dividends to its owners (shareholders) acting in
their capacity as owners. The appendix applies to the non-reciprocal
distributions of non-cash assets (e.g. items of property, plant and equipment,
intangible assets, businesses as defined in Ind AS 103, ownership interests in
another entity or disposal groups as defined in Ind AS 105) by an entity to its
owners acting in their capacity as owners. The appendix addresses only the
accounting by the entity that makes a non-cash asset distribution, not the
accounting by recipients.
The appendix
does not apply
to a distribution
of a non-cash asset
that is ultimately
controlled by the same party or parties before and after
the distribution. This exclusion applies to the separate, individual and
consolidated financial statements of an entity that makes the distribution. A
group of individuals shall be regarded as controlling an entity when, as a
result of contractual arrangements, they collectively have the power to govern
its financial and operating policies so as to obtain benefits from its
activities, and that ultimate collective power is not transitory.
therefore, for a distribution to be
outside the scope of this appendix on the basis that the same parties control
the asset both before and after the distribution, a group of individual
shareholders receiving the distribution must
have, as a
result of contractual
arrangements, such ultimate collective power over the entity making the
distribution.
The
Appendix does not apply when an entity distributes some of its ownership
interests in a subsidiary but retains control of the subsidiary. The entity
making a distribution that results in the entity recognising a non-controlling
interest in its subsidiary accounts for the distribution in accordance with Ind
AS 110.
When
an entity declares a distribution and has an obligation to distribute the
assets concerned to its owners, it must recognise a liability for the dividend
payable. Consequently, this appendix addresses the following issues:
(a)
When should the entity recognise the dividend payable?
(b)
How should an entity measure the dividend payable?
(c)
When an entity settles the dividend payable, how should it account for any
difference between the carrying amount of the assets distributed and the
carrying amount of the dividend payable?
When to Recognise a Dividend Payable
The
liability to pay a dividend shall be recognised when the dividend is
appropriately authorised and is no longer at the discretion of the entity,
which is the date:
(a) When declaration of the dividend, e.g. by
management or the board of directors, is approved by the relevant authority,
e.g. the shareholders, if the jurisdiction requires such approval, or
(b) When the dividend is declared, e.g. by
management or the board of directors, if the jurisdiction does not require
further approval.
Since
the demerger is to be approved by the court, a question may emerge as to
whether the dividend liability is accounted when the demerger is approved by
the shareholders or when finally approved by the court. If the court approval
is substantive and not a mere formality, then the dividend liability shall be
recorded when the final court approval is received. If the court approval is
treated as a mere formality, then dividend liability should be recognized on
approval from shareholders. Under the indian jurisdiction, the court order
would generally be treated as substantive and determine the acquisition date.
However, this issue is not very relevant for the purposes of this article.
Measurement
of a Dividend Payable
An
entity shall measure a liability to distribute non-cash assets as a dividend to
its owners at the fair value of the assets to be distributed. At the end of
each reporting period and at the date of settlement, the entity shall review
and adjust the carrying amount of the dividend payable, with any changes in the
carrying amount of the dividend payable recognised in equity as adjustments to
the amount of the distribution.
Accounting For Any Difference between the Carrying Amount of
the Assets Distributed and the Carrying Amount of the Dividend Payable when an
Entity Settles the Dividend Payable
When
an entity settles the dividend payable, it shall recognise the difference, if
any, between the carrying amount of the assets distributed and the carrying
amount of the dividend payable in profit or loss.
Example: Non – Cash Asset Distributed To Shareholders
TCO
is an Ind-AS and a listed company. TCO has two divisions, hardware
manufacturing and software. TCO is professionally managed and has a widely
dispersed shareholding. There is no group of shareholders that controls TCO.
TCO’s accounting period ends at 31st march 2017. On 29th march 2017, the
shareholders of TCO approve a non-cash dividend in the form of demerger of the
hardware division. The hardware division will be hived off into a resultant
company (RCO). The shareholders of TCO shall become the shareholders of RCO in
the same proportion. The court approves the demerger scheme on 20th July 2017,
and the demerger is executed.
In
TCO’s separate financial statements at 29th march 2017 and 31st march
2017, the net assets of the hardware division, is carried
at INR 250. The fair value of the hardware division
at 29th march and 31st march 2017
is INR 350. The fair value increases to INR 400 when the non-cash asset is distributed
on 20th July 2017. For simplicity, it is
assumed that there is no change in the carrying amount of the net assets of the
hardware division from 29th march 2017 to 20th july 2017.
In
this example, for illustration purposes only, we have assumed that the court
order is a mere formality1 and hence the dividend liability is recognised on
approval of the demerger by the shareholders. On that basis, the dividend is a
liability in the books of TCO when the annual financial statements are prepared
as at 31st march 2017. At 31st march 2017 TCO would record a dividend liability
of INR 350 with a corresponding debit to its equity. In TCO’s separate
financial statements, the net assets in hardware division of INR 250 are
classified as held for distribution to owners. When the non-cash asset is
distributed on 20th July 2017, the fair value has increased by INR 50. At that
date, TCO shall record an additional dividend liability of INR 50 with a
corresponding debit to equity.
The
non-cash asset is distributed on 20th July 2017 at which point the fair value
of the division is INR 400. The difference between the carrying amount of the
net assets distributed (INR 250) and the liability (INR 400) which is INR 150,
is recognised as a gain in profit or loss of TCO.
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1 Under the Indian Jurisdiction, the court
order would generally be treated as substantive and determine the acquisition
date.
The
above example included the following assumptions:
1. TCO is an Ind-AS and a listed company. TCO
needs to provide an auditor’s certificate of compliance with Ind AS, in order
for the court to approve the demerger scheme. Effectively, this means that TCO needs to comply with
Ind-AS standards. RCO is the resulting
company.
2. TCO and RCO are not controlled by the same
party or parties before and after the demerger.
TCO
needs to address the following challenges from an income-tax angle
arising from the above demerger scheme:
1. TCO is a listed company and hence should
comply with the accounting standards in a court scheme, as per SEBI
requirements. If TCO was a non-listed entity, to which Ind AS was applicable,
SEBI requirements for providing an
auditor’s certificate with respect to Ind AS compliance would not apply.
Therefore, if TCO is a non-listed entity, there is a possibility, not to comply
with Ind AS to account for the demerger. However, additional consequence may
have to be examined, such as, the registrar of Companies, enforcing compliance
with Ind AS or auditors providing a matter of emphasis in the audit report.
2.
Under Ind AS the transfer of the non-cash asset is recorded at
fair value and
the resultant gain/loss is taken to the P&l. Would this be considered as a revaluation and
hence not meet the condition of section 2(19AA)? one
view is that TCO records a gain/loss on distribution of the assets,
which is not the same as revaluation of assets in the books of TCO. Therefore
with respect to this matter it may be argued that section 2(19AA) is not
violated.
3. On the other hand, if it is concluded that
the scheme is not in compliance with section 2(19AA), there could be an issue
of dividend distribution tax (DDT) on the distribution of non-cash assets.
arguments against this possibility would
be (a) Companies act 2013, prohibits any dividend distribution in kind – hence
the demerger cannot be treated as dividend for income- tax purposes also (b)
the legal form of the transaction as a ‘demerger’ cannot be disregarded.
4. Fair valuation is at the core of Ind AS. TCO
may have used the fair value option to determine the deemed cost at the
transition date to Ind AS for certain assets such as PPE or investments.
Alternatively, TCO may have used fair value option as a regular basis of
accounting for certain assets, where such a basis is allowed/ required. Fair
valuation may have resulted in an upwards or downwards adjustment. When TCO has
used such fair valuation under Ind AS, compliance with the condition u/s. 2(19AA)
to consummate the demerger transaction at book value will become challenging.
5. In our example, TCO records a profit of INR
150 on the distribution of non-cash assets. Whilst this would not be taxable
from a normal income tax computation perspective, if TCO is under mat, this credit would be counted
for the purposes of determining the profits for MAT purposes.
From
the perspective of RCO, the following aspects need to be considered:
1. Under Ind AS, from an RCO perspective, this
would be treated as a business restructuring transaction. RCO will have to
account for the assets and liabilities at book value, because under Ind AS, a
change in the geography of assets, arising from the restructuring, does not on
its own result in accounting for the exchange at fair value. The difference
between the fair value of shares issued by RCO to the shareholders and the book
value of assets and liabilities received from TCO will be debited to equity.
Assuming the fair value of shares issued by RCO to the shareholders is INR 445;
the amount to be debited to equity would be INR 195 (INR 445 – INR 250).
2. In other words, RCO will not be able to
create a goodwill for INR 195, and hence will not be able to derive any tax
benefits from goodwill.
Conclusion
It does
not appear fair
that Ind AS
should result in an unintended consequence for TCO with
respect to demerger schemes under
the income-tax act.
At the same time, it is not appropriate to try and meddle with Ind AS
and create more differences between IASB IFRS and Ind AS. The finance ministry and the Income-tax authorities
should move into swift action to resolve these issues by making suitable
changes in the income-tax act. If this is not done, the restructuring of
businesses will be hampered. Consequently, all this will have a negative impact
on the indian economy in the long run.
