Evaluation of spin off of indian companies

2011-12

Akanksha Bijalwan (16018)Parthsarthi Gupta (16025)Nikita (16030)

CORPORATE RESTRUCTURING AND MERCHANT BANKING

SHAHEED SUKHDEV COLLEGE OF BUSINESS STUDIES

ACKNOWLEDGEMENT

We owe a great many thanks to a great many people who helped and supported us during the project.

The project benefited from reviews and comments of Mr. Kumar Bijoy who always guided us with his knowledge in all the fields of finance and the corporate world. This project would not have been possible without the basic and advanced inputs provided by him. He has taken pain to go through the project and make necessary correction as and when needed.

The credit for this project not only goes to the members of the group but also many other people who contributed for the project and helped us to complete it.

We would also like to extend their acknowledgement to our other teachers for their valuable support and guidance and for solving our doubts as and when they arrived. We are also thankful to our Institution and our faculty members who supported us with their valuable suggestion time to time and were always eager to participate with us in the proceeding of the project.

Regards extended and my heartfelt thanks to our family and well wishers constantly by our sides to help us out in any situation.

Signature

(Dr. Kumar Bijoy)

( Critical Evaluation of Spinoff of Indian Companies : Issues And Challenges )

TABLE OF CONTENTS

INTRODUCTION1

CORPORATE RESTRUCTURING

ISSUES AND CHALLENGES

Operational Issues

Legal Issues

Tax Issues

Strategic Issues

CONCLUSION

ANNEXURE30


1INTRODUCTION

Several Indian corporations engaged in entirely different businesses are, at present, structured as conglomerates, usually involving a parent company and several subsidiaries. Such conglomerates often trade at a discount to the overall individual value of their businesses. Individual subsidiaries of most Indian conglomerates are at different points in their business lifecycle. As a result, it is imperative for managements to evaluate these structures and their inherent business synergies periodically.

“Smart apple farmers routinely saw off dead and weakened branches to keep their trees healthy. Every year, they also cut back a number of vigorous limbs - those that are blocking light from the rest of the tree or otherwise hampering its growth. And, as the growing season progresses, they pick and discard some perfectly good apples, ensuring that the remaining fruit gets the energy needed to reach its full size and ripeness. Only through such careful, systematic priming does an orchard produce its highest possible yield.” - Dranikoff, Koller and Schneider (2002)

Companies have many similarities to orchards – like smart apple farmers, managers should focus on prudent, systematic pruning that means following a regular, proactive program of restructuring. The measures of the management should be directed to expand the crop in the coming seasons, thus enabling them to harvest more than the average and exceed the expected crop.

The Indian economy is one of the fastest growing in the world, and this growth has benefited emerging Indian multinational companies with domestic and global operations as well as foreign multinationals with investments and operations in India. Foreign investment into India also continues to thrive. As the domestic and global business opportunities for Indian and foreign multinationals continue to expand, there has been increasing activity regarding corporate restructuring and business integrations across industries. More and more, companies are opting to capitalize on synergies and to overcome weaknesses through strategic transactions.

An ongoing task of managers is to monitor, improve and hence restructure their businesses. Rationales for restructurings are manifold:

Significant operating underperformance Triggering role of stock market underperformance Fundamental economic shocks in the industry Intensifying global competition and changes in technology Input prices Regulations

Companies are always seeking for new ways to remain competitive. An effective and popular strategy of doing so is to divest non-core or underperforming assets. The philosophy behind these break ups is that ‘the separate parts are greater than the whole’.

In the next sections, we will be discussing the different types of these ‘corporate break-ups’, with a focus on spin-offs (explained in the next section). We will be critically evaluating spin off in Indian context, i.e. we will be discussing the various issues and challenges faced by the Indian companies while considering spin off.


2CORPORATE RESTRUCTURING

Restructuring is the corporate management term for the act of reorganizing the legal, ownership, operational, or other structures of a company for the purpose of making it more profitable, or better organized for its present needs. Corporations occasionally require restructuring their entity through merging with other corporations, acquiring other firms and divesting certain divisions or subsidiaries.

There is an increasing realization among companies that demerger may allow them to strengthen their core competence and realize the true value of their business. This may also be necessary to undo a previous merger or acquisition which proved unsuccessful.

Corporate divestiture can be implemented in many different ways:-


31. Spin off

A spin-off (also called spin out or starbust) is defined as a pro-rata distribution of shares of the subsidiary to the parent's shareholders. As a result of a 100% spin-off, the subsidiary becomes a totally independent company.

There is neither dilution of equity nor transfer of ownership from the current shareholders, and involve no cash transaction. Following the transaction, the former parent shareholders own two securities: The shares from the parent company and the shares from the spun-off subsidiary. Hence a spin-off leaves the portfolio decision (of whether to be shareholder of the parent and the subsidiary company or not) up to the shareholders.

The primary consequence of spin-off is that the asset base of the parent company declines and the spun-off company becomes a separate decision-making entity with the assets received from the parent. The original shareholders still control both the parent and the spun-off firms, but debt holders cease to have any claim on the spun-off’s assets and earning.

2. Split off

A split-off is a mechanism that allows shareholders of a parent company to exchange their shares for shares in a subsidiary that is normally majority-owned by the parent firm. It is the redemption of shares in an existing company in exchange for shares in a newly created one.

Split-off is closely related to spin-offs – the end result of the transaction is that the public stockholders of a parent company own stock in two enterprises, the parent and a split-off subsidiary.

The main difference between the two types of transactions is that after the completion of a split-off, the stock of the subsidiary is held by the parent’s stockholders on a non-pro rata basis. Some shareholders may hold only parent stock, while others may hold only subsidiary stock, and still others may hold both.

3. Split up

A split-up is an alternative type of spin-off in which a company separates into several parts, distributes stock of each part to its shareholders, and ceases to exist.

A company can split up for many reasons, but it typically happens for strategic reasons or because the government mandates it.

Some companies have a broad range of business lines, often completely unrelated. This can make it difficult for a single management team to maximize the profitability of each line. It can be much more beneficial to shareholders to split up the company into several independent companies, so that each line can be managed individually to maximize profits.


4The government can also force the splitting up of a company, usually due to concerns over monopolistic practices. In this situation, it is mandatory that each segment of a company that is split up be completely independent from the others, effectively ending the monopoly.

4. Equity carve out

A carve-out is the sale of shares in a non-listed subsidiary to the markets through an initial public offering (IPO). The shares offered that are sold to new shareholders could be either in a secondary carve-out existing shares owned by the parent company, or in a primary carve-out newly-issued shares sold by the subsidiary itself.

Equity carve-outs increase the access to capital markets, enabling carved-out subsidiary strong growth opportunities, while avoiding the negative signaling associated with a seasoned offering (SEO) of the parent equity.

Combinations of these

The above listed types of restructuring are used independently as well as in a combination. The possible combinations are as under:

Many a times, spin off is used as a precursor of equity carve outs. In such cases, 15-20% of the shares in the spun off company are offered in the primary market to generate some cash inflow as spinning off does not involve any cash transaction, but equity carve-out does. Also, the old shareholders continue to hold the majority of the shares to the extent of 80-85%.

Split off is sometimes also applied as a second step after an equity carve out, but has also been used independently to take a private subsidiary public.


5ISSUES AND CHALLENGES

OPERATIONAL ISSUES

Organizational spin-offs offer companies the chance to reinvent the business while keeping a core of the familiar; start a new company, yet keep the advantages of existing customers, products, operations, and people. Re-focus an existing company (Parent) around a tighter core of business and a new cost/operating model. It is an exciting time of opportunity and possibility.

Yet the opportunity in a spin-off is balanced by the challenges. These include splitting up the two organizations, refocusing the Parent, and launching New Company, all the while keeping both organizations operating profitably and serving customers.

Furthermore, all of these things must be done in a short time frame to respond to the expectations of shareholders, analysts, customers, and employees. Execution of the spin-off significantly affects cost savings, employee motivation, and speed of mobilization to business performance. Therefore, these operational issues are to be kept in mind when a company is considering spinning off.

a) Companies typically use this structure to enable separate pieces of a larger business to more readily pursue individual long-term goals. Spun-off subsidiaries are fully independent of their parents and hence have clear goals and decision processes. Both firms involved in spin-offs can focus on their business and no longer have to concern themselves with the others’ business.

b) As an independent company, they lose potential synergies with the parent company. As parents and subsidiary firms often are active in disparate lines of businesses with different business environments, the synergy potential is limited and parents and subsidiaries’ managers face different operational challenges.

c) As there are no conflicts of interest with the parent, spun-off subsidiaries can approach competitors of their former parent as customers, suppliers or partners more easily.

d) On the one hand, spun-off subsidiaries lose access to the internal capital market of their former parent firm. On the other hand, they can use external financing opportunities that are tailored to their needs. This may include providing the spun-off business with opportunities to access capital under separate, often more favourable, terms or to pursue strategic merger and acquisition activity.

Since parent companies and some subsidiaries often unrelated business lines, they also have different business risks, which affect operating earnings. Parent companies sometimes spin-off subsidiaries to protect both companies from each other's risks, which generally stabilizes the earnings of the parent company. The spin-off of a riskier subsidiary allows each company to finance its expansion based on its own growth rates and projections.

e) The spin-off transaction, by itself, does not raise capital for the parent or the spun-off company, nor does it change the overall value held by the shareholders. However, post-spin, shareholders do recognize the impact of separate market valuations and borrowing rates that otherwise might not have been available to the spinnee under the combined company structure.


6Many portfolio managers prefer "pure play" companies. Investment professionals may be interested in one or the other of a company's basic businesses, but not both. To the extent that financial markets are incomplete, spin-offs provide investors with a wider range of investment opportunities appealing to different investor clienteles. In addition, the issuance of separate financial reports on the operations of the subsidiary facilitates the evaluation of the firm's performance. Thus, this technique enables managers to uncover the hidden value of the subsidiary.

f) A spin-off can provide Human Resources with a significant showcase for its capabilities, enabling it to build credibility in the organization.

g) Consumers and suppliers may think that the parent company is not committed to its core line of business if it has an unrelated subsidiary. This will not be the case if the unrelated line of the parent company has been spun-off as an independently operating unit.

h) Spun-off companies may also attract more desirable management talent.

A Few Operational Challenges

Obviously, what we’re talking about is change on a massive scale. It touches upon virtually every aspect of the organization. And each of the issues involved could easily provide the grist for a separate paper. Our intent here is to address the multiple issues that revolve around the operations of the organization as a social enterprise, and to suggest specific areas where executives must be ready to manage the human dynamics associated with break-ups. Specifically, we’ve identified eight sets of related challenges, which we’ll consider in turn (see Figure 1)


71. Loss of Identity

Any time a company breaks up—just as when one falls prey to a merger or acquisition—the event has a profound impact on the organization’s sense of collective identity. People naturally wonder: Who are we now? What are we all about? What do we stand for? How are we different from the company we were part of yesterday? What exactly is our business? The questions don’t get much more basic than these—even to the point of having to decide upon a new name. Others are exceptionally complex, such as how the new entity views itself in relation to its constituents—its customers, shareholders, suppliers, partners, government regulators, and the communities where it operates.

For enterprises that are being spun off from the core organization, creation of an identity quickly becomes a critical issue. In some situations, there can be a palpable sense of depression and loss, with people feeling they’ve been rejected and cast off. To a considerable degree, personal identity can become deeply entangled with corporate identity; after spending a career working for an industry leader or corporate behemoth, people who are suddenly working for a much smaller enterprise can suffer significant loss of self-esteem.

On another level, identity embraces the set of perceptions employees have about the organization—career expectations, management styles, performance requirements, and behavioral norms. Suddenly there’s potential for a major disconnect. People had a pretty good idea of what kind of performance, style, and relationships would help them get ahead in the old AT&T. But how do you succeed in Lucent? It’s a whole new ball game.

2. Re-contracting With Constituents

While the identity issue deals with the company’s internal focus, there’s a related issue involving the new company’s external identity and network of relationships. These historic relationships with external constituents are likely to have been frayed—perhaps even shattered—by the very act of the break-up. What will be the relationship between the new Board of Directors and senior management? What kinds of expectations should shareholders have about the new company’s performance, and how it will affect the return on their investment? What sort of corporate citizen will the new company be, and what kind of role will it play in its various communities? What kinds of products, quality, and service should customers expect?

In terms of external identity, various stakeholders have bonded with the corporation in different ways over the years; the corporation created and sustained those bonds through a huge investment in brand equity. Suddenly, it’s all gone. At Lucent, for example, thousands of people spent their careers helping to build AT&T’s reputation for quality and service. All of a sudden, their ability to capitalize upon that hard-won reputation was in danger of vanishing along with their affiliation with AT&T.

In essence, what is required of the new organization is that it contract—or re-contract—with each of its constituencies. It must develop an agenda for deliberately reconnecting with each, renewing old relationships and building new ones. There are two important points to remember. First, assuming this is a fundamental break-up in keeping with our earlier definition, the leaders of each of the remaining companies must keep in mind the extent to which old relationships have been altered with customers, competitors, communities, partners, suppliers, unions, regulators, and public officials. Second, this reconnecting process provides break-up companies with a unique opportunity to aggressively redefine


8relationships in productive ways. The key is to take the lead in reshaping the terms of the relationships, rather than passively allowing them to re-emerge while management’s attention is focused elsewhere.

3. Distraction

Make no mistake—senior-level attention will be focused on financial and legal issues. The distraction factor is immense, particularly if the break-up involves an initial public offering. Even if there isn’t an IPO, executives will find their time and energy consumed by explaining the situation—to customers, shareholders, lenders, potential investors, suppliers, and partners. At the precise time when the organization requires the strongest leadership and closest management, powerful forces converge to make running the company a secondary concern.

Legal and financial issues supersede the “hardware” issues involved in running the company, which in turn drive out the “software” issues involving people. Marathon sessions with lawyers and analysts don’t leave much time to reconnect with confused, anxious employees who are desperate for leadership and a sense of mission. Unless “software” issues are identified by senior management as a top priority, they will inevitably fall by the wayside at the worst possible time.

4. Downsizing

Break-ups provide not only the opportunity, but often the necessity, for downsizing. Many of the coordinating processes and functions that were necessary in the larger organization no longer have any role in the streamlined companies. Nor can those companies justify maintaining the substantial expense of all the managers who were involved in those now-obsolete coordinating functions. Downsizing is also driven by accounting issues, which generally provide one-time opportunities to take below–the–line charges that otherwise would be tied to continuing operations.

Having said that, it’s still essential that downsizing be done well, with a full understanding of the pain it inflicts on the employees, their families, their communities, and the colleagues who are left behind. Downsizing presents management with a delicate counterpoint: working to get people excited, energized, and enthusiastic about the opportunities presented by the new start-up, while at the same time throwing many of their friends and co-workers out of a job. While they might not like it, if given sufficient information, people often understand the economic case for downsizing. It is the way in which it is handled that leaves an indelible impression upon those who remain with the organization, and defines the nature of the contract between the new enterprise and its people.

5. Integration

Frequently, companies that result from break-ups face the immediate challenge of integrating units that had little to do with each other when all were part of a much larger corporation. Now, given the new focus of the off-shoot enterprise, these once distant corporate cousins are suddenly thrown together because they share some common element involving technologies, markets, or offerings.

For managers, this involves another set of inherently opposite challenges. On one hand, their concentration is fixed on detaching the break–up company from the rest of the corporation; they’re working through all the legal, financial, and structural issues involved in splitting the enterprise apart. But simultaneously, they also have to choreograph an internal merger, aligning units that were only


9distantly related in the past. That dual process, difficult in itself, is often complicated by a feeling on the part of some units that they’ve been “taken over” and folded into the new, smaller entity.

6. Start-Up

In the life of any enterprise, the earliest events offer the greatest leverage. In other words, it’s infi nitely easier to shape the key technical and social elements of the organization at the outset than it is later on, after people—individually and collectively—have become set in their ways and accustomed to specific structures, processes, and social mores. So the break-up offers a major window of opportunity, a chance to carefully manage the dynamics of a start-up. For a relatively brief moment—a matter of only a few months, in reality—management has the full attention of all the key stakeholders, and unusual latitude to move them quickly and dramatically in new directions.

For senior executives, the challenge is to make the most of this one-time opportunity, and to remember that style and process are just as important as substance and content when it comes to shaping a new operating environment. The symbols, the slogans, and the processes used to communicate, implement, and build support for the new operation will send crucial messages about the kind of organization its leaders want it to be.

7. Rebuilding the Enterprise

Beyond the initial start-up, there is typically a phase lasting somewhere between one and three years in which to fundamentally rebuild the enterprise. The companies involved in the break-up—and sometimes, even the core entity that keeps the name of the original company—end up tackling the challenge of creating a new enterprise from top to bottom. In all likelihood, each new company’s leaders will be faced with developing a new strategy, designing a new organizational architecture, configuring new work processes, shaping a new operating environment, and, in many cases, making hard choices about putting the right people in the right jobs. Of course, those are the same functions involved in a start-up. But rebuilding is infinitely harder.

Following break-ups, managers don’t have the luxury of starting with a blank slate. They don’t have the traditional incubation period that allows most entrepreneurs to make mistakes and learn from experience in the sheltering cocoon of the proverbial garage. They don’t have time to gradually grow the business, instill values, and slowly add hand-picked people. Instead, rebuilders, in essence, have to engineer a fresh start for a collection of existing businesses employing thousands of people and generating literally billions of dollars in revenue. And they have to do it in the full glare of post break-up publicity under the close scrutiny of customers, competitors, investors, partners, employees, and host communities.

8. Change Management

As if all the issues we’ve already talked about weren’t enough, break-ups and the ensuing start-ups also require managers to grapple with all the classic elements of change management: the movement of an organization from a current state through a transition period to a significantly different future state. Whether that transition happens in two months or a year, it involves critical issues of power, anxiety, and control throughout the organization—issues that demand strong leadership and careful, deliberately planned transition management. The new enterprise will not simply rise up from the ashes


10of the break-up simply because someone makes an announcement and issues a new organizational chart. The successful management of large-scale organizational change requires leadership, focus, personal involvement by the most senior officials, widespread participation by others, and a thoroughly conceived, deftly implemented transition plan. Simply telling everyone to focus on business as usual while top executives deal with the financial and legal aspects of the break-up will not produce a viable organization over the long haul.

EXAMPLE

o In 2007, Tyco International split itself into three companies: Covidien, Tyco Electronics, and the original Tyco International.

o Shortly after the spin-off, then-CFO Chris Coughlin described the advantages, reporting that the health care business, Covidien, had made significant strides in attracting new talent that would probably not have been attracted to the old Tyco.

o In a health care company with a clearly defined strategy, employees and prospective employees could see themselves advancing professionally while remaining in health care and playing a significant role in the business.

o During an interview by McKinsey Quarterly, Chris Coughlin told that “The most challenging part was to get the management teams in place and transferring the technical knowledge from some of the corporate functions that resided at the Tyco headquarters to the two new businesses. So we set up a formal mechanism to manage the whole transition process and held reviews every month with each function.One of the nice things about this separation is that it provided some enormous opportunities for our people. We had built some real strength in some of the functions, so as we separated and needed, say, treasurers for all three companies, we were able to fill those positions internally. The CFO for electronics, for instance, came from inside that organization, and we appointed a new CEO from another Tyco business. In health care, we had an experienced team in place that pretty much remained intact. There were other opportunities for people to move up many other functions including tax, treasury, and legal.”


11LEGAL ISSUES

There are various legal issues which are a matter of concern to the Indian companies. These issues have to be considered in the decision making for the company. These issues affect the demerger process as well as sometimes become a reason for it (as in the case mentioned in the end of this section).

Legislation in India

There is no specific law governing spin offs in India. But, spin-off is considered to be a type of demerger for legal and taxation purposes. Although, the term “Demerger” itself, has not been defined in the Companies Act, 1956.

However, it has been defined in Sub-section (19AA) of Section 2 of the Income-tax Act, 1961. According to the said Sub-section, demerger in relation to companies, means transfer, pursuant to a scheme of


12arrangement under Sections 391 to 394 of 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

ii. All the liabilities relatable to the undertaking, being transferred by the demerged company, immediately before the demerger, become the liabilities of resulting company of virtue of the demerger.

iii. The property and the liabilities of the undertaking, 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;

v. The shareholders holding not less than three fourths in value of the share 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,

vi. The transfer of the undertaking is on a going concern basis;

vii. The demerger is in accordance with the conditions, if any, notified under Sub section (5) of Section 72A of the Income Tax Act 1961 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 utilized 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


13be, 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.

From the above, the following points emerge about demergers:

1) Demerger is essentially a scheme of arrangement under Section 391 to 394 of the Companies Act, 1956 requiring approval by: a) Majority of shareholders holding shares representing three-fourths value in meeting convened

for the purpose; and b) Sanction of High Court.

2) Demerger involves ‘transfer’ of one or more ‘undertakings‘.

3) The transfer of ‘undertakings’ is by the demerged company, which is otherwise known as Transferor Company. The company to which the undertaking is transferred is known as resulting company which is otherwise known as Transferee Company.

Demerged Company

According to Sub-section (19AAA) of Section 2 of the Income-tax Act, 1961, ―demerged company‖ means the company whose undertaking is transferred, pursuant to a demerger, to a resulting company.

Resulting Company

According to Sub-section (41A) of Section 2 of the Income-tax Act, 1961 ―resulting company‖ means one or more companies (including a wholly owned subsidiary thereof) to which the undertaking of the demerged company is transferred in a demerger and, the resulting company in consideration of such transfer of undertaking, issues shares to the shareholders of the demerged company and includes any authority or body or local authority or public sector company or a company established, constituted or formed as a result of demerger.

The definition of ‘resulting company’ has clearly brought out three important requirements while establishing its relationship with demerging company. They are –

i. Consideration for transfer of undertaking would be by issue of shares only, by resulting company.

ii. Such consideration would be paid only to the shareholders of demerged company. iii. Resulting company can also be a subsidiary company of a demerged company.

Case study

Let us consider the demerger of Zee Entertainment Enterprise Limited to explain the legal issues. In this case, the regulations in India were a reason for the demerger.


14Demerged Company: Zee TelefilmsResulting Companies: Zee News Limited, Wire and Wireless India Limited & ASC enterpriseEffective Date: 22nd November 2006 Reason for demerger: Non compliance with the Indian regulations.

Below is the pre-demerger structure:

According to the Indian regulations, only 26% total foreign equity shareholding was allowed in News business and only 49% total foreign equity shareholding was allowed in Cable business & Direct to home (DTH) business.

The existing structure was not complying with the regulations and the company was demerged as:-

Cable and DTH business: Cable and DTH business of Zee were demerged into two separate companies and part of the foreign promoter holding in the new company was transferred to Indian promoters to meet regulations.

News business: News business of Zee was demerged into a new company and the entire foreign promoter holding in the news company was transferred to Indian promoters and FIIs were issued Preference shares in excess of their 26% holding.


15TAX ISSUES

Several issues related to taxation are taken into account while demerging a company. As the scheme of demerger needs the approval of the high court to be implemented, the court looks into various aspects of the scheme including taxation. There have been many cases where the schemes of demerger have been refused to be sanctioned by the court on the grounds of the objections raised by the Income Tax Department regarding tax evasion.

The Income-tax Act, 1961 provides the tax reliefs to the demerged company, the shareholders of the demerged company, who are issued and allotted shares in the resulting company in the exchange for the shares held by them in the demerged company and the resulting company which emerges as a result of a demerger.

TAX BENEFITS TO DEMERGED COMPANY:

1. Capital Gain Tax not attracted: As per section 47 (vib) of the Income Tax Act, the transfer of any capital asset by the demerged company to the resulting company will not be regarded as transfer for the purpose of capital gain.

2. Tax relief to Foreign Demerged Company: As per section 47 (vic), where a foreign company holds any shares in an Indian company and transfer the same to resulting company in the course of demerger, such transfer will not be regarded as “Transfer” for the purpose of capital gain, if following conditions are satisfied:

75% of the shareholders of demerged foreign company continue to remain shareholders of the resulting foreign company.

Capital gains tax is not attracted on the demerged foreign company in the country of its incorporation and S. 391 to S. 394 of the Companies Act will not be applicable.

TAX BENEFITS TO THE SHAREHOLDERS OF THE DEMERGED COMPANY:

1. Dividend: Section 2(22) has been amended by inserting a new clause to provide that no dividend income shall arise in the hands of shareholders of demerged company on demerger.

2. Capital Gains: As per section 47, any transfer or issue of shares by the resulting company to the shareholders of the demerged company, in scheme of demerger, is not regarded as “Transfer” for the purpose of Capital Gains.

In case, the shareholders transfer these shares subsequent to the demerger, the cost of such shares will be calculated as under:


16EXAMPLE: RIL

We can illustrate and substantiate the concept by means of an example of Reliance Industries Limited which is the Demerged Company and the new companies of which shares were issued are the Resulting Companies.

In this case, Reliance Industries Ltd. (RIL) has transferred four of its businesses to four separate companies. The telecom leg has been transferred to Reliance Communication Ventures Ltd, the coal based energy system has been transferred to Reliance Energy Ventures Ltd; the financial services leg has been transferred to Reliance Capital Ventures Ltd. and lastly the gas based energy business has been transferred to Reliance Natural Resources Ltd.

Consequence of the demerger:

The existing shareholders of RIL got one share each in the Resulting Companies for every share that they held in RIL.

Tax impact of the above:

As per the Income Tax Act, a transaction of demerger, per se, has no tax implications on the shareholders. In other words, when the shareholders of RIL are allotted the new shares in each of the four companies, there would be absolutely no tax implication whatsoever.

The tax implication will only arise when either the shares of RIL or the shares of the new Resulting Companies are sold.

Tax implications when shares are sold:

When the shares of any of the companies are sold, it would give rise to capital gains tax liability. The three issues that arise are:

Whether the new shares (in the Resulting Companies) are long-term assets or short-term. Indexation of the capital gains. Cost of acquisition of the various shares after the demerger transaction

a) To find out whether or not shares in the Resulting Companies are long-term or not, the holding period of the RIL shares will be included in the period of holding of the new shares.

b) The indexation will start from the date of allotment of the new shares and not from the date of acquisition of RIL. Relevance of indexation is only for working out the capital gain amount if the same has to be set-off against capital loss. However, as explained further on, for most shareholders, there will be no need of this.

c) To calculate capital gains when the shares are sold, a vital piece of information is the cost of acquisition. Your original cost of acquisition of RIL shares will change now on account of the demerger. Plus there will be a new cost accorded to the new shares of the Resulting Companies. The Income Tax


17Act specifies a complicated formula that takes into account the proportion of the net worth of RIL vis-a-vis the book value of the businesses transferred to arrive at the new costs of acquisition.

The net results of the above calculations are summarized in the following table:

Name of Company % of Cost of Acquisition of RIL Shares

Reliance Industries Limited 52.0%Reliance Communication Ventures Limited 38.7%Reliance Energy Ventures Limited 7.3%Reliance Capital Ventures Limited 1.3%Reliance Natural Resources Limited 0.7%

100.0%

What the above table indicates is the proportion in which your original cost of acquisition of RIL shares will be apportioned to the new shares.

It can be understood by an example:

Say, X had purchased 100 shares of RIL for Rs. 534 on January 10th 2005. Consequently, his total cost of acquisition would be Rs. 53,400. Now, post the demerger, his new costs would as in the table here.

RIL (52% of Rs. 53,400) Rs. 27,768RCVL (38.7% of Rs. 53,400) Rs. 20,666REVL (7.3% of Rs. 53,400) Rs. 3,898RCVL (1.3% of Rs. 53,400) Rs. 694RNRL (0.7% of Rs. 53,400) Rs. 374Total Rs. 53,400

For the per share cost, the above values be divided by the number of shares. For example, Rakesh's new cost of acquisition of RIL post demerger would be Rs. 27,768 divided by 100 which work out to Rs. 277.68.

Now let us say he sells the all the above shares on January 15th. As explained earlier, since he has bought the shares on Jan 10th last year, 12 months have elapsed and hence the RIL shares will be long-term capital assets. Similarly, for the new shares, the period of holding RIL will be taken into account, thereby making these too long-term assets.

Therefore, since long-term capital gains are tax-free, if any or all of the above shares are sold on a recognized stock exchange, there would be absolutely no tax payable by Rakesh in the entire process.


18TAX BENEFITS TO RESULTING COMPANY:

1. Amortisation of expenditure in case of amalgamation or demerger (Sec. 35DD): Expenses by an Indian company incurred after 1-4-1999 for amalgamation or demerger of an undertaking, shall be amortized @ 20% each year starting from the year in which amalgamation or demerger takes place.

2. Depreciation shall be apportioned between the demerged company and the resulting company in the ratio of number of days for which the assets were used by them.

3. The accumulated losses and unabsorbed depreciation in a demerger shall be allowed to be carried forward by the resulting company

4. Benefits available for demerger are also extended to authorities or boards set up by Central or State Government.

Conditions prescribed for a ‘tax neutral’ de-merger

All properties and liabilities of undertaking being transferred should be transferred to the resulting company and transfer should be at book value. Liabilities to include:

o Liabilities which arise out of activities or operations of the undertaking

o Specific loans or borrowings (including debentures) raised, incurred and utilized solely for activities or operations of the undertaking

o General or multipurpose borrowings to extent of following amount:Total of such borrowings X Value of assets transferred in de-merger

Total value of assets of such de-merged company

Consideration for de-merger should be met by issue of resulting company shares

At least 3/4th of de-merging company shareholders should become shareholders of resulting company

Shares to be issued as consideration to shareholders on a proportionate basis

Undertaking should be transferred on a going concern basis

DIFFERENCE BETWEEN DEMERGER AND SLUMP SALE

Generally, the gains arising from a demerger are exempt from capital gains tax, while those arising from a slump sale are not. But, then, what exactly is a ‘demerger’ for the purposes of the exemption from capital gains tax? Can a demerger ever be characterized as a ‘slump sale’? Several sections of the Income Tax Act, 1961 deal with these issues.


19The statutory provisions in the Income Tax Act:

A. Section 2(19AA) says that a ‘demerger’ means a transfer pursuant to a scheme under Sections 391-394 of the Companies Act, 1956 (by a demerged company of its one or more undertakings to any resulting company) such that a list of seven conditions enumerated in separate clauses is fulfilled. Clause [iv] is particularly relevant for the present discussion. It says that the resulting company must issue, in consideration of the demerger, its shares to the shareholders of the demerged company on a proportionate basis.

B. A slump sale is defined in Section 2(42C) to mean the transfer of one or more undertakings as a result of the sale for a lump-sum consideration without values being assigned to independent assets and liabilities.

C. According to Section 45, any profits or gains arising from the transfer of a capital asset are chargeable to capital gains tax.

D. Under Section 47(vii), the provisions of Section 45 do not apply to a transfer in a demerger of a capital asset by the demerged company to a resulting company if the resulting company is an Indian company.

E. Under Section 50-B, capital gains arising from slump sales are chargeable to tax. The capital gains from such slump sales are to be calculated by subtracting the net worth of the undertaking that is transferred from the lump-sum consideration (as per Explanations 1 and 2 to the Section).

In short, if a transfer is a demerger under the Income Tax Act, capital gains liability would not arise. If it is a slump sale, such liability would arise. For the transfer to be a ‘demerger’, the conditions mentioned in Section 2(19AA) must be complied with. But what happens when one or more of the conditions are irrelevant to a particular transaction? How this may happen is exemplified by the facts of the complex case of Avaya Global Connect v. ACIT, ITA No.832/Mum/07.

The Facts:

The assessee ‘A’ was a company having two divisions – ‘B’ and ‘T’. ‘T’ was transferred by ‘A’ to ‘I’, an Indian company. For this transfer, a scheme of arrangement filed before the Bombay High Court provided, “… ‘T’ without any further act, instrument or deed… shall stand vested in or deemed to be vested in ‘I’ as a going concern…” Significantly, the scheme went on to say “Upon the demerger of ‘T’ into ‘I’, ‘I’ would not pay consideration either to ‘A’ or to the shareholders of ‘A’…”

The Bombay High Court sanctioned this scheme. The value of the assets taken over by ‘I’ was less than the value of the liabilities; and ‘A’ showed the difference in the capital reserve account in the balance sheet. A question arose as to whether the gains which accrued to the assessee (as it had transferred more liabilities than assets) would be chargeable to capital gains.


20The claims:

The Department took the view that the scheme would not qualify as a demerger; on the basis that clause [iv] mentioned above was not satisfied. The assessee contended that clause [iv] was inapplicable to the case, as the clause would have effect only when there was some consideration for the transfer. In the case, the value of its liabilities exceeded its assets, leading to negative net worth. Therefore, there was no consideration for the transfer – as a practical matter, it was impossible for there to be any consideration. As there was no consideration whatsoever, the question of complying with clause [iv] would not arise.

Without prejudice, it was argued by the assessee that the transfer could not have been a slump sale given that no lump-sum consideration was paid. Further, it was contended that there being no sale consideration received in respect of the transfer, no question of computing capital gains arose.

The AO and the CIT (Appeals) however rejected these contentions. It was held that the transaction was a slump sale. The assessee had not received consideration as such; yet it had transferred liabilities in excess of assets and had credited the difference to its capital reserve account. This was sufficient to constitute consideration received on account of the transfer; and the assessee was liable to pay capital gains tax.

The issues before the Tribunal:

Essentially, the Tribunal faced the following questions:

a) Was the transfer to be characterized as a ‘demerger’ for the purposes of the Income Tax Act, 1961?

b) If not, could it be referred to as a slump sale? If it was a slump sale, would there be any capital gain on facts (considering the negative net worth of the assessee and the fact that no actual consideration was received)?

c) What would be the position if the transfer was categorized as neither a demerger nor a slump sale?

The decision:

The Tribunal agreed with the lower authorities that there was no ‘demerger’ in the present case. It was held that the legislature must be presumed to have foreseen all practical possibilities while adding the conditions. The fact that there was no consideration whatsoever (as a matter of practical impossibility) would not be sufficient to hold that the condition was inapplicable.

The Tribunal then went on to hold that it is only a transfer as a result of a sale which can be considered as a slump sale. The presence of a money consideration is essential for a sale. Also, when


21a Court sanctions a scheme under the Companies Act, the transfer in pursuance of that scheme would be not be a result of sale, but would be a result of the operation of law.

Essentially, the capital asset which was transferred in the case was a going concern. It would not be possible to “… conceptualize the cost of acquisition of … a going concern (or) the date of acquisition thereof…” As such, it was held that the computation provisions of the Act in Section 48 would fail in the given factual matrix. In such a scenario, no capital gains could be levied. Accordingly, the assessee’s appeal was allowed.

The significance:

From the point of view of the corporate world, the judgment serves to highlight an important point. Merely because a transfer is carried out in accordance with a scheme for a demerger under the Companies Act sanctioned by the competent High Court, the transfer will not be characterized as a demerger for the purposes of taxation.

At the same time, such a transfer will not be a slump sale; and liability to capital gains will depend on whether or not the provisions for computation of capital gains would be workable. The safer course, it appears, would be to ensure that the requirements for a demerger under tax laws are complied with in the first place.

CASE STUDY: Issue of tax evasion

In January 2011, the High Court of Gujarat refused to sanction a Scheme of Demerger after it noted that the scheme would result in tax evasion. The ruling was in the case of a large Telecom Company, wherein the Court observed that there was no business justification for the proposed Scheme and alleged that it would have resulted in evasion of taxes and stamp duties, if it was approved by the High Court.

The transferor company proposed a Scheme of Demerger to transfer its ‘Passive Infrastructure Assets' ("PIAs") to a group company ("Transferee"), free of liabilities and encumbrances. Under the scheme, no consideration was to be paid by the Transferee. After the demerger, the Transferee Company was to be merged with an independent telecommunication tower company ("Tower Company").

As per the standard procedure, the Court directed the companies to issue public advertisements of the proposed demerger in leading newspapers. The income tax department responded to the advertisements and filed its objections to the proposed demerger on the ground that the scheme, if approved, would result in tax evasion.

The Court observed that that the proposed demerger was not a mere internal restructuring as ultimately the PIAs were to be transferred by merger with the Tower Company, which was an independent company and in that case, the criterion of the ‘same persons carrying on the same business' would not be met.


22 It further noted that in the absence of any consideration, which was a basic requirement under

the contract law, the scheme would not qualify as an arrangement.

The Court further observed that the agreement was a forced one and not a voluntary action and hence, it would not satisfy the condition for ‘gift' under the Transfer of Property Act.

On the issue of tax evasion, the Court observed that the transferee company was a shell / paper company, being an intermediate vehicle for transferring PIAs from the transferor and ultimately to Tower Company with the sole purpose of tax evasion.

It noted that if the PIAs were directly sold to Tower Company, the transaction would have attracted capital gains tax computed on market value apart from levy of stamp duties and Value Added taxes.

The Court also noted that if the scheme was approved, the transferee would be in a position to claim tax holiday on the profits derived from the same block of assets, which were used by the transferor earlier to claim the tax benefits.

Further, it noted that the transferor, who was under the Minimum Alternate Tax regime sought to artificially reduce its book profits by writing off the assets and depressing its taxable income.

It also noted that the transferee company would also have claimed depreciation on the PIA, thereby resulting in double deduction for tax purposes. It also noted that the approval by the Court would have led to the circumvention of section 281 of the Income-tax Act, 1961, which required taxpayers to seek a prior approval from the tax authorities before transferring assets.

In the background of these observations, the Court accepted the objections which were raised by the income tax department and refused to sanction the scheme of demerger.


23STRATEGIC ISSUES:

Several strategic issues may come up during a spin-off. Unsurprisingly, strategic contentions might prompt the demerger/ spin-off in the first place. In the following pages about the strategic issues in demergers, we attempt to analyse each of the said issues through case studies:

1. BAJAJ AUTO : Focussing on core competencies / Recapitalisation-

PRE-DEMERGER STRUCTURE

Bajaj Auto incorporated two wholly owned subsidiaries & pre capitalized them to the extent required:

Bajaj Holdings and Investment - Rs 43.5 cr (4.35 cr shares @ Rs 10) Bajaj Finserv - Rs 21.75 cr (4.35 cr shares @ Rs 5)

Bajaj Auto demerged identified businesses in the following manner:

Bajaj Holdings and Investment

2-wheeler and 3-wheeler business Investment in PT Bajaj Auto Indonesia Cash

Bajaj Finserve

Wind power business Investment in Bajaj Auto Finance

Limited Investment in insurance business Cash


24Bajaj Auto retained remaining assets and liabilities, investments and balance cash and cash equivalentsScheme of arrangement provided for:

Issuance of shares to the share holders of Bajaj Auto in the ratio of 1:1 Such that post demerger, Bajaj Auto continue to hold 30% stake in respective companies with

balance being held by shareholders of Bajaj Auto in proportion of their holding Bajaj Auto to be renamed Bajaj Holdings and Investment Ltd ‘BHIL (New)’ Bajaj Holdings and Investment Ltd to be renamed Bajaj Auto Ltd ‘BAL (New)

POST-DEMERGER STRUCTURE

As can be clearly observed from the scheme of demerger, it was clearly for the purposes of focussing on the core competencies of the individual firms i.e. Bajaj Auto Ltd. and Bajaj Finserv Limited. A more detailed scheme of the demerger, along with the reasons the company provided for the same can be found annexed.

2. Various Cases : Unlocking shareholder value –

Empirical analysis has often showed that spin-offs have enhanced shareholder value more often than not. This is true for spin-offs not only in India, but across the world. However, keeping in line with our Indian background, we provide some Indian cases:


25 The Reliance Demerger:

Although the case of Reliance serves to act more as a case for solving family feuds, it also led to the creation of a substantial amount of shareholder wealth.

THE SCHEME OF DEMERGER

The demerger helped in the following ways: It put to rest the family agreement Resulted in dedicated management

team for each of the businesses Diversified business risk Increased Shareholder Value Facilitated investors / strategic partners

for each business It resulted in a growth story in each

business segment:o Energyo Financial Serviceso Telecommunications

Cadila Healthcare:


RIL

Petroleum Business

Investment Business

Reliance Energy (Energy Business)

Reliance Capital (Financial Services)

Reliance Infocom (Telecom Business)

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The scheme of demerger paved the way for the spin-off of the Consumer Product Division (CPD) from Cadila Healthcare Ltd. ‘CHL’ to Carnation Nutra – Analogue Foods Ltd. ‘CNAFL’; and the Merger of ZHMRPL into CHL.


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It can be clearly discerned that the demerger resulted in increased shareholder wealth for Cadila Healthcare Ltd. A few other examples have been briefly mentioned as below.

Eveready Industries resulted in a total wealth creation of 258% compared to only 66% pre-demerger. In the case of Eveready Industries, the demerger resulted in the creation of two companies :

McLeod Russel Eveready Industries

Similarly the demerger of GE Shipping also resulted in the creation of shareholder wealth. GE Shipping demerged into:

Great Offshore GE Shipping


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As can be seen, GE shipping resulted in a total wealth creation to the tune of 60%.

3. Hiving off non-core assets-

This has happened frequently in the case of telecom companies in India. The evolutionary years of Telecom business in India forced Telecom companies to invest in captive Infrastructure (towers) of their own. But gradually concept of sharing of infrastructure developed. Thus :

To unlock value from passive assets, Companies hived off Telecom infrastructure to subsidiaries /companies where infrastructure could be used by multiple operators.

These demergers were carried out under a High Court approved Scheme of Arrangement.

They were generally not classical demerger.

No shares issued pursuant to demerger.

Investments were then sought in the Infrastructure company.


29CONCLUSION

Companies are in a race to sell or spin off businesses. Large numbers of companies are parting with divisions that are firmly integrated with the rest of the enterprise or cutting loose discrete businesses. Spinning off a subsidiary has its own advantages and disadvantages. In the frenzied environment that inevitably accompanies corporate break-ups, it’s essential that senior managers address the challenges implicit in starting up, building an enterprise, and managing change.

Therefore, to be on a safer side, companies should analyse the various aspects that can get affected by the spin-off, positively as well as adversely. Most of the times, companies decide to spin-out a subsidiary only by seeing it as a solution for one of the issues of the company as a whole. But it is not enough to be focussed on one issue and not be concerned for the other prevalent adverse conditions.

The operations, of both the spinnee and the spinner, get affected. While at one hand both the firms (the parent company and the spun-off subsidiary) can focus on their own businesses, at the other hand they lose the potential synergies.

There are various legal and tax issues which are to be taken care of. While the regulations allow the companies to have tax benefits when they spin off, they also put some restrictions on the companies. If these regulations are not followed properly or are ignored, may lead to some adverse implications.

There are also some strategic issues which are to be considered. While many such strategic issues get solved through spin-offs, many other issues crop up after the spin-off decisions. All these issues are to be kept in account while deciding to spin-off a subsidiary. They need to be handled appropriately, otherwise there might be a situation where in the spun-off company faces more disadvantages than advantages.

We’re fully cognizant of how difficult it can be to make time for those issues. Nevertheless, executives must devote a significant share of their time and attention exclusively to these start-up issues.Why? Because one way or another, all the issues we’ve described will arise, and failing to handle them is tantamount to mishandling them. From a purely legal standpoint, at some point there will certainly be a new start-up, even though it may waste precious time just backing out of the driveway. A new enterprise will be created, even though its initial dealings with key shareholders may be so poorly managed as to poison relationships for years to come. And organizational change will occur, though not necessarily the kind of change that the management would have hoped for if it had taken the time to plan for it.

The question isn’t whether any of these things will happen. It’s whether they will happen randomly, with untold repercussions, or whether they will be deliberately guided and led in the service of strategic objectives. The price of indifference can be immense, sowing the seeds for the next round of de-mergers and break-ups in the years ahead.


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ANNEXURE


Evaluation of spin off of indian companies

Documents

indian conglomerates

indian companiesissues

indian corporations

indian economy

indian companies bfia

corporate world

business lifecycle

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