How Is Your Purchase Price divided after a Demerger?

Before we move ahead and know how the purchase price is divided in case of a demerger, it is equally important that we build a strong foundation of the concept of demerger. Read on and find below.

Understanding Demerger

In simple terms, demerger refers to a transfer of a company's one or more of its business operations into another company(s). The entity that transfers its business operations is known as a “demerged company”, and the entity created as a result of the demerger is known as a “resulting company”.

To simplify the concept of Demerged Company and Resulting Company, consider the case of the India Infoline Limited (IIFL) Group. The company, which announced a demerger this year, paves the way for the listing of three entities:

• IIFL Finance
• IIFL Wealth
• IIFL Securities

Thus, here IIFL would be considered the demerged company while IIFL Finance, IIFL Wealth and IIFL Securities would be considered as resulting companies.

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Types of Demerger

A Demerger can happen in multiple ways. Consider the three situations:

1. Company A used to operate in two lines of business, viz. Transportation and Hospitality. If Company A decides to separate all of its transportation business into a separate entity, say Company B, it will be called a spinoff. In this situation, a new separate/independent legal entity would be created. However, it is important to note that Company A would not cease to exist due to the creation of Company B. Thus, a spinoff involves the creation of a separate entity from the division of a line of a business.
2. Suppose company A decides to create two new companies, say B and C, for its transportation and hospitality business. This would be known as a Split. However, keep in mind that after a split, company A would cease to exist.
3. Suppose company A decides to sell its transportation business to an external investor. The company may sell some part of its equity shareholding in the subsidiary company, say company B, by way of public issue. This is known as an equity carve out. In case of an equity carve-out, the parent company A would not cease to exist, and it would enjoy full control over company B by holding a controlling interest in it.

Will there be any tax implications for demerger?

Well, keeping in mind that a demerger is just a transfer of assets and not a sale of assets, it could thus be concluded that there are no tax implications in the case of a demerger. For instance, in the case of IIFL Group, shareholders received seven shares of IIFL Finance and IIFL Securities and one share of IIFL Wealth for every share they held in the parent company (IIFL Group). Certainly, investors received these shares because of the splitting of assets of the parent company, IIFL Group. Thus, there would be no tax implications or what we popularly call the tax neutrality concept.

The matter of tax implications will arise only when the shareholder decides to sell its shareholding either in the parent company or in the subsidiary company. It would give rise to capital gains tax liability.

The issues that will be addressed for finding out tax implications would be:

• The date of purchase of Demerged Assets: The date of purchase of the New Shares would be the same as the date of purchase of shares of the demerged company. The date of purchase is relevant since it would be required to find out whether the investments are subject to short-term or long-term capital gains tax.
• Indexation of Capital Gains: The indexation, i.e. adjusting the prices based on a particular index to adjust the impact of inflation, will start from the date of acquisition of the New Shares and not from the date of acquisition of the original assets.

Till now, we have covered two issues which are of relevance in the calculation of tax liabilities. However, the most important aspect to address while calculating the capital gains tax liability is the cost of the acquisition of new shares, which is also the central theme of this article.

The Price of the New Shares: Split by Book Value

Book Value refers to the value of a firm’s assets as appearing on its Balance Sheet.

Due to demerger, a certain portion of book assets, book debt, etc., gets transferred to the resulting companies. Based on the split of such book value, the cost of acquisition of new shares can be calculated.

The company issues a note saying that this is how we have split the book value, so this is how you can split the stock price.

To understand the concept better, consider the example of Raj and IIFL Limited.

Suppose Raj purchased 100 shares of IIFL at Rs 205 on April 1, 2016. Therefore, his total amount of acquisition would Rs 20,500. Post the demerger, his acquisition costs would be:

                                                                        Table 1

To arrive at a per-share cost, simply divide the purchase price (Table 1) by the number of shares purchased.

Summarizing the results:

Suppose Raj wishes to sell these shares in the market today. Since he has been holding the shares for a period of more than 1 year, and since the date of purchase of the new shares is the same as the date of purchase of the old shares, he will be subjected to long-term capital gains tax.

In the above scenario, we have adjusted the cost of acquisition by splitting up the book value of the parent company’s assets. However, according to the Ind-As Standards (Indian Accounting Standards aligned with the international reporting standards), a company has to determine the cost of acquisition as per the fair value and not the book value. This increases the risk of the demerger process being construed as tax-neutral. Thus, the Finance Bill of 2019 decided to amend certain sections of the Income Tax Act, stating that demerger would be undertaken as per the Ind-As provision without compromising tax neutrality.

Since we have fairly understood the valuation of shares in case of a demerger, let us finally understand that why a company may prefer to go for a demerger.

If you want to read about the Impact of the Demerger on Shareholders, then click on the link.

Advantages of Demerger:

• Focus on core business: If a company wishes to improve its competency in its core business, it can separate its less valuable business in order to exploit its resources to the best possible enhancement of its core business.
• Debt Reduction: There are times when a company is debt-laden; the debt is distributed among the demerged companies, thus increasing the ability to raise funds independently through independent entities, reducing the debt.
• Attracts Investors: Demerger helps to attract a different set of investors. For instance, Pantaloons earlier used to attract only retail investors. However, the spinning of a private equity fund, Kshitij, attracted a different set of investors.
• Increase Shareholder Value: When a company demerges some of its businesses, it has been observed that the resulting business performs better when isolated, increasing the cash flows and thereby increasing shareholders’ value.

Our Take

Demergers are no doubt beneficial if a company is engaged in diversified businesses. However, it is futile to ignore the importance of “Value out of Diversity” as rightly pointed out by ITC’s Chairman, Sanjiv Puri. He rightly pointed out the benefit of synergies, which are derived from diversity. Thus, even though specialization is essential in this competitive world, diversification is often the key to success.

Demergers without any adequate planning may not turn out to be profitable. For instance, Reliance, when it demerged, gave some massive list of tiny shares like “Reliance Communication Ventures”, which had to merge with other companies to be really valued eventually. Thus, it didn’t work out well.

Demergers can sometimes be undertaken to evade taxes because the transfer of assets to different entities reduces the tax obligations of the parent company. Thus, proper scrutiny is equally important to undertake successful and value-creating demerger transactions.