TAX TREATMENT TO DEMERGED COMPANIES

SUBMITTED TO –MS. NEHA PATHAKJI

SUBMITTED BY – KANIKA SACHDEVA

SUBJECT –TAXATION

ID NO – 2006 – 31, VIII SEMESTER

NALSAR UNIVERSITY OF LAW, HYDERABAD, INDIA

1
2
 TABLE OF CONTENTS
1. INTRODUCTION........................................................................... 3
1.1. RESEARCH METHODOLOGY...............................................................................3
2. DEMERGER DEFINED................................................................... 4
3. TAX ASPECTS OF DEMERGER....................................................... 5
3.1 DEMERGERS AND INCOME TAX ACT, 1961...................................................5
3.2 DEFINITION OF AMALGAMATION.......................................................................5
3.3 DEMERGER DEFINED UNDER THE TAX LAWS...............................................6
3.4 SECTION 2(19AA) AND ITS ANALYSIS............................................................7
3.4.1] DEFINITION..................................................................................................7
3.4.2] WHAT COULD BE DEMERGED?..................................................................7
3.4.3] WHAT THE DEMERGER SHOULD RESULT
IN?...............................................................................................................................8

3.4.4] THE ADDITIONAL CONDITIONS.................................................................8

3.4.5] ANALYSIS.......................................................................................................9
3.5 TAX CONCESSION/ INCENTIVES IN CASE OF
DEMERGER...................................................................................................................11
3.5.1.] TAX CONCESSION TO DEMERGED
COMPANY..................................................................................................................11

3.5.2] TAX CONCESSIONS TO SHAREHOLDERS

OF DEMERGED COMPANY......................................................................................12

3.5.3.] TAX CONCESSIONS TO RESULTING

COMPANY..................................................................................................................13

4. DEMERGER UNDER THE COMPANIES ACT,

1956..........................................................................................
1956.......................................................................................... 16
4.1 SUB-DIVISION OF A COMPANY.........................................................................16
4.1.] TRANSFER BY SCHEME OF
ARRANGEMENT/ PROVISIONS OF SECTIONS 391
TO 394 ARE NOT APPLICABLE TO DEMERGER OF
FOREIGN COMPANIES:..........................................................................................16

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 4.2.] TRANSFER UNDER SECTION 395 OF THE
COMPANIES ACT, 1956:.......................................................................................17
1956:
4.2 STATUTORY FRAMEWORK FOR DEMERGER
THROUGH SALE UNDER SECTION 293(1)(A) OF

COMPANIES ACT, 1956............................................................................................17

5. DIFFERENCES BETWEEN INCOME TAX ACT
AND COMPANIES ACT IN THE CONTEXT OF

DEMERGER................................................................................... 18

6. CONCLUSION............................................................................ 20

1. INTRODUCTION

Companies often reorganize and restructure their

operations to carry out various business activities in more
focused manner. The operational reorganization or
restructuring may be done for various reasons and may have
various objectives. A conglomerate company carrying out
various activities may transfer one or more of its existing
activities to a new company to give effect to rationalization
or specialization in its operations1. A company may
downsize or contract its operations with a view to sideline
some activities and promote some other activities with
changed focus by splitting them under separate corporate
entities. An operational activity or division of a company
may be hived off either to dispose it off or to ensure into a

1
This forms the part of ‘Takeover and Acquistion’

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 strategic partnership with some other company. Then there
could be buying, selling and combining of different
companies that can aid, finance, or help a growing company
in a given industry grow rapidly without having to create
another business entity2. Split off may be a result of the
family owned properties of the company being transferred
to the new companies formed by the different family
members to carry on their own different activities.
Demerger helps in strengthening the core competencies in
business and allows structured business operations.

1. RESEARCH METHODOLOGY

The research methodology employed in this paper is

purely doctrinal in nature. The research has been conducted
in the library of NALSAR University of Law, Hyderabad.
Both primary as well as secondary sources have been used.
The library mentioned here were imperative in conducting
relevant research for the proper culmination of this project
along with the internet facilities. Online research databases
consulted for this project included Manupatra. Through the
course of the project the researcher aims to study the
provisions related to the demerger. Also, the conclusion has
the illustrations supporting the fact that demerger is a very
essential tool in order to help the companies sail through
corporate restructuring.
However owing to the vastness of the topic the
researcher has limited herself to covering only the most
imperative portions of the subject. Secondly, the paucity of
space, it was cumbersome to include any substantial case
material on the same. Also fundamental insights were

2
This is referred to as ‘Mergers and Acquisitions’.

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 provided by Ms. Neha Pathakji which paved the road for the
inception of this paper.

2. DEMERGER DEFINED

“Demerger” can be defined as split or division of a

company into more number of companies. The new
companies, the transferees, need not be the subsidiaries of
the parent companies undergone such split or division3. The
New Oxford Dictionary defines the term “demerger” as “the
separation of a larger company into two or more smaller
organizations.”
Justice NV Balasubramanam observed that a
Scheme of demerger is in fact a corporate partition of a
company into two or more undertakings, thereby retaining
one undertaking with it and by transferring the other
undertaking to the resulting company or companies. It is a
scheme of business reorganization.4 The term ‘demerger’
has not been defined in the Companies Act, 1956. The
concept of ‘demerger’ may, however, be deduced from:
(a) The expression, “arrangement” include “a
reorganization of share capital of the company by
the consolidation of shares of different classes, or by
the division of shares into shares of different classes
or by both those methods”5;
(b) Sale, lease or otherwise disposal of the whole or the
substantially whole of the undertaking or where the
company owns more than one undertaking of the

3
J. C. Verma, ‘CORPORATE MERGERS AMALGAMATIONS AND TAKEOVERS: CONCEPT, PRACTICE AND
PROCEDURE’, 5th ed. 2008, at p.264
4
Lucas TVS Ltd. in re CP No. 588 and 589 of 2000 (Mad-unreported)
5
Under Section 390 of the Companies Act, 1956

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 whole or substantially whole of any such
undertaking6;
(c) The scheme of compromise, arrangement or
reconstruction under section 391/394 of the
Companies Act, 1956.
“Demerger” has been defined under sub-sections
(19AA)7 of section 2 of the Income Tax Act, 1961. The
concept of demerger under the Income Tax Act 1961 is
identical to that under section 293(1) (a) of the Companies
Act, 1956. However, it must satisfy the requirements of
section 391 and 394 of the Companies Act, 19568.

3. TAX ASPECTS OF DEMERGER

3.1 DEMERGERS AND INCOME TAX ACT, 1961

With the introduction of Finance Act, 1999 which

has brought about major changes in the Income Tax Act,
1961 in the area of demerger much of the mystery
surrounding demerger has been demystified. The Finance
Act, 1999 while lavishing several tax concession on
‘demergers’ has also placed ‘demerger’ in its proper place
under the Income Tax Act, 1961. To be precise, the Finance
Act, 1999 has amended the following sections namely
sections 2(1B), 2(41A), 35BB, 41, 42, 43, 47, 72A, 79 of
the Income Tax Act, 1961 to quote a few and introduced
sections 2 (19AA), 2(19AAA).

3.2 DEFINITION OF AMALGAMATION

6
Under the provisions of Section 293(1)(a) of the Companies Act, 1956
7
As amended by the Finance Act, 1999 w.e.f. 1-4-2000.
8
K. R. Chandratre, ‘CORPORATE RESTRUCTURING’, 1st ed. 2005, at p.865

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 The definition of the expression is contained in
section 2(1B) of the Income-Tax Act, 1961. This section
was amended by the Finance Act, 1999 when the Act for the
first time defined “demerger”. The amendment of the
section 2(1B) of the Income Tax Act, 1961 brings definition
of “amalgamation” on par with “demerger”.
The major change made to the definition of the
expression related to the post amalgamation scenario. Prior
to amendment in terms of clause (iii) “shareholders holding
not less than NINE-TENTHS” in value of shares in the
amalgamating company or companies (other than the shares
already held therein immediately before the amalgamation
by or a nominee for, the amalgamated company or its
subsidiary) become shareholders of the amalgamated
company by virtue of amalgamation. After the amendment,
this requirement has been changed and it is enough if
shareholders holding not less than “THREE FOURTHS” in
value of shares in the amalgamating company or companies
become shareholders of the amalgamating company. In
other words in the amalgamated company the requirement
of continuation of shareholders holding shares of 90% has
been reduced to 75% of shares in terms of value.

3.3 DEMERGER DEFINED UNDER THE TAX

LAWS

Demerger has been defined under the Income Tax

Act, 1961 as amended vide Finance Act, 1999 effective
from 1-4-2000. Section 2(19AA) defines ‘demerger’.
Demerged Company has also been defined under Section
2(19AAA) of the said Act to mean as the company whose

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 undertaking is transferred, pursuant to a demerger, to a
resulting company9.
Resulting company has also been defined under
Section 2(41A) of the said Act as 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 demerger10.
The practices followed in UK are known as “Tax
Consequences of distributions”. The normal practice is that
the existing shareholders either receive shares from another
company, or new shares issued by a new company, in
proportion to their holdings in the existing company. Such
issue of shares emerges as a result of the transfer of assets of
a target company to an acquiring company11. The issue of
new shares by the acquiring company to the shareholders of
the target company is in consideration of such transfers and
is in proportion of their shareholdings. This is known as
‘qualifying distribution’12.

3.4 SECTION 2(19AA) AND ITS ANALYSIS

The finance Act 1999 has inserted clause 19AA in

section 2, w.e.f. 1.4.2000, i.e., for and from AY 2000-2001.
This new provision is part of the measures to promote

9
Sridharan & Pandian, ‘GUIDE TO TAKEOVERS & MERGERS’, Edition 2002, p.286
10
Ibid. at p.287
11
A. C. Sampath Iyengar, ‘THE LAW OF INCOME TAX’, 10th ed. Vol. 1. 2004, at p. 530
12
K Chaturvedi and Pithisaria, ‘INCOME TAX LAW’, 6th ed. Vol. 1. 2001, at p. 173

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 infrastructure development, industrialization and encourage
economic growth so as to make business reorganization tax
neutral13.

3.4.1] DEFINITION

There are different contours to the definition. They are

mentioned as below-
 Demerger in relation to companies is possible only
through a Scheme of arrangement approved by the
Court;
 The companies from which the various undertakings
are transferred pursuant to a demerger is called the
Demerged Company;
 The company which takes over the undertaking from
the demerged company and inturn allots shares to
the shareholders of the demerged company is known
as resulting company(ies). This also will include a
company established, constituted or formed as a
result of demerger14.

3.4.2] WHAT COULD BE DEMERGED?

The explanation clarifies the meaning of ‘undertaking’

which is referred in the main definition in section 2(19AA).
According to the explanation ‘undertaking’ shall include:
 Any part of an undertaking;
 Or a unit;
 Or a division of an undertaking;

13
A.Ramaiya, ‘GUIDE TO THE COMPANIES ACT’, 16th Ed. 2004, Volume 2, pp.1259
14
Section 2(19AA) of the Income Tax Act, 1961

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  Or a business activity taken as a whole; But does
not include:
 Individual assets or liabilities or any combination
thereof not constituting any business activity15.
The definition which is extracted clarifies that what is
demerged need not be an industrial activity or an industrial
undertaking but should be an undertaking, not falling within
the exclusion clauses. This approach exhibited for the first
time in the Income Tax Act is a refreshing change from the
usual ‘bias’ exhibited in favour of industrial companies.
Every word defining the ‘undertaking’ has already been
made use by many companies, achieving in the process tax
neutrality16.

3.4.3] WHAT THE DEMERGER SHOULD RESULT

IN?

The definition spells out the conditions to be

satisfied before the restructuring is recognized as falling
within the definition:
These are:
 All the properties and all the liabilities relating to the
undertaking to be transferred belonging to the
demerged company immediately before the
demerger becomes the properties and liabilities of
the resulting company.
 All the properties and liabilities are transferred at
book values appearing in the books of the demerged
company.

15
Ibid.
16
Abhishek Tripathy, ‘MERGERS & DEMERGERS’ on July 27, 2008, http://jurisonline.in/2008/07/mergers-
demergers/, last accessed on 24th Feb, 2010.

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  The resulting companies in consideration for the
demerger issue its shares to the shareholders of the
demerged company on a proportionate basis.
 The shareholders holding not less than three-fourths
in value of shares in the demerged company (other
than shares already held prior to the demerger or by
a nominee for the resulting company or its
subsidiary) becomes shareholders of the resulting
company by virtue of demerger.
 Otherwise than as result of acquisition of the
property or assets of the demerged company or any
undertaking thereof17.

3.4.4] THE ADDITIONAL CONDITIONS

 The transfer of assets should happen on a going

concern basis.
 The demerger in accordance with the conditions if
notified under sub-section (5) of section 72A by the
Central Government
Some more additional factors are indicated in the
Explanation 4 contained under the definition.
Explanation 2 refers the mode of splitting up the liabilities:
 The liabilities which arise out of the activities or the
operations of the undertaking will have to be
transferred along with the demerged undertaking.
 If there are specific borrowings or loans are raised,
incurred and utilized solely for the activities of the
undertaking, then the same has to be transferred.

17
Sec 2(19AA) of the Income Tax Act, 1961. Also, see A.K.Majumdar & G.K.Kapoor, ‘COMPANY LAW
AND PRACTICES’, 12th Ed. 2007, p.1026

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  In respect of cases not falling in the above two cases,
(referred as multi-purpose borrowings or general
borrowings) the same will be transferred in the same
proportion as described below:
General purpose borrowings * Value of the assets18 of
the demerged Undertaking
Value of the assets of the demerged company
immediately before the demerger19

3.4.5] ANALYSIS
Analysis of sub-sections (i) to (v): The legal
view appears to be that a scheme of arrangement satisfying
all the conditions enumerated in (i) to (v) should also fall
outside the arena of acquisition of assets by the resulting
company. In other words, a Scheme of Arrangement should
not result in a simple acquisition of assets by the resulting
company, but should cover all the liabilities as well20.
Analysis of sub-sections (vi) and (vii): These
two sub-clauses refer to the demerged undertaking that is
being transferred. Firstly, it is stated that the undertaking
should be transferred as a ‘going concern’. This presupposes
a running undertaking that is likely to continue its
operations in the foreseeable future and has no intention to
curtail materially the scale of neither its operations nor the
necessity for liquidation.” The second condition refers to
section 72A(5) which is an enabling clause for the Central
Government to impose conditions to ensure that demerger is
for genuine business purposes21.
18
‘Value of assets’ indicates the total value of assets comprising of fixed assets, investments and current
assets.
19
Section 2(19AA) of the Income Tax Act, 1961 Explanation 2
20
Section 2(19AA) of the Income Tax Act, 1961
21
Section 2(19AA) of the Income Tax Act, 1961

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 Undertaking- Explanation 1- The demerger need
not be of all businesses or even of all the undertakings of a
single business. Undertaking has been defined widely to
cover a part of undertaking or a unit or division or a
business activity. What is ruled out is only a transfer of an
individual asset. In the context of requirement of transfer of
all assets and liabilities, it should be an identifiable unit
especially in the context of further requirement of the
transfer having to be of a going concern22. But any bunch of
assets and liabilities identifiable as an independent activity
should satisfy the definition of undertaking in Explanation
1. The definition can be understood as probably being more
liberal than what may be construed as an undertaking as for
example under section 80-IA or 80-IB.23.
Allocation of liabilities- Explanation 2
provides that liabilities identified as relating to transfer of
assets and liabilities incurred for acquiring such assets will
be treated as part of the undertaking. In addition, the
balance of assets, which can not be so identified, will be
allocated to the transferred undertaking in the same
proportion as the value for the assets of transferred
undertaking to the value of the total assets24.
Prior Evaluation to be ignored-
Explanation 3: For the purposes of demerger,
revaluation if any will have to be ignored. This is provided
by Explanation 3. this is in view of the fact that swap ratio
for purposes of the arrangement under the company law
considers the effect of revaluation in deciding the number of

22
S.Ramanujan, ‘MERGERS ET AL, ISSUES, IMPLICATIONS AND CASE LAWS IN CORPORATE
RESTRUCTURING’, 2nd Ed. 2006, at p.395
23
Section 2(19AA) of the Income Tax Act, 1961, Explanation 1, See also Sampath Iyengar, ‘THE LAW OF
INCOME TAX- A COMMENTARY’, 10th Ed., 2005, Volume 4, at p.3029
24
Section 2(19AA) of the Income Tax Act, 1961 Explanation 2, See also Ibid., Volume 1 , at p.556

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 shares of the resultant company to be allotted to he
shareholders of the demerged company. Valuation for that
purpose, is therefore, not barred by Explanation 3. What is
expected is that the incorporation of the demerged company
with the resultant company should be at book value without
revaluation. This avoids redundancy25.
Demerger to cover bodies other than
Companies- Explanation 4 expands the scope of
demerger not merely to companies, but any authority or any
body created by the Government or local authority or Public
Sector Company. The rearrangement contemplated by
company law will be recognized as demerger under Section
2(19AA). But then such splitting up or such reconstruction,
even if it is treated as transfer, may not involve liability, if
the transfer is at cost. Notification No. 1159 dated 26th
December, 2000 relating to power undertakings infra is in
pursuance of power to prescribe conditions for these bodies
conferred by retrospective amendment to Explanation 4 by
the finance Act, 2000. Section 2(22) was amended to spare
deemed dividend on demerger26.
The definition of 'demerger' as given under Section
2(19AA) of the Income Tax Act is unduly restrictive, and
subject to various conditions as mentioned above

3.5 TAX CONCESSION/ INCENTIVES IN CASE OF

DEMERGER

If any demerger takes place within the meaning of

section 2(19AA) of the Income Tax Act, the following tax
concession shall be available:
1. Tax concession to demerged company
25
Section 2(19AA) of the Income Tax Act, 1961 Explanation 3, See also Ibid., Volume 1, at p.633
26
Section 2(19AA) of the Income Tax Act, 1961, Explanation 4, See also Ibid., Volume 1, at p.642

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 2. Tax concessions to shareholders of demerged
company.
3. Tax concessions to resulting company

3.5.1.] TAX CONCESSION TO DEMERGED

COMPANY
Capital Gains not attracted 27: Where there is a
transfer of any capital asset in a demerger by the demerged
company to the resulting company, such transfer will not be
regarded as a transfer for the purpose of capital gain
provided the resulting company is an Indian Company.
Tax concession to a foreign demerged
company28: Where a foreign company holds any shares
in an Indian company and transfers the same, in a demerger,
to another resulting company, such transaction will not be
regarded as transfer for the purpose of capital gain under
section 45. thus, where the demerged and the resulting
companies are foreign companies holding shares in an
Indian Company, there is no requirement for compliance of
sections 391 and 394 of the Companies Act in terms of the
proviso to sub-section (vic) of section 47.
Reserves for shipping business:
business Where a ship
acquired out of the reserve is transferred in a scheme of
demerger, even within the period of eight years of
acquisition there will be no deemed profits to the demerged
company.

3.5.2] TAX CONCESSIONS TO

29
SHAREHOLDERS OF DEMERGED COMPANY
In the case of demerger the existing shareholder of the
demerged company will now hold:
27
Section 47(vib) of the Income Tax Act, 1961
28
Section 47(vic) of the Income Tax Act, 1961
29
Section 47(vid) of the Income Tax Act, 1961

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 a. Shares in resulting company; and
b. Shares in demerged company
And in case the shareholder transfers any of the above
shares subsequent to the demerger, the cost of such shares
shall be calculated as:
Deemed Dividend: The Finance Act, 1999 has
introduced a new category of receipt not covered under the
term “dividend” by adding sub-clause (v) after section 2(22)
(e). Generally any distribution of assets by a company to its
shareholders would be treated as dividend in the hands of
the shareholders to the extent of the undistributed profits of
the company. However, it is provided that this fiction will
not apply to any distribution of shares pursuant to a
demerger by the resulting company to the shareholders of
the demerged company (whether or not there is a reduction
of capital in the demerged company)30.
The purpose of this amendment is to exclude shares
allotted by the resulting company to the shareholders of
demerging company from the definition of “dividend”. But
in the process a reference has been made to a probable
reduction of share capital. A careful examination of a
demerger situation would show that when assets of an
undertaking are demerged there would be hiving off of
certain assets along with the capital corresponding to the net
value of these assets hived off. Therefore in the demerger
there would certainly be a reduction of share capital of the
demerging company, provided the part of the capital
proposed to the reduced can be attributed to the undertaking
that is being demerged. However, the consideration in a
demerger can also be paid out of general reserves and other

30
Section 2(22)(e)(v) of the Income Tax Act, 1961

17
 distributable profits without there being any reduction of
share capital31.
Cost of acquisition of shares in the
resulting company32: It shall be the amount which
bears to the cost of acquisition of shares held by the
assessee in the demerged company, the same proportion as
the net book value of the assets transferred in a demerger
bears to the net worth of the demerged company
immediately before such demerger.
Cost of acquisition of shares in the
demerged company33: The cost of acquisition of the
original shares held by the shareholder in the demerged
company shall be deemed to have been reduced by the
amount as so arrived at under section 49(2C) of the Income
Tax Act.
Period of holding of shares of the
resulting company34: in the case of a capital asset,
being a share or shares in an Indian company, which
becomes the property of the assessee in consideration of a
demerger, there shall be included the period for which the
share or shares held in the demerged company were held by
the assessee.

3.5.3.] TAX CONCESSIONS TO RESULTING

COMPANY
The resulting company shall be eligible for tax
concessions only if the following 2 conditions are satisfied:
i the demerger satisfies all the conditions laid down in
section 2(19AA) of the Income Tax Act, 1961; and

31
Supra n. 13 at p.1251
32
Section 49(2C) of the Income Tax Act, 1961
33
Section 49(2D) of the Income Tax Act, 1961
34
Section 2(42A)(g) of the Income Tax Act, 1961

18
 ii. The resulting company is an Indian Company.
The following concessions are available to the resulting
company pursuant to a scheme of a demerger:
a. Expenditure on acquisition of patent
rights or copy rights35: Where the patent or
copyrights acquired by the demerged company is transferred
to any resulting Indian company, the provisions of section
35A of the said Act which were applicable to the demerged
company shall become applicable in the same manner to the
resulting company consequently:
i The expenditure on patents, copyrights not yet written off
shall be allowed to the resulting company in the same
number of balance installments.
ii. Where such rights are later on sold by the resulting
company, the treatment of the deficiency/ surplus will be
same as would have been in the case of Demerger
Company.
However, if such expenditure is incurred by the
demerged company after 31-3-1998, deduction under
section 35A of the said Act is not allowed, as such
expenditure will be eligible for depreciation as intangible
asset. In this case, provisions of depreciation shall apply.
b. Expenditure on know-how36 : W.e.f.
assessment year 2000-2001, where there is a transfer of an
undertaking under a scheme of demerger, the resulting
company shall be entitled to claim deduction section 35AB
of the said Act in respect of such undertaking to the same
extent and in respect of the residual period as it would have
been allowable to the demerger company, had such
demerger not taken place.
35
Section 35A(7) of the Income Tax Act, 1961
36
Section 35AB(3) of the Income Tax Act, 1961

19
 However, if such expenditure is incurred by the
demerger company after 31-3-1998, deduction under section
35AB of the said Act is not allowed, as such expenditure
will be eligible for depreciation as intangible asset.
c. Expenditure for obtaining license to
obtain telecommunication services37: Where
in a scheme of demerger, the demerged company sells or
otherwise transfers its license to the resulting company
(being an Indian company), the provisions of section
35ABB of the said Act which were applicable to the
demerged company shall become applicable in the same
manner to the resulting company.
d. Treatment of preliminary expenses 38:
Where the undertaking of an Indian company which is
entitled to deduction of preliminary expenses is transferred
before the expiry of ten years/5 years, as the case may be, to
another company in a scheme of demerger, the preliminary
expenses of such undertaking which are not yet written off
shall be allowed as deduction to the resulting company in
the same manner as would have been allowed to the
demerged company. The demerged company will not be
entitled to the deduction thereafter.
e. Treatment of expenditure on
prospecting, etc. of certain minerals 39 :
Where the undertaking of an Indian company which is
entitled to deduction on account of prospecting of minerals,
is transferred before the expiry of period of 10 years to
another company in a scheme of demerger, such expenditure
which is not written off shall be allowed as deduction to the

37
Section 35ABB(7) of the Income Tax Act, 1961
38
Section 35D(5A) of the Income Tax Act, 1961
39
Section 35E(7A) of the Income Tax Act, 1961

20
 resulting company in the same manner as would have been
allowed to the demerged company. The demerged company
will not be entitled to the deduction thereafter.
f. Treatment of bad debts40: Where due to
demerger the debts of the company have been taken over by
the resulting company and subsequently by such debt or part
of debt become bad, such bad debt will be allowed as a
deduction to the resulting company. This is based upon the
decision of the Supreme Court in the case of CIT v.
Veerabhadra Rao(T.), K. Koteswara Rao & Co.41) which
was decided in the case of amalgamation of companies.
g. Amortisation of expenditure in case of
demerger42: Where an assessee being an Indian
company, incurs any expenditure, on or after the 1 st day of
April, 1999, wholly and exclusively for the purposes of
demerger of an undertaking, the assessee shall be allowed a
deduction of an amount equal to one-fifth of such
expenditure for each of the five successive previous years
beginning with the previous year in which the demerger
takes place. No deduction shall be allowed in respect of the
expenditure mentioned in sub-section (1) under any other
provision of this Act.
h. Carry forward and set-off of business
losses and unabsorbed depreciation of the
demerged company/Revamping section
72A of the Income Tax Act43: The accumulated
loss and unabsorbed depreciation, in a demerger, should be
allowed to be carried forward by the resulting company if

40
Section 36(1)(vii) of the Income Tax Act, 1961
41
(1985) 155 ITR 152 (SC)
42
Section 35DD of the Income Tax Act, 1961
43
Section 72A(4) & (5) of the Income Tax Act, 1961

21
 these are directly relatable to the undertaking proposed to be
transferred. Where it is not possible to relate these to the
undertaking, such loss and depreciation shall be apportioned
between the demerged company and the resulting company
in proportion of the assets coming to the share of each as a
result of demerger.
i.) Deduction available under section 80-IA
or 80-IB:
80-IB of the Income Tax Act, 1961
Where an undertaking which is entitled to deduction under
section 80 I-A/80 I-B is transferred in the scheme of
demerger before the expiry of the period of deduction under
section 80 I-A/80 I-B, then-
i. no deduction under the sections shall be available to the
demerged company for the previous year in which
amalgamation takes place; and
ii. the provisions of sections shall apply to resulting
company in such manner in which they would have applied
to the demerged company.
j. Demerger and Slump Sale
Slump Sale means the 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.44 Therefore, demerger cannot be accomplished
with “slump sales” since “slump sales” is only for sale of
undertaking.

4. DEMERGER UNDER THE COMPANIES

ACT, 1956

4.1 SUB-DIVISION OF A COMPANY

44
Section 2(42C) of the Income Tax Act

22
 A sub-division in the form of bifurcation or trifurcation,
as the case may be, can be affected by adopting the
following modes:
a. By way of a scheme of Arrangement under sections
391-394 of the Companies act, 195
b. By transfer of business divisions of the company as
ongoing business under section 395 of the
Companies Act, 1956.

4.1.] TRANSFER BY SCHEME OF

ARRANGEMENT/ PROVISIONS OF SECTIONS 391
TO 394 ARE NOT APPLICABLE TO DEMERGER OF

FOREIGN COMPANIES: It can be drawn under sections

391-394 of the Companies Act, 1956, under which the
company may contemplate to transfer two of its divisions to
the other two new entities, which may or may not be its
wholly owned subsidiaries. The scheme shall provide all the
terms and conditions and mode of transfer of assets and
liabilities of the respective divisions to the new entities and
the method of allotment of shares to the shareholders. The
share capital of the company may also be split into
respective companies on the basis of net assets transferred
to the respective companies45.

4.2.] TRANSFER UNDER SECTION 395 OF THE

COMPANIES ACT, 1956: It enables a company to

transfer the whole of its undertaking to another company by
as scheme or contract involving offer by the transferee
company to purchase shares of the transferor company,
when all or statutory majority of shareholders of the

45
Sections 391-94 of the Companies Act, 1956. Also, see Supra n.9 at p.292

23
 transferor company agree to such a scheme or contract.
Thus, this process does not require any application to be
made to the court either by the transferor company or by the
transferee company, as required under section 391 of the
Companies Act, 1956 for carrying out the Scheme46.

4.2 STATUTORY FRAMEWORK FOR DEMERGER

THROUGH SALE UNDER SECTION 293(1)
(A) OF COMPANIES ACT, 1956

Popularly known as hiving off, this is, in the Company

Law Terminology, either
a. a ‘sale’ or ‘disposal’ of the whole or substantially the
whole of the undertaking, or
b. An ‘arrangement, compromise and reconstruction’.
The former is governed by section 293(1) (a) of the
Companies Act, 1956 and the latter falls within the ambit of
sections 391/394 of the Companies Act, 1956. the former
requires approval of the shareholders of the concerned
company by an ordinary resolution, while the latter calls for
the shareholders’, the creditors’ and the High Court’s
approval. A straightforward hiving-off of any business of
the company, for a lump-sum price, is mostly routed
through section 293(1) (a) of the Companies Act, 1956,
which is an enabling provision. It facilitates sale of
business, which the section calls, ‘the whole or substantially
the whole undertaking or one or more undertakings’. By
resorting to the mechanism provided in this section, any
company can sell the whole of its business or any one of its
businesses as a going concern. The business to be hived-off
is intended to become transferred from the main body of a

46
Section 395 of the Companies Act, 1956. Also, see Supra n.9 at p.294

24
 commercial or industrial enterprise through the agency of
new ownership47.
In the hiving-off, the business or the undertaking is
sold and transferred by the company to the buyer at a pre-
determined price, under an agreement between the seller
and the buyer. This agreement is usually called ‘Business
Transfer or Assignment Agreement’48. The various
properties and assets and their values are not individually
identified and determined. The price is a lump-sum or a
‘slump-price’. Although it comprises, inter alia, current
assets or movables, the values of individual assets are not
identified and stated in the agreement49.

5. DIFFERENCES BETWEEN INCOME TAX

ACT AND COMPANIES ACT IN THE
CONTEXT OF DEMERGER50

1. The demerged company under Income Tax Act is

known as Transferor Company under Companies Act and
the resulting company under the Income tax Act is identified
as Transferee Company under the Companies Act51.
2. Demerger under the income Tax includes a
transfer of an undertaking but does not include an
undertaking not engaged in business activity. But under the
Companies Act there can be a scheme of demerger

47
Section 293(1)(a) of the Companies Act, 1956. See also, Supra n.
48
This agreement seeks to transfer to the buyer the business as a going concern, lock, stock and barrel, that
is to say, all properties (immovable and movable), assets, other rights, licences, permits, titles, liabilities,
employees, etc. at the negotiated price.
49
Vivek Kaul, ‘THE INDIAN DEMERGER SCENARIO: YOU AIN'T SEEN ANYTHING YET’ on Tuesday, December
27, 2008, http://www.dnaindia.com/money/report_reliance-demerger-you-ain-t-seen-anything-
yet_1004360, (last accessed on 25th Feb 2010).
50
Ibid.
51
Rejariya Sushant, ‘THE DEMERGER DE-MYSTIFICATION’
http://economictimes.indiatimes.com/news/news-by-industry/indl-goods-/-svs/steel/Texmaco-to-demerge-
engg-steel-ops/articleshow/5613529.cms, (last accessed on 26th February, 2010)

25
 involving the transfer of an undertaking whether it carries
on a business activity or not for example there can be
transfer of shell companies, single/ individual assets of a
transferor company to a transferee company52.
3. Under the provisions of the companies Act a
Scheme of Arrangement involving a demerger would
require for approval by majority of shareholders holdi ng
3/4ths in values of shares and the sanction of High Court.
The Income Tax Act is silent on these two issues but defines
demergers as Scheme of arrangement coming under
Sections 391 to 394 of the Companies Act, 1956 and
therefore implying that both the requirements should be
complied with53.
4. In the post demerger scenario, the income tax Act
visualizes the continuity of shareholders holding 3/4ths in
value of the demerged company to become shareholders of
the resulting company, whereas the Companies Act, 1956
does not impose such restrictions on the post demerger
scenario54.
5. Under the Income Tax Act the consideration for a
demerger should be by way of issue of shares to the
shareholders of the demerged company. However, under the
Companies Act the consideration for a demerger can be in
the form of “allotment or appropriation by the transferee
company of any shares, debentures, policies or other like
interests in that company which under the arrangement are

52
Ibid.
53
T.Banusker, ‘CAPITAL GAINS ON SALE OF DEMERGED COMPANY SHARES’, The Business Line, on Jan 9,
2010, http://www.thehindubusinessline.com/iw/2005/01/09/stories/2005010901371400.htm, (last accessed
on 16th Feb, 2010)
54
Supra n.9

26
 to be allotted or appropriated by that company to or for any
person”55.
6. Under the Income-Tax Act in a demerger all the
properties of the undertaking being transferred by the
demerged company immediately before the demerger
becomes the properties of the resulting company. Such
transfer would be at values appearing in its books of
account immediately before the demerger and would also be
on a going concern basis. Further, for determining the value
of the property, any change in the value of the assets
consequent to their revaluation shall be ignored. But under
the Companies Act such conditionalities are absent56.
7. Under the Income Tax no direct reference is made
to reduction of capital as a result of demerger except to
make a passing reference in a new sub-clause (v) to section
2(22)(e) to elaborate on what would not include dividend. It
states that any distribution of shares pursuant to a demerger
by the resulting company to the shareholders of the
demerged company (whether or not there is a reduction of
capital in the demerged company) does not form part of the
dividend. In the case of a demerger there is bound to be a
depletion of capital of the demerged company exactly
corresponding to the net value of the assets transferred to
the resulting company. There is no such reference to the
reduction of capital in a scheme of demerger under the
Companies Act57.

55
Supra n.53
56
Tushyant Trivedi, ‘THE DEMERGERS AND CAUSTIC CHANGES’, as in ENS Economic Bureau on August 4,
2005, http://www.indianexpress.com/oldStory/75636/, (last accessed on 25th February, 2010)
57
Supra n. 9 at p.321

27
 6. CONCLUSION

In the year of 1991, the then Finance Minister had

started the liberalization of economy which has been carried
on by successive Finance Ministers. One of the things
which he had introduced was to allow foreign investors to
bring their capital in India and invest it in different areas.
Now, the Government of India has brought out the concept
of demerger to tax to neutralize demerger, if it takes place
by fulfilling the prescribed conditions. Perhaps, the govt.
has been pressed by these investors to bring out such things
so that the Indian partner may get demerged from his
foreign partner and the foreign partner may take back his
investment. I personally feel that it is the main reason for
the introduction of the concept of demerger. In other words,
it is the main cause for tax neutralization of demerger.

28
 BIBLIOGRAPHY

BOOKS REFERRED
 C. Sampath Iyengar, ‘The Law of Income Tax’, 10th
ed. Vol. 1. 2004, Wadhwa Publications Nagpur
 A.K.Majumdar & G.K.Kapoor, ‘Company Law and
Practices’, 12th Ed. 2007, Taxmann Publications Pvt.
Ltd.
 A.Ramaiya, ‘Guide to the Companies Act’, 16th Ed.
2004, Volume 2, Wadhwa Nagpur
 J. C. Verma, ‘Corporate Mergers Amalgamations
and Takeovers: Concept, Practice and Procedure’, 5th
ed. 2008, Bharat Law House, New Delhi
 K Chaturvedi and Pithisaria, ‘Income Tax Law’, 6th
ed. Vol. 1. 2001, Maxwell Publications
 K. R. Chandratre, ‘Corporate Restructuring’, 1st ed.
2005, Bharat Law House, New Delhi
 S.Ramanujan, ‘Mergers et al, Issues, Implications
and Case Laws in Corporate Restructuring’, 2nd Ed.
2006, Bharat Law House
 Sridharan & Pandian, ‘Guide to Takeovers &
Mergers’, Edition 2000, Wadhwa and Company
Nagpur

ARTICLES REFERRED

 Abhishek Tripathy, ‘MERGERS & DEMERGERS’ on

July 27, 2008, http://jurisonline.in/2008/07/mergers-
demergers/, last accessed on 24th Feb, 2010.

29
 Vivek Kaul, ‘THE INDIAN DEMERGER SCENARIO:
YOU AIN'T SEEN ANYTHING YET’ on Tuesday,
December 27, 2008,
http://www.dnaindia.com/money/report_reliance-
demerger-you-ain-t-seen-anything-yet_1004360,
(last accessed on 25th Feb 2010).

 Rejariya Sushant, ‘THE DEMERGER DE-

MYSTIFICATION’,

http://economictimes.indiatimes.com/news/news-by-
industry/indl-goods-/-svs/steel/Texmaco-to-
demerge-engg-steel-ops/articleshow/5613529.cms,
(last accessed on 26th February, 2010)

 T.Banusker, ‘CAPITAL GAINS ON SALE OF

DEMERGED COMPANY SHARES’, The Business Line,
on Jan 9, ‘2010,
http://www.thehindubusinessline.com/iw/2005/01/09
/stories/2005010901371400.htm, (last accessed on 16th
Feb, 2010)

 Tushyant Trivedi, ‘THE DEMERGERS AND CAUSTIC

CHANGES’, as in ENS Economic Bureau on August
4, 2005,
http://www.indianexpress.com/oldStory/75636/, (last
accessed on 25th February, 2010)

30