By Abhishek Wadhawan and Devarsh Shah, second-year students at Gujarat national law university, Gandhinagar
Conceptualising Demergers under Indian Laws
A demerger is a type of restructuring strategy through which a single company gets divided into two or more entities and the resulting companies are registered as separate corporate entities under the law and function independently. However, neither the Companies Act, 1956 nor the Companies Act, 2013 (‘the Act’) define the term demerger. Thus, before examining the idea of cross border demergers and their legality in India, it is necessary to analyse the status quo. Section 2(19AA) of the Income Tax Act, 1961 defines demerger in relation to companies as ‘a transfer by the demerged company of its one or more undertakings to any resulting company as per the scheme of arrangement under sections 391 to 394 of the Companies Act, 1956’. The Bombay High Court in Renuka Datla v. Dupahar Interfran Ltd. acknowledged the formal recognition of the definition of demergers in Indian jurisprudence by its inclusion in the Income Tax Act and noted that the same are relevant to the Companies Act as well.
To allow demergers in India, the Courts have often taken the aid of section 232(1)(b) of the Act that corresponds to the Companies Act, 1956 which clearly states that a scheme of arrangement may also propose to divide the undertaking among one or more companies.
In 2017, the Ministry of Corporate Affairs had notified section 234 of the Act and also inserted Rule 25A in the Companies (Compromises, Arrangements, and Amalgamations) Rules 2016 (Merger Rules) (‘Companies Rules, 2016’) to allow the cross-border mergers and amalgamations in India. While this solved the issues pertaining to cross border mergers, the debate over the legality of cross border demergers under the Indian laws is not yet settled. This debate has been further fuelled by the recent series of contrary decisions given by the National Company Law Tribunal of Ahmedabad (‘NCLT’). In the matter of Sun Pharmaceutical Industries Limited (2018) of 2018, (‘2018 Order’) the Bench allowed an application for an inbound cross border demerger by making reference to section 234(1) of the Act which specifies that the provisions of Chapter XV of the Act, dealing with Compromises, Arrangements, and Amalgamations, will apply to it mutatis mutandis unless otherwise provided. Thus, the scheme of arrangement as provided under section 232(1) of the 2013 Act can be read into it. It further noted that since an ‘arrangement’ includes a demerger, a cross border demerger was allowed by the Act. Reference was also made to Regulation 9 of FEMA (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017 (‘TISPROI Regulations’) which provides that the Tribunal may allow a company subsequent to its scheme of merger or demerger to issue capital instruments to the shareholders of the existing company, even if they are residing outside India. Thus, the scheme for an inbound cross border demerger was allowed.
Subsequently, in 2019, NCLT Ahmedabad (‘2019 Order’) took a completely opposite view of its aforementioned 2018 Order involving the same entity and held that cross border demergers are not allowed in India. In this matter, Sun Pharmaceutical Industries Limited had sought permission for the scheme of arrangement (demerger) from NCLT Ahmedabad, whereby it wanted its two specified investment undertakings to be transferred to its two wholly-owned subsidiaries incorporated in the Netherlands and the USA and hence had a feature of outbound cross border demerger arrangement. While rejecting the petition, it was specifically noted by the Bench that cross border demergers are prohibited in India as there is no mention of the term ‘demerger’ in either section 234 of the 2013 Act or in the Rule 25A of the Companies Rules. Further, it also stressed upon the legislative intent to not permit cross border demergers in India as the draft FEMA (Cross Border Merger) Regulations, 2018 included the term demerger in the definition of ‘cross border merger’ but the same was removed in the final regulations as notified by the Reserve Bank of India (‘RBI’) which, according to the Tribunal, highlights the intent of the legislature and the RBI to exclude cross border demergers in India.
Thus, through the two extremely contrary orders, the NCLT Ahmedabad on one hand sanctioned a scheme of arrangement that proposed an inbound cross border demerger and on the other hand, rejected an identical scheme that proposed an outbound cross border demerger. These contrasting decisions are based on different interpretations made by NCLT Ahmedabad on the basis of the legislative intent and accordingly, this conundrum can be solved only by the analysis of the true legislative intent in reference to cross border demergers in India.
Analysing the true legislative intent
The 2018 Order appraises Regulation 9 of TISPROI Regulations which deals with merger, demerger, or amalgamation of companies registered in India. The order recognizes that if the legislature had intended to disallow cross border mergers, it would not have been covered explicitly under the regulations. On the contrary, the 2019 Order of the NCLT absolutely ignores the 2017 Regulations while arriving at its conclusion.
The 2019 Order asserted that the true legislative intention was to disallow cross border demerger of companies. It further justified this assertion by pointing out that though the draft FEMA (Cross Border Merger) Regulations, prepared in April 2017, included the word “demerger” in the definition of a merger, upon the notification in March 2018, they excluded the term ‘demerger’ and the definition remained restricted only to merger, amalgamation, and arrangement. This, according to the NCLT, was enough indication that cross border demergers were not permitted.
In its order, the NCLT blatantly failed to appreciate the wide scope of the term ‘arrangement’. Section 19AA of Income Tax Act, 1961 explicitly mentions that demerger can be pursuant to a scheme of arrangement. Further, ‘arrangement’ as understood under section 232(1)(b) is inclusive of “whole or any part of the undertaking of any company proposed to be divided among and transferred to two or more companies”. This implies assent to schemes of demerger as it supports an idea of a restructuring strategy that aims at dividing the undertaking, in whole or in part, between two or more companies. The argument is further strengthened by the fact that despite the absence of the term ‘demerger’ in Chapter XV of the Act, domestic demergers have been allowed by various tribunals and courts under section 230 read with section 232 of the 2013 Act. Thus, the Courts have essentially read the legality of demerger as a process of restructuring even when it has not been explicitly recognised by the Legislature under the 2013 Act.
Most importantly, the 2019 Order in paragraph 15 by itself mentioned that ‘arrangement’ is inclusive of the word demerger. The Tribunal’s reasoning that Regulation 2(iii) of the Cross-Border Regulations of 2018 does not include the term demerger explicitly and hence cross border demergers are not permitted in India is contrary to the inclusive and wide interpretation of the term ‘arrangement’ by the Courts and Tribunals. Furthermore, section 234 of the 2013 Act stipulates that provisions of Chapter XV (which permit demergers) of the 2013 Act shall apply mutatis mutandis to cross border schemes of merger and amalgamations.
Hence considering all the regulations and the broad ambit of provisions of merger and arrangement in the 2013 Act, it is difficult to assume that the legislature had an intention to prohibit cross border demergers.
The Companies Act 2013 neither expressly permits nor prohibits the cross-border demergers. However, Foreign Exchange Management (Cross Border Merger) Regulations, 2018, and Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India), 2017 are supportive of the proposition that cross border demergers are permitted under Indian law.
The narrow interpretation by the Tribunal in its 2019 Order is against the spirit of the progressive character of the 2013 Act. It seems that the Tribunal, in its 2019 Order, has erred in rejecting the petitioner’s proposal on the ground of lack of legislative intent. The tribunal’s reasoning that it cannot make law is undisputed but adopting a narrower approach by overlooking the law in its entirety is glaringly unfair and creates regulatory uncertainty for companies.
In essence, though the permissibility of allowing cross border demergers in India can be made out through a proper interpretation of section 232(1)(b) read with section 234 of the Act, the entire debate on this matter can be settled only by a clarification from the Legislature or a decision of the Appellate Tribunal in this regard.