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LEGALITY OF CROSS BORDER DEMERGERS IN INDIA

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LEGALITY OF CROSS BORDER DEMERGERS IN INDIA

August 5, 2021

A demerger is a reorganisation plan in which a single company is separated into two or more organisations, each of which is legally registered as a separate corporate entity and operates independently. The term demerger is not defined under the Companies Act of 1956 or the Companies Act of 2013, however Section 2(19AA) of the Income Tax Act, 1961 lays down the definition of demerger. Before delving into the concept of cross-border demergers and their legality in India, it’s important to assess the whether the definition provided for ‘demerger’ under section 2(19AA) of the Income Tax Act, 1961 would have applicability in matters related to the Companies Act 2013.

In this regard, the Bombay High Court, in Renuka Datla v. Dupahar Interfran Ltd [(2002) 1 Comp LJ 318], recognised the official acknowledgment of the term of demergers in Indian law by its inclusion in the Income Tax Act. The Court had stated as follows:

Though this is a special definition contained in the provisions of the Income Tax Act and is not of universal application, it gives an indication of the general concept of demerger which has been noticed and formally introduced into the Income Tax Act”.

As per the above judgement, the general meaning of the term ‘demerger’ could be understood from Section 2(19AA) of the Income Tax Act, 1961. Now, in order to approve demergers in India, the Indian courts have relied on the provisions provided in section 232(1)(b) of the Companies Act, 2013 which states as follows:

“232. Merger and amalgamation of companies:

(1) Where an application is made to the Tribunal under section 230 for the sanctioning of a compromise or an arrangement proposed between a company and any such persons as are mentioned in that section, and it is shown to the Tribunal— 

(a) that the compromise or arrangement has been proposed for the purposes of, or in connection with, a scheme for the reconstruction of the company or companies involving merger or the amalgamation of any two or more companies; and 

(b) that under the scheme, the whole or any part of the undertaking, property or liabilities of any company (hereinafter referred to as the transferor company) is required to be transferred to another company (hereinafter referred to as the transferee company), or is proposed to be divided among and transferred to two or more companies

The Tribunal may on such application, order a meeting of the creditors or class of creditors or the members or class of members, as the case may be, to be called, held and conducted in such manner as the Tribunal may direct and the provisions of sub-sections (3) to (6) of section 230 shall apply mutatis mutandis”

Further, in 2017, the Ministry of Corporate Affairs has notified section 234 of the Companies Act 2013 (the “Act”) which shall be read along with rule 25A in the Companies (Compromises, Arrangements, and Amalgamations) Rules 2016 (“Rules’) in order to facilitate cross-border mergers and amalgamations in India. While this resolved the difficulties surrounding cross-border mergers, the legality of cross-border demergers under Indian law remains unresolved. 

With regard to cross-border demerger, the National Company Law Tribunal of Ahmedabad (“NCLT”) has issued a series of contradictory rulings, adding fuel to the fire.

  1. In re: Sun Pharmaceutical Industries Limited [(2020)3CompLJ316: MANU/NC/1339/2021] (“Inbound Demerger Case”)

In this matter, the Hon’ble NCLT, vide its order dated 31.10.2018, had approved the application for inbound merger involving transfer of specified undertaking of Sun Pharma Global FZE (a company incorporated under the provisions of the United Arab Emirates, and which is an indirect wholly owned subsidiary of Sun Pharmaceutical Industries Limited) to Sun Pharmaceutical Industries Limited (i.e., the Indian Company) under Section 230 and Section 232 read with Section 234 of Act.

While adjudicating this matter, the NCLT had received contention that section 234 of the Act refers only to cross border mergers and amalgamations and that the same does not refer to De-mergers. However, negating such contention, the Hon’ble NCLT had stated as follows:

“…..In this regard it is submitted on behalf of petitioner that all the applicable sections of the Companies Act, viz 230 to 232 have the same nomenclature as mergers and amalgamations. However, looking at the provisions of Section 232 (b) closely, it indicates that the undertaking being transferred could be whole or any part of the undertaking of the Petitioner Transferor Company. This permissible transfer of part of the undertaking implied de-merger and all other applicable provisions of the Act for merger or amalgamation can be applied even to the De-merger involving transfer of any part of the Undertaking. Further, Section 234 (1) in the opening part itself, confirms that the said section shall apply mutatis mutandis to the schemes of mergers and amalgamations. This view is also supported by Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017 where Regulation 9 provides as under….”

Hence, in this case the Hon’ble NCLT had approved the inbound cross-border demerger for Sun Pharmaceutical Industries Limited. However, in 2019, the Hon’ble NCLT adopted the completely opposite view of its aforementioned order, holding that cross-border demergers are not permitted in India.

2. In re: Sun Pharmaceutical Industries Limited [MANU/NC/12403/2019] (“Outbound Demerger Case”)

Sun Pharmaceutical Industries Limited had sought permission from NCLT for a scheme of arrangement (demerger) in which it wanted its two specified investment undertakings to be transferred to its two wholly owned subsidiaries incorporated outside India namely, Sun Pharma (Netherlands) B.V., and Sun Pharmaceutical Holdings USA Inc., thus, leading to an outbound cross border demerger feature.

On 19th December 2019, the Hon’ble NCLT passed the order in which it rejected this application, by expressing that the cross-border demergers are illegal in India. The Hon’ble NCLT observed as follows:

15. While going through the provisions as enshrined in the Companies Act, 2013 – Sections 230, 232 and 234 of the Companies Act, 2013 it is evident that provisions of Section 230 as well as Section 232 which relate only to the Indian companies, contain the words “compromise” and/or “arrangement” which is inclusive of the term “demerger “being the crux of the present company petition. 

Moreover, it is also evident that the provisions of Section 234 which relate to the cross border mergers of Indian companies with foreign companies and vice versa, mention only about the words “merger” and/or “amalgamation” and do not seem to contain the words “compromise” and/or “arrangement” and/or “demerger” and hence it may be construed that the provisions of Section 234 of the Companies Act, 2013 do not permit the “compromise” and/or “arrangement” and/or “demerger” of the Indian companies with foreign company and vice versa. In other words, it can be said that the provisions of Section 234 of the Companies Act, do not provide for or rather restrict the demerger of the Indian companies with foreign company.

In addition to the above, it is pertinent to mention that Rule 25A of the Companies (Compromises, Arrangements and Amalgamations) Rules, 2016 in which the detailed procedure and requirements are enumerated with respect to the cross border mergers, is silent on “demergers” and mentions only “mergers” and “amalgamations“.

Additionally, the Hon’ble NCLT has also emphasized on the fact that the term ‘demerger’ which was included under the definition of ‘Cross Border Merger’ in the draft Foreign Exchange Management (Cross Border Merger) Regulations, 2017 (“FEMA CBM Regulation 2017“) was subsequently omitted in Foreign Exchange Management (Cross Border Merger) Regulations, 2018 (“FEMA CBM Regulations 2018“). Pursuant to this, the Hon’ble NCLT concluded that such omission clearly signified that the cross-border demerger was not permitted in India. It stated that if cross-border demerger was permitted in India, then the word ‘demerger’ would not have been specifically deleted from the FEMA CBM Regulations 2018. 

Pursuant to this observation, the NCLT had rejected the application for the scheme of demerger by concluding that section 234 of the Act does not permit cross border demerger.

Analysis

In accordance with the observation made in the above matters, it can be well understood that the Hon’ble NCLT had sanctioned one scheme of arrangement (suggesting an inbound cross border demerger) while rejecting an identical scheme (suggesting an outward cross border demerger) through two diametrically opposed rulings. These contradictory rulings are based on divergent interpretations by the Hon’ble NCLT, and so this dilemma can only be answered by analysing the real legislative intent in relation to cross-border demergers in India. Hence, in this regard, this article analyses as follows:

We have observed that the Hon’ble NCLT, in the Outbound Demerger Case (as discussed above), has assumed that since section 234 of the Act, read with Rule 25A is silent on outbound demerger, therefore it means that outbound demerger is being prohibited under the Act and rules made thereunder. In this regard, it is to be noted that, under Section 394 of the Companies Act, 1956 (“1956 Act“), there was a prohibition on outbound merger/demerger as the provision had limited the scope of transferee company to mean and include only Indian companies which are registered under the 1956 Act. However, such restriction does not exist anymore under the present Act. Therefore, it can be reasonably argued that the legislature has, by removing the said prohibition, permitted cross-border merger and demerger and thereby allowing both inbound as well as outbound mergers and demergers in India.

In the Outbound Merger Case, the NCLT, in order to understand the intention of the legislators, had heavily relied on the changes brought by the FEMA CBM Regulations 2018. FEMA CBM Regulations 2018 had re-defined the term ‘cross-border merger’ as “any merger, amalgamation or arrangement between an Indian company and foreign company in accordance with Companies (Compromises, Arrangements and Amalgamations) Rules, 2016 notified under the Companies Act, 2013″. The deletion of the term ‘demerger’ (which was earlier present in the definition of ‘cross-border merger’ under FEMA CBM Regulation 2017) has let the Hon’ble NCLT to conclude that the legislators do not consider ‘demerger’ to fall within the purview of cross-border mergers. However, while doing so, the Hon’ble NCLT has failed to observe that, even though specifically deleted from the new definition of ‘cross-border merger’ in FEMA CBM Regulations 2018, the term ‘demerger’ could still be considered within its meaning through the term ‘arrangement’ which by its own holding is a wider term that includes ‘demerger’.

Lastly, the Hon’ble NCLT has, in the Outbound Demerger Case failed to recognize its own logic of interpretation in the Inbound Demerger Case where it had allowed an inbound demerger under Section 234 of the Act. 

Conclusion

The Act does not explicitly allow or ban cross-border demergers. From a preliminary review, it can be clearly understood that FEMA CBM Regulations 2018 and the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations of 2017 support the idea that cross-border mergers are applicable to India. At the same time, none of the applicable laws have described demergers as illegal in India.

To address the law’s hidden and latent flaws with cross-border demergers, the legislature should make necessary changes in the Act to incorporate an express provision for demergers. This would not only clear up the ambiguity, but it would also assist to provide an objective approach when adjudicating a demerger case, leaving little or no space for judicial discretion. 

Authors: Anita Dugar, Principal Associate.

Disclaimer: The content of this article is intended to provide a general guide to the subject matter. For any queries, the authors can be reached at (i) anitadugar@samistilegal.in

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