Demergers are now a common feature in the corporate landscape. Companies are increasingly taking this route to unlock shareholders' value as well as create individual profit making entities. Also, it helps them garner better valuation for the new companies and that translates into greater returns for the investors.

However, an investor needs to be clear about the changes that occur in the taxation rates. And often, this is a rather complex process. Let us take a detailed look at the process and the tax implications.

The process

When a company spins off some of its divisions or businesses into separate companies, shareholders of the original company are given shares of the new company or companies.

Obviously, the holding of the shareholder now changes because it will include all the separate companies that have been created. As these are usually listed on the stock exchanges, investors are expected to get better value for these holdings.

Tax issues

For the investor, there are two things to consider when it comes to taxation. And both involve selling of shares. If they sell shares of either the original company or the newly listed companies, some tax component will be attached with it. The first is the cost of shares in the entity that has been sold. This determines the extent of the capital gain or loss from the transaction.

Next, is the holding period of the newly listed scrips. This gives the nature of the capital gain or loss due to short-term or long-term gain involved in the transaction. The end result of these transactions gives one the final tax burden.

Cost determination

As far as the determination of the cost is concerned, the price that has been paid for the purchase of the original share is the total cost as far as the investor is concerned. This total cost will have to be broken up between the various companies that have been created during the demerger. 

For instance, if an investor bought 100 shares in company A for Rs 50 per share, then the total investment is Rs 5,000. Now, if A is demerged into companies A, B and C then the cost of Rs 5,000 has to be distributed between these three companies.

The good news for the investor is that as far as the determination of the break-up is concerned, they do not have to do the working. According to the Income Tax Act, the break up of the cost has to be done in proportion of the net book value of assets distributed in relation to the net worth of the company that was demerged.

This has to be done for each new entity that has been created. The exact figure on this area is known only to the companies involved and hence they will put out a specific ratio for the allocation of cost between the new entities. Investors can use this ratio for their calculations.

Continuing with our example above, after the demerger it might be announced that the ratio for allocation of cost should be 70:20:10 for company A:B:C respectively.

In this case, our investor will apportion his total cost as Rs 3,500 for company A, Rs 1,000 for company B and Rs 500 for company C. This exercise completes one half of the transaction which is, arriving at the cost price of the holdings.

Holding period

The next part is determining the taxation which is dependent on the holding period of these shares. The Income Tax Act says that the holding period for the new companies shall be considered from the date of purchase of the in the original company. Here, the investor gets the benefit of the holding period of the old company which was demerged into the new entities.

For example, consider an investor who bought shares on April 1, 2006 in the original company A in and the demerger took place on January 1, 2007 into company B and company C. Further, if the investor divests those shares in company B on June 1, 2007 then the capital gains would work out like this.

In order to determine the nature of the capital gains, the holding period of the shares in company B will be considered from April 1, 2006 (the purchase date of company A) and not January 1, 2006, when company B was created separately. The time period, till the sale on June 1, 2007, works out to more than 12 months. The gains here are long-term capital gains.

If the shares are sold on the stock exchange and securities transaction tax is paid, then the gains are tax-free. On the other hand, if the shares are sold before April 1, 2007, the applicable rates would be 10 per cent. In our example, if the shares of company C are sold on March 12, 2007 at Rs 2000. Then the tax would be Rs 200.

The writer is a certified financial planner.