Common Control Transactions (CCT)
A common control transaction is a transfer of assets or an exchange of equity interests among entities under the same parent’s control. Common control transactions involves arrangements involving entities or businesses under common control is a business combination in which all of the combining entities or businesses are ultimately controlled by the same party or parties both before and after the business combination, restructuring or the transaction and that control is not transitory. Determining whether common control exists requires judgment and could have broad implications for financial reporting, deals and tax.
Common control transactions arise in a range of circumstances. Some of the examples of the common control transactions are:
- An entity creates a newly formed entity to effect a transaction
- A company transfers assets to a subsidiary
- Two companies under common control combine to a separate company
- Prior to spin-off of a subsidiary by a parent entity, another wholly owned subsidiary transfers net assets to the “SpinCo.”
- Reorganization transaction where a parent entity merges with and into a wholly owned subsidiary
Non-Recognition Rules for CCT
Common control transactions generally do fall outside the application of the Financial Reporting Standards and the Income Tax Laws because there is no change in control over the assets by the ultimate beneficiary. This means that assets transferred to the entity are generally not stepped up to fair value or subjected to tax at the deemed disposal values.
Non-Recognition Rules for CCT under ITA
The golden rule of Characterization of Income Tax is that no transaction can be made at non-market value for the purpose of taxation. Section 45(1) of the Income Tax provides that when there is no consideration in the transaction (it also covers instances of the lower consideration than actually prevalent at the market values).
It is true that internal reconstructions, allocations and redistributions of assets within companies of the same underlying ownership usually leads to no significant change in the ownership structure of company. While at face the provision of Section 57 and Transfers between Associates at Tax Base under Section 45 seems like different provisions, the requirement that the nature of the use of the assets and minimum continuing underlying ownership in the assets being transferred should remain at least 50%, gives a meaning that the rationale behind Section 57 and Section 45 is almost similar.
When does a transaction qualify as CCT under ITA?
We will try to dissect every condition that are required to be fulfilled compulsorily for the qualification of Section 45.
Condition One: The nature of the assets/liabilities after transfer should not change
The primary condition of the associate transfer is that the asset/liability being transferred should be used substantially in the same manner that it was being used in the previous entity. The form of the assets in previous entity and the nature in which it can be used in the new entity is illustrated in the table below:
Form of assets/liability in previous entity | Form of assets/liability in new entity |
Business Assets | Business Assets, Trading Stock, Depreciable Assets of Business |
Trading Assets | Business Assets, Trading Stock, Depreciable Assets of Business |
Depreciable Assets of Business | Business Assets, Trading Stock, Depreciable Assets of Business |
Non-Business Chargeable Assets | Business Assets, Trading Stock, Depreciable Assets of Business, Non-Business Chargeable Assets, Depreciable Assets of Investments |
Depreciable Assets of Investments | Business Assets, Trading Stock, Depreciable Assets of Business, Non-Business Chargeable Assets, Depreciable Assets of Investments |
Liability | Business Liability |
The essence here is that the same nature of business/investment should continue in after the transfer of the assets between associates. This is the very reason why an exemption should exist in the application of Section 57. An exemption should exist in Section 57 such that the implication of Section 57 should not trigger in case where the same business continues for a certain period of time. Similar, exemption to Change in Control exists in Tanzania.
Condition Two: Transferor and Transferee should be Resident Person
At the time of transfer both the transferor and transferee should be resident person. What is the meaning behind this?
Well, in normal circumstance any non-market transfers would be treated to have been made in market value. If transfer of assets between associated person is made at tax base and the transferee is nonresident, this would mean the erosion of the potential income at the point of transfer had it been at the market value. It is true because when the asset is eventually transferred to the non-resident person, tax authority will loose any taxing right in the context of that asset.
Similarly, the idea that the transferor should also be a resident person is also valid. Any incomings to an entity is either an income of the entity or contribution received towards the capital. The assets being handed down from the nonresident associate will be incomings to the associate resident in Nepal and in that context the deemed incomings of the transferor will be the outgoings of the transferee without any cost being incurred in Nepal. This will lead to erosion in the potential tax income in context of revenue as the deemed outgoings to the transferee would be qualified as cost deduction in future tax periods, elsewise.
Condition Three: Transferee should not be tax exempted person
Transferee should not be tax exempted person.
Well, in normal circumstance any non-market transfers would be treated to have been made in market value. If transfer of assets between associated person is made at tax base and the transferee is tax exempt entity, this would mean the erosion of the potential income at the point of transfer had it been at the market value. It is true because when the asset is eventually transferred to the non-resident person, tax authority will lose any taxing right in the context of that asset.
Condition Four: Continuing underlying ownership on the asset should be at least 50%
This might just be the most relevant and important condition in context of the transfer of asset/liability with an associate.
This condition requires that the transferor who is transferring the asset should not only be a associated person to the transferee but should also have retained 50% or more ownership/obligation in the asset/liability both before and after the transfer.
The essence of this condition is that as per the definition of “associated person” in Income Tax Act 2058, it has a very broad meaning and area of definition. So, most related parties could be eligible to opt the transfer of assets/liabilities between associates. However, this condition of continuing 50% ownership that has to be retained in the asset essentially blocks all other arrangements of manipulation to this benefit.
For Example: Two person A and B equally owns a company X 50%: 50% in a joint control. Here, Person A and Company X are associated person. Similarly, Person B and Company X are also associated person. However, it is not necessary that Person A and Person B are associated person simply by the reason of joint control they exercise over company X. Lets say, person A established another company Y with 100% ownership. This would make Company X and Company Y associated person.
Let’s say an identifiable business operation consisting of assets and liabilities of Company X are being purposed to be transferred to the Company Y as a spin off arrangement. Here,
- Transferor: Company X
- Transferee: Company Y
- Underlying Owners before the transfer: Person A (50%) and Person B (50%)
- Underlying Owners after the transfer: Person A (100%)
- Continuing underlying ownership of at least 50% has been maintained?: Yes
Condition Five: Application should be made to the tax office for this option
This application is optional. This application should be opted by transferor and transferee by applying in writing to the concerned tax office. Where this application is not opted and not applied to tax office for its election, the general provision of the transfer between associates would apply. In such case the transfer will be deemed to be made in the market value irrespective of the actual consideration or intrinsic arrangement.
Combination Arrangement
Propositions
Co.A (“Controlling Entity”) and Co.B (“Controlled Entity”) are the common control entities under Income Tax Act. Co.A will acquire net assets of Co.B. The method theoretically should work as follows:
- A acquires net assets from Co.B
- A compensates the external liabilities or non-controlling interests of Co.B in form of equity interests / other considerations
- A’s shareholders will realize the shares of Co.B by liquidating Co.B
Tax Consequences on Controlled Entity
For tax purposes, under Section 45, the incomings for the Co.B is equal to the tax base of the net assets being transferred to Co.A. Tax Accounting Aspect: Permanent Tax Differences to Net Assets.
Tax Consequences on Shareholders of Controlled Entity
Non-Controlling Interests: In case where the non-controlling interests are compensated in form of equity interest in the controlling entity and if the approval under Rule 16 for the application of Section 46 is obtained, then such shareholders will not be subjected to taxation on the disposal of their shares due to the non-recognition rule under Section 46. In any other case they will be subjected to tax on the gain from the disposal of their shares in controlled entity.
Controlling Interests: The controlling interests of Co.B (i.e. Co.A) will realize their investment in Co.B by the reason of liquidation of Co.B. Tax Accounting Aspect: Liquidation Realization to Investment in Co.B to Reserves.
Tax Consequences on Controlling Entity
For tax purposes, under Section 45, the outgoings for the Co.A is equal to the tax base of the net assets being transferred from Co.B. Tax Accounting Aspect: Net Assets to Permanent Tax Differences.
Split Arrangement
Propositions
Co.A (“Controlling Entity”) and Co.B (“Controlled Entity”) are the common control entities under Income Tax Act. Co.A will spin off some of its net assets into Co.B. The method theoretically should work as follows:
- A provides some net assets to Co.B
- A may or may not receive the consideration in form of equity interests in Co.B
Tax Consequences on Controlled Entity
For tax purposes, under Section 45, the outgoings for the Co.B is equal to the tax base of the net assets being transferred from Co.A. Tax Accounting Aspect: Net Assets to Permanent Tax Differences.
Tax Consequences on Shareholders of Controlled Entity
When the controlling interests of Co.B (i.e. Co.A) receives consideration in form of equity interests in Co.B as a result of the transfer of the assets, Co.A as a shareholder will not have any tax consequences. Since no cost has been incurred by Co.A for this investment in Co.B the tax base for this investment will be zero. Tax Accounting Aspect: n/a
When the controlling interests of Co.B (i.e. Co.A) doesn’t receive any consideration, this will not have any tax consequences.
Tax Consequences on Controlling Entity
For tax purposes, under Section 45, the incomings for the Co.A is equal to the tax base of the net assets being transferred to Co.B. Tax Accounting Aspect: Permanent Tax Differences to Net Assets.