1. Meaning of Tax Attributes
Tax attribute refers to tax losses, tax credits, and the tax basis of assets or liabilities of the taxpayers that gets adjusted / realized during the disposal of the particular asset / liability or during the disposal or the realization of the entity as a whole. Tax attributes typically includes: Net operating loss from any business, General business tax credit carryover, Alternative minimum tax credit, Capital loss, Tax basis of property, Tax basis of the liabilities, Passive activity loss or Foreign tax credit carryover. In more simpler terms, and also following the concept of deferred tax under IAS 12 Income Taxes, tax attributes are (i) the tax basis of the net assets / liabilities and (ii) unused tax credits of an entity.
2. Rationale for carryover of the losses
2.1 What is the meaning of net profit/loss for the purpose of tax?
One widely accepted definition of income is the Haig-Simons definition for the purpose of developing and refining and implementing tax legislation. Under Haig-Simons definition, income is equal to the sum of the market value of the taxpayer’s consumption during the period and the net increase in the taxpayer’s wealth during the period (whether from the accumulations of savings or the increase in the value of property held). While the computational approaches may vary, both the tax law and the Haig-Simons approach seek to tax income net of costs incurred to generate the income.
2.2 Why does the concept of carryover of tax losses arise?
Once the decision has been made to tax net income, there arises a decision regarding the proper time horizon over which to measure net income; as a matter of temporal proximity, which costs and expenses should be allocated to which period in determining net income of a given period? For purposes of their theory of economic income, which was not overly concerned with any arbitrary temporal cutoff date, an appropriate period for determining tax liability should be identified.
From a theoretical perspective, the determination of an economic income could (and probably should) be judged over the business’s lifetime, because it is only over that period that economic income could be definitely measured and fixed. However, the crafters of our income tax law could not take such a long view, regardless of the compelling underlying arguments to do so. For administrative purposes and to ensure that the government has revenues to carry out its functions, the tax code requires taxpayers to calculate and pay tax on their income annually. An annual accounting period is generally presumed to be “tentative and provisional” solution to this problem.
Following the Haig-Simmons definition, it is also because that the tax laws generally does not provide for payments from the government to taxpayers who experience negative taxable income for a tax year, a concept of carryover of the losses is essential.
3. Meaning of Loss Trafficking
Everyone is concerned with navigating tax laws and limitations on the use of tax losses in transactions with commercial objectives. Where one is able to carryover the tax losses (i.e. loss preservation) it will have a meaningful impact and is always an important part of any transaction. Tax losses limitations rules are usually non-sensical and more often than not doesn’t lead to meaningful prevention of abuse of tax attributes but rather creating unnecessary costs and friction in transactions of mergers and acquisitions. In the paragraph below we will discuss what is the rationale for carryover of losses, what is the rationale for prevention of carryover of losses and why is there even a need to do that?
4. Abuse of tax losses?: The problem. And, why prevent it?
4.1 Abuse of tax losses?: The problem. And, why prevent it?
A corporation with accumulated tax loss carryovers is more valuable than an otherwise similarly situated corporation without loss carryovers, because the loss carryovers can be used to offset future tax liabilities. Assuming each of the two corporations projects the same future stream of pretax income, the corporation with loss carryovers will anticipate higher after-tax yields. At least in theory, an acquirer should be willing to pay an additional amount for the loss corporation up to the present value of the projected future tax savings resulting from the anticipated use of loss carryovers to offset future income.
4.2 But is there anything wrong in pursuing such incentives?
Is there anything wrong with that? Does an acquirer’s payment of incremental purchase price for this type of tax asset result in some distortion or unfairness that cannot be tolerated by our tax system? Are there important differences between the purchase of a tax asset as compared with, say, the purchase of a machine or a real estate?
There aren’t any published discussions on the review of the anti-loss trafficking tax legislation of Nepal, but the tax authorities naturally look into the abusive efforts of taxpayers in loss trafficking. A principal consideration should be given to the fact that whether such loss motivated transaction actually reflect a widespread market view or is there even any meaning to prevent the so called “trafficking of tax losses”.
5. What is the wisdom to prevent the utilization of tax attributes during transactions?
The answers often received is that trafficking in tax losses must be curtailed to prevent several “evils” – real, imagined, or manufactured. Even when this principal undergoes development of legislative, administrative, and judicial efforts to curb loss trafficking there doesn’t seem to be widely accepted principle on “why the tax loss trafficking should be prevented?”.
The following are those most consistently or frequently offered wisdom on why the tax trafficking should be prevented and we will discuss below why there is little or no sense to them, and why they are nonsensical most of the times.
The discussion below examines whether and the extent to which these articulated concerns are in fact compelling. It also explores whether current law is effective at achieving its stated goals and whether alternative approaches might be better from a tax policy standpoint.
Wisdom One: tax law must not encourage or permit transactions that have no nontax purpose and are driven entirely with a goal to reduce or eliminate tax liability (tax avoidance);
But what is wrong with transactions having as their sole motivation to reduce the taxes? We have come to understand and acknowledge that taxpayers are permitted to take steps to reduce taxes, and that “tax avoidance” is not per se a bad thing. Courts have long held that a taxpayer “may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury.”
Apparently, while there is nothing inherently objectionable about what we now commonly call “tax planning”, that kind of planning becomes unacceptable if it is not somehow connected with other objectives. Why? The answer seems to be that purely tax motivated transactions are undesirable because they violate the principle of tax neutrality, which holds that the tax law should neither induce nor impede business transactions. On hearing this answer, a bit of skepticism takes hold and one is tempted to list the many ways our tax law is intentionally and incontrovertibly designed to encourage or discourage different types of activity and conduct, calling into severe question the validity of any argument relying on this imagined principle of tax neutrality.
However, this weakness in the very premise of tax neutrality as a principle can be significantly or fully discounted by merely acknowledging that there are in fact many situations in which the tax law is clearly designed to cause or inhibit specified conduct, and that in the absence of a legislative desire to cause or inhibit targeted conduct, the principle of tax neutrality fills the vacuum.
The Recoupment Principle: Recoupment proponents fall within (at least) two thoughts.
- One thought focuses on the need to create, and the societal benefit attendant on, a tax system that helps those who have suffered loss or encountered hardship. This is something of a welfare view of our tax system, whose adherents stress our communal obligation to prop up those less fortunate.
- The second thought is less inclined towards communal principle and simply wants fairness within the four corners of the tax system. This thought, recognizing the completely arbitrary nature of our annual reporting system, bristles at the notion that taxpayers who (directly or indirectly) have net losses in a given tax period might have paid tax in an earlier period or may pay tax in a future period with no offset for those losses.
As an example, assume the shareholders of the loss corporation receive cash in exchange for their stock. In that transaction, the acquirer is paying an amount upfront for the ability to reduce future tax. The selling shareholders, who otherwise would have been unable to benefit from the loss carryovers, receive value for the tax losses from a party able to make use of them. In this way, selling shareholders who had suffered the economic loss and, through that loss gained ownership of a tax asset, would be permitted to realize at least some portion of the value of that asset.
Wisdom Two: the benefits that can be derived from tax losses must be enjoyed exclusively by the person that suffered the economic loss that gave rise to the benefit (same person);
Does Income Tax Act, 2058 entirely follow the same person principle consistently and completely? Is Section 57 of the Act consistent with the principle to pursue the same person object?
For example, why are the tax losses carryover under Section 20 are limited for the period of 7 years despite the enterprise being under the control of the same shareholders? No, the losses are limited despite the same old shareholders continuing to own the enterprise even after 7 years from any point of time. If the goal is to adhere to and pursue the same-person objective, why limit the continued use of the tax losses?
Again, however, this merely begs the question: Why should the tax benefit, unlike other assets, be usable exclusively by these shareholders? And why, even under this view that the shareholders who bore the economic loss should be able to enjoy the associated tax benefit, should these shareholders be precluded from realizing that value through a sale of the benefit?
Similarly, why does Section 57 include the convention of a three-year testing period, which allows new shareholders – meaning shareholders who acquire shares of a loss corporation after the incurrence of tax losses – to be treated as old shareholders after 3 years? How is that consistent with a goal to ensure the same-person objective? And the fact that the inconsistency of the test of years under Section 20 and 57 also is an indication that the Income Tax Act is not fashioned completely with the same person principle.
The limitation of the adjustment of the losses under Section 11 of the Act for concessional businesses of the enterprise could have arisen from a separate notion. However, the fact that the enterprise is not allowed to readjust the tax losses w.r.t the applicable tax rates to be reflected in another concessional or non-concessional business is yet another inconsistent application of Section 11 of the Act.
Clearly, the current Income Tax Laws of Nepal was not fashioned with a singular or overarching focus on the same person objective. Perhaps more likely, the same person principle is only an ingredient in the mix, an additional – but not primary or guiding – factor driving legislative efforts to curtail loss trafficking.
This is even more evident from the fact that the option to transfer tax attributes between associates holding 50% continuing underlying ownership of the asset under Section 45 doesn’t apply in the case of the entities enjoying business concession under Section 11. This also supports the notion that Income Tax Laws of Nepal was not fashioned with a singular or overarching focus on the same person objective. Section 11 of the Income Tax Act probably is the most randomly legislated and problematic both in philosophy and in application. However, this is a topic for separate discussion altogether.
Most likely, when invoked at all, the same-person principle serves as a backstop to the tax avoidance concern discussed above. Were the legislators even focused on stopping acquisitions having tax avoidance as their primary goal? The present test applicable under Section 11, Section 20, Section 45 and Section 57 has and never will be sufficiently effective to achieve that before establishing a well-founded discussion on why a need is there even to legislate such provisions, simply assuming that same person objective has any validity, or take legislative actions without also balancing important countervailing considerations.
Wisdom Three: if the tax law permitted the sale of tax losses, sellers would almost certainly be inadequately compensated (inadequate compensation)
Some have argued that loss carryovers should not be freely transferable because selling shareholders would not receive adequate compensation in exchange for those attributes. On its face, this argument seems both overly paternalistic and fairly archaic. In today’s economic system, which permits and encourages the sale of just about any kind of asset – real or imagined, contingent or otherwise – it is difficult to understand a concern that the shareholders of the loss corporation won’t get paid enough for the transfer of their tax asset. Indeed, our economies and our sophisticated markets have little difficulty placing a value on just about anything; surely they could figure out a proper value for these tax assets. Ironically, the fact that loss carryovers are not freely transferable is probably the only real barrier precluding an efficient system in which tax losses are evaluated, bought, and sold with facility, a system in which shareholders selling a loss corporation could realize full value for their loss corporation shares.
Some have offered a corollary to the idea that only the historic owners should get the tax benefit associated with having endured the economic loss: According to this notion, the reason to constrain trafficking in tax losses is to protect these historic owners from the eventuality that acquirers will not adequately compensate selling shareholders for the tax attribute. Under this theory, it is argued that acquirers will discount their payment to account for uncertainty regarding the potential acquirer’s ability to use a loss carryover, and so selling shareholders will simply be unable to obtain adequate compensation for the underlying tax benefit. Consequently, the selling shareholders would be underpaid and the acquirer might accede to a windfall if it can use more of the loss carryover than it anticipated at the time of the acquisition. This concern, further examined later, has the hallmarks of a rationale concocted after the fact to explain a rule that may simply have no good underlying purpose.
Wisdom Four: the tax benefits that can be derived from tax losses should be available only through offsetting the income generated by the same business activity from which the underlying tax losses arose in the first place (same business).
One significant shortcoming of this “same business” approach is that if our limitation rules actually restricted use of tax losses to the same business, a loss corporation would be compelled (or at least encouraged) to continue a losing business line in order to realize value from its loss carryforwards, which is both economically inefficient and poor tax policy.
Moreover, the same-business principle is simply not in any way a staple of our tax law. There are
many provisions within the Income Tax Act, 2058 that explicitly permit a taxpayer to average its tax liability across multiple lines of business. For instance, Section 20 of the Act allows an enterprise to set off the losses incurred in one line of business with the gains from another line of business, or utilize the business losses to set off with even investment incomes.
Further, if, as a policy matter, we do not want to permit taxpayers to offset income and loss across business lines, the focus of our trafficking rules should shift away from ownership changes, which do not necessarily result in changes to the business activities of a loss corporation, and focus instead on the activities of the loss corporation. However, any system implementing that policy would be complex from an administrative and compliance standpoint.
There would be a definitional question about what activities of a corporation should constitute a line of business; taxpayers would need to begin tracking their taxable income on a business-by-business basis (rather than on an aggregate basis); and the tax authorities would need to have some method to determine when a corporation with losses shifted its business lines in a manner that should trigger a loss use limitation.
All in all, not only does the same business approach lead to bad economic and tax policy, and not only is the approach inconsistent with many other elements within our tax system, but the underlying goal would be quite difficult to achieve. The emerged wisdom among the tax practitioner’s community is that a loss corporation’s ability to use pre-acquisition loss carryovers should be limited to prevent so-called trafficking in loss corporations. But why? Several rationales are offered. Trafficking is often presented as a self-evident evil, generally defined by reference to a motive to engage in a transaction primarily to acquire a loss corporation’s tax attributes. This, however, merely begs the question: Why is that bad? If it is acceptable for a purchaser to acquire a machine, for example, why not a tax attribute?
Wisdom Five: the tax laws should discourage the transactions only driven by tax (insubstantive transaction)
One answer often provided is that: The tax laws cannot abide by an acquisition undertaken solely with a tax-driven motivation. The tax law, under this way of thinking, cannot be driving transactions and should ‘‘allow’’ only transactions that would have been undertaken even in the absence of tax loss carryovers. Under this view, a transaction whose sole result is a net decrease in tax revenue to the revenue authority should not have any place within the tax system. This violates the principle of tax neutrality, which posits that tax implications should neither impede nor induce business transactions. As will be explored below, not only are the ethical, moral, and practical underpinnings of this principle unclear, it is even debatable whether this principle is followed with sufficient consistency within the tax law to cloak it with respectability.
6. Is Section 57 a taxing provision or an anti-abuse provision?
Much discussions has been made in the application of Section 57. What is the primary legislative intent behind it? I believe that, just like intended by Peter Harris in Model Tax Act, the intent of Section 57 is to prevent the abuse of the tax attributes. View my other blogs on Section 57 here:
1. What the bug is Section 57?
2. Issues that arises when applying Section 57
3. Involuntary Disposal with Replacement: Definitive Analysis
4. Transfer of tax base between associates
5. Principles underpinning the Ncell Case
6. Capital Gains Tax in Nepal
However, tax practitioners in Nepal provide the following wisdom behind the application of Section 57: (1) Preventing Abuse of Tax Attributes, (2) Capturing Off-Shore Transactions and (3) Reflecting actual Business Transactions and Taxation of Unrealized Gains. We will dissect them one by one here.
6.1 Preventing Abuse of Tax Attributes
Sections 20 and Section 45 permit, in limited circumstances, the direct transfer of tax attributes to and from entities. This is essentially an issue of looking through the form in which a business or investment is held and looking to economic substance. Section 57 is of an opposite nature in seeking to prevent an indirect transfer of tax attributes of an entity to persons who do not own or are not commonly owned with the entity. A provision of this nature is recommended in order to prevent tax arbitrage irrespective of whether the corresponding provisions are implemented to permit the direct transfer of entity tax attributes. Section 57(1) prevents the carry forward of tax attributes under the transactional basis income tax. It treats an entity as realizing all its assets and liabilities where there is a change of 50 percent or more in the underlying ownership of the entity within a 3-year period. This level of underlying ownership is consistent with that required for the direct transfer of tax attributes to associates. Section 41 will apply a market value rule to the realization. The result is that the entity will realize any previously unrealized gains and losses just before the change. This, combined with section 57(2), prevents the purchaser of an entity indirectly obtaining access to these tax attributes.
Section 57(2) denies the carry forward of certain tax attributes of an entity under the payments-basis income tax where a change in ownership of the entity occurs. The provision also applies to the carry back of tax attributes, where that is possible. The tax attributes described in section 57(2) are self-explanatory. Section 57(1) and 57(2) may apply in tandem, e.g. where section 57(1) causes the realization of a loss that is not available to be carried forward by reason of section 57(2). Section 57(3) applies the rules in section 57(2) to parts of tax years.
Similar to the discussions made above, IMF Commentary from Commonwealth of Symmetrica has highlighted that Section 57 is intended to prevent the transfer of broad value shift of tax attributes from entity to another. Commonwealth of Symmetrica is a model tax law on which the tax law of Nepal is substantially based on. The Brains behind Income Tax Act of Nepal: Peter Harris
But this begs other questions:
- Why should this prevention apply in case where AcquirerCo is a newly established company intending to continue the same business of AcquireeCo with reasonable expectation of profits? [New Investor Acquisition]
- Why should this prevention apply in the case where AcquirerCo is a company involved in similar business and is intending to continue the same business of AcquireeCo with reasonable expectation of profits? [Horizontal Acquisition]
- Why should this apply if total Profit / Loss for Section 57 purpose is profit?
Tanzania’s Income Tax Law is also based on the model tax law “Commonwealth of Symmetrica” and Section 56 of the Income Tax Law of Tanzania is very much comparable with the Change in Control provision under Section 57 of the Income Tax Act, 2058 of Nepal.
How has Tanzania implemented the “Continuity of Business” test and solved this issue?
Section 56(4): The provisions of Section 56(2) shall not apply where for a period of two years after a change of the type mentioned in Section 56(1), the entity –
(a) conducts the business or, where more than one business was conducted, all of the businesses that it conducted at any time during the twelve month period before the change and conducts them in the same manner as during the twelve month period; and
(b) conducts no business or investment other than those conducted at any time during the twelve month period before the change.
6.2 Capturing Off-Shore Transactions
Another view generally provided on the favor of the application of Section 57 is that it is intended to apply to capture the offshore transactions whose underlying business or investment is in Nepal. Section 57 of the Act requires the entity to assume a deemed disposal of its assets and liabilities at their market values and the entity is subject to taxation at their normal taxation rate. Is this the real intent behind the Section 57? Since Section 57 requires the deemed disposal of the assets at their market values it doesn’t right to the idea to capture the tax on transaction price of the deal.
A general economic understanding is that: Transaction Price = Market Price ± Goodwill
Goodwill is created by the reason of value of a company’s brand name, location, solid customer base, good customer relations, good employee relations, and proprietary practices and technology. None of these are identifiable assets. Intangible assets like Intellectual Property, Business License, Software are intangible and yet identifiable (i.e. market value can be assigned to them). However, Goodwill is the portion of the purchase price that is higher than the sum of the net fair value of all of the assets purchased in the acquisition and the liabilities assumed in the process. Also, as per IFRS, Goodwill cannot self-created for recognition unless transaction takes place. This clearly indicates that the deemed disposal of the asset/liabilities at their market values cannot lead to the taxation on the deemed gain made on the transaction / deal made to acquire the underlying entity.
6.3 Reflecting actual Business Transactions and Taxation of Unrealized Gains
Another view, not so much popular, is the view of Symmetric interpretation of the transactions. Under normal business scenario, business assets are transacted at their intended value-in-use and the provisions of taxation works in relative to that value-in-use of business. However, when the transaction is made through the instruments representative of the underlying asset in the transaction (i.e. shares) such value-in-use of the asset is not reflected in the actual underlying asset in the transaction (i.e. the net assets of the entity whose share is being transacted). Section 57 eliminates this asymmetry by taxing on the deemed profit from deemed disposal of net assets of the entity whose substantial ownership has been changed. This may be a different school of the thought but the tax consequences under this approach doesn’t differ than the thought under “Preventing Abuse of Tax Attributes”.
7. Tax Laws of Nepal on preservation of Tax Attributes
7.1 Tax Exemptions and Business Concessions
Section 10 of the Act provides various areas. Section 10 is the primary exemption provision in Nepal. Exemptions are kept to a minimum and certain industry concessions are provided under Section 11 of the Act. Conventional wisdom suggests that these types of concessions often cause more harm than good.
Once the entity enjoys tax exemptions or business concessions it is more likely that the entity will be subject to certain provisions that prevents the entity from abusing those facilities. Industries dealing in entirely tax-exempt businesses under Section 10 do not come under the purview of the Income Tax.
Even in the case of industries enjoying the business concessions restrictions does apply. Section 11(4) of the Act provides that a person entitled to a multiple concession under Section 11 shall calculate income as stated in those Sub-sections as a separate person has earned only that income. This will significantly limit capacity of the enterprise to cross utilize the losses arising in the concessional businesses in other businesses. Further, Section 20(8) of the Act provides that if any person has received full tax exemption in respect of income of business or investment in any income year, the loss incurred in that income year shall not be carried forward to upcoming income year.
7.2 Carryover of Losses & transfer of Losses between Associates
Under Section 20 of the Act, Loss suffered by that person from any business and not deducted in the last 7 income years can be adjusted with the income earned by the person following the rules of loss quarantine under the same Section. This limitation of 7 income years is itself a limitation. The tax practitioners who believe strongly on the recouple principle do not prefer this limitation of 7 years.
Loss relief, such as the carry forward under section 20, does not fully address problems with income fluctuating from year to year within bands of taxation. Where two persons have the same amount of income over a five year period, the one whose income fluctuates the most year by year over that period may find they pay more tax than the person with the more stable stream of income. Two industries particularly prone to this problem are the agriculture industry and that of artists and entertainers. However, the issue is not specific to these or any other industries, e.g. it arises with respect to gains recognized on a transactional basis (such as capital gains) and some lump sum retirement payments. This is a general issue under an income tax calculated on a periodic basis.
Section 20 is the primary provision that controls the use of losses from one earning activity to reduce income from another earning activity. The general approach is that any loss from a business for a tax year may reduce any other income from a different business or investment for the same year but not income from an employment.
Another important note to be taken is that, Model Tax Law of Symmetrica allows the deduction of any unrelieved loss of the year or a previous tax year of an associate of the person from any business or investment that is transferred to the person for the year. This is an specific provision under the Model Tax Law of Symmetrica but this hasn’t been carried in the Tax Laws of Nepal. These transfers recognize that many entities and their associates form but one economic unit and are consistent with a general approach of basing recognition on the substance of activities rather than their form. Income Tax Act, 2058 doesn’t specifically contain this provision, but will this limit an entity from obtaining tax attributes from the associated person and utilizing for deduction in the enterprise? Will the provision under Section 45 allow a person to carry loss attributes from the associated person under Section 45? This can be a issue for separate detailed discussion.
The view to transfer the loss between associated enterprises has not been specifically covered under Section 20 of the Income Tax Act neither has been explicitly limited under any other provision. Here it might be relevant to discuss the relevant commentary from the Model Tax Law of Symmetrica so as to gather the idea and intent behind the eligibility of the transfer of such losses between associates. Commentaries from Model Tax Law of Symmetrica provides that: Firstly, one of the parties to the transfer must be an entity and neither a partnership. Secondly, the transferor and the transferee must be residents from the time the loss is incurred until it is transferred. This requirement seeks to protect the tax administration against bogus claims where the administration may have difficulty in substantiating a transfer claim. Where substantiation is not an issue, e.g. where there is good exchange of information under a double tax treaty, this requirement may be relaxed. Thirdly, this also requires common underlying ownership of at least 50 percent between the transferor and the transferee of a loss. The justification for transfer where there is 100 percent common underlying ownership is strong, i.e. the difference of identity between the transferor and the transferee is only a matter of form and not economic substance. Where the required level of common underlying ownership is less, there is potential for tax arbitrage. These conditions are also discussed below in the context of the non-recognition treatment of transfers of assets and liabilities under section 45. Section 45 may permit the transfer of unrealized losses on assets and liabilities between associates. It is, therefore, important that the requirements for transfer of realized losses between associates are similar to those for the transfer of unrealized losses under section 45.
The exclusion of the specific allowance of the transfer of losses between the associates under Section 20 of the Act is nonsensical. One could preserve the tax losses by the way of Section 45 in form of transfer at the respective market values and recoupment of losses. It would have been better if this was specifically permitted under Section 20 so that the transactions of the sales/purchase of entities could avoid this unnecessary friction. Another way to recoup the tax losses from the associated transferor is to simply invoke the application of Section 45 and transfer the tax losses to the transferee on the basis that even tax losses do create the deferred tax assets which can be priced and can form the economic part of the consideration in a transaction.
7.3 Nonmarket pricing arrangements between Associated Persons
Under Section 33 of the Act, any arrangement between persons who are associates, the tax authorities may distribute, apportion, or allocate amounts to be included or deducted in calculating income and foreign income tax paid between the persons as is necessary to reflect the taxable income or tax payable that would have arisen for them if the arrangement had been conducted at arm’s length. This general anti-avoidance principle has the potential to prevent the broad unethical and non-market value shifting (other than those specifically allowed) between the associates.
7.4 Transfer of tax base between Associates
A detailed discussion on the transfer of the tax base between associates under Income Tax Act of Nepal has been made in my other blog: Taxation on Variable Considerations
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).
We have discussed why the Implication of Change in Control as per Section 57 should not apply in case of internal restructuring here. Issues that arises when applying Section 57
It is generally true that internal reconstructions, allocations and redistributions of assets within companies of the same underlying ownership, with 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 all these conditions under Section 45(6) are met:
- The trading stock/depreciable asset/business asset of transferor becomes trading stock/depreciable asset/business asset of the transferee
- The investment asset/NBCA of transferor becomes trading stock/depreciable asset/business asset/NBCA
- The liability of the transferor becomes the business/investment income generating source of the transferee
- At the time of transfer, both transferor & transferee should be resident person and transferee should not be tax exempted person
- Continuing underlying ownership on the asset should be at least 50%
- Application should be made for this option
- The incoming for the person disposing the asset/liability = Tax Base of the asset/liability being disposed (TB)
- The outgoing for the person disposing the asset/liability = Tax Base of the asset/liability being disposed (TB)
- Difference = Incoming – Outgoing = TB – TB = 0
- Nature of Difference = n/a
7.5 Change in Control: The Section 57 of Income Tax Act
View my other blogs on Section 57 here:
1. What the bug is Section 57?
2. Issues that arises when applying Section 57
3. Involuntary Disposal with Replacement: Definitive Analysis
4. Transfer of tax base between associates
5. Principles underpinning the Ncell Case
6. Capital Gains Tax in Nepal
Much discussion has been made on the application of Section 57. Section 57(2) of ITA puts some restrictions on the entity undergoing change in control to prevent abuse of tax attributes. The entity cannot:
Carry Forward Interest Expense u/s 14(2)
Section 14(2) of the Act has the restrictive provision that limits the amount of interest paid to exempted controller that can be deducted as an expense. This is in line with the OECD plan to prevent base erosion through thin capitalization mechanism. By this limitation in the amount of interest that can be claimed for deduction, some interest expense that cannot be claimed during the year are treated as interest expense for the following income year. However, once the Change in Control as per Section 57 is triggered then this is not allowed to be carried over. The amount of interest expense accumulated by this reason lapses and is not eligible to be carried forward in the next income year.
Carry Forward/backward Losses u/s 20
Section 20 of the Income Tax Act states that a resident person may for the purposes of calculating the income of a person for an income-year from a business or investment, there shall be deducted any unrelieved loss of the previous 7 income years incurred by the person from any business. Provided that, in case of electricity projects involving in building power station, generating and transmitting electricity and the projects conducted by any entity so as to build public infrastructure, own, operate and transfer to the GON, any unrelieved loss of the previous 12 years shall be deducted. However, once the Change in Control as per Section 57 is triggered then this is not allowed to be carried over. The amount of deductible losses accumulated by this reason lapses and is not eligible to be carried forward for deduction in the next income year. Similarly, once the Change in Control as per Section 57 is triggered the person is not eligible to reduce gains under Section 36 from the disposal of assets or liabilities after the change by losses incurred on the disposal of assets or liabilities before the change.
Carry Forward Foreign Tax Credit u/s 71
Section 71 of the Income Tax Act states that a resident person may claim a foreign tax credit for an income-year for any foreign income tax paid by the person to the extent to which it is paid with respect to the person’s assessable foreign income for the year. However, such foreign tax credit to be claimed shall not exceed the average rate of Nepal income tax of the person for the year applied to the person’s assessable foreign income. Any amount of foreign income tax that could not be claimed by the reason of this limitation may be carried forward. However, once the Change in Control as per Section 57 is triggered then this is not allowed to be carried over. The amount of foreign income tax accumulated by this reason lapses and is not eligible to be carried forward in the next income year.
Carry Forward Unrealized Forex Loss u/s 24(4)
Section 24(4) of the Income Tax Act 2058 states that In case where a person includes a payment to which the person is entitled or deducts a payment that the person is obliged to make in calculating the person’s income from a business or investment on an accrual basis, and the actual payment received or made by the person comes to be different including by reason of a change in currency valuations that took place afterwards, an appropriate adjustment should be made at the time the payment is received or made so as to account for the inaccuracy.
Carry Forward prior Bad Debts u/s 25(1)
A person accounting for an amount derived on an accrual basis may later disclaim the entitlement to receive such amount. Similarly, the person may also write-off the amount as bad debt where the amount constitutes a debt claim of the person. For tax purposes such amount disclaimed/written-off can be written off as bad debt only after the person has taken all reasonable steps in pursuing payment and the person reasonably believes that the entitlement or debt claim will not be satisfied as per Section 25(2).
However, once the Change in Control as per Section 57 is triggered then the person will not be eligible to claim such amount as bad debt even after satisfying the conditions under Section 25(2), that were accounted for or accrued in the period prior to the Change in Control.
Carry Forward prior Returns of Premiums u/s 60
Section 60 of the Income Tax Act deals with General Insurance Business. Return of Premium means the situation where an insured intends to cancel the policy and gets refunds for the amount of premium that remained unutilized in respect of the policy. In normal situation those payments are allowed to be deducted as per Section 60(2)(b)(ii). However, once the Change in Control as per Section 57 is triggered then such returns of premiums cannot be claimed for deduction in respect of policies that were issued prior to the Change in Control.
8. Is there an attribute abuse infestation? If yes, what is the best mousetrap?
So, what have we learned? And what shall we do? We can draw several conclusions:
• while there is a strong sense that there is a problem – trafficking – that needs to be addressed, there is no clear articulation of what
the problem actually is;
• the legislative, judicial, and administrative efforts to prevent trafficking in tax losses have been inconsistent, nonsensical at times, and lacking a defining and fixed focus;
• the most prevalent reasons offered to prevent trafficking appear to be either superficial or flawed in important ways; and
• there has never been, as far as one can tell, a genuine effort to explore the benefits to our economy and to the perception of fairness within our tax system that might result from eliminating or drastically altering the rules that disallow or discourage so-called trafficking.
Another important question is, assuming the tax authorities do have a argument on the favor of the anti-loss trafficking, is this even such a serious problem that demands the provisions under Section 11, Section 20, Section 33, Section 45, Section 57 and Section 71, altogether causing unnecessary frictions in the mergers, acquisitions and consolidation arrangements?
Maybe we would have difficulty finding common ground and that we would all agree on just one principle: The tax law should not respect transactions that are without substance. If a purported transaction changes nothing, the tax implications should correspondingly be nothing. This one principle already is a staple of our tax law in the form of judicial constraints such as the sham transactions and principle of substance over form. One could reflexively say that transactions pursued entirely with tax avoidance as a goal should not be respected. But when transacting in economic benefits provided by the tax attributes, validity of argument on substance over form is unseemly, and that even the transaction motivated by tax attributes should be a compelling rationale for taking a position in favor of such transactions.
What is the best Mousetrap?: Maybe the best mousetrap is no mousetrap at all. But in an unlikely case, even when the case for the prevention for economic transaction for tax attributes is made: the attributable loss recoupment principle would be a best solution. The principal is known as ‘‘pool of capital’’ concept. A loss corporation’s tax loss carryovers following an acquisition transaction should be allowed to offset only income from that loss corporation’s pool of capital existing on the date of the acquisition transaction. A loss corporation could apply its losses to offset post-merger profits only to the extent of profits allocable to shares of the loss corporation outstanding when the loss was incurred. For example, if in a merger the target loss corporation’s shareholders receive 10 percent of the total outstanding shares of acquirer common stock (suggesting that the loss corporation represents 10 percent of the combined entity), the tax loss carryovers of the loss corporation could be used to offset only 10 percent of the acquiring corporation’s post-merger earnings.
The conclusion is: Let’s first agree on what, if anything, needs to be accomplished or should be avoided. Why have such a lot of limitations under tax legislation without even founding a strong overarching theory?
Free Commerce of Tax Attributes !!