What is an involuntary disposal?
Sometimes a person might have to part with his existing assets, not by their choice or will, but due to some events not wholly within their control. Such events could be:
1. Deemed disposal by the reason of death of a natural person
2. Forceful takeover of properties/assets by authorities or government order
3. Assets lost in accidents/calamities
4. Disposal of securities by the reason of reconstruction/mergers
5. By the reason of court orders/decisions
6. Any other involuntary events
It is interesting to see how income taxation triggers in such situations. We will discuss the issue relating to deemed disposal by the reason of death of a natural person seperately in another blog. Other situations, listed above, we will cover in this blog.
Meaning of involuntary disposal with replacemet
Now that we know what is an “Involuntary Disposal”, what is invountary disposal with replacement? Let’s dissect in the events below:
1. A land was forcufully taken over by government by providing consideration and the person buys another land in its replacement utilizing those proceeds.
2. A machinery plant was destroyed in a fire hazard. The company to continue its operation bought another similar plant in replacement.
3. A company underwent merger arragement by the reason of court approved reconstruction. In that case the interest of shareholders in previous company was replaced with equity in the newly formed entity.
4. Court ordered a person to transfer the assets under lien to its debenture holders. The company replaced the asset with similar other asset as it was necessary for the operation of the business.
Provisions of Law
Income Tax Act, 2058 and Income Tax Rules, 2059
Section 46(1): Where a person involuntarily disposes of an asset in any of the manners described in section 40(1), the person acquires ownership of a replacement asset of the same type within 1 year of the disposal, and the person elects in writing for this subsection to apply:
(a) The person shall be treated as deriving in respect of the disposal an amount equal to the sum of the following:
(1) The net outgoings for the asset immediately before disposal; plus
(2) The amount, if any, by which amounts derived in respect of the disposal exceed expenses incurred in acquiring the replacement asset; and
(b) The person shall be treated as incurring in acquiring the replacement asset expenses in an amount equal to the sum of the following
(1) The net outgoings for the asset disposed of immediately before disposal; plus
(2) The amount, if any, by which costs incurred in acquiring the replacement asset exceed the amounts derived in respect of the disposal.
Section 46(2): Where a person involuntarily disposes of a liability in any of the manners described in section 40(2), the person incurs a replacement liability of the same type within 1 year of the disposal, and the person elects for this subsection to apply:
(a) The person shall be treated as incurring expenses for the disposal in an amount equal to the difference remained after subtracting the amount of subparagraph (2) from subparagraph (1) of the following:
(1) The net incomings for the liability immediately before disposal; less
(2) The amount, if any, by which the costs incurred for the disposal exceed the amounts derived in respect of incurring the replacement liability; and
(b) The person shall be treated as deriving in respect of incurring the replacement liability an amount equal to the sum of the following:
(1) The net incomings for the liability disposed of immediately before disposal; plus
(2) The amount, if any, by which the amounts derived in respect of incurring the replacement liability exceed the expenses incurred for the disposal.
Section 46(3): The circumstances shall be as prescribed in which the replacement of one security in an entity with another security in an entity as a result of conversion of the security or reconstruction of the entity constitutes an involuntary disposal.
Rule 16(1): The conditions, where a person replaces a security in an entity with another security in the entity or with a security in another entity under a merger or reconstruction of the entity, shall be treated as an event of an involuntary disposal with replacement.
Rule 16(2): Where the event of the involuntary disposal takes place under Rule 16(1), the person or the entity shall file an application with the Department for an approval.
Rule 16(3): The Department may give an approval to the application filed with under Rule 16(2).
Summary of the above please?
The essence of the above provision is explained in mathematical terms below. Where the disposal qualifies to be an “involuntaory disposal with replacement” then:
- Incomings = Tax Base + MAX(Disposal Proceeds – Replacement Cost, 0) = TB + Max(DP–RC, 0)
- Outgoings = Tax Base + MAX(Replacement Cost – Disposal Proceeds, 0) = TB + Max(RC-DP, 0)
- Gain/(Loss) = Incomings – Outgoings = TB + Max(DP–RC, 0) – [ TB + Max(DP–RC, 0) ] = DP – RC
From Income Tax Directive
कुनै व्यक्तिले सम्पत्ति वा दायित्व आफ्नो स्वेच्छाले नभई, सरकारी आदेश, कानुनी निर्णय वा यस्तै अन्य बाध्यात्मक परिस्थितिवश निःसर्ग गरेको भए यस्तो निःसर्गलाई अस्वेच्छिक निःसर्ग मानिन्छ । कुनै व्यक्तिले कुनै सम्पत्ति आफ्नो स्वेच्छाले नभई सरकारी आदेश, कानुनी निर्णय वा यस्तै अन्य बाध्यात्मक परिस्थितिवश निःसर्ग गरेको र यसरी अस्वेच्छिक (Involuntary) निःसर्ग गरेको एक वर्षभित्र सो सम्पत्तिको बदलामा सोही किसिमको अन्य सम्पत्तिको स्वामित्व प्राप्त गरी यो दफा लागूहुन लिखित रूपमा सम्बन्धित आन्तरिक राजस्व कार्यालयमा अनुरोध गरेमा सो व्यक्तिले निःसर्ग बापत सो सम्पत्तिको लागि भएको खुद खर्च र सो प्रतिस्थापित सम्पत्ति प्राप्त गर्दा गरिएको खर्च भन्दा सो निःसर्गबाट प्राप्त रकम बढी भए यस्तो बढी भए जतिको रकमको जम्मा रकम प्राप्त गरेको मानिन्छ । पहिलो निःसर्गको एक वर्षभित्र (आय वर्षभित्र होइन) प्रतिस्थापित सम्पत्ति खरिद गर्न पाउने हुनाले वास्तविक निःसर्ग भएको वर्ष सो सम्पत्ति आफ्नै स्वामित्वमा रहे सरह मानिन्छ र यसका लागि करदाताले आय विवरण पेश गर्दा सो निःसर्गमा दफा ४६ को सुविधा माग गरेको हुनु पर्दछ । अर्को आय वर्षमा जब प्रतिस्थापन गरिएको सम्पत्ति प्राप्त हुन्छ सो बखत दफा ४६ छनौट गरी गणना गरेको हुनु पर्दछ । पहिलो वर्षको आय विवरण पेश गर्दा दफा ४६ को सुविधा छनौट गरेको तर दोस्रो वर्षमा पहिलो निःसर्गको एक वर्षभित्रै प्रतिस्थापित सम्पत्ति प्राप्त गर्न नसकेको अवस्थामा पहिलो वर्षको आय विवरण दफा १०१ बमोजिम संशोधन हुन्छ ।
उदाहरण २२.१३.३: मानौं, एन्. डि. एल्. फाईनान्स लि.लाई नेपाल राष्ट्र बैंकले नेपाल धन लक्ष्मी बैंक लि.मा गाभिन निर्देशन दिएको रहेछ । सोही निर्देशन बमोजिम उक्त फाइनान्स कम्पनी सो बैंकमा बिलय भएको रहेछ । यसरी बिलय हुने सन्दर्भमा सो फाइनान्स कम्पनीका शेयरहोल्डरले नेपाल धनलक्ष्मी बैंक लि.को शेयर प्राप्त गरेका रहेछन् । यस्तो प्रकारबाट सो फाईनान्स कम्पनीका शेयरहोल्डरले गरेको शेयरको निःसर्ग एवम् शेयर प्रतिस्थापन भएमा अस्वेच्छिक निःसर्ग सिर्जना भएको मानिने छ । यसरी अस्वेच्छिक निःसर्ग सिर्जना भएको मानिनको लागि विभागबाट स्वीकृति लिनुपर्ने हुन्छ ।
Does "merger" qualify to be an "involuntary disposal with replacement" under Income Tax Act?
A common confusion to be addressed in case of merger arrangement is whether the deemded consideration under merger arrangement will be assumed as transaction price of the merger. This is mostly significant because the assumption of deemed consideration will lead to taxation in unrealized gains. This leads to situations where the transaction will have to bear the capital gains taxes leading to tax frictions in a merger transaction, even when it is purely done for business synergies.
One view may be that merger arrangement qualifies to be a “Involuntary Disposal of Asset or Liability with Replacement within 1 year” under Section 46 of the Income Tax Act, 2058. However, this will not be true. We can refer to the following commentary from the “Income Tax Act of Commonwealth of Symmetrica”:
Para 195: Section 46 provides non-recognition treatment for involuntary realisations by way of parting with ownership of assets or obligations of liabilities. Non recognition is available where a replacement asset or liability is acquired or incurred within one year of the realisation. The rule is complicated somewhat by covering situations in which the replacement asset or liability is of a greater or lesser value than the asset or liability realised. These situations may result in part recognition of any gain. Non-recognition only applies where the person makes an election. The section does not define “involuntary”, which will take its ordinary meaning. The application of the term to particular circumstances may be an appropriate subject for practice notes. However, “involuntary” would not cover, e.g. the exchange of securities in a merger. This is a situation in which relief is often provided in order to prevent lock-in. This lock-in is similar to that which may occur through the taxation of transfers between associates and which is addressed by section 45. The regulations may however prescribe the circumstances in which the replacement of one security in an entity with another security in an entity as a result of conversion of the security or reconstruction of the entity constitutes an involuntary realisation.
Has Income Tax Act, 2058 provided any criteria for considering the replace of shares by the reason of merger as “involuntary disposal with replacement”?
Answer: Interestingly, Yes. Rule 16 of Income Tax Rule, 2059 states that where a person’s security in one entity is replaced by another security in the same entity or with a security in another entity as a result of merger or reconstruction of the entity, the same shall be treated as an event of an involultory disposal with replacement. However, IRD reserves a right to approve such transaction to qualify for “involuntory disposal with replacement”. IRD will look into the matter and may give an approval to that effect. In the examples below, we will assume that the approval for the same has been provided by the IRD.
See how a business combination arrangement works from tax perspective in my other blog here: Tax Implications in Business Combination Arrangements in Nepal
Yet another translation fluke
Income Tax Act, 2058 has been substantially derived from Income Tax Act, Commonwealth of Symmetrica, a work of Dr. Peter Harris.
In my previous blog Issues that arises when applying Section 57, In Issue 2: Issue 2: What is counted for computing “Change in Control”? Direct Ownership or Underlying Ownership?, we had discussed a translation error that caused a huge trouble in the application of Section 57.
Yet another translation error exists in Section 46(3) of the Income Tax Act, 2058, which reads:
दफा ४६(३) कुनै निकायमा रहेको हितको परिवर्तन वा निकायको पुननिर्र्माणको फलस्वरूप सो निकायको एउटा हितको अर्को हित बाट प्रतिस्थापना भई अस्वेच्छिक निःसर्ग सिर्जना हुने अवस्थाहरू तोकिए बमोजिम हुनेछ ।
This is drawn from Section 96(7) of Commonwealth of Symmetrica which reads:
Section 96(7): The regulations may prescribe the circumstances in which the replacement of one security in an entity with another security in an entity as a result of conversion of the security or reconstruction of the entity constitutes an involuntary realisation.
Income Tax Act, 2058 however has made provided a concrete definition for the term ” interest/हित”. However, it has failed to provide such concrete definition for the term “security”. Since the term “interst” in intended to encompass the equtity element of financial instruments, this has certainly brought confusions regarding to what extent and to what instruments the provisions of Section 45(3) of Income Tax Act, 2058 applies.
I think the intent for this subsection was to cover for all form of securities rather than just equity instrument, just like as it was intended in The Commonwealth of Symmetrica.
Distinction between Security and Financial Instrument
So, let’s say we settled that Section 46(3) indents to covers restructuring of one from of security into another form of security.
However, does this mean that Section 46(3) doesn’t cover the situation where financial instruments (which are not securities) are converted into another form of financial instrument (whether or not the financial instrument is a security)? And what exactly is the difference between financial instrument and security?
There is a difference between a security and a financial instrument. Not all financial instruments are securities, but all securities are financial instruments. Primarily, the securities (instruments) are designed to be traded on the secondary markets (creation of exchange). Some financial instruments can be converted into securities in a process called securitization. In the case of a bank loan, securitization allows a financial instrument to be changed from one which is not traded on the secondary market into one which is traded on the secondary market. Some instruments transfer capital (e.g., debt instruments, equity instruments), whereas other derivative instruments (e.g., credit default swaps, options) transfer solely risk. Instruments with a mixture of these characteristics are called hybrid instruments. In addition to those financial instruments that are traded on the secondary market, some instruments that are not an example of those are bank deposits or credit loans. Historically, securities existed prior to the term financial instruments being introduced. Securities were the legal institution that allowed transfer of cash in return for rights and future payments or residual assets. The difference between securities and ordinary debt or liability was the possibility to create a secondary market with securities. However, from a technical point of view, each security, in order to be created, had firstly to be designed as a legal instrument, thus the risk profile was given to the public. By evolution of financial markets, the organization ruling the markets, and those involved in the over-the-counter (OTC) market, started standardizing different contracts and trading them on the secondary market. In order to capture this process, the financial accounting industry introduced the concept of a financial instrument that encompasses both securites and non securities.
Financial instruments are monetary contracts between parties. They can be created, traded, modified, and settled. A financial security is a type of financial instrument that is issued by corporations or governments in order to generate capital that are generally tradable/fingible, permanent and negotiable. There is no clear definition provided, in International Financial Reporting Standards and Income Tax Acts, however, the above can be used as a parameter for distinction.