What is this blog about?
One of these days, the provision of Section 57 in Income Tax Act 2058 Nepal will be removed and folks in tax and accounts market will have nothing to talk about. The deals on mergers, acquisitions and share transfers will not be that much interesting from tax perspective. But until then …
This is a part in series of blogs discussing the Section 57, its provisions, applications and its tax implications.
The first one is: What the bug is Section 57?
The next one is: Principles underpinning the Ncell Case
The another one is: Transfer of Tax Base between Associates: Intro and its Unintended Consequences
In this blog lets outline the issues that generally arises in application of Section 57 and identify the issues and solutions. If solutions are not available we will see the rational approach and concepts that supports them.
Issue 1: The issue relating to Market Value of Assets and Liabilites
Now that we know the disposal is deemed to be made at Market Value, the question is what is Market Value?
As per Section 2(Sh) of the Income Tax Act 2058 Market Value of an asset and services denotes the normal buying and selling price for the asset or services in the ordinary course of a business amongst unrelated parties.
The definition of the Market Value is not very far from the definition of Fair Value as per International Financial Reporting Standard (IFRS). IFRS 13 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (an exit price).
Different assets of the entity may have separate treatment for computation of Market Value:
- Tangible Assets
- Trading Stock: @ Market Value (not Net Realizable Value)
- Depreciable Asset: @ Market Value (not piecemeal approach but holistic approach)
- Business Asset
- Financial Instruments: @ Market Value (also adjust for bad debts)
- Bank Balances
- Local Currency: @ Market Value (No restatement needed)
- Foreign Currency: @ Market Value (NRB Buying Rate)
- Land: @ Market Value (huge burden as Land is not further depreciable)
- Intangible Assets
- Goodwill: n/a (goodwill is not an identifiable asset as per tax)
- License/Copyright/Trademark: @ Market Value (valuation of intangibles is a topic for separate discussion)
This is probably the much debated and discussed issue on application of Section 57.
Section 57(1) states that where there is a change of 50% or more in the underlying ownership of an entity as compared with its ownership 3 years previously, the entity shall be treated as disposing of any assets owned by it and any liabilities owed by it.
When Section 57 applies the entity shall be treated as disposing of any assets owned by it and any liabilities owed by it pursuant to Section 41: Disposal with Retention of Asset or Liability. For the purpose of Section 41 the person shall be treated as deriving an amount in respect of the disposal equal to the market value of the asset at the time of the disposal.
There may be two views here:
View 1: Considering the MV of both identifiable and non-identifiable assets
View 2: Considering the MV of only the identifiable assets
Section 2(Ka.dha): Asset means a tangible or intangible asset and includes currency, goodwill, know-how, property, an owner’s interest in a foreign branch, a right to income or future income, and a part of an asset.
As per ITA the definition of assets includes goodwill as well. Although goodwill is an asset, it is a non-identifiable asset. It itself doesn’t have any value to it for tax purpose. Rather, goodwill is the excess value perceived in a pool of business assets. Meaning, although goodwill is an asset in definition, it is not possible to assign any value to goodwill. We can refer to Section 49 of the Act for this concept. “A person shall be required to apportion the costs incurred or the amounts derived by the person in acquiring, incurring, or disposing of each asset or liability between the assets and liabilities according to their market values at the time of acquisition, incursion, or disposal, as the case requires.” Meaning even when goodwill arises as per the business transaction, for tax purposes goodwill is apportioned to identifiable assets (which may be both tangible or intangible) according to their market values.
Why is goodwill a non-identifiable asset?: Goodwill is a non-identifiable asset because goodwill cannot be determined alone. Goodwill is baked in with other assets of the entity. It cannot be separately valued unless the actual transaction takes place.
For the purpose of Section 57, the assets are deemed to be disposed because they aren’t actually disposed. In such case it is only possible to identity the market values of the identifiable assets of the entity but not the actual value of goodwill. Here, distinction may be necessary between two terms Transaction Price of Asset and Market Value of Asset.
Transaction Price of Asset and Market Value of Asset
We Know, Goodwill = Transaction Price of Asset – Market Value of Asset
OR, Market Value of Asset = Transaction Price of Asset – Goodwill
What is Transaction Price?
Transaction Price is a value to an asset, which is a present value of all economic advantages of the asset.
What is Goodwill?
Goodwill is a value to an asset, in addition to its market value, which is a present value of all unique economic advantages of the asset.
What is Market Value?
Market Value is a value to an asset, which is a present value of all non-unique economic advantages of the asset.
In this basis, the meaning of MV of assets of the company doesn’t include the value of goodwill of the company. Additionally, the transaction price that triggers the application of Section 57 doesn’t not always indicate the entire change of 100% ownership of the business. Hence the transaction price is not a wise substitute for the Market Value of the assets that are deemed disposed.
Then. why was transaction price taken as the basis of taxation under Section 57 in Ncell Case?
In Ncell Case, the decision to consider transaction price as MV of the asset is probably wrong. However, they might have taken that view because
(i) of Ncell’s failure to submit accurate details of transactions
(ii) for the purpose of determining the MV of the license (presence of identifiable intangible asset like license, unlike goodwill)
(iii) Supreme court reserves reserves the “उचित उपचार प्रदान गर्ने” र “विवादको टुङ्गो लगाउने” असाधारण अधिकार as per संविधानको धारा १३३
Whatever might be the logic behind to consider the transaction price as basis for taxation under Section 47 in Ncell Case, the decision has clearly stated that:
सेयर तथा हितहरू बिक्री कारोबारसँग सम्बन्धित कागजातहरू पेस गर्न एनसेललगायत एक्जिएटा टेलिया सोनेरालाई पटकपटक माग गर्दासमेत हालसम्म पेस गरेको छैन । सेयर हस्तान्तरण गरिँदा कुन मूल्यलाई आधार मानी लाभ र दायित्व तय गरी कारोबार गरिएको छ भन्ने कुरा Due Diligence Audit Report, Share Purchase Agreement (SPA), Escrow Agreement, Escrow Account सम्बन्धी विवरणलगायतका कागजातहरू उपलब्ध नभएसम्म स्पष्ट हुन सक्ने देखिँदैन । यी कागजातहरू विपक्षी ठूला करदाता कार्यालयले मागेको र सो प्राप्त नभएपछि तत्काल देखिएका प्रमाणका आधारमा कर निर्धारण गरी थप प्रमाण र सूचना प्राप्त हुँदा लाभकर्ताको थप आय भएको पाइएमा पुनः कर निर्धारण गर्दै जाने नीति अख्तियार गरी मिति २०७४।३।१३ मा सो समयसम्म प्राप्त कागजातका आधारमा बिक्री मूल्य रू.१,४४,७८,२५,०६,०००।- कायम गरी सो आधारमा ठुला करदाता कार्पुँयालयले पुँजीगत लाभकर निर्धारण गरेको पाइयो ।
So it is likely that using the transaction price for the taxation under Section 57 was not the intention of Ncell case afterall.
Issue 2: What is counted for computing "Change in Control"? Direct Ownership or Underlying Ownership?
In the Ncell Case, due to the interpretation of the word ownership as both direct ownership and indirect ownership there has been room for interpreting the provisions under Section 57 to be applied even if the underlying ownership in fact has not been changed. However, I think, we should not be of two-minds here. It is a fact that, an entity suffers a change in control where there is change in underlying owners in fact.
- Although the Nepalese translation of the Income Tax Act 2058 doesn’t mention “निहित स्वामित्व” but simply only mentions the word “स्वामित्व” only, the English translation of the Section 57 (Nepal Tax, Peter Harris), Income Tax Act of Commonwealth of Symmetrica (“Symmetrica”) published by IMF, specifies that the the ownership to be considered for the purpose of Section 57 is the “underlying ownership”. In determining whether there is a change of control, it is the “underlying ownership” that counts.
- One could say that this is just a translation fluke and may not hold its meaning/rational but for corroboration we can compare this with Income Tax Act of Tanzania (which was drafted by Peter Harris as well). Section 56 of Tanzania’s Income Tax Act is very much similar to Income Tax Act of Nepal which also states that only the change in underlying ownership should be considered for the purpose of counting change in ownership.
- ITA, ITA Directive doesn’t state that change in control will be triggered by direct changes in shareholding even if the underlying ownership remains with the same entity. There aren’t any case laws to this effect decided either. Also as per the view of Peter Harris, while determining whether there is a change of control, it is the “underlying ownership” that is the defining criteria. “Underlying ownership” is particularly important where entities hold interests in other entities and there are changes in the shareholding within the group entities for the internal restructuring purposes. Applying Section 57 of ITA without regard to underlying ownership will result in unintended consequences of triggering change in control of an entity even though no interests in the entity have directly changed hands. Further this approach is also supported by uniform model law instruments like . Section 57 of ITA is substantially based on Section 171 of Income Tax Act of Commonwealth of Symmetrica (“Symmetrica”) published by IMF.
What is ownership as per Income Tax Act 2058?
The term ownership is not defined in Income Tax Act 2058. However, reading the definition of underlying ownership provided by the Income Tax Act 2058, Ownership can be defined as
- In relation to an entity: The interest in an entity, or
(As per Section 2(Ma), Interest in an entity means a right, including a contingent right, to participate in the income or capital of an entity.)
- In relation to an asset: The right to possession or the right to beneficial ownership
(Beneficial Ownership has not been explicitly defined in Income Tax Act 2058 but has been implied in various Chapters including Chapter 8 of the Act)
What is underlying ownership (indirect ownership) as per Income Tax Act 2058?
As per Section 2(Ra) Underlying ownership means following ownership:
- In relation to an entity: An ownership created on basis of an interest held in the entity directly or indirectly through one or more interposed entities by an individual or by an entity (in which no individual has an interest); or
- In relation to an asset owned by an entity: An ownership of the asset that is determined on basis of proportion to the ownership held by the persons having underlying ownership of the entity.
Although the Ncell case has not given clarity in this regard, it is though common sense and commentary of Income Tax Act of Commonwealth of Symmetrica (“Symmetrica”) published by IMF, that we derive that Section 57 is triggered only in the case of change of 50% or more in underlying ownership.
Issue 3: Provision of Section 117, 118 and 119 in in line with Section 57
Second decision on Ncell Case states that
कारोबारपश्चात् विवरण दाखिल नगरेबापत उक्त शुल्क लाग्ने व्यवस्थाअनुरूप उक्त शुल्क लगाइएको हुँदा सोलाई अन्यथा मान्न मिल्ने हुँदैन । त्यस्तै ऐनको दफा ११८ मा किस्ताबन्दीमा दाखिल गर्ने कर रकमभन्दा कम हुने गरी बुझाएकोमा ब्याज लाग्ने व्यवस्था भएबमोजिम लगाइएको ब्याज पनि अन्यथा देखिएन । त्यस्तै ऐनको दफा ११९ मा पनि कर तिर्नुपर्ने मितिसम्म कुनै व्यक्तिले कर दाखिल नगरेमा दाखिल गर्न बाँकी रहेको रकममा दाखिल गर्न बाँकी रहेको अवधिभरको लागि सो व्यक्तिलाई प्रत्येक महिना र महिनाको भागमा सामान्य ब्याजदरले ब्याज लाग्ने भन्ने व्यवस्था तथा ऐनको दफा २(क ब) मा सामान्य ब्याजदर भन्नाले वार्षिक १५ प्रतिशतको ब्याजदर सम्झनुपर्ने भन्ने व्यवस्था भएअनुसार ब्याज लगाइएको पाइन्छ । टेलियालाई लाग्ने कर एनसेल प्रा.लि.लाई लागेको हुँदा विवादित करको दायित्व कारोबार मिति २०७२।१२।२९ गते नै सिर्जना भई समयमै कर दाखिल नभएबापत उपर्युक्त शुल्क ब्याजहरूसमेत लाग्ने तथ्यमा विवाद गरिरहनु पर्ने आवश्यकता रहेको छैन ।
It was established that the fines for non filer of return under Section 117, interest on instalment taxes to be paid under Section 118 and interest on delay on payment of taxes under Section 119 were applicable even in the case where Section 57 is triggered. There aren’t any exceptions or relaxation to these fines and interest even though the concept of taxation under Section 57 is rather different than normal business taxation. But it is what it is.
Filing of Income Tax Return
As per Section 57(3), where there is a change in ownership of the type referred to in Section 57(1) during the income-year of an entity, the parts of the income-year before and after the change in ownership are treated as separate income years.
This means that the entity’s normal income year is divided into several income years as need be, as per the change in ownership. For example say the Change in control occurred only one during the fiscal year, the fiscal year would be separated into two parts:
- Part One: From the beginning of the fiscal year to the date of change in ownership
- Part Two: From the day immediately following the date of change in ownership till the end of the fiscal year
When to file the Income Tax Return?
As per Section 96 of the Income Tax Act 2058, every person shall file at the place prescribed by the Department not later than 3 months after the end of each income year a return of income for the year. So, the “Change in Control Return” shall be filed within three months from the date of change in ownership.
Payment of Taxes
As per Section 57(1) the entity shall be treated as disposing any assets owned by it and any liabilities owed by it once the Change in Control as per Section 57 is triggered.
How to determine the taxable amount for the case of disposal of net assets?
Section 40(3)(e) of the Act has identified the deemed disposal under Section 57 of the Act as Disposal with Retention. Further, Section 41 of the Act has specified the amount of incoming and outgoings for this deemed disposal:
- The person shall be treated as deriving an amount in respect of the disposal equal to the market value of the net assets at the time of the disposal; and
(meaning the incomings for the deemed disposal shall be the market value of the net assets)
- For the purpose of subsequent disposal of the net assets, the net outgoings for the net assets to the time of the disposal under this Section shall be treated as equal to the amounts derived.
(meaning, the market value treated as incomings, shall be treated as the cost for the future)
So, the entity shall be taxed on the following transactions at the point of filing the tax returns for the “Change in Control”
- Transactions from the beginning of the fiscal year to the date of change in ownership
- Market value of the net assets reduced by the tax base of the net assets
How to pay installment taxes in fiscal year where Section 57 is triggered?
We know that a person who derives taxable income during the year is required to pay tax for the year by three instalments as follows:
- By the end of Poush: 40% of the estimated tax
- By the end of Chaitra: 70% of the estimated tax
- By the end of Ashad: 100% of the estimated tax
Meaning income tax is collected in installments before the end of the fiscal year. Any delay in submitting the tax in instalment as above attracts interest at the rate of 15% per annum. A 10% margin is allowed for any difference that might occur by the reason of the inaccuracy in estimate as per Section 118(1)(Kha) of the Act.
Now the question arises, if there are any relaxation in payment of instalment taxes in situation where Section 57 is triggered? No, there aren’t any relaxations. The entity is supposed to pay the taxes in instalments as usual.
How to pay the taxes? Once Section 57 is triggered the taxable amount and tax liability till the date of change in ownership is computed. If any due date for instalment tax payment had fallen before that date, taxpayer should have deposited the instalment amount accordingly and any amount remaining thereafter should be deposited within 3 months from the end of the income year.
Example: Let’s say Section 57 triggered on an entity on Magh end during an income year and the total tax to be paid including the transactions till Magh and gain from deemed disposal under Section 57 came out to be Rs. 100,000 and total tax to be paid after the date of Change in control came out to be Rs. 50,000.
- Liability of Rs. 100,000
- 100,000×40% should be deposited within Poush End
Elsewise u/s 118(1): Interest @15% p.a. until Baisakh End
- Any remaining amount should be deposited within Baisakh End
Elsewise u/s 119(1): Interest @15% p.a. after Baisakh End
3 months from the end of Magh End is Baisakh End
- 100,000×40% should be deposited within Poush End
- Liability of Rs. 50,000
- 50,000×70% should be deposited within Chaitra End
Elsewise u/s 118(1): Interest @15% p.a. until Ashad End
- 50,000×100% should be deposited within Ashad End
Elsewise u/s 118(1): Interest @15% p.a. until Ashoj End
- Any remaining amount should be deposited within Ashoj End
Elsewise u/s 119(1): Interest @15% p.a. after Baisakh End
3 months from the end of Ashad End is Ashoj End
- 50,000×70% should be deposited within Chaitra End
Issue 4: What kind of entities are subject to application of Section 57?
The concept of “Change in Control” as per Section 57 is more mathematical and methodic rather than testing actual composition/dilution of ownership in fact. Just because a 50%+ ownership of a company is held by a person might not mean that the substantial control of the entity is exercised by the person. it simply requires a mathematical test relating to the change in shareholding pattern of the entity.
If 50% or more of the more of the ownership of the entity is changed by the change in shareholder holding 1% or more of the total ownership of the company, then Section 57 will be triggered.
At face it might seem that Section 57 applies on any entity but the Change in Control under Section 57 is triggered only when the said change is occured by the reason of the change in shareholders of the company. Meaning, the variable that triggers the application of Change in Control under Section 57 is the person constuting the ownership being a shareholder of a company (such a shareholder may be direct owner or underlying owner). And in this same meaning, as a shareholder is the beneficiary of the company, Section 57 applies only to a company.
But let’s look into the definitions provided by the Income Tax Act 2058 on what is a company?
Section 2(Da): Company means:
a. A company established under the Company Laws
b. Corporate body established under the laws for the time being in force (Institutions, Associations, NGOs, INGOs)
c. Any unincorporated association, committee, institution, society, or group of persons whether registered or not (other than a partnership or a proprietorship firm or a trust)
d. A partnership firm; (that has 20 or more partners, whether registered or not)
e. A retirement fund, a co-operative, a unit trust, or a joint venture (JV)
f. Foreign company
g. Any foreign institution as prescribed by the DG
So what does this mean?
This means that Section 57 applies to Companies under Companies Laws, Corporate Bodies, Partnership firms with 20 or more partners, unit trusts, joint ventures, branch offices etc.
One could say that a Partnership Firm doesn’t have shareholders, it has partners. Or, one could say that a Branch Office doesn’t have shareholder, it has head office ledger. Who actually is a shareholder? That is the isssue. This will be discussed in Issue 5 in detail.
Issue 5: What kind of shareholders are included in computation of Change in Control for the purpose of Section 57?
But who is a Shareholder? Who? What does the act say?
Section 2(Ka.Ya): Shareholder means a person who is a beneficiary of a company.
Section 2(Ka.La): Beneficiary means a person who has an interest as specified in Section 2(Ma) in an entity.
Section 2(Ma): Interest in an entity means a right, including a contingent right, to participate in the income or capital of an entity.
So this means in the context of the Income Tax Act 2058, any holder of the financial instrument which gives the holder to participate in the income or capital of an entity.
No much else is described in Income Tax Act 2058. It gives a short description on how these rights are characterized in different forms of entities. Interest in an entity in context of the follwing entities means the followings:
● Partnership: Right to participate in the profit, Right to ownership against the asset in the partnership
● Company: The return of the investment made by the shareholder in the company, Right to receive in liquidation of the company in normal or contingent terms
● Retirement Fund: The investment made by the beneficiary or the return of investments to the beneficiary
● Trust: Interest of the beneficiary
● Foreign Permanent Establishment: The interest of the owner
In absence of additional clarification we can assume that the even the Preference Shareholders do have interest in an entity.
1. Do Preference Shareholders have right to participate in the income of an entity? Well, what is “right to participate in the income of an entity”? Simply because Preference Shareholders receive the income from the after tax reserve of the company, does this amount to the right to participate in the income of an entity? As per IFRS, No. This depends more on the substance of the instrument. IAS 32 establishes principles for distinguishing between liabilities and equity. The substance of the contractual terms of a financial instrument governs its classification, rather than its legal form. More on that concept of IFRS here. What creates an equity element in a financial instrument?
However, Income Tax Laws do not view this concept in the same manner. This has been implied in the Income Tax Act’s “Entity and Distributions” Chapter, Income Tax Directive and Definition of “Interest”, Defnition of “Controlled Foreign Entity” and also in other instances. So it is safe to assume that as per Income Tax Act, Preference Shareholders do have the right to participate in the income of the entity.
2. OR, Do the Preference Shareholders have the right to participate in the capital of an entity? Same concept as above follows here too. This is because that some form of preference shares may be classified as debt component based on its subtance for financial purpose. More on that concept of IFRS here. What creates an equity element in a financial instrument?
3. The meaning of contingent right to participate in the capital of an entity? Well this is a confusing one. This probably means that when a financial instrument has the right to be settled in shares based on the contingent event. However as per IFRS, when such contingent event is in the control of the issuer i.e. entity then no equity element aries. Also, when such contingent event is the control of the holder i.e. the holder of the instrument then equity element will arise.
This does mean that the term “contingent” is intended to encompass the equity element of the Financial Liabilities with option to convert into fixed number of Equity Shares where as per IFRS present value of Principal is recognized as Liability
and present value of the Option is recognized as Equity. In the same tune, the term “continget” also intends to encompass the quity element of Puttable Financial Liabilities that meets all the characteristics of Equity Shares.
So we can conclude that, unlike in IFRS, for tax purposes, all kinds of shares do have the right to participate in the income or capital of the entity and such right also includes contingent right which gives rise to equity element in instuements like Puttable Financial Liabilities and Financial Liabilities with option to convert into variable number of Equity Shares.
Issue 6: Does Section 57 apply in case of Involuntary disposals e.g. by death?
Yes, even the changes in ownership that occurs due to the change in holding structure due to partition of a family, are also considered for calculating the changes in ownership as per Section 57. And if the situation is such that more than 50% ownership of the entity is changed by the reason of such partition then Section 57 is triggered.
In case of death of owner of assets, the assets is deemed to be disposed under Section 44 of the Act. By the reason of this deemed disposal, the shares held by such owner is also treated to be disposed for the purpose of Section 57 and if more than 50% ownership of the entity is changed in this regard, then Section 57 is triggered.
This might be an unintended consequence of the application of Section 57 of Income Tax Act 2058. This is because normally when a person dies and the propety is inherited by person within 3 generations, the person deriving the asset is deemed to derive the asset in the same value which the person who died incurred in acquisition of the asset. This is envisaged in Section 45(1)(c) of the Income Tax Act 2058. However, there aren’t any such expections for the application of Section 57. In absence of such provisions, even in the case of involuntary disposal we can expect that the Section 57 applies and the consequence of tax liabities will arise.
Issue 7: Which date is to be considered for the purpose of Change in Control?
As the title to Section 57 suggests, the date of “Change in Ownership” needs to be considered for the purpose of date of change in ownership. Depending upon the agreement of the transfer and nature of the transfer of the ownership any of these dates may be date of change in ownership:
- Date of updating Share Registers
- Date of consideration being received for the share transfer agreement
- Date of enforcement of transfer agreement
- Date of transition of company with the new management function
We need to identify based on the nature of the transaction at which date the ownership in fact has been transferred. Usually, it is the date of consideration being received as in most transactions, ownership is deemed to be transferred as the consideration for the transaction is received.
Issue 8: During market valuation a receivable was valued downward due to its bad debt component. Will this be allowed for deduction?
Yes, it will be allowed for deduction and there aren’t any reason why it should not be. Section 41 on Disposal with Retention, has clearly stated that for the deemed disposal under Section 57, market value will be incoming and the tax base of the asset will be outgoings. It is a case of deemed disposal of assets and not particularly a case of disclaiming or writing off of an asset.
In case of disclaiming or writing off of an asset, as per Section 25(2) of the Act, it will be allowed for deduction only after all reasonable steps in pursuing payment has been taken and reasonably believes that the entitlement or debt claim will not be satisfied.
Issue 9: Treatment of Gratuity and Leave Pay liabilities and its implications
Gratuity and Leave pay liabilities do qualify to be recognized as expense for the income year to which they pertain for financial purpose but for tax purpose these costs are eligible to be claimed only at the point of actual flow of funds associated to such liabilites.
However, when Section 57 applies all assets and liabilites in the books are restated to their market values and the company is deemed to dispose such assets and liabilites at their market values. In this approach, the company is required to recognize the gratuity and leave pay liabilites and other similar form of assets as liability even for the tax purpose. This will lead to the situation that costs that were not recognized for tax will be recognized.
In such cirsumstances, if the unfunded gratuity and leave pay liabities in the books are subtantial, the sudden recognition of these costs for the purpose of Section 57 for tax purpose will lead to huge lossess which might not always be recovered by the deemed income from valuing assets to their market prices. This becomes a concern because the losses cannot be carried forward once the Section 57 is triggered. It lapses. This will also lead to the early reconciliation of the deferred tax asset recognized in the books towards gratuity and leave pay liabilites.
Issue 10: Treatment of depreciation expense for the Purpose of Section 57
With the application of Section 57 the assets of the entities are deemed to be disposed at MV. By this reason there will be no depreciation base and any gains/loss by this computation will be charged as terminal depreciation or balancing charge.
As per Section 41(a)(2), for the tax period following the date of Change in ownership, the entity shall be treated as incurring the cost equal to the market value at the date of deemed disposal. In this meaning, the entity shall include in its depreciation basis such restated valued as the cost, and based on the absorption rates as specified in Schedule 2(2)(5) of the Act, charge depreciation accordingly.
Issue 11: Application of Section 57 in reconstruction of the Entity
No specific exception exists for the application of Section 57. It is generally true that internal reconstructions do not create major changes in the underlying ownership structure of the entities. If the change in the underlying ownership doesn’t lead to the change of more than 50% of the shares, Section 57 should not apply.
This is more clarified in Issue 2 above.
Issue 12: Deferred taxes arises because of the application of Section 57?
When the tax base of the assets are restated to their market values by the application of Section 57, deferred tax assets and liabilities arises. This is an obvious application if IAS 12 Income Taxes.
However, when non-depreciable assets like land are restaed to their market values, the deferred taxes that arise though those assets do not reconcile in near future when they are not held for trading purpose. Generally, land are held for more permanent objective and it is as perpetual as the perpetuity of the business establishment.
Deferred Tax in case of Investment Assets is a little tricky.
If a deferred tax liability or asset arises from investment property that is measured using the fair value model in IAS 40, there is a rebuttable presumption that the carrying amount of the investment property will be recovered through sale. Accordingly, unless the presumption is rebutted, the measurement of the deferred tax liability or deferred tax asset shall reflect the tax consequences of recovering the carrying amount of the investment property entirely through sale. This presumption is rebutted if the investment property is depreciable and is held within a business model whose objective is to consume substantially all of the economic benefits embodied in the investment property over time, rather than through sale. If the presumption is rebutted, the requirements of paragraphs 51 and 51A shall be followed.
Meaning, unless rebutted (the presumption may be rebutted only in the case of depreciable asset), deferred taxes do arise by the reason of carrying the investments at fair value model in IAS 40, whether it is depreciable asset or non depreciable asset. In case of depreciable asset, the deferrred taxes may be rebutted on the assumtpion that the economic benefits embodied in the investment property will be consumed substantially over time rather than through sale. In such case, deferred taxes is not recognized. But such rebuttal may not be made in the case of non-depreciable asset and deferred taxes will have to be recognized.
However, is the above case comparable to the deemed revaluation as a result of Application of Section 57?
Lets talk about non depreciable asset. When an entity is carrying its investment assets in cost model as per IAS 40 and Section 57 leads to the revualtion of the non depreciable land to a revised value, does this require the recognition of deferred taxes. Sure it is temporary difference and will be settled when the asset is sold/recovered. But what does the IFRS say?
IFRS says that it is inherent in the recognition of an asset that its carrying amount will be recovered in the form of economic benefits that flow to the entity in future periods. When the carrying amount of the asset exceeds its tax base, the amount of taxable economic benefits will exceed the amount that will be allowed as a deduction for tax purposes. This difference is a taxable temporary difference and the obligation to pay the resulting income taxes in future periods is a deferred tax liability. As the entity recovers the carrying amount of the asset, the taxable temporary difference will reverse and the entity will have taxable profit. This makes it probable that economic benefits will flow from the entity in the form of tax payments. Therefore, this Standard requires the recognition of all deferred tax liabilities, except in certain circumstances described in paragraphs 15 (relating to initial recognition of goodwill) and 39 (relating to investments in subsidiaries, branches and associates, and interests in joint arrangements).
So yes, deferred taxes will be recognized even in the case of non-depreciable asset carried at cost under IAS 40 once Section 57 applies.
Issue 13: Can I claim the tax reductions like donation doubly as Section 57 applies?
Yes, all the donation reductions under Section 12, Section 12Ka (applicable to company only) and Section 12Kha are allowed for reduction for an income year. Since, with the application of Section 57 the entity is treated as having multiple income years, donation reductions can be claimed for all such income years.
Issue 14: Only ownership changed, the business(es) didn't. Still Section 57?
The owners in the business changed and Section applied. What is the rationale behind this?
Example One: If a person sells an asset of cost price (CP) to another person at a selling price (SP) his profit is SP-CP. In the purview of taxation, he disposes the tax base of his asset CP for an income of SP and is taxed at the profit of SP-CP. In this transaction, the item being transacted is the asset and there aren’t any other underlying assets to this transaction.
Example Two: If a person sells his shares of cost price (CP) to another person at a selling price (SP) his profit is SP-CP. In the purview of taxation, he disposes the tax base of his shares CP for an income of SP and is taxed at the profit of SP-CP. In this transaction, the item being transacted is the asset but there are other assets (the net assets of the entity whose share is being transacted) which are underlying assets to this transaction.
Analysis of above examples: If we evaluate the first transaction the income (SP) of the seller is the cost for the buyer. This cost is attributed to actual underlying asset in the transaction. However, in the second transaction, the cost is being attributed to the instrument representative of the underlying asset in the transaction (i.e. shares) but not to actual underlying asset in the transaction (i.e. the net assets of the entity whose share is being transacted).
Symmetric Interpretation: In doing business, when we buy an asset, we use that asset, derive benefit from it and sell those assets when it is not usable in the business. Under normal business scenario, business assets are transacted at their intended value-in-use and the taxation jurisprudence 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).
Symmetric Justice by Section 57: When there is a substantial change in ownership of an entity, the entity shall be treated as disposing of any assets owned by it and any liabilities owed by it. With this provision, the transaction of change in ownership is taxed
- at the actual profit of the disposal of instruments (taxation on seller)
- at the deemed profit from disposal of net assets of the entity (taxation on entity)
Is this a double taxation?: It is not a double taxation per se, as different person are being taxed. It also cannot be interpreted as economic double taxation because the income that is being taxed are different to different person. However, it is a taxation on unrealized gains of the entity that may be an economic burden to the entity.
The conclusion is that, yes Sectio 57 applies even if the same business continues with same operation module and techniques. No exceptions. However, it might be relevant to highlight the provision in Section 56 of Tanzania’s Income Tax Act to bring more clearer context into this. In Tanzania a specific exception exists:
Seciton 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.
But this relief doesn’t exist in Nepal.
Issue 15: The Continous Test Issue
Continous test or aggregate test? Explain
Thanks for reading. This was a long one !!