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.
What is the difference between transaction price of the asset and fair value of the asset?
Let’s be blunt and clear here. There is no difference between transaction price and fair values. It all depends on the asset subject to valuation.
Let’s take an example here: Say Co.A owns 100% of the shares in Co.B. Co.B has individual assets that could be realized at Rs. 2,000,000 by selling in market. Some assets may be realizable in market, there could be a active market for that asset, or there could be no market as well and some assets even may be needed to be disposed by incurring additional costs. But despite these parameters, Co.B still could realize amount that is more than Rs. 2,000,000 by selling all its assets a functioning business unit rather than at piecemeal approach. So what is happening here? What is transaction price and what is fair values? Its all the same.
If its the assets of Co.B that acquirer wants to acquire the fair value is Rs. 2,000,000. But if its the functioning business and unique economic advantages of the asset (as perceived by the buyer) that the buyer wants to acquire the fair value very well could be Rs. 3,000,000.
So for this reason the transactions made through investment instruments like shares and stock are also known as transaction price, which in fact is the fair values of such shares/stocks.
So, when will the transaction price be greater than the fair values of individual assets?
1. The unique economic advantages of the asset that is perceived by the buyer
2. The existence of industry specific licences of the acquiree (that may not have market or other buyers but do represent the income generating capacity of the entity)
3. The prospects of future gains and growths in business
4. The existence of entity specific patent, trademark and other intangibles
5. The existence of uniqueness of business, location, loyal customers and brand
When will the transaction price be lesser than the fair values of individual assets?
1. Acquiree is suffering market distress (loyalty issues, disreputing litigations, liquidity etc)
2. The acquirer has the market control
3. The acquiree is a loss making entity
4. The cost to realize the fair values of the assets is significant
Will there be any tax consideration as a reason of internal restructuring within a group?
Application of Section 57
Whether change in control will be triggered if there is a direct change in ownership but underlying ownership remaining the same has not been subject to explicit interpretation in courts of Nepal. Income Tax Act and the famous Ncell Case is also not clear on this if the change in control will be triggered by direct changes in shareholding even if the underlying ownership remains with the same entity.
A rational view is that in 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 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 Commonwealth of Symmetrica (“Symmetrica”) published by IMF.
View my blog on IMF Model Tax Act by Peter Harris here: the Brains behind Income Tax Act of Nepal: Peter Harris
Additionally, Section 45 of ITA may permit the transfer of assets/liabilities between associates at their tax base, even when the transfers non-market transfers. For the eligibility of such transfers between associates at the tax base, it is required that: (i) the nature of the assets/liabilities after the transfer should remain same as before the transfer, (ii) a required level of at least 50% continuing common underlying ownership in the asset/liability, and (iii) similarity in taxability of the transferor and transferee, among others. These conditions envisaged under Section 45 of ITA adopts to allows for the transfer of tax attributes between associates and are also adjusted to prevent the broad value shifting between associates. Thus, some of the restructuring arrangements that could be achieved through change in direct ownership of an entity, could also be achieved through the transfer of tax attributes of assets/liabilities between associates under Section 45 where the required level of continuing underlying ownership on the asset is maintained. This also further supports the notion that the consequence of application Section 57 should not apply in case of change in direct ownership, one that doesn’t lead to change in control in the entity through underlying ownership.
View my blog on transfer of tax base between associates here: Transfer of Tax Base between Associates
Application of Section 95A
Section 95A is one of the problamatic application of tax law in Income Tax Act, 2058. It absolutely disregards the source based taxation principle and is not consistency with other Section of the Act including Section 67.
Section 95A also brings problems in transfer of shares between associates or subsidiaries of the group for the purpose of internal restructuring within the group. Say for an example, Co.A and Co.B are wholly owned subsidiaries of Co.C. It was decided that a new Co.D (also wholly owned by Co.C) would acquire the shares of Co.A and Co.B from Co.C and engage in operational and managerial improvement of Co.A and Co.B while Co.C would focus in new business prospects. To execute this arrangement:
1. The ownership structure of Co.A and Co.B will undergo significant changes (Section 57 could apply here)
2. Co.C would sell its shares in Co.A and Co.B to Co.D (Section 95A could apply here)
Regarding the application of Section 57, we have already discussed in previous question. It should not apply.
However, no specific exemption is available in Income Tax Act, 2058 for the non-application of Section 95A, even if the arrangement is an arrangement of internal restructuring within a group. So, Section 95A applies, there is no exception. However, will there be adverse tax consequences? Will the transaction be subject to deemed Market Values and as a result will Co.C have to pay taxes in deemed gains?
Answer: Let’s go deeper into the above example. What actually is happening? The investment asset of Co.C is being transfered to Co.D, both of them are associated person. So, the relief under Section 45 could be availed and the tax attributes of the investment assets of Co.C could be transfered to Co.D without triggering the deemed disposal at market values.
Are there any exceptions to Banking and Insurance Sectors?
Section 47A of Income Tax Act, 2058 provides some exception on application of Change in Control Tax and Tax on Disposal of Assets and Liabilities.
Regarding Change in Control Tax
Section 47A states that where a entity in banking / insurance sector combines with entities of similar nature with each other (through merger or acquisition), the provisions of Section 57(2)(Ka), 57(2)(Kha), 57(2)(Gha), 57(2)(Gna), 57(2)(Cha), 57(2)(Chha) and 57(3) will not apply to the entity. The exception is pretty interesting because it does not totally exempt the application of Section 57 to business in banking / insurance sector.
It can be interpreted as follows:
1. Does the entity need to test for the application of Section 57?: Yes
2. Does the entity need to assume the deemed disposal of the assets owned by it and liabilites owed by it?: Yes
3. Is carry forward of interest expense restricted?: No
4. Is carry forward of losses under Section 20 restricted?: No
5. Is carry backward of losses restricted?: No
6. Is bad debts prior to change in control restricted to be deducted in future income years?: No
7. Is carry forward of unrealized forex loss restricted?: No
8. Is carry forward of losses by the reason of disposal of assets/liabilties restricted?: No
9. Is prior returns of premiums restricted to be deducted in future income years?: No
10. Is carry forward of foreign tax credit restricted?: Yes
11. Does the entity need to treat the income year as seperate income year after the application of Section 57?: No
12. Does the entity need to pay taxes under Section 57, if any?: Yes
Gains doesn’t arise because the disposal is deemed to have been made at the tax base as per Section 47A(2)
13. When does the entity need to pay taxes under Section 57?: Along with the business taxes to be paid for the particular income year. No seperate income year treatment is required.
Regarding disposal of Assets/Liabilities
What are the circumstances where Section 47A(2) may be invoked for relief by businesses in banking/insurance sector?
Case A: When Co.A acquires shares in Co.B for the purpose of business combination, Section 57 change in control may be applicable in Co.B. For the purpose of deemed disposal under Section 57, relief under Section 47A(2) may be invoked.
Case B: When Co.A acquires net assets of Co.B for the purpose of business combination, relief under Section 47A(2) may be invoked for the purpose of disposal of the net assets of Co.B.
Case C: When Co.A and Co.B merges to form a new Co.C under Asset Acquisition Merger Arrangement, relief under Section 47A(2) may be invoked for the purpose of disposal of the net assets of Co.A and Co.B.
Case D: When Co.A and Co.B merges to form a new Co.C under Shares Acquisition Arrangement, relief under Section 47A(2) may be invoked for the purpose of disposal of the net assets of Co.A and Co.B. Section 47A(2) may also be invoked for the purpose of deemed disposal under Section 57.
Other benefits provided to banking / insurance sector undergoing business combination
Additional benefits to banking/insurance sector business has been provided to the employees and shareholders in addtion to above. They are:
To Employees Retiring as a Result Employees
As per Section 47Ka(3), in case of the retirement payment (other than retirement payments made through the retirement fund or as per the employment service contract) made to the employees employed in entity formed or the entity that ceases to exist by the reason of this combination who are getting retired from the service as a result of the combination, tax shall be withheld at 50% of the applicable rate.
As per Section 47Ka(4), if the shareholders existing in the entity being disposed after combination dispose their shares through sale within two years of such merger, no capital gain tax shall be levied in the gain earned from such disposed shares.
As per Section 47Ka(5), no tax shall be levied in dividends distributed to the shareholders existing at the time of combination of the entity within two years of such combination.
To Entity formed as a result of Merger
As per Section 47Ka(1), if there remains any loss of the entity not in existence due to combination which could not be deducted, such loss shall be deducted on pro rata in the upcoming seven years. If the entity so deducting the loss in equal installment undergoes business seperation (demerger) prior to the deduction of the whole loss, tax shall be paid in amount deducted for such loss at the rate of tax prevailing in the fiscal year in which merger or acquisition took place.