Rollup Transactions
In rollup transaction two different companies merge to form a new company.
A common confusion to be addressed in case of merger arrangement is whether the deemed 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 realizations 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 realization. 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 realized. 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 realization.
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 involutory disposal with replacement. However, IRD reserves a right to approve such transaction to qualify for “involuntary 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.
Rollup Transaction through Asset Acquisition Arrangement
How does it work?
Co.C will acquire net assets of Co.A and Co.B and the enterprise value of Co.C will be allocated to the shareholders of Co.A and Co.B which will be treated as the deemed consideration derived by these companies.
The method theoretically should work as follows:
- C acquires net assets from Co.A and Co.B by providing consideration in form of shares in Co.C to both the companies Co.A and Co.B (This would require a net asset acquisition agreement between Co.C, Co.A and Co.B)
- A’s shareholders will realize the shares of Co.A in Co.C by liquidating Co.A. Co.B’s shareholders will realize the shares of Co.B in Co.C by liquidating Co.B.
- A’s and Co.B’s shareholder certificate will be updated by Co.C by action of Companies Law.
It could also be worked out as follows:
- C acquires net assets from Co.A and Co.B by providing consideration in form of shares in Co.C to both the shareholders of Co.A and Co.B directly. (This would require a seperate merger agreement between Co.C, Co.A, Co.B, Co.A’s shareholders and Co.B’s shareholders in addition to net asset acquisition agreement)
- Co.A’s shareholders will liquidate Co.A. Co.B’s shareholders will liquidate Co.B
Propositions
- C acquires net assets from Co.A and Co.B by providing shares in form of consideration to Co.A and Co.B.
- The total enterprise value of the Co.C is determined to Rs. 4,000,000 and is allocated to Co.A and Co.B based on bargained share exchange. Rs. 2,500,000 to Co.A and Rs. 1,500,000 to Co.B
- The fair market values of the assets of the Co.A is determined to be Rs. 2,000,000 and those of Co.B is determined to be Rs. 1,000,000
- The tax base values of the assets of the Co.A is determined to be Rs. 1,300,000 and those of Co.B is determined to be Rs. 800,000
- The cost of investment for the shareholders of Co.A and Co.B is Rs. 500,000 and Rs. 300,000 respectively.
Tax Consequences on Co.A
- Incomings for Co.A u/s 39 = Rs. 2,500,000
- Outgoings for Co.A u/s 39 = Rs. 1,300,000
- Gains for Co.A = Rs. 2,500,000 – Rs. 1,300,000 = Rs. 1,200,000
Tax Consequences on Co.B
- Incomings for Co.B u/s 39 = Rs. 1,500,000
- Outgoings for Co.B u/s 39 = Rs. 800,000
- Gains for Co.B = Rs. 1,500,000 – Rs. 800,000 = Rs. 700,000
Tax Consequences on current shareholders of Co.A
If the approval under Rule 16 for the application of Section 46 is not provided
- Incomings for the current shareholders of Co.A u/s 39 = Rs. 2,500,000
- Outgoings for the current shareholders of Co.A u/s 39 = Rs. 500,000
- Gains for the current shareholders of Co.A = Rs. 2,500,000 – Rs. 500,000 = Rs. 2,000,000
The proceeds under this is not derived by the reason of disposal of shares under Section 95A so the advance taxes to be withheld under 95A would not be applicable. This proceeds is derived by the reason of liquidation realization. However, the shareholders of Co.A will be liable to deposit taxes by considering the gains as investment income and applying the rates specified in Schedule 1 of the Act.
- For Resident Individual: 10% in case of unlisted securities and 5% in case of listed securities under Schedule 1(1)(4)(Kha)(3)
- For Resident Entity: 25% under Schedule 1(2)(1)
- For Others: Not Applicable
If the approval under Rule 16 for the application of Section 46 is provided
- Incomings for the current shareholders of Co.A u/s 46 = Tax Base + Max(Disposal Proceeds – Replacement Cost, 0) = Rs. 500,000 + MAX(Rs. 2,500,000 – Rs. 2,500,000 , 0) = Rs. 500,000
- Outgoings for the current shareholders of Co.A u/s 39 = Tax Base + Max(Replacement Cost – Disposal Proceeds, 0) = Rs. 500,000 + MAX(Rs. 2,500,000 – Rs. 2,500,000 , 0) = Rs. 500,000
- Gains for the current shareholders of Co.A = Rs. 500,000 – Rs. 500,000 = Rs. 0
Tax Consequences on current shareholders of Co.B
If the approval under Rule 16 for the application of Section 46 is not provided
- Incomings for the current shareholders of Co.B u/s 39 = Rs. 1,500,000
- Outgoings for the current shareholders of Co.B u/s 39 = Rs. 300,000
- Gains for the current shareholders of Co.B = Rs. 1,500,000 – Rs. 300,000 = Rs. 1,200,000
The proceeds under this is not derived by the reason of disposal of shares under Section 95A so the advance taxes to be withheld under 95A would not be applicable. This proceeds is derived by the reason of liquidation realization. However, the shareholders of Co.B will be liable to deposit taxes by considering the gains as investment income and applying the rates specified in Schedule 1 of the Act.
- For Resident Individual: 10% in case of unlisted securities and 5% in case of listed securities under Schedule 1(1)(4)(Kha)(3)
- For Resident Entity: 25% under Schedule 1(2)(1)
- For Others: Not Applicable
If the approval under Rule 16 for the application of Section 46 is provided
- Incomings for the current shareholders of Co.A u/s 46 = Tax Base + Max(Disposal Proceeds – Replacement Cost, 0) = Rs. 300,000 + MAX(Rs. 1,500,000 – Rs. 1,500,000 , 0) = Rs. 300,000
- Outgoings for the current shareholders of Co.A u/s 39 = Tax Base + Max(Replacement Cost – Disposal Proceeds, 0) = Rs. 300,000 + MAX(Rs. 1,500,000 – Rs. 1,500,000 , 0) = Rs. 300,000
- Gains for the current shareholders of Co.A = Rs. 300,000 – Rs. 300,000 = Rs. 0
Tax Consequences on Co.C
Co.C will not have any income tax consequences at this point as it is the buyer in the above merger transaction. However, since this is a acquisition of assets and as observed in the above proposition the transaction price is actually not equal to the fair market values of the assets, the consideration price of Rs. 4,000,000 should be divided among the assets acquired on the basis of their market values as per Section 49 of the Act. The entire cost of Rs. 4,000,000 will be the tax base cost for Co.A apportioned among the identifiable asset in respect to their market values. Basically, the concept under Income Tax Act, 2058 is that, Goodwill is non identifiable asset and the cost association with goodwill created by the reason of transaction is divided among the identifiable assets.
Rollup Transaction through Shares Acquisition Arrangement
How does it work?
Co.C will acquire shares in Co.A and Co.B and the enterprise value of Co.C will be allocated to the shareholders of Co.A and Co.B which will be treated as deemed consideration derived by these shareholders.
The method theoretically should work as follows:
- C acquires shares in Co.A and Co.B by providing consideration in form of shares in Co.C to the shareholders of Co.A and Co.B
- C will execute a asset transfer arrangement and transfer the assets of Co.A and Co.B to Co.C. (Such transfers will be allowed to be made in the tax base as Co.A, Co.B and Co.C are associated companies for the purpose of Section 45 of the Income Tax Act)
- C will liquidate Co.A and Co.B as per the action of Companies Law.
Propositions
- C acquires shares in Co.A and Co.B by providing shares in form of consideration to shareholders of Co.A and Co.B in Co.C
- The total enterprise value of the Co.C is determined to Rs. 4,000,000 and is allocated to Co.A and Co.B based on bargained share exchange. Rs. 2,500,000 to Co.A and Rs. 1,500,000 to Co.B
- The fair market values of the assets of the Co.A is determined to be Rs. 2,000,000 and those of Co.B is determined to be Rs. 1,000,000
- The tax base values of the assets of the Co.A is determined to be Rs. 1,300,000 and those of Co.B is determined to be Rs. 800,000
- The cost of investment for the shareholders of Co.A and Co.B is Rs. 500,000 and Rs. 300,000 respectively.
Tax Consequences on current shareholders of Co.A
If the approval under Rule 16 for the application of Section 46 is not provided
- Incomings for the current shareholders of Co.A u/s 39 = Rs. 2,500,000
- Outgoings for the current shareholders of Co.A u/s 39 = Rs. 500,000
- Gains for the current shareholders of Co.A = Rs. 2,500,000 – Rs. 500,000 = Rs. 2,000,000
- Tax applicable u/s 95A on the amount of gains which is required to be deducted in advance by the Co.A and deposited in Revenue Office
The taxes applicable u/s 95A is
- For Unlisted Shares: 10% on gains on disposal by Resident Natural Person, 15% for Resident Entity and 25% on in other Case
- For Listed Shares: Listed Shares: 5% on gains on disposal by Resident Natural Person, 10% for Resident Entity and 25% on in other Case
View my another blog where the capital gains taxes on disposal of securities in Nepal are discussed in detail Capital Gains Tax in Nepal
If the approval under Rule 16 for the application of Section 46 is provided
- Incomings for the current shareholders of Co.A u/s 46 = Tax Base + Max(Disposal Proceeds – Replacement Cost, 0) = Rs. 500,000 + MAX(Rs. 2,500,000 – Rs. 2,500,000 , 0) = Rs. 500,000
- Outgoings for the current shareholders of Co.A u/s 39 = Tax Base + Max(Replacement Cost – Disposal Proceeds, 0) = Rs. 500,000 + MAX(Rs. 2,500,000 – Rs. 2,500,000 , 0) = Rs. 500,000
- Gains for the current shareholders of Co.A = Rs. 500,000 – Rs. 500,000 = Rs. 0
Tax Consequences on current shareholders of Co.B
If the approval under Rule 16 for the application of Section 46 is not provided
- Incomings for the current shareholders of Co.B u/s 39 = Rs. 1,500,000
- Outgoings for the current shareholders of Co.B u/s 39 = Rs. 300,000
- Gains for the current shareholders of Co.B = Rs. 1,500,000 – Rs. 300,000 = Rs. 1,200,000
- Tax applicable u/s 95A on the amount of gains which is required to be deducted in advance by the Co.B and deposited in Revenue Office
The taxes applicable u/s 95A is
- For Unlisted Shares: 10% on gains on disposal by Resident Natural Person, 15% for Resident Entity and 25% on in other Case
- For Listed Shares: Listed Shares: 5% on gains on disposal by Resident Natural Person, 10% for Resident Entity and 25% on in other Case
View my another blog where the capital gains taxes on disposal of securities in Nepal are discussed in detail Capital Gains Tax in Nepal
If the approval under Rule 16 for the application of Section 46 is provided
- Incomings for the current shareholders of Co.A u/s 46 = Tax Base + Max(Disposal Proceeds – Replacement Cost, 0) = Rs. 300,000 + MAX(Rs. 1,500,000 – Rs. 1,500,000 , 0) = Rs. 300,000
- Outgoings for the current shareholders of Co.A u/s 39 = Tax Base + Max(Replacement Cost – Disposal Proceeds, 0) = Rs. 300,000 + MAX(Rs. 1,500,000 – Rs. 1,500,000 , 0) = Rs. 300,000
- Gains for the current shareholders of Co.A = Rs. 300,000 – Rs. 300,000 = Rs. 0
Tax Consequences on Co.A
At the point of transfer of shares from previous shareholders of Co.A to Co.C
As per Section 57, when there is a substantial change (50% or more) 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 deemed profit from disposal of net assets of the entity (taxation on entity). As a result of the above transaction the shareholder of the Co.A has been changed by more than 50%, thus Section 57 will be triggered and it will lead to tax consequences on Co.A. The taxation under Section 57 has many issues in application. Find my other blogs on Section 57 issues discussed in detail here:
At the point of transfer of assets from Co.A to Co.C
- Incomings for Co.A u/s 45 = Rs. 1,300,000
- Outgoings for Co.A u/s 45 = Rs. 1,300,000
- Gains for Co.A = Rs. 1,300,000 – Rs. 1,300,000 = Rs. 0
The transfer of assets from Co.A to Co.C qualifies for the transfer of tax attributes between associates under Section 45. View my blog on transfer of tax base between associates here: Transfer of Tax Base between Associates
Tax Consequences on Co.B
At the point of transfer of shares from previous shareholders of Co.B to Co.C
As per Section 57, when there is a substantial change (50% or more) 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 deemed profit from disposal of net assets of the entity (taxation on entity). As a result of the above transaction the shareholder of the Co.B has been changed by more than 50%, thus Section 57 will be triggered and it will lead to tax consequences on Co.B. The taxation under Section 57 has many issues in application. Find my other blogs on Section 57 issues discussed in detail here:
At the point of transfer of assets from Co.B to Co.C
- Incomings for Co.B u/s 45 = Rs. 800,000
- Outgoings for Co.B u/s 45 = Rs. 800,000
- Gains for Co.B = Rs. 800,000 – Rs. 800,000 = Rs. 0
The transfer of assets from Co.B to Co.C qualifies for the transfer of tax attributes between associates under Section 45. View my blog on transfer of tax base between associates here: Transfer of Tax Base between Associates
Tax Consequences on Co.C
Co.C will not have any income tax consequences at this point as it is the buyer in the above merger transaction. However, there are two folds to this approach of merger:
- C acquires shares in Co.A and Co.B at the cost of Rs. 2,500,000 and Rs. 1,500,000 respectively
(Tax Consequence: Incurrence of cost of Rs. 2,500,000 and Rs. 1,500,000 by Co.C as investment in Co.A and Co.B respectively) - A and Co.B will undergo the application of Section 57 and their net assets will be revalued to Rs. 2,000,000 and Rs. 1,000,000 respectively
- The net assets (after application of Section 57) from Co.A and Co.B will be transferred to Co.C through the application of Section 45 at their respective tax bases
- The investment of Co.C in Co.A and Co.B is disposed off when Co.A and Co.B are liquidated by Co.C. This will lead to derecognition of tax cost of investment and tax cost of deemed liabilities of Co.C towards Co.A and Co.B
Tax Consequence: The incomings of Rs. 2,000,000 and Rs. 1,000,000 from disposal of deemed liabilities of Co.C towards Co.A and Co.B and the outgoings of investment cost incurred in point 1 above. So the total gain/loss by the reason of merger to Co.C is Rs. 2,000,000 + Rs. 1,000,000 – Rs. 2,500,000 – Rs. 1,500,000 = Rs. 1,000,000. This loss of Rs. 1,000,000 has occurred as a result of disposal of investment assets and liabilities. Thus, this loss can be claimed for tax purposes in the particular tax period. Another view could be that, as this loss is incurred as a result of merger arrangement so provision of Section 49 should apply. However, considering that the fair values of the net assets acquired from Co.A and Co.B are already incorporated as tax costs in the books of Co.C, the view that this loss should be claimable is entirely valid under Chapter of Disposal of Assets and Liabilities of Income Tax Act, 2058.