The Synopsis
Section 45: Transfer of Tax Base between Associates
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).
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.
It is generally true that internal reconstructions, allocations and redestributions 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.
The non recognition rule under Section 45(2) is applied 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
This is how the non recognition rule works under Section 45(2) of the Income Tax Act. See more detailed discussion on this topic here: Transfer of tax base between associates
Section 46: Involuntary Disposal with Replacement
No discussion is ever enough regarding the non recognition rule under Section 46 of the Income Tax Act, 2058.
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 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.
See more detailed discussion on this topic here: Involuntary Disposal with Replacement: Definitive Analysis
Difference between Section 45 and Section 46
Before the discussion on balancing the choice between Section 45 and Section 46 let’s quickly go through the restructuring arrangement under Section 45 and Section 46:
|
Basis |
Section 45 |
Section 46 |
|
Notice /Approval |
The option of non-recognition under Section 45 for transfer of tax base between associates has to be notified to the concerned tax office. This is not an approval requirement but only a pre-notice requirement. |
The option of non-recognition under Section 46 for involuntary disposal by the reason of merger/ reconstruction (Rule 16) had to be applied to the Inland Revenue Department (IRD). This is an approval requirement. |
|
Detailed Discussion |
||
|
Relief provided |
Allows the transfer of the assets between associated parties at their cost rather than at market values upon fulfilling certain conditions. |
Allows the involuntary disposal of the security in an entity by the reason of merger/ reconstruction to be recognized at their cost rather than at market values upon obtaining approval from the IRD. |
|
Conditions to be fulfilled |
1. The nature of the assets/liabilities after transfer should not change |
1. Application to be made to IRD for the approval |
|
Preferable in M&A |
Asset reorganization arrangements |
Share restructuring arrangements |
M&A Arrangement: How to balance the choice between Section 45 and Section 46?
As discussed in the above table, the non-recognition rules under Section 45 and Section 46 are quite opposite. Section 45 is very limited in its application where many conditions has to be fulfilled to qualify its application. On the other hand, Section 46 (Rule 16) is quite wide but there is a need to obtain approval from the IRD.
The main issue is how does IRD balance the approval to be provided under Rule 16? IRD probably looks into the following criteria to provide such approval:
1. That the share restructuring arrangement doesn’t contain substantial changes in the percentage of the underlying ownership.
2. That the share restructuring arrangement facilitates the merger and acquisition arrangement between the public companies with large number of general shareholders.
3. That the share restructuring arrangement doesn’t lead to any creation of wealth but only transfer of the wealth.