Section 47 of ITA: when does this really apply?

Which provision applies in case of business combinations?

How does the merger and acquisition arrangement work under Income Tax Act, 2058? In case of two entities merged and formed new entity in the form of absorption or amalgamation, take over, merger or acquisition, in all cases, tax treatments are same. When the business combination arrangement are made between the associated enterprises, Section 45 permit, in limited circumstances, the direct transfer of tax attributes to and from the associated person. This is essentially an issue of looking through the form in which a business or investment is held and looking to economic substance. The disposal of the assets / liabilities in business combination arrangement (mergers, acquisitions, absorption, takeover etc.) will be subjected to the taxing provision under Section 39 of the Act. When the combination arrangement takes place between the associated persons, Section 45 permits in limited circumstances, the transfer of the tax base between the associates. More on the transfer of tax base between the associates here: Transfer of tax base between associates

Where consideration is received in the form of securities under the business combination arrangement, the shareholder obtaining such consideration in limited circumstances may be subjected to non-recognition under Section 46 of the Act, more on that here: Involuntary Disposal with Replacement: Definitive Analysis

Why doesn’t Section 47 apply in the case of business combination arrangement?

There aren’t much literature on the limitation of the application of Section 47. This hasn’t been much discussed among the tax practitioners and there aren’t any detailed and helpful commentary regarding Section 47 in Income Tax Directive. Let’s discuss on why the Section 47 should not apply in the case of business combination arrangement:

Business Combination arrangements are commercial arrangements. Business combination arrangement inherently contains bargain purchase gain or losses or attributable goodwill to the transaction. Section 47 is a non-recognition rule. If it were to be applied in the case of business combination arrangement, there would be no tax consequences as such in the combination arrangement. Principle of the Income Tax is “Tax is applicable in the creation of wealth not the transfer of the wealth”. To achieve this the Tax Laws are structured in a way that that no transactions can be made for inadequate consideration, if made, they are deemed to have been executed in the market values. And to allow for the transfer of wealth without taxing the deemed gains, the non recognition rules such as Section 43, Section 45, Section 46 and Section 47 are applied.

Another reason would be to take guidelines from the indicative list and examples from income tax directive. The circumstances in which the Section 46 could apply include

  • the exercise of an option by the person to acquire or sell an asset, (सो व्यक्तिले कुनै सम्पत्ति प्राप्त गर्न वा बिक्री गर्ने कार्य गरेमा)
    The term “option” was omitted when borrowing the provision from the Income Tax Act of Commonwealth of Symmetrica: डेरिभेटिभ अप्सनमामात्र सम्पति दायित्व गाभिन सक्ने हुदा डेरिभेटिभ अप्सन अन्तर्गत कुनै सम्पति प्राप्त गर्ने राखी संशोधन नआएसम्म सबै विक्रिमा खुद खर्चमात्र आम्दानी मान्ने अवस्था पर्ने
  • the acquisition of an asset that is leased by the person, (सो व्यक्तिबाट पट्टामा दिइएको सम्पत्तिको प्राप्ति गरेमा)
    “पट्टामा लिइएको सम्पति” वाक्यांश राखी संशोधन नआएसम्म दफा ३२ र यो दफा दुवैमा अनमेल हुने
  • the transfer of a liability that is guaranteed by the person (हस्तान्तरण गरिलिने व्यक्तिबाट जमानत दिइएको दायित्वको हस्तान्तरण भएमा)

How does Section 47 work?

Under Section 47, in case of merger of assets and liabilities, quantification on the disposing assets is to be done at net-outgoing and net-incomings in case of liability.

Let’s assume two assets/liabilities “x1” and “x2” merge to form asset / liability “x3” by the reason of disposal of assets or liabilities by merger. “x1” and “x2” are the tax base of the particular assets/liabilities. In the merger:

  • Asset + Asset = Asset e.g. Debtors, Receivables, Production Process
  • Liability + Liability = Liability e.g. Creditors, Payables
  • Asset + Liability = Asset e.g. Net Debtor
  • Asset + Liability = Liability e.g. Net Creditor

Here, under Section 47:

  • Incoming = x1 + x2
  • Outgoing = x1 + x2

This rule is a non-recognition rule because no element of gain or loss arises in any situation by the reason of this merger as the value of the merged asset is entirely omitted for the purpose of computing incoming and outgoing. Only the tax base of the merging asset is considered for the purpose of computing the gains under Section 47 of the Act.

When does it apply then?

Section 47 and 48 deal with two particularly difficult issues. The separate existence of an asset or liability (the “merging asset or liability”) may be extinguished where it is combined with another asset or liability (the “combined asset or liability”). As the holder of the merging asset or liability will no longer own or owe the asset or liability, the holder will realize the asset or liability. It is possible for an asset to be combined with an asset or a liability and for a liability to be combined with an asset or a liability. Section 47(2) provides a non-exhaustive list of some circumstances in which section 47 applies. Where it applies, section 47 provides a non-recognition of any gain or loss from the realization of the merging asset or liability with an appropriate adjustment to the outgoings and incomings for the combined asset or liability. This rule is complicated by the possibility, e.g. via section 47(1)(b), that the addition of net incomings for a merging liability may turn the net outgoings for a combined asset pre-combination into net incomings for the asset post-combination. In this case, the non-recognition rule only partly applies and a part gain may be recognized for the realization of the merging liability. This is consistent with the approach to realization in section 40(3)(b), i.e. where the incomings for an asset exceed the outgoings for the asset, and is appropriate for the reasons that income tax being primarily targeted at creations of wealth rather than transfer of wealth. Section 47(1)(a) covers the opposite variation on this theme and may result in partial recognition of a loss on realization of a merging asset.

Reason behind, non-recognition in case of merger is to avoid intermediary profits for tax purpose. For example, according to Section 40(3)(d), in case two raw materials merged for finished goods, the raw materials are deemed to be disposed at market price, to avoid the profit under production, Section 47 has non-recognition principle.

An example: H Ltd. accepted a bill of exchange of Rs.100,000 payable on the end of 90 days. After 60 days H Ltd. received another bill amounting Rs.60,000 payable by G Ltd on the same date. H Ltd. and G Ltd. agreed to cancel both bills and issuing Rs.40,000 bills for 30 days. In this case, on the books of H Ltd, one asset has disposed and one liability has disposed.

  • On disposal of Bills Receivable, Incomings = Amount received Rs.60,000 | Outgoings Rs.60,000 | Gain (loss) Rs.0.00
  • On disposal of Bills payable, Incomings = Amount received Rs.100,000 | Outgoings Rs.100,000 | Gain (loss) Rs.0.00

So, to conclude Section 47 applies in case of the combination of the assets or liabilities but not the combination of business. Combination of Assets and liabilities includes the combinations that are closely similar in nature (e.g. combination of receivables and payables, conversion of raw materials into finished goods, conversion of forward receivable and consideration into underlying asset, conversion of lease receivable/s into asset except where Section 32 applies etc.)