Introduction
Much discussion has been made in the application of Section 57. What is the primary legislative intent behind it? I believe that, just like intended by Peter Harris in Model Tax Act, the intent of Section 57 is to prevent the abuse of the tax attributes. View my other blogs on Section 57 here:
1. What the bug is Section 57?
This post provides the introduction of the Section 57, how does Section 57 gets triggered, the mathematics behind it, filing of income tax return, payment of income taxes and prevention in carryover of the tax attributes.
2. Issues that arises when applying Section 57
This post discusses various issues that arises in applying Section 57: valuation of MV, direct and underlying ownership, entities subject to Section 57, treatment of gratuity expense: leave pay liabilities: depreciation expense, deduction and claiming expenses.
3. Transfer of tax base between associates
This post discusses on Section 45 which permits, in limited circumstances, the direct transfer of tax attributes to and from entities.
4. Principles underpinning the Ncell Case
This post discusses on how the Section 57 was implemented in the Ncell Case.
However, tax practitioners in Nepal provide the following wisdom behind the application of Section 57: (1) Preventing Abuse of Tax Attributes, (2) Capturing Off-Shore Transactions and (3) Reflecting actual Business Transactions and Taxation of Unrealized Gains. We will dissect them one by one here.
Preventing Abuse of Tax Attributes
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. Section 57 is of an opposite nature in seeking to prevent an indirect transfer of tax attributes of an entity to persons who do not own or are not commonly owned with the entity. A provision of this nature is recommended in order to prevent tax arbitrage irrespective of whether the corresponding provisions are implemented to permit the direct transfer of entity tax attributes. Section 57(1) prevents the carry forward of tax attributes under the transactional basis income tax. It treats an entity as realizing all its assets and liabilities where there is a change of 50 percent or more in the underlying ownership of the entity within a 3-year period. This level of underlying ownership is consistent with that required for the direct transfer of tax attributes to associates. Section 41 will apply a market value rule to the realization. The result is that the entity will realize any previously unrealized gains and losses just before the change. This, combined with section 57(2), prevents the purchaser of an entity indirectly obtaining access to these tax attributes.
Section 57(2) denies the carry forward of certain tax attributes of an entity under the payments-basis income tax where a change in ownership of the entity occurs. The provision also applies to the carry back of tax attributes, where that is possible. The tax attributes described in section 57(2) are self-explanatory. Section 57(1) and 57(2) may apply in tandem, e.g. where section 57(1) causes the realization of a loss that is not available to be carried forward by reason of section 57(2). Section 57(3) applies the rules in section 57(2) to parts of tax years.
Similar to the discussions made above, IMF Commentary from Commonwealth of Symmetrica has highlighted that Section 57 is intended to prevent the transfer of broad value shift of tax attributes from entity to another. Commonwealth of Symmetrica is a model tax law on which the tax law of Nepal is substantially based on. The Brains behind Income Tax Act of Nepal: Peter Harris
But this begs other questions:
- Why should this prevention apply in case where AcquirerCo is a newly established company intending to continue the same business of AcquireeCo with reasonable expectation of profits? [New Investor Acquisition]
- Why should this prevention apply in the case where AcquirerCo is a company involved in similar business and is intending to continue the same business of AcquireeCo with reasonable expectation of profits? [Horizontal Acquisition]
- Why should this apply if total Profit / Loss for Section 57 purpose is profit?
Tanzania’s Income Tax Law is also based on the model tax law “Commonwealth of Symmetrica” and Section 56 of the Income Tax Law of Tanzania is very much comparable with the Change in Control provision under Section 57 of the Income Tax Act, 2058 of Nepal.
How has Tanzania implemented the “Continuity of Business” test and solved this issue?
Section 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.
Capturing Off-Shore Transactions
Another view generally provided on the favor of the application of Section 57 is that it is intended to apply to capture the offshore transactions whose underlying business or investment is in Nepal. Section 57 of the Act requires the entity to assume a deemed disposal of its assets and liabilities at their market values and the entity is subject to taxation at their normal taxation rate. Is this the real intent behind the Section 57? Since Section 57 requires the deemed disposal of the assets at their market values it doesn’t right to the idea to capture the tax on transaction price of the deal.
A general economic understanding is that: Transaction Price = Market Price ± Goodwill
Goodwill is created by the reason of value of a company’s brand name, location, solid customer base, good customer relations, good employee relations, and proprietary practices and technology. None of these are identifiable assets. Intangible assets like Intellectual Property, Business License, Software are intangible and yet identifiable (i.e. market value can be assigned to them). However, Goodwill is the portion of the purchase price that is higher than the sum of the net fair value of all of the assets purchased in the acquisition and the liabilities assumed in the process. Also, as per IFRS, Goodwill cannot self-created for recognition unless transaction takes place. This clearly indicates that the deemed disposal of the asset/liabilities at their market values cannot lead to the taxation on the deemed gain made on the transaction / deal made to acquire the underlying entity.
Reflecting actual Business Transactions and Taxation of Unrealized Gains
Another view, not so much popular, is the view of Symmetric interpretation of the transactions. Under normal business scenario, business assets are transacted at their intended value-in-use and the provisions of taxation 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). Section 57 eliminates this asymmetry by taxing on the deemed profit from deemed disposal of net assets of the entity whose substantial ownership has been changed. This may be a different school of the thought but the tax consequences under this approach doesn’t differ than the thought under “Preventing Abuse of Tax Attributes”.
Summary of Key Problems to be addressed in Section 57
So, what are the problems to be addressed by the suggested in Section 57:
- There needs to be clarity on if the Section 57 applies on direct change in control or only in case of underlying change in control
- There needs to be clarity regarding what types of entities are subject to the Change in Control
- The gains derived from the deemed disposal under Section 57 should not be considered for the purpose of calculating the interest under Section 117, Section 118 and Section 119
- What provides the actual test of test in control? Should the “change in control” be defined by “income and capital rights” or “the voting rights” or “any other tests”?
- There is a need to exclude the application of Section 57 in case of involuntary disposal.
- Which date should be considered as the effective date for the change in control?
- Special exclusion for the liabilities like Gratuity, Leave Pays and non-depreciable assets like land.
- There needs to be clarity on the form of test for Section 57: Continuous Test v/s Aggregate Test
Suggested Changes in Section 57
To address these issues in the Section 57 the purposed changes in Section 57 would be:
Section 57(1): If the underlying ownership of any entity changes by fifty per cent or more as compared to its ownership until before the last three years, the entity shall be deemed to have disposed the property under its ownership or the liability borne by it. Provided that the entity shall not be treated as disposing liabilities relating to employment obligations (e.g. Gratuity Liability, Retirement Liabilities, Accrued Leave Pays) and non-depreciable assets (e.g land).
Section 57(1a): For the purpose of computing change in ownership of fifty percent or more than fifty percent of any entity referred to in sub-section (1), the following ownership of such entity shall only be included:
- Ownership held by a beneficial owner shareholder holding one percent or more than one percent of the total ownership, and
- Ownership held by the associated person of a beneficial owner shareholder holding more than one percent of the total ownership of such entity, among beneficial owners shareholder holding less than one percent of the total ownership.
Clarification: For the purpose of this Section, ownership shall be computed by calculating the weighted averages of the percentages of “ownership” and “voting right” possessed by the beneficiaries.
Section 57(2): If the ownership of any entity is changed as mentioned in sub-section (1), the entity shall not be allowed to carry out the following acts after such change:
(a) To deduct interest incurred by that entity prior to the change in ownership and carried forward pursuant to sub-section (3) of Section 14,
(b) To deduct the loss suffered by that entity prior to the change in ownership, pursuant to Section 20,
(c) To carry back a loss suffered after the change in ownership in any income year before such change, pursuant to sub-section (4) of Section 20,
(d) To make adjustment pursuant to sub-section (4) of Section 24, if it has been calculated for any amount or expenses pursuant to clause (a) of subsection (4) of Section 24 prior to the change in ownership, and correction has been made on that amount or expenses pursuant to sub-section (4) of Section 24 after the change in ownership,
(e) To make adjustment pursuant to sub-section (1) of Section 25, if any amount has been calculated pursuant to clause (b) of sub-section (1) of Section 25 prior to the change in ownership and the right to receive that amount has been relinquished or in the event of that being a debt claim, such person has written off such amount as a bad debt, after the change in ownership,
(f) To subtract, pursuant to Section 36, the loss suffered in disposing any property or liability prior to the change in ownership from the income earned from the disposal of the property or liability after the change in ownership,
(h) If premium has been calculated pursuant to sub-clause (1) of clause (b) of sub-section (4) of Section 60, prior to the change in ownership and such premium has been returned to the insured after the change in ownership, to claim for credit accordingly, or
(i) To carry forward in the forthcoming year the tax paid in respect of a foreign income prior to the change in ownership, pursuant to Sub Section (3) of Section 71.
Section 57(3): If the ownership of any entity changes in any manner mentioned in subsection (1) in any income year, the parts before and after the change in ownership in that income year shall be treated as separate income years.
Section 57(4): The provisions under this Section shall not apply where the entity –
(a) undergoes change in ownership by the reason of involuntary disposal of shares (e.g. by reason of death of owner, gift and bequest, inheritance, court or competent authority’s orders etc.)
(b) for a period of two years after a change of the type mentioned in Section 57(1), 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 conducts no business or investment other than those conducted at any time during the twelve-month period before the change, or
(c) as at the date of change in control:
(i) doesn’t have any tax attributes under Section 57(2)(a), Section 57(2)(b), Section 57(2)(c), Section 57(2)(d), Section 57(2)(f), Section 57(2)(h) or forgoes such attributes, and
(ii) forgoes the ability to adjust the attributes arising under Section 57(2)(e) and Section 57(2)(g) in the forthcoming income years.
Section 57(5): The income derived by the reason of Section 57(1) shall not be considered for computing payment of income tax by instalments under Section 94 and computation of interest under Section 118(1).
And, if we really want to tax offshore transactions
Like discussed above, Section 57 is primarily an anti-abuse provision rather than taxing provision. Section 57 was applied in the famous Ncell Case to actually tax the transaction. The transaction gains of the Ncell deal between Telia and Axiata was considered for the purpose of taxation. The existing tax laws of Nepal doesn’t have adequate basis for the taxation of the transaction that took place offshore even when the underlying asset is situated in Nepal. The correct approach to tax such transactions would be to amend the source principle under Section 67 and introduce a taxing right to that effect.
To capture tax on the gains derived in offshore transactions:
The suggested change in Section 67 would be:
Section 67(6)(tha)(3): The gains attributable to the disposal of underlying interest of 50% or more in an entity in Nepal by a non-resident person.
And, the suggested change in Section 95Ka would be:
Section 95Ka(2Kha): When a nonresident person disposes underlying ownership in an entity in Nepal, which is not subject to taxation under Section 95Ka(2), the entity whose interest has been disposed shall collect the applicable advance tax at the rate of 25% on the gains as attributable under Section 67(6)(tha)(3).
However, this is create additional philosophical issues. Countries around the world do not typically practice these forms of taxing rights. Generally, the offshore disposal of the beneficial interest in a resident entity is not subjected to source principle taxation. The equitable implementation of these forms of taxing mechanism brings additional challenges like:
(i) How to administer such taxation equally and cautiously among all scale of the entities, both huge and small enterprises?
(ii) What might be the appropriate threshold to start defining (e.g say, 50%) the taxing rights and what gives the basis for such thresholds?
(iii) How to equitably provide benefits to the onerous offshore transactions and recording of the losses incurred in such transactions to be allowed for setoff in the future?
(iv) Will the introduction create unnecessary frictions in the business combination transactions? Will such taxing provisions discourage the foreign investments in Nepal?
These are some important aspects that should be considered before introducing such taxing rights. The Ncell Case is still unfurling in The International Centre for Settlement of Investment Dispute, an international tribunal, and could potentially have negative implications in the tax recovery strategy of the Tax Authorities in Nepal, leading to huge financial losses, just from the Ncell Case.
We need to be extremely careful before treading into these murky and treacherous taxing provisions !!