You bet, even capital contributions are taxable?

Let’s start with the meaning of “Capital Contribution”

Oh, the nostalgia of those accounting days, where Ram played the role of the benevolent investor making investments from his wealth across the financial landscapes of countless problem sets in every page of your accounting curriculum. Debiting Cash/Kind and crediting Share Capital felt like a routine to keep track of his investments in our journals.

And all we had to do was debit the Cash/Kind and credit the Share Capital account. Those were simple fun days. We didn’t have to deal with the tax headaches that Mr. Ram would face for just putting his assets into the company to run the business, which we will explore in the following paragraphs.

But let’s start with the meaning of “capital contribution”. A capital contribution is the investment of money or assets into a business in exchange for equity ownership. In the context of a “company” this is called share capital. It is the cornerstone of funding for businesses, providing the resources necessary to operate, grow, and expand.Capital contributions can be both cash or in-kind. Cash contributions? Piece of cake. We’d assign a value to the cash, record it in the capital account, and call it a day. Cash contributions are not an issue of the topic we are discussing because the money value assigned to the cash is the capital contribution that is accounted for and recorded at the same value into the capital account under the capital maintenance concept of accounting system and also the same approach is followed for recording the capital by the Office of the Company Registrar’s in Nepal.

But when the capital contribution is made in-kind, the in-kind contribution has to be assigned a value which is then recorded as the capital contribution, in which case we need to assess if this transaction leads to any tax implication on the part of the investor who is making the capital contribution.

In kind capital contribution = “disposal” of an asset?

In the context of in-kind contribution of capital into a business, the question arises as to whether such an act constitutes a “disposal” of the contributed asset and an “acquisition” of share stock assets in the investee entity. To address this, we turn to the extract from Section 40(1) of the Income Tax Act, 2058.

Section 40(1) of the Act provides a comprehensive understanding of the concept of “realization” concerning assets. Delving into Section 40(1), it explicitly defines the disposal of an asset. According to the section, a person is considered to dispose of an asset when parting with ownership occurs. This encompasses various scenarios such as distribution, merger, installment sale, lease under a finance lease, cancellation, redemption, destruction, loss, expiration, or surrender. Applying this to the in-kind contribution of capital scenario, if the contributor parts with ownership of the “asset” and acquires “stock” assets in its return from the investee entity. It therefore aligns with the definition of disposal as outlined in Section 40(1) thus the act of contributing the asset to the business can be seen as a form of disposal of “asset” and acquiring another asset i.e. “equity interest / stock” in investee entities as income, falling within the ambit of disposal and realization under the provisions of the Income Tax Act, 2058.

In the context of acquiring share stock assets in the investee company, the language of Section 40(1) focuses on the person disposing of the asset. Therefore, the investee company, in receiving the in-kind contribution, may be seen as acquiring the assets in the form of capital contribution against the liability towards capital contributions.

Here is the relevant Section from the law:
Section 40(1) of the Income Tax Act, 2058: A person disposes of an asset when the person parts with ownership of the asset including when the asset is distributed by the owner of the asset, merged with another asset or a liability, installment sale, leased to another person under a finance lease, canceled, redeemed, destroyed (extinguishment), lost, expired, or surrendered.

So, in conclusion, yes, an in-kind contribution made by the investor in the entity would mean the investor parting with that particular “asset” and acquiring the “stock / equity interest” in the investee entity as an income. Exchange your asset with Share Certificates – under Companies Act, 2063

Individual's in-kind capital contribution

The General Principle

The general principle of income tax is that only disposal assets/liabilities in relation to business or investments are subject to income tax. Any assets other than investment and business assets, i.e. personal assets of an individual, are not subject to income tax.

(1) Mr.A, an individual owns a trading business. He has purchased some assets like trading assets, admin office assets and a few office equipment for the operation of the business. The gain/loss derived from the disposal of such assets, related to the business is subject to income taxation.
(2) Mr.A also owns a Bentley Mulsanne and uses it for personal purposes. The car is very exotic in Nepal and he sold it and made a handsome profit. Such profit is not subject to income tax, as it is his personal asset and are not business/investment assets of Mr.A.

So are all personal assets not subjected to income taxation? No.
(i) Land, (ii) Building or (iii) Interest/Security, which qualifies to be Non Business Chargeable Assets, in an entity may be subject to taxation even if they are personal assets. Personal assets other than those that are not subject to taxation are not under the purview of Income Tax Act, 2058.

Meaning of Non Business Chargeable Assets

So what is Non Business Chargeable Assets (NBCA)?
Section 2(da): “Non-business taxable assets” means any land, building and interest or security in any entity except the following properties:
(1) Business assets, depreciable assets or stocks-in-trade,
(2) A private building owned by an individual in the following situation: (a) Being under ownership for a continuous period of ten years or more, and (b) Where that person has resided for a total period of ten years or more continuously or at several times, Explanation: For the purpose of this clause, “private building” means building and the land occupied by the building or one Ropani of land whichever is lesser.
(3) Any interest of any beneficiary in retirement fund,
(4) A land, land with building and private building belonging to and disposed of by any individual for a value less than ten million rupees, or
(5)An asset disposed of by way of transfer in any manner other than the purchase and sale within three generations.

Pictorial Summary for Dummies

So, when an individual makes in-kind capital contribution

Despite the fact that personal assets are also covered by the definition of Asset under Section 2(Ka.dha) and every asset is subject to computation of gains/losses under Chapter 8: Calculation Of Net Gains From Assets And Liabilities, the gains/losses so derived are still not taxable in context of personal assets, if such personal assets do not meet the definition of Non Business Chargeable Assets under the Act. This is because the holding of personal assets is not a taxable activity under Section 5 and Section 3 of the Act. However, according to Section 2(Ka.Kha), the act of holding non-business chargeable assets is treated as an investment. 

So when an individual makes land/building as in-kind capital contribution into an entity the general rule computation of gains for the disposal applies to that transaction. 

  1. Firstly we will need to test whether or not the asset that is being contributed as capital does or doesn’t qualify as Non-Business Chargeable Assets (NBCAs) – in which case they will be subject to taxation as the disposal. If such assets are personal assets then they will not be subject to taxation at the point of disposal. 
  2. The individual will be treated as disposing the asset and acquiring the value of the share / stock in the investee entity – the market value of the stock will be considered as the income and the value of the outgoing of the asset being contributed will be considered as an expense as per the provision under Section 45 and Section 39 of the Income Tax Act, 2058. 
  3. The gains so computed are subject to taxation to an individual if the asset qualifies as an NBCA, as per the taxes specified under Section 95Ka and Schedule 1(1)(4)(Kha) of the Income Tax Act. More on the tax rates on such capital transaction here:  Capital Gains Tax in Nepal

Entity making in-kind capital contribution

Similarly when it is the entity making the in-kind contribution, unlike in case of an individual’s personal asset – there are no exceptions like “personal assets” that do not fall under the ambit of the tax laws. So, when an entity makes the in-kind contribution, the entity will be treated as disposing the asset and acquiring the value of the share / stock in the investee entity – the market value of the stock will be considered as the income and the value of the outgoing of the asset being contributed will be considered as an expense as per the provision under Section 45 and Section 39 of the Income Tax Act, 2058.

The “Oh-no, am I getting taxed for this?”

According to Section 18(1) of the Companies Act 2063, the Memorandum of Association (MOA) of a company is required to state certain matters. If certain actions are to be undertaken, including subscribing shares or acquiring title in a manner other than cash Section 18(2)(Ka) or obtaining special privileges or rights from the company Section 18(2)(Gha), these matters must also be explicitly mentioned in the MOA.

In the case of in-kind capital contributions, Section 18(2)(Ka) is particularly relevant, as it pertains to subscribing shares or acquiring title in a manner other than cash. Furthermore, Section 18(2)(Kha) addresses the acquisition of property by the company from the promoter or another person at the start of its transactions.

For public companies, additional provisions come into play. According to Section 18(3), if a public company is involved in subscribing shares or acquiring property in consideration other than cash, these non-cash considerations must be valued by an engineer or accountant with a certificate to conduct valuation work under prevailing law. Section 18(4) outlines that criteria for the valuation of such property shall be as prescribed, and in the absence of prescribed criteria, the valuator must specify the criteria employed.

Although this at the outset seems a market value assessment of the in-kind contribution is not required in the case of the private companies, that is not true entirely, at least on the tax perspective. The provision of the law under Section 45 of the Act at minimum requires even in the non-market transfers the transaction is deemed to have been made in the respective market values of the assets being disposed/traded for the purpose of capital contribution transaction.

Let’s dive in with an example. Mr. Ram owned land for investment purposes which he acquired only 3 years earlier for CU 5,000,000 (here the land doesn’t qualify as NBCA under the prevalent income tax laws of Nepal). He decides to invest into a business and transfer this land to the business vehicle’s name. At the time of the capital contribution the market value of the land is CU 7,000,000. Essentially Mr. Ram would acquire the stock in the entity worth CU 7,000,000 by disposing of his asset with the historical cost / outgoing of CU 5,000,000. In this case the gain of CU 2,000,000 is the gain made by Mr. Ram on disposal of land by Mr. Ram and the withholding taxes under Section 95Ka and final taxes under Schedule 1(1) of the Income Tax Act, 2058 would apply in this capital transaction. But this is not the end of this story see this example unfold in the paragraphs below.

Fortunately, there is one exception

Fortunately if the capital contribution qualifies to be an “associate transfer” under Section 45 of the Income Tax Act, 2058 – it permits the disposal of the asset in its tax base rather than at its deemed market value – effectively relieving of any taxes in the capital contributions. 

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 covers transactions when there is no consideration in the transaction  or lower consideration than actually prevalent at the market values. 

When all these conditions under Section 45(6) are met, the deemed income from the disposal of the “asset” being contributed can be effectively the tax base of the “asset”, escaping the deemed market value for tax purposes. These conditions are: 

  1. The trading stock/depreciable asset/business asset of transferor becomes trading stock/depreciable asset/business asset of the transferee
  2. The investment asset/NBCA of transferor becomes trading stock/depreciable asset/business asset/NBCA
  3. The liability of the transferor becomes the business/investment income generating source of the transferee
  4. At the time of transfer, both transferor & transferee should be resident person and transferee should not be tax exempted person
  5. Continuing underlying ownership on the asset should be at least 50%
  6. Application should be made for this option

Here is the computation of taxable gains/loss when non-recognition rule under Section 45 is applied: 
● 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
Nature of Difference = n/a 

But for two/six reasons, this exception is not so meaningful

All the six conditions specified under Section 45(6) should be required to be met to be able to elect this non-recognition rule, in my opinion these two / six conditions do make it difficult to fully appreciate this exception provision. Let’s discuss in detail below:

Reason One: This has to be elected

For one to benefit from the non recognition rule under Section 45 and avoid the tax frictions this option has to be elected by the beneficiary. This will create practical difficulties. This application should be opted by transferor and transferor by applying in writing to the concerned tax office. Where this application is not opted and not applied to the tax office for its election, the general provision of the transfer between associates would apply. In such cases the transfer will be deemed to be made in the market value irrespective of the actual consideration or intrinsic arrangement. So basically if you miss to elect this non-recognition rule amidst the administrative hassle at the revenue authorities in Nepal, you are in for paying taxes on unrealized gains.

Reason Two: Continuing underlying ownership on the asset should be at least 50%

This might just be the most relevant and important condition in context of the transfer of asset/liability with an associate. This condition requires that the transferor who is transferring the asset should not only be an associated person to the transferee but should also have retained 50% or more ownership/obligation in the asset/liability both before and after the transfer. The essence of this condition is that as per the definition of “associated person” in Income Tax Act 2058, it has a very broad meaning and area of definition. So, most related parties could be eligible to opt the transfer of assets/liabilities between associates. However, this condition of continuing 50% ownership that has to be retained in the asset essentially blocks all other arrangements of manipulation to this benefit.

Basically, in our above example, since Mr. Ram and the new entity are associated parties (Mr. Ram being sole owner of the entity) so the transfer of land from Mr. Ram to the entity is effectively a transfer between associates and thus would qualify to be transferred at its tax base by electing the non-recognition facility given by Section 45 of the Income Tax Act.

In summary, the tax implications of in-kind capital contributions involve a careful examination of legal provisions, particularly Section 40 and Section 45 of the Income Tax Act, 2058. For individuals, the categorization of assets as non-business chargeable assets (NBCAs) determines the tax impact. Notably, the provision for “associate transfers” under Section 45 offers a potential benefit, allowing for a tax base assessment instead of market value, contingent on active election and the retention of 50% ownership. In essence, the intricacies of in-kind contributions require a measured approach for tax compliance.