Transfer of tax base between associates

Posted by Parajuli Sushil 4 years Ago 8 Comments 34 Min Read

This article is in context of Income Tax Act 2058 of Nepal. 

Concepts as per Income Tax Act 2058

Associated Person

(कन) “सम्बद्ध व्यक्ति” भन्नाले एक अर्को व्यक्तिको मनसाय अनुसार काम गर्ने एक वा एकभन्दा बढी व्यक्ति वा त्यस्ता व्यक्तिहरूको समूह सम्झनु पर्छ र सो शब्दले देहायका व्यक्तिहरू समेतलाई जनाउँछ :–
(१) प्राकृतिक व्यक्ति र सो व्यक्तिको नातेदार वा कुनै व्यक्ति वा सो व्यक्तिको साझदार,
(२) विदेशी स्थायी संस्थापन र सो संस्थापनमा स्वामित्व भएको व्यक्ति, र
(३) कुनै निकाय आफै वा आफूसँग सम्बन्धित अन्य व्यक्ति वा सहयोगी निकाय वा त्यस्ता सहयोगी निकायसँग सम्बन्धित अन्य कुनै व्यक्ति वा निकायसँग मिलेर कुनै निकायको आय, पुँजी वा मताधिकारको पचास प्रतिशत वा सोभन्दा बढी हिस्सा नियन्त्रण गर्ने वा सोबाट फाइदा प्राप्त गर्ने निकाय ।
तर देहायका व्यक्ति सम्बद्ध व्यक्ति हुने छैन:– (१) कर्मचारी, (२) विभागले सम्बद्ध व्यक्ति होइन भनी तोकेको व्यक्ति ।

As per Income Tax Act 2058 Section 2(Ka.Na): Associated Persons means two or more persons or group of such persons where one may reasonably be expected to act in accordance with the intentions of the other and includes:
1. An individual and a relative of the individual; or
2. An individual and a partner of the individual; or
3. A foreign permanent establishment and its owner; or
4. An entity and a person who, either alone or together with an associate or associates controls or may benefit from 50 percent or more of the rights to income, capital, or voting power of the entity, as the case requires, either directly or through one or more interposed entities; or
5. A person who is an associate of such person
Provided that, the term does not include the following persons: Employees, Persons prescribed by the department as not being associate persons.

Relative

“नातेदार” भन्नाले प्राकृतिक व्यक्तिको पति, पत्नि, छोरा, छोरी (धर्मपुत्र, धर्मपुत्री समेत), बाबु, आमा, बाजे, बज्यै, दाजु, भाइ, भाउजू, बुहारी, दिदी, बहिनी, सासू, ससुरा, साला, जेठान, साली, जेठी सासु, काका, काकी, भतिजा, भतिजी, नाति र नातिनी सम्झनु पर्छ ।

As per Income Tax Act 2058 Section 2(Ba): Relative means a spouse, children (including adopted children) parent, grandparent, sibling, aunt, uncle, nephew, niece, grandson, granddaughter, brother in laws, sister in laws, father in laws and mother in laws of an individual. 

IFRS’s “related party” definition may not be exactly comparable to the “associated person” definition as per the Income Tax Act 2058. Income Tax Act 2058 aims to establish “associated party” relationship between any two person but the concept of IFRS laid down in IAS 24: Related Party Disclosures relating to “related party” is relationship between the reporting entity and any other person. 

Relevant Definitions from IFRS

  1. A related party is a person or entity that is related to the entity that is preparing its financial statements.
  2. A related party transaction is a transfer of resources, services or obligations between a reporting entity and a related party, regardless of whether a price is charged.
  3. Close family member of a person are those family members who may be expected to influence, or be influenced by, that person in their dealings with the entity and include:
    1. That person’s children and spouse or domestic partner;
    2. Children of that person’s spouse or domestic partner; and
    3. Dependents of that person or that person’s spouse or domestic partner.
  4. Key management personnel are those persons having authority and responsibility for planning, directing and controlling the activities of the entity, directly or indirectly, including any director (whether executive or otherwise) of that entity.
  5. Government refers to government, government agencies and similar bodies whether local, national or international. A government-related entity is an entity that is controlled, jointly controlled or significant influence by a government.
  6. Group members means each parent, subsidiary and fellow subsidiary.
  7. Associate includes subsidiaries of the associate and a Joint Venture includes subsidiaries of the joint venture. 
  • A person or a close member of that person’s family is related to a reporting entity if that person:
    1. has control or joint control of the reporting entity;
    2. has significant influence over the reporting entity; or
    3. is a member of the key management personnel of the reporting entity or of a parent of the reporting entity.
  • An entity is related to a reporting entity if any of the following conditions applies:
    1. The entity and the reporting entity are members of the same group (which means that each parent, subsidiary and fellow subsidiary is related to the others).
    2. One entity is an associate or joint venture of the other entity (or an associate or joint venture of a member of a group of which the other entity is a member).
    3. Both entities are joint ventures of the same third party.
    4. One entity is a joint venture of a third entity and the other entity is an associate of the third entity.
    5. The entity is a post-employment benefit plan for the benefit of employees of either the reporting entity or an entity related to the reporting entity. If the reporting entity is itself such a plan, the sponsoring employers are also related to the reporting entity.
    6. The entity is controlled or jointly controlled by a person identified in (a).
    7. A person identified in (a)(i) has significant influence over the entity or is a member of the key management personnel of the entity (or of a parent of the entity).
    8. The entity, or any member of a group of which it is a part, provides key management personnel services to the reporting entity or to the parent of the reporting entity.

The Dissection and Mind Mapping

Let’s discuss the parties related through person. 
A person is related party of a reporting entity if: 
1. The person or his close family has control or joint control over the reporting entity
2. The person or his close family has significant influence over the reporting entity
3. The person or his close family is key management personnel of the reporting entity

Let’s discuss the related party through entity. 
An entity is related party of a reporting entity if: 
1. The entity and the reporting entity are the member of the same group. 
2. The entity is associate or joint venture of the reporting entity or the group member of the reporting entity: The reporting entity is associate or joint venture of the other entity or the group member of the other entity
3. The entity and the reporting entity are the joint venture of same third party. 
4. The entity is a joint venture and the reporting entity is an associate of the same third party: The reporting entity is a joint venture and the entity is an associate of the same third party
5. The entity is a post-employment benefit plan for the benefit of employees of either the reporting entity or an entity related to the reporting entity. If the reporting entity is itself such a plan, the sponsoring employers are also related to the reporting entity.
6. A person identified as related person (above: 1, 2 or 3) to the reporting entity controls or jointly controls the entity.
7. A person identified as related person (above: 1) to the reporting entity has significant influence over the entity or is a member of the key management personnel of the entity or of a parent of the entity.
8. The entity or its group member provides key management personnel services to the reporting entity or to the parent of the reporting entity.

Some Important Concepts

Significant Influence and Associate

Associate is an entity in which an investor has significant influence but not control or joint control. Significant influence is the power to participate in the financial and operating policy decisions but not control them.

A holding of 20% or more of the voting power (directly or through subsidiaries) will indicate significant influence unless it can be clearly demonstrated otherwise. If the holding is less than 20%, the investor will be presumed not to have significant influence unless such influence can be clearly demonstrated. The existence of significant influence by an investor is usually evidenced in one or more of the following ways: 
• representation on the board of directors or equivalent governing body of the investee
• participation in the policy-making process material transactions between the investor and the investee
• interchange of managerial personnel
• provision of essential technical information

Potential voting rights are a factor to be considered in deciding whether significant influence exists. 

Joint Arrangement and Joint Control (Joint Venture and Joint Operation)

Joint arrangement is an arrangement of which two or more parties have joint control. Joint control is a contractually agreed sharing of control of an arrangement, which exists only when decisions about the relevant activities require the unanimous consent of the parties sharing control. 

A joint arrangement has the following characteristics:
• the parties are bound by a contractual arrangement, and
• the contractual arrangement gives two or more of those parties joint control of the arrangement.
A joint arrangement is either a joint operation or a joint venture. 

A joint operation is a joint arrangement whereby the parties that have joint control of the arrangement have rights to the assets, and obligations for the liabilities, relating to the arrangement. Those parties are called joint operators.
A joint venture is a joint arrangement whereby the parties that have joint control of the arrangement have rights to the net assets of the arrangement. Those parties are called joint venturers. 

The basis for classification of Joint Arrangements
The classification of a joint arrangement as a joint operation or a joint venture depends upon the rights and obligations of the parties to the arrangement. An entity determines the type of joint arrangement in which it is involved by considering the structure and form of the arrangement, the terms agreed by the parties in the contractual arrangement and other facts and circumstances. 
Regardless of the purpose, structure or form of the arrangement, the classification of joint arrangements depends upon the parties’ rights and obligations arising from the arrangement. 
A joint arrangement in which the assets and liabilities relating to the arrangement are held in a separate vehicle can be either a joint venture or a joint operation. 
A joint arrangement that is not structured through a separate vehicle is a joint operation. In such cases, the contractual arrangement establishes the parties’ rights to the assets, and obligations for the liabilities, relating to the arrangement, and the parties’ rights to the corresponding revenues and obligations for the corresponding expenses. 

In the context of this Standard, the following are not related parties:
a. two entities simply because they have a director or other member of key management personnel in common or because a member of key management personnel of one entity has significant influence over the other entity.
b. two joint venturers simply because they share joint control of a joint venture.
c. (i) providers of finance, (ii) trade unions, (iii) public utilities, and (iv) departments and agencies of a government that does not control, jointly control or significant influence the reporting entity, simply by virtue of their normal dealings with an entity (even though they may affect the freedom of action of an entity or participate in its decision-making process).
d. a customer, supplier, franchisor, distributor or general agent with whom an entity transacts a significant volume of business, simply by virtue of the resulting economic dependence.

Transfer of Tax Base between associates?

The General Rule

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). 

Provision of the Income Tax Act 2058

Section 45(1): Where a person disposes off an asset through transfer to any associated person or to any other person, without obtaining consideration, the following provisions shall apply:

  1. The person shall be treated as deriving in respect of the disposal an amount equal to the greater of the market value of the asset or the net outgoings for the asset immediately before the disposal; and
  2. The person who acquires ownership of the asset shall be treated as incurring in the acquisition costs of an amount equal to as mentioned in paragraph (a).
    However, this provision shall not be applicable in the circumstance where the provision under Section 43 (Transfer of Asset to Spouse or Former Spouse) or Section 44 (Transfer of Asset on Death) is applicable.
  3. The person who acquires the ownership of the asset under Section 2(da)(5) by the reason of transfer shall be treated as incurring the acquisition cost of an amount equal to the net outgoings of the transferor. (Disposed of by way of bequest/inheritance within 3 generations)

Section 45(2): Notwithstanding Section 45(1), where a person disposes of an asset, being a business asset, a non-business chargeable asset, or trading stock, by way of transfer of ownership of the asset to an associate of the person and the requirements of Section 45(6) are met, the following provisions shall apply:

  1. The person shall be treated as deriving in respect of the disposal an amount equal to the net outgoings for the asset immediately before the disposal; and
  2. The associate shall be treated as incurring in acquiring the asset costs of an amount equal to as mentioned in Section 45(2)(a).

Section 45(3): Notwithstanding Section 45(1), where a person disposes of a depreciable asset by way of transfer of ownership of the asset to an associate of the person, the asset constitute all of the assets of a pool of the person’s depreciable assets, and the requirements of Section 45(6) are met, the following provisions shall apply:

  1. The person shall be treated as deriving in respect of the disposal an amount equal to the written down value of the pool pursuant to Schedule 2(4)(3) at the time of disposal; and
  2. The associate shall be treated as incurring in acquiring the asset or assets costs of an amount equal to as mentioned in paragraph (a).

Section 45(4): Where a person disposes of a liability as per Section 43 and Section 44 by way of transfer of the liability to an associate of the person or by way of transfer to any other person for no cost, the following provisions shall apply:

  1. The person shall be treated as incurring costs for the disposal in an amount equal to the lesser of market value or the net incomings for the liability immediately before the disposal; and
  2. The person to whom the liability is transferred shall be treated as deriving in respect of incurring the liability an amount equal to the liability.

Section 45(5): Where a person disposes of a liability that was incurred in the production of income from a business of the person by way of transfer of the liability to an associate of the person and the requirements of Section 45(6) are met, the following provisions shall apply:

  1. The person shall be treated as incurring costs for the disposal in an amount equal to the net incomings for the liability immediately before the disposal; and
  2. The associate shall be treated as deriving in respect of incurring the liability an equal amount.

Section 45(6): For the purpose of Section 45(2), Section 45(3) and Section 45(5), the following requirements shall be required to be met:

  1. In the case of business assets, trading stock, or depreciable assets of a business, the asset or assets are business assets, trading stock, or depreciable assets of a business of the associate immediately after transfer by the person;
  2. In the case of non-business chargeable assets or depreciable assets of an investment, the asset or assets are business assets, nonbusiness chargeable assets, depreciable assets, or trading stock of the associate immediately after transfer by the person;
  3. In the case of a liability, the liability is transferred to the associate in the production of income from a business of the associate;
  4. At the time of the transfer, both the person and the associate are residents and the associate is not exempt from tax;
  5. There is continuity of underlying ownership in the asset or underlying obligation of the liability, as the case requires, of at least 50 percent; and
  6. An election for subsection (2), (3) or (5), as the case requires, to apply is made by both the person and the associate in writing.

The What?

Three cases can be extracted from the provisions of the Section 45: 

Case A: Qualifying transfer of tax base between Associated Persons

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 
Nature of Difference = n/a

Case B: Disposed by way of bequest / inheritance within 3 generations

One thing is to be clear here. Individal assets other than Non Business Chargeable Assets (NBCA: this warrants a seperate blog for further understanding. Find the link here). 
When one transfers individual assets (e.g. car, gold, household assets etc.) either by way of gift, bequest or inheritance etc this doesn’t attract any taxes on such transfer. It doesn’t attract any characterization or applicaiton of the income taxes. But there is only one exception to this. If the indovidual’s assets meets the category of the Non Business Chargeable Assets under Section 2(da) of the Income Tax Act 2058. 

So what are Non Chargeable Individual’s Assets?
Individual’s assets are generally not NBCA. However Individual’s private residence and land is NBCA when it’s not a:
Non–chargeable building:
Private building of an individual is not chargeable when it is:
 • Been; or (If this condition is however, partly satisfied by various levels of building, tax is paid only to the proportion of level to the total level which doesn’t satisfy)
    › Owned continuously for ≥10 years; and
    › Lived in by the individual continuously or intermittently for ≥ 10 years
 • Disposed-off for < 10 lakhs; or
 • Disposed of by way of bequest/inheritance within 3 generations
(any type of transfer other than sales and purchase made)
Non–chargeable land:
 Land of an individual is not chargeable when it is:
 • Disposed-off for < 10 lakhs; or
 • Disposed of by way of bequest/inheritance within 3 generations
(any type of transfer other than sales and purchase made)
 • If private building of an individual is not chargeable then private land of an individual of area MIN(1 Ropani, 2 × Area occupied by the building)

But worry not. If the asset is disposed by the way of gift, bequest or inheritance within three generation by then no taxes is applicable as: 
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 = [Net Financial Charge] – [Incoming – Outgoing] = [CV]-[TB-TB]=CV 
Nature of Difference = Permanent Difference, By the reason of Section 21

Case C: Other transactions between Associated Persons

Any other transfers other than the Case A and Case B as discussed above falls under other transactions between associated persons. This aims to deem the incoming of the transaction at market value irrespective of the amount at which the transaction took place: 

The incoming for the person disposing the asset/liability = Higher of the Market Value or Tax Base of the Assets i.e. Maximum of MV or TB
The outgoing for the person disposing the asset/liability = Tax Base of the asset/liability being disposed (TB)
Difference = [Net Financial Charge] – [Incoming – Outgoing] = [0]-[ Max(TB, MV)-TB]= Min(TB-MV,0)
Nature of Difference = Temporary Difference

The Rationale of "Transfer of Tax Base between Associated Person"​

Transfer of assets between associated person between 

We have discussed why the Implication of Change in Control as per Section 57 should not apply in case of internal restrucuring here. Issues that arises when applying Section 57

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. 

However, we will try to dissect every condition that are required to be fulfilled compulsorily for the qualification of Section 45. 

Condition One: The nature of the assets/liabilites after transfer should not change

The primary condition of the associate transfer is that the asset/liability being transferred should be used substaintially in the same manner that it was being used in the previous entity. The form of the assets in previous entity and the nature in which it can be used in the new entity is illustrated in the table below: 

Form of assets/liability in previous entityForm of assets/liability in new entity
Business AssetsBusiness Assets, Trading Stock, Depreciable Assets of Business
Trading AssetsBusiness Assets, Trading Stock, Depreciable Assets of Business
Depreciable Assets of BusinessBusiness Assets, Trading Stock, Depreciable Assets of Business
Non Business Chargeable AssetsBusiness Assets, Trading Stock, Depreciable Assets of Business, Non Business Chargeable Assets, Depreciable Assets of Investments
Depreciable Assets of InvestmentsBusiness Assets, Trading Stock, Depreciable Assets of Business, Non Business Chargeable Assets, Depreciable Assets of Investments
LiabilityBusiness Liability

The essence here is that the same nature of business/investment should continue in after the transfer of the assets between associates. This is the very reason why an exemption should exist in the application of Section 57. An exemption should exist in Section 57 such that the implication of Section 57 should not trigger in case where the same business continues for a certain period of time. Similar, exemption to Change in Control exists in Tanzania. 

Condition Two: Transferor and Transferee should be Resident Person

At the time of transfer both the transferor and transferee should be resident person. What is the meaning behind this?
Well, in normal circumstance any non market transfers would be treated to have been made in market value. If transfer of assets between associated person is made at tax base and the transferee is non resident, this would mean the erosion of the potential income at the point of transfer had it been at the market value. It is true because when the asset is eventually transfered to the non-resident person, tax authority will loose any taxing right in the context of that asset.  
Similarly, the idea that the transferor should also be a resident person is also valid. Any incomings to an entity is either an income of the entity or contribution received towards the capital. The assets being handed down from the non resident associate will be incomings to the associate resident in Nepal and in that context the deemed incomings of the transferor will be the outgoings of the transferee without any cost being incurred in Nepal. This will lead to erosion in the potential tax income in context of revenue as the deemed outgoings to the transferee would be qualified as cost deduction in future tax periods, elsewise. 

Condition Three: Transferee should not be tax exempted person

Transferee should not be tax exempted person. 
Well, in normal circumstance any non market transfers would be treated to have been made in market value. If transfer of assets between associated person is made at tax base and the transferee is tax exempt entity, this would mean the erosion of the potential income at the point of transfer had it been at the market value. It is true because when the asset is eventually transfered to the non-resident person, tax authority will loose any taxing right in the context of that asset.

Condition Four: 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 a 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.

For Example: Two person A and B equally owns a company X 50%: 50% in a joint control. Here, Person A and Company X are associated person. Similarly, Person B and Company X are also associated person. However, it is not necessary that Person A and Person B are associated person simply by the reason of joint control they exercise over company X. Lets say, person A established another company Y with 100% ownership. This would make Company X and Company Y associated person. 
Lets say a identfiable business operation consisting of assets and liabilites of Company X are being purposed to be transfered to the Company Y as a spin off arrangement. Here, 
Transferor: Company X
Transferee: Company Y
Underlying Owners before the transfer: Person A (50%) and Person B (50%)
Underlying Owners after the transfer: Person A (100%)
Continuing underlying ownership of at least 50% has been maintained?: Yes

Condition Five: Application should be made for this option

This application is optional. This application should be opted by transferor and transferor by applying in writing to the concerened tax office. Where this application is not opted and not applied to tax office for its election, the general provision of the transfer between assocaites would apply. In such case the transfer will be deemed to be made in the market value irrespective of the actual consideration or intrinsic arrangement.