So what is Section 57? (AKA Change in Control)
Example One: If a person sells an asset of cost price (CP) to another person at a selling price (SP) his profit is SP-CP. In the purview of taxation, he disposes the tax base of his asset CP for an income of SP and is taxed at the profit of SP-CP. In this transaction, the item being transacted is the asset and there aren’t any other underlying assets to this transaction.
Example Two: If a person sells his shares of cost price (CP) to another person at a selling price (SP) his profit is SP-CP. In the purview of taxation, he disposes the tax base of his shares CP for an income of SP and is taxed at the profit of SP-CP. In this transaction, the item being transacted is the asset but there are other assets (the net assets of the entity whose share is being transacted) which are underlying assets to this transaction.
Analysis of above examples: If we evaluate the first transaction the income (SP) of the seller is the cost for the buyer. This cost is attributed to actual underlying asset in the transaction. However, in the second transaction, the cost is being attributed to the instrument representative of the underlying asset in the transaction (i.e. shares) but not to actual underlying asset in the transaction (i.e. the net assets of the entity whose share is being transacted).
Symmetric Interpretation: In doing business, when we buy an asset, we use that asset, derive benefit from it and sell those assets when it is not usable in the business. Under normal business scenario, business assets are transacted at their intended value-in-use and the taxation jurisprudence 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).
Symmetric Justice by Section 57: When there is a substantial change in ownership of an entity, the entity shall be treated as disposing of any assets owned by it and any liabilities owed by it. With this provision, the transaction of change in ownership is taxed
- at the actual profit of the disposal of instruments (taxation on seller)
- at the deemed profit from disposal of net assets of the entity (taxation on entity)
Is this a double taxation?: It is not a double taxation per se, as different person are being taxed. It also cannot be interpreted as economic double taxation because the income that is being taxed are different to different person. However, it is a taxation on unrealized gains of the entity that may be an economic burden to the entity.
Rationale for Section 57
Rationale for Change in ownership
Agreed, Section 57 is an economic burden for the taxpayers. But why do countries have this provision for “Taxation on Entity at the point of Change in Ownership” including Nepal?
Symmetric interpretation of Taxation
In doing business, when we buy an asset, we use that asset, derive benefit from it and sell those assets when it is not usable in the business. Under normal business scenario, business assets are transacted at their intended value-in-use and the taxation jurisprudence 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.
Capturing offshore transactions
Taxation of offshore transaction relating to gain on disposal of shares that are attributable to the asset situated in Nepal is not possible under any other Sections of Income Tax Act 2058 excepting the characterization from Anti Avoidance Rules (Not to start about the complications with Anti Avoidance Rules). Further to this, “Article on Capital Gains” of Double Taxation Avoidance Agreement under OECD model explicitly states that the taxation of capital gains of resident of an state arising from states other than the contracting states (e.g. gains from disposal of equity instruments in countries other than contracting state by resident of a contracting state) shall be taxable in resident state only. However, Section 57 is a taxation on entity situated in Nepal, so this taxation would be able to capture the offshore ownership change in Nepal, without violating the terms of Double Tax Avoidance Agreement.
Capturing the non-market transaction of the buyer and seller
There might be situations where the non-market transfer of the shares may occur between buyer and seller and they might not be captured by Section 45 of the Income Tax Act in all cases. This might occur due to the limitation in tax administration and for reasons that the buyer and sellers are not subject to the local tax jurisdictions. In such scenario, the deemed disposal of the net assets of the entity as per Section 57 will be able to capture the gains (some gains, if not all) in such non-market transaction of the buyer and seller.
Preventing asset & loss stripping benefits
Entities might engage in the practice of taking over a n entity in financial difficulties and selling each of its assets separately at a profit and also utilizing the losses carried over by such entities to generate tax benefits through eligible deductions under the provisions of the Income Tax Act. After the change in control is triggered by the provision of Section 57, the entity after the change in ownership is deemed to be a different entity than the entity prior to the such change, so losses are not allowed to be carried over and loss stripping will not be possible. This will also discourage entities to be taken over simply for the purpose of asset stripping that occurs in situations other than normal business as the stripping gains will be entirely taxed in absence of carried forward losses.
How is Change in Control triggered?
At the outset it is to be understood that the term “ownership” is intended to include “underlying ownership” as well. This further supported by the case Dwarikanath Dhungel vs. Large Taxpayer’s Office (Ncell Case).
What is ownership as per Income Tax Act 2058?
The term ownership is not defined in Income Tax Act 2058. However, reading the definition of underlying ownership provided by the Income Tax Act 2058, Ownership can be defined as
- In relation to an entity: The interest in an entity, or
(As per Section 2(Ma), Interest in an entity means a right, including a contingent right, to participate in the income or capital of an entity.)
- In relation to an asset: The right to possession or the right to beneficial ownership
(Beneficial Ownership has not been explicitly defined in Income Tax Act 2058 but has been implied in various Chapters including Chapter 8 of the Act)
What is underlying ownership (indirect ownership) as per Income Tax Act 2058?
As per Section 2(Ra) Underlying ownership means following ownership:
- In relation to an entity: An ownership created on basis of an interest held in the entity directly or indirectly through one or more interposed entities by an individual or by an entity (in which no individual has an interest); or
- In relation to an asset owned by an entity: An ownership of the asset that is determined on basis of proportion to the ownership held by the persons having underlying ownership of the entity.
What happens when Change in Control is triggered?
Where to start? There are plenty of things to be done after Change in Control as per Section 57 is triggered. Follow these tabs:
As per Section 57(3), where there is a change in ownership of the type referred to in Section 57(1) during the income-year of an entity, the parts of the income-year before and after the change in ownership are treated as separate income years.
This means that the entity’s normal income year is divided into several income years as need be, as per the change in ownership. For example say the Change in control occurred only one during the fiscal year, the fiscal year would be separated into two parts:
- Part One: From the beginning of the fiscal year to the date of change in ownership
- Part Two: From the day immediately following the date of change in ownership till the end of the fiscal year
When to file the Income Tax Return?
As per Section 96 of the Income Tax Act 2058, every person shall file at the place prescribed by the Department not later than 3 months after the end of each income year a return of income for the year. So, the “Change in Control Return” shall be filed within three months from the date of change in ownership.