The Budget 2018 has proposed two changes in the income tax law that was widely expected to be brought in to provide relief to the already beleaguered companies fighting to survive the insolvency and bankruptcy process under the Insolvency and Bankruptcy Code, 2016 (IBC). While these two changes provide much-needed relief and clarity in respect of MAT (alternative minimum tax) burden of these companies and their ability to carry forward operating losses, few other issues plaguing the distressed companies remain unaddressed.
Carry forward of losses:
Currently, Section 79 of the Income-tax Act, 1961 (Act) provides that losses cannot be carried forward if ownership of majority shareholding in a company changes hands. For losses to be allowed to be carried forward, there must be continuity of ownership (more than 50% of the voting power) between the year in which loss was incurred and the year in which loss is being allowed to be carried forward and/or set-off. Since companies in bankruptcy have significantly brought forward losses, in the event of a change of ownership as part of the plan of revival under the IBC, they stand to lose out by not being able to set-off these losses against future profits. Tax losses are considered deferred tax asset.
The Finance Bill, 2018 proposes to amend Section 79 to provide for the exclusion of companies whose resolution plans have been approved under the IBC from its ambit. However, the amendment also provides for a curious rider that the approval of the resolution plan should be given after providing a reasonable opportunity to the Income Tax Department. This is an interesting proposal because it effectively gives the Income Tax Department legal standing in the resolution process of companies that are covered by Section 79. All companies are not covered by this section and its applicability is limited to companies that are closely held (in which public are not substantially interested).
It would be worthwhile to bear in mind that the Income Tax Department has been classified as an operational creditor by the IBC and it does not have any standing in the resolution plan or process allowing it object or veto a resolution plan that provides for a write-off of outstanding income tax demand.
By way of this amendment, in cases of closely held distressed companies undergoing resolution within the IBC framework, Income Tax Department will have the standing to present its view before the NCLT. However, this amendment does not give any ability to the Income Tax Department to object or veto the resolution plan. The rationale of this pre-condition is not entirely clear and may act as an irritant in the resolution process.
It is also important to consider that in respect of closely held companies, the Income Tax Department can recover outstanding tax dues from the directors who are guilty of gross neglect, misfeasance or breach of duty. The IBC casts a duty on the Insolvency Resolution Process to determine any syphoning-off of funds or misfeasance on the part of the directors/promoters.
Tax on book profits- applicability of Minimum Alternate Tax (MAT):
Any waiver of loan or interest in a resolution plan must be credited to the statement of profit and loss of the companies under the accounting standards leading which may lead to the incidence of MAT on the book profits. Taxing distressed companies struggling to come out of insolvency is neither desirable nor intended. Accordingly, the Finance Bill, 2018 proposes an amendment in Section 115JB which provides for the benefit of set-off of brought forward losses and depreciation against the book profits for companies against whom applications for resolution process has been admitted under the IBC by the Adjudicating Authority. As can be seen, the amendment does not provide for the exclusion of waiver amount from the book profits but a set-off for brought forward losses depreciation against the amount credited as income on account of waiver as book profits. There may, however, be situations (in rare cases), where the amount of loan and interest waiver is more than the brought forward losses and depreciation; in such instances, book profits may still arise which would be subject to MAT.
Some unaddressed issues
Application of section 56 (2) (x) and Section 50CA:
Potential buyers/bidders desirous of acquiring insolvent companies face the possibility of tax authorities challenging the valuation aspects of the acquisition. Under Sections 50CA and 56(2)(x) of the Act, revenue authorities can impose an income tax on the difference between the consideration and the “fair market value” of the securities on the ground that the buyer has received a consideration that is less than the fair market value of the securities. Section 50CA imposes a tax on this notional capital gain income on the seller and Section 56 imposes a tax on the buyer by treating the difference as income from other sources.
The FMV of the securities has to be calculated as per the Rule 11 UA of the Income Tax Rules, 1962 which book value or stock market prices to be taken into account. There may be situations, where the bid price of these securities is lower than the FMV determined under Rule 11UA. Since these transactions of bidding are being undertaken in the open market through a competitive bidding process, it would be grossly unfair to tax the sellers and buyers on this notional income. The Finance Bill, 2018 does not address this problem.
Requirement of No objection under section 281 of the Act
Section 281 of the Act enables the Income Tax Department to recover outstanding tax dues pending on the date of transfer or arising from proceedings pending on the date of transfer by treating the transfer of assets (including securities) as void. Buyers of securities in a resolution plan have to assess whether they stand the risk of losing the ownership of securities because of any recovery proceedings that may be launched after the acquisition against the seller. Though the Act provides for two exceptions for the application of this provision – where the buyer is a bonafide purchaser without notice or where a no-objection is obtained from the Income Tax Department, in any acquisition of securities in a resolution plan, the buyer is likely to have notice of the outstanding tax dues and therefore the seller would necessarily have to approach the Income Tax Department to obtain a NOC which experience shows is difficult to obtain.
A general exemption by way of an amendment in Section 281 of the Act would have eased the anxiety of the buyers and encouraged the more conservative bidders to participate in the resolution process.
Amalgamation of the stressed company with another company:
Section 72A of the Act provides for the benefit of carry forward of accumulated losses and unabsorbed depreciation of a company in the event of an amalgamation of the company into another. However, to obtain this benefit two conditions must be met: the surviving company must hold at least 75% of the book value of fixed assets of the merged company for a minimum period of five years from the date of amalgamation; and continue the business of the stressed company for a minimum period of five years from the date of amalgamation. If either of the conditions is not met, the tax benefit of loss and depreciation is to be taxed in the year the condition is breached.
Both these conditions, may in a certain type of resolution plans, be difficult to comply with. Plans which require significant divestment of fixed assets for reasons of business viability may be hit by this embargo. The limitation on the continuation of the old business after amalgamation hampers the flexibility of the acquirer to bring about a turnaround by restructuring the old business into a new business which is viable. In such situations, acquirers/bidders would be hampered by not being able to take the amalgamation route.
It is important for the Finance Ministry officials to examine these unresolved issues in greater detail and with a higher degree of sensitivity to soothe the tax anxieties of the bidders and investors. Since the government has identified the success of IBC as a key determinant of economic growth, one would hope that it would address these concerns in the modified Bill that would be presented as the Finance Act, 2018.
(The author is tax partner, Trilegal)