De-coding the tax implications upon insolvency
Non-Performing Assets (NPAs) have become an abiding issue with the Indian banking industry impacting the credit quality of bank loans. The state of the bankruptcy process, prior to introduction of the Insolvency and Bankruptcy Code, 2016 (IBC) was highly fragmented which posed a deterrent to India’s future growth prospects.
IBC is the bankruptcy law of India which seeks to consolidate the current insolvency regime and provide a unified framework. IBC has been passed by Parliament in May 2016 and became effective in December 2016.
Prior to IBC, multiple regulations at times not in congruence were leading to disputes and defaults. The laws addressing the revival and financial reconstruction were provided for under different Acts. It is problematic that these different laws were implemented in different judicial forums, namely (i) Provincial Insolvency Act. 1920 (ii) Presidential Towns Insolvency Act, 1909 (iii) Winding up provisions of the Companies Act, 1956 (iv) Sick Industrial Companies (Special Provisions) Act, 1985 (v) Recovery of Debts Due to Banks and Financial Institutions Act, 1993 (vi) Securitization & Reconstruction of Financial Assets, Enforcement of Security Interests Act, 2002.
The new Insolvency and Bankruptcy Code has given a headroom to companies indebted massively and performing miserably to declare themselves as bankrupt and it has also facilitated the lenders to expedite recovery and resolution of stressed assets.
IBC earmarks a separate insolvency resolution processes for individuals, companies and partnership firms. The process may be initiated by either the debtor or the creditors. A maximum time limit, for completion of the insolvency resolution process, has been set for corporates and individuals. For companies, the process will have to be completed in 180 days, which may be extended by 90 days, if a majority of the creditors agree.
One of the consequences of the insolvency resolution process is the varied tax issues. The taxation rules governing the insolvency proceedings in India are ambiguous and complex and subject to interpretation led by a catena of the judicial interpretations. Sooner the thought is given to taxation in respect of the insolvent company, the better this will be for the seller, the remaining group and for any buyer.
In this article, we have aimed to cover certain consequential tax issues arising under the Income-tax Act, 1961 (‘the Act’) on the remedial measures taken under an insolvency resolution plan for revival of the company.
Tax implications on conversion of interest into loan / shares
Section 43B of the Act provides that deduction for certain expenses would be allowed only on ‘payment basis’. Clause (d) and Clause (e) to Section 43B provides that any sum payable as interest on any loan or advances from a Public Financial Institution / Scheduled bank in accordance with the terms and conditions of the agreement governing such loans or borrowing should be allowed only on payment basis.
Explanation 3C and Explanation 3D to Section 43B clarify that any sum payable by the assesse as interest on any loan or borrowing or advance shall be allowed as deduction if such interest has been ‘actually paid’ and any interest which has been converted into a loan or borrowing or advance but has not been actually paid shall not be allowed as deduction in the computation of income.
In view of the above, interest which has been converted into a loan or borrowing or advance, shall not be deemed to have been ‘actually paid’ on account of its conversion into loan. Conversion of interest into loan shall be allowed as a deduction in the year in which the ‘converted interest’ is actually paid. Further, the nomenclature of the sum of converted interest will make no difference as the sum of converted interest whenever is actually paid will not represent the repayment of principal.
It may be relevant to note that the provisions of Explanation 3C and 3D refer to interest into a ‘loan or borrowing’ and does not cover conversion of interest into shares. In the context of conversion of interest into shares, the Delhi High Court in the case of Rathi Graphics Technologies Limited[1] held that conversion of portion of interest into shares would be taken to be ‘actual payment’ within the meaning of Section 43B of the Act.
The High Court observed that when pursuant to a settlement, the creditor agrees to convert a portion of interest into shares, it must be treated as an extinguishment of liability to pay interest to that extent. Consequently, the situation when an interest payable on a loan is converted into shares in the name of lender/ creditor, is different from the situation envisaged in Explanation 3C to Section 43B of the Act viz. conversion of interest into a ‘loan or borrowing’. In the latter instance, the liability continues in a different form. However, where the interest or a part thereof is converted into equity shares, the said interest amount for which the conversion is taking place is no longer a liability and may be claimed as a deduction in the year of conversion of interest into shares.
Taxability of waiver of loan / interest under Section 41(1) of the Act
Section 41(1) of the Act deals with tax implications arising out of remission and cessation of trading liabilities. As per the said provision, when a taxpayer claims a deduction of any loss or expenditure or trading liability in any earlier assessment year, and has obtained (a) any amount (whether in cash or any other manner) in respect of such loss or expenditure; or (b) any benefit in respect of a trading liability, in subsequent assessment year, the amount of benefit so obtained shall become taxable as business income of the tax payer.
In view of the above, Section 41(1) of the Act is not wide enough to cover an item of liability in respect of which no deduction / allowance has been granted to the assesse in any assessment. It is very specific and restricted in its application to a remission / cessation in respect of loss, expenditure or trading liability, which is once allowed as a deduction in earlier years.
In the context of waiver of loan taken for purchase of a capital asset, the Bombay High Court in the case of Mahindra and Mahindra Ltd. vs. CIT[2] held that in order to apply Section 41(1), the assessee should have obtained a deduction in the assessment for any year in respect of loss, expenditure or trading liability incurred by the assesse. Although, a receipt may be in connection with business, it could not be dealt with by the assesse, as a result of trade. Therefore, amounts referable to loans received for purchase of capital assets would not constitute a trading liability and accordingly Section 41(1) is not attracted.
Further, the Supreme Court in the case of Nectar Beverages Pvt Ltd vs. DCIT[3] held that depreciation is neither a loss, nor an expenditure, nor a trading liability as contemplated under Section 41(1) of the Act. Several judicial precedents[4] have followed this principle and held that the loan which was originally taken for capital expenditure, if waived, does not give rise to taxable income under Section 41(1) of the Act.
In the context of waiver of interest, taxability under Section 41(1) becomes relevant where the assessee had, in earlier years claimed the deduction of interest under Section 36(1)(iii) read with Section 43B of the Act.
Taxability of waiver of loan / interest under Section 28(iv) of the Act
Section 28(iv) of the Act deals with a benefit or perquisite, which arises from the exercise of a business or profession. The said provision comes into play when a benefit arises from normal incidence of business i.e. there is a positive inflow otherwise than in monetary terms.
In the context of the waiver of loan amount, what follows from the judicial precedents is that the answer would depend upon the purpose for which the loan has been taken. A loan can be taken for the purchase of a capital assets, for working capital or business purpose. Therefore, the chargeability of waiver of loan depends upon on the nature for which the loan was taken.
The Madras High Court in the case of Iskraemeco Regent Limited[5] observed that it is a well-established principle of law that every deposit of money would not constitute a ‘trading receipt’. Broadly, though a receipt may be in connection with the business, it cannot be said that every such receipt is a trading receipt. Therefore, the amount referable to the loans obtained by the assessee towards purchase of capital asset would not constitute a trading receipt.
However, the Madras High Court in the case of CIT vs. Ramaniyam Hotels Pvt. Ltd.[6] differed from its aforesaid co-ordinate bench ruling and held that waiver of principal portion of the term loan should have been taxable under Section 28(iv) of the Act. The High Court dissected the language used in Section 28(iv) to hold that the benefit may not arise from ‘the business’ of the taxpayer, but it certainly arose from ‘business’. The High Court observed that there was no distinction between waiver of loan taken for acquiring a capital asset and waiver of loan taken for trading activities in accounting practice, and that such waiver would either be credited to profit and loss account or to the capital reserve.
In our view, the High Court, in the said ruling, while giving a different dimension to the settled principle, dealt with the limited sense of accounting principles rather than discussing the purpose of the loan taken from the aspect of taxability.
In view of the majority of decisions of various High Courts, it may be possible to take a view that waiver of loans borrowed for capital investment should not be taxable as business income. It may be noted that the decision of the Madras High Court in the case of Iskraemeco Regent Limited (supra) is currently sub-judice before the Supreme Court and it may be worthwhile to wait for the decision of the Supreme Court for finality on the issue.
If the loans are obtained for working capital purposes, waiver of the same may be taxed as business income. The Delhi High Court in the case of Logitronics Pvt. Ltd[7] has held that if a loan taken for trading purpose, is treated as such from the very beginning in the books of accounts, the waiver thereof may result in income, moreso when it was transferred to the Profit and Loss account. In arriving at the said conclusion, the Delhi High Court relied upon the decision of the Supreme Court in the case of T.V. Sundaram Iyengar & Sons Ltd.[8].
However, another important aspect which needs to be considered while determining the taxability under Section 28(iv) of the Act, is whether the value of benefit or perquisite should be in the nature of non-cash /non-monetary benefit. Courts[9] have held that the question of including the value of benefit or perquisite would arise only if the benefit or perquisite is not in cash or money.
Reduction from the relevant block of assets
In certain cases, the Indian Revenue Authorities have taken a view that the waiver of loan, to the extent they are capital in nature must be reduced from the relevant block of assets. This would have the effect of reducing the quantum of depreciation allowable to the taxpayer for the relevant block for the subsequent assessment years. The Delhi High Court in the case of Steel Authority of India Ltd. Vs. CIT[10] held that the taxpayer’s action of reducing the amount of loan waived from the block of assets in their books of accounts shows that there is a belief that the subsequent waiver is towards meeting a part of the cost of assets. Hence, it was held that the waiver cannot have a different treatment for tax purposes and should be reduced from the relevant block of assets.
In this regard, reference may be made to judicial precedents[11] to contend that the amount of liability waived off may not be reduced from the block of asset so long as such a treatment has not been made for accounting purposes in the books of accounts.
Taxability of waiver of loan under Section 115JB of the Act
Another important issue that arises is when the portion of the loan waived has been written back and credited to the profit and loss account as far as taxability under the provisions of Minimum Alternative Tax (‘MAT’) is concerned. In this regard, the Mumbai Tribunal in the case of JSW Steel Limited[12], held that capital surplus in respect of waiver of loan amount cannot be regarded as amount available for distribution through the profit and loss account. A mere disclosure of an extraordinary item in the profit and loss account does not mean that the said item represents the ‘working result’ of the company. Accordingly, it has been held that the waiver of loan being capital receipt cannot be taxed as ‘book profit’ as envisaged under the provisions of Section 115JB of the Act.
Carry forward of losses in case of change in shareholding under Section 79 of the Act
The insolvency resolution plan may involve change in the shareholding of the Corporate Debtor. In view of the losses incurred by the Corporate Debtor, one may need to be mindful of the provisions of Section 79 of the Act.
In case of a closely held company, Section 79 of the Act creates a restriction to carry forward and set off losses to subsequent years, when there is a change in shareholding such that 51% of the voting power is not beneficially held by the same set of shareholders who held such voting power at the end of the year to which the loss relates.
Conclusion
It is interesting to note that the first insolvency resolution order under this Code was passed by National Company Law Tribunal (NCLT) in the case of Synergies-Dooray Automotive Ltd on 14 August 2017. The resolution plan submitted in the said case involved in the said case envisaged relief from the Central Board of Direct Taxes to exempt the Company from the applicable provisions of Section 79 of the Act with respect of the business losses and from payment of tax under Section 115JB of the Act.
It may be noteworthy that under the erstwhile provisions of the Sick Industrial Companies (Special Provisions) Act, 1985, the provisions of MAT provided for reduction of profits earned by a sick industrial company till the year wherein the entire net worth of such company becomes equal to or exceeds the accumulated losses.
Whilst, it fair to conclude that the Government has started moving in the positive direction but still a lot has to be done to provide a cohesive legislative and legal atmosphere to all various stakeholders. The road for change is still filled with its share of challenges and difficult answers.
In view of the lack of clarity on the taxation aspects of an insolvency resolution process, the Government may look to provide similar benefit for companies involved in IBC, as it would facilitate in faster rehabilitation of company. Further, it would lead to a more watertight solution to the taxation issues and success at large of the IBC.
[1] (2015) ITA No. 780/2014
[2] (2003) 261 ITR 501 (Bombay HC)
[3] (2009) 314 ITR 314 (SC)
[4] Tosha International vs. CIT [2009] 319 ITR (St) 7 (SC)
[5] […] 331 ITR 317 (Mad HC)
[6] [2016] 68 taxmann.com 289 (Mad HC)
[7] (2011) 333 ITR 386 (Delhi HC)
[8] (1996) 222 ITR 344 (SC)
[9] [Logitronics Private Limited vs. CIT [2011] 333 ITR 386 (Delhi), Rolltainers Limited vs. CIT [2011] 339 ITR 54 (Delhi)
[10] (2012) 20 Taxmann.com 198 (Delhi HC)
[11] Cochin Co. Ltd. [1990] 81 CTR 115 (Ker HC); Shri Kansara Modular Ltd. [2013] 143 ITD 218 (Jodhpur ITAT)
[12] ITA No. 923/Bang/2009 (Mumbai Tribunal)
Author Bio
Dear Mr.Amit Jain,
Thanks for writing such an interesting article. I agree with you that in view of importance of uniform IBC, many corporate may opt for resolution under this code. Thus importance of tax implication are very important especially in view of such issues as:
1) Carry forward of business loss.
2) Conversion of loan/interest to equity.
3) MAT.
4) After the new valuation of assets, their treatment under I.T
5) Other operating income/expenses.