Taxation of Share Transfer Due To IBC

Insolvency and Bankruptcy Code, 2016 (IBC) brought in a robust insolvency regime in India which is a novice for the corporates. The bankruptcy code is a one-stop solution for resolving insolvencies which previously was a long process that did not offer an economically viable arrangement. The code aims to protect the interests of small investors and make the process of exiting from the business less cumbersome. Lawmakers are actively bringing changes in law as per the need of the industries and economy[1].

Resolution professionals with the support of the members of the committee of creditors have resolved some of the big-ticket cases, such as Bhushan Steel Limited, Binani Cements, Bhushan Power & Steel Limited, etc. Though, such resolutions have been subject to prolonged litigation as certain provisions in other statues effects the interest of resolution applicant[2]. JSW Limited has provided for resolution of the stressed Bhushan Power & Steel Limited, in form of transfer of the entity as a going concern. However, the process is halted by the actions of Enforcement Directorate in respect of attachment of assets of the Bhushan Power & Steel Limited, under the provisions of the Prevention of Money Laundry Act,2002.

Therefore, there is a need to harmonize the code with different laws such as Income Act Act,1961, Prevention of Money Laundary Act , Foreign Exchange Management Act, Sebi act Prevention of Money Laundering Act, 2002, Foreign Exchange Management Act,1999,  Securities Exchange Board of India Act, 1992, in order to ensure that interested resolution applicants can resolve the stressed assets without much intervention of courts, in an efficient manner.

There have been certain efforts made by the legislature to harmonize the various laws such as the Companies Act, SEBI Act, Income Tax Act, etc. Certain amendments were brought in Finance Act, 2018 to provide certain tax advantages to the entities resolving the stress assets. Section 79 of the Income-tax Act has been amended and the rigors of the said section have been relaxed in case of such companies, whose resolution plan has been approved under the Code, after affording a reasonable opportunity of being heard to the jurisdictional Principal Commissioner or Commissioner.

Section 115JB of the Income-tax Act has been amended to provide that the aggregate amount of unabsorbed depreciation and loss brought forward (excluding unabsorbed depreciation) shall be allowed to be reduced from the book profit, if a company’s application for corporate insolvency resolution process under the Insolvency and Bankruptcy Code, 2016 has been admitted by the Adjudicating Authority. A company whose application has been admitted shall be entitled to reduce the loss brought forward (excluding unabsorbed depreciation) and unabsorbed depreciation for the purposes of computing book profit under section 115JB.

However, there are issues that are still to be resolved in respect of interplay between income tax and IBC. One such issue that may arise in the future is taxation of the company acquired under the resolution process under section 56 i.e Income under Other Sources.

Section 56(2)(x)(c) of the Income Tax Act was introduced in order to prevent generation and circulation of unaccounted money. It provides, if a person transfers any assets other than immovable assets at price lower than fair market value or for no consideration, exceeding ₹50000/-, then the difference between fair market value and such consideration, shall be taxed as income from other sources. However, there is a certain exception provided to such taxation that includes transfer from relatives, transfer on occasion of marriage etc.

As per section, the Fair market value shall be higher of the following :

(1) As per the methods prescribed in Rule 11UA of the Income Tax Rules, 1962.

(2) As may be substantiated by the company to the satisfaction of the Assessing Officer, based on the value on the date of issue of shares of its assets, including intangible assets being goodwill, know-how, patents, copyrights, trademarks, licenses, franchises or any other business or commercial rights of similar nature.

The Rule 11UA provides two methods of valuation, i.e., Net Asset Value Method and the fair market value determined by the merchant banker as per the Discounted Free Cash Flow method. Earlier, the Chartered Accountants were also allowed to determine the FMV using the Discounted Free Cash Flow method. However, after the amendment by the Income-tax (Sixth Amendment) Rules, 2018, w.e.f. 24-5-2018, only merchant bankers can determine the FMV.

Practically speaking, under the code, as per Section 30(2) (b) the resolution plan is accepted when the resolution plan offers amount to the creditors greater than its liquidation value. As per Regulation 2(k) of the IBBI(Insolvency Resolution Process for Corporate Persons) Regulation 2016, the liquidation value means the estimated realizable value of the assets of the corporate debtors which were to be liquidated on the insolvency commencement date. As per regulation 27 read with regulation 2(m) of the IBBI (Insolvency Resolution Process for Corporate Persons) Regulation 2016, such valuation has to be done by the registered values under section 247 of the act.

Generally, under the resolution plan, it provides for the transfer of existing shares on a value lower than FMV or book value. Therefore, a transfer can be taxed in the hand of a resolution applicant.

In case of resolution of Alchemist Asset Resoconstruction Co. Ltd (AARC) Vs Hotel Gaudavan Private Limited (HGPL), vide order no IB-23(PB)/2017 by NCLT-Principal Bench, New Delhi. As per the resolution plan, the liquidation value is 36.12 Crores and the amount offered by resolution applicant for transfer of all assets of the company is Rs 45.45 Crores. Such payment includes repayment of debt to creditors and ‘NIL’ amount to shareholders for the transfer of such assets/ shares. The plan offered the following terms in relation to equity shares to transfer the share to the resolution applicant at a consideration of Re 1.

As per the balance sheet for the year ending 2017, the fair market value of such shares based on Net Asset Value is calculated as follows

As per the above facts, the resolution applicant got the shares of the company to have fair market value as per the net asset method for Rs 197.89 for ‘NIL’ amount of consideration. Therefore Rs 34.41 Crores could be taxed under section 56(2)(x)(c).

Such taxation as demonstrated above can create a problem and further litigation for the resolution applicant. This can result in making the resolution process under the code unattractive.

The said provision was introduced by the Finance Act. 2017. As per the memorandum explaining the provisions in the finance bill, the said section was introduced to prevent the practice of receiving the sum of money or the property without consideration or for inadequate consideration. IBC is a judiciary supervised process, where the transfer has occurred due to the order of the competent tribunal, therefore there was no intention between the transferrer and transferee to enter such a contract without consideration or for inadequate consideration. The liquidation value of the shares is nil. Therefore, by following the spirit of the law, such amount should not be taxed.

A second option available with the assessee under this circumstance is to get it valued as per the provisions of Rule 11U of the income tax act where fair market value can be determined by the merchant banker on discounted cash flow method. However, the transfer and valuation under the IBC code can be based on some other premise and some other method may have been used to determine the fair market value. Therefore, such ambiguity can again lead to litigation and will overall harm the effectiveness of the resolution process.

In order to do away with such ambiguity, the following changes can be made in the income tax act:

1) Providing an exception under section 56(2)(x)(c) for any transfer that is entered, as a part of the resolution plan under CIRP. Recent amendment was made in finance (No.02) Act,2019, where centre government is empowered to notify certain class of persons, who will be exempted from the provisions, but nothing has been yet notified.

2) Assuming the transfer of shares and other assets has been done at fair market value if such transfer was a part of resolution plan under IBC, which is approved by the respective authorities.

In order to provide easy exit and ensuring efficient economic use of the asset and capital in the economy, the income tax act has to be harmonized with provisions of IBC, in order to ensure easy resolution of stress assets in a time-bound manner.

[1] Law has been amended thrice, i.e. in year 2017, 2018, 2019 since its introduction in year 2016 and also have constituted many committees, that includes Insolvency Committee on Group Insolvency, Cross Border Insolvency etc.

[2] Resolution applicant is the entity which provides the resolution for the stressed asset, by investing in the assets and paying out the creditor as per provisions of the code.