Nepel: Impact of Change in Control - Tax Provisions of Nepal

A company is an independent legal entity whose existence is separate from its shareholders. A change in control occurs when the majority of its ownership is transferred which generally doesn’t impact the company’s legal existence. However, in case there is a change in control in Nepal, the tax system perceives that the old controlled entity is deemed to have been disposed at the market value and a new controlled entity is formed (disposal with retention). 

The Income Tax Act allows, in limited circumstances, direct transfer of tax attributes to and from entities. However, Section 57 of the Income Tax Act 2058 (2002 AD) is the opposite as it seeks to prevent an indirect transfer of tax attributes of an entity to other persons who do not own the entity or are not commonly owned by the entity. Under Section 57, where there is a change of 50%or more in the underlying ownership of an entity (other than insurance, banks and financial institutions) as compared to the ownership three years previously on the moving basis, the entity is treated as realizing any assets owned by it and any liabilities are borne by it immediately before the change and is required to pay tax on such realized gains. Shareholdings of owners holding 1% or more shares and their associated person shall be considered for calculating the change in control. Certain tax attributes such as carried forward of losses that are available before a change of control can no longer be offset against current year (nor future) tax profits. The period before and after the change of control of a particular income year shall be treated as two separate income years for taxation resulting in two different tax returns for each period. 

One of the major reasons behind the introduction of this anti-avoidance provision is to avoid misutilization of tax losses and tax credits of an entity through aggressive tax planning schemes such as loss shifting schemes, schemes shifting profits to a loss-making party, schemes circumventing time restrictions on the carry-over of losses and so on. A 2011 study of 17 countries conducted by OECD showed that most countries have rules restricting the use of losses in cases of changes of ownership and/or of activity, although some contain exceptions for internal reorganizations.

Implication to an Entity 

Due to the application of this Section, the tax will be levied to old shareholders (as a capital gain tax on disposal of the shares) and the company (as a gain for its deemed disposal). Levying capital gain tax to the taxpayer seems to be logical, however, the process of taxing the entity with no real added benefit to the entity itself just acts as a burden to its operation. The provisions of this section apply in the cases of mergers and acquisitions, increasing share capital or inviting new shareholders and venture capital firms.