TAXATION ON MERGER

TAXATION ON MERGER <!--[if gte mso 10]> TAXATION ON MERGER By Mr. M. Iqbal Patel, F.C.A., Karachi The banking and the financial institutions are considered to be the backbone of the economy. In Pakistan the financial sector has been in financial crisis due to interference in their financial management by the politicians in or without uniform in power from time to time. Though the management of the financial sector is not absolved from their responsibility to this state of affairs, being they frame and follow the financial policies of their bank or institution. The default of loans of billion of rupees is the result of joint venture of the bank officials and the big group of industries to whom they financed on the basis of the personalities of the sponsors. The Governor of State Bank of Pakistan (S.B.P) has recently disclosed that non-performance loans stands outstanding at Rs.266 billion. This huge amount is still outstanding despite the Government owned banks and DFI's has written off around Rs.44 billion. Moreover the SBP estimates to write off further Rs.25-30 billion during next three years. Thereby the SBP has failed to recover the stuck of loans of billion of rupees from the defaulters and has adopted soft and flexible policy allowing them to write off/waive their outstanding loans at the cost of the depositors and taxpayers. The world donors IMF and WB have been complaining for poor governance of the financial sector and has been suggesting for their privatization since long; but has been disappointed with the delaying tactics of the Government. The IMF in their imposed Income Tax Ordinance, 2001 has first time inserted a provision of amalgamation of one or more banking companies or non-banking financial institutions. It excludes the companies registered under the Companies Ordinance, 1984 (CO.). It provides that the assets and the liabilities of the amalgamating company standing on amalgamation date will become the assets and the liabilities of the amalgamated company by virtue of amalgamation. Further it requires that the Scheme of amalgamation to be approved by the SBP or by the Securities and Exchange Commission of Pakistan (SEC). The Finance Act, 2003 requires that in order to avail concessions on such mergers by the financial sector such Scheme of amalgamation shall have to be approved by the SBP or SEC by June 30th, 2004. The only provision to allow benefit to encourage the sick and small banks or financial institutions for merger available in the Ordinance is the section 57-A which allows accumulated losses under the head Income from Business of an amalgamating company for the period prior to amalgamation to be carried forward for set-off loss against the business profits and gains of the amalgamated company, for a period of six tax years immediately succeeding tax year in which the loss was sustained by an amalgamating company. The unabsorbed depreciation, the initial allowance and also the amortization of intangibles that have not been set-off against income of amalgamating company will also be allowed under section 152(2) to be set-off in the assessment of amalgamated company as consequent to amalgamation. Further legislature has made conditional to allow the benefit to set-off of business loss consequent to amalgamation by the amalgamating companies to fulfill conditions as laid down by the SBP or the SEC, as the case may be, in the Scheme of amalgamation. It is also provided that in case the set-off of loss or allowance for depreciation is allowed by the Assessing Officer in any tax year in the assessment of the amalgamated company subsequently and it is discovered by the Commissioner that any condition imposed by the SBP or SEC were not fulfilled then such relief allowed by them will be treated as income in the year in which default is discovered by the Assessing Officer. The banking companies and non-banking companies on merger enjoy the incentives of (a) admisibility of expenses on merger/amalgamation (b) continued availability of unabsorbed depreciation (c) transfer/carry forward of losses of merged entities. Besides the above incentives, the Ordinance, also allows a nationalized bank as on 1 June, 2002 and approved by SBP to carry forward their losses relating to assessment year commencing from 1 July, 1995 and ending on 30 June, 2001 for a period of ten years. These discriminatory provisions of treatment to taxpayers of public and private sector, agriculture and non-agriculture has been retained in the new Ordinance too instead of treating all taxpayers at par. Fair and impartial taxation system is necessary to improve its image and extend tax net. The Ordinance has provided for amalgamation for banking companies and financial institutions only just to meet the conditionality of the IMF to promote a process of privatization of Government owned banks and financial institutions. However, other banks and financial institutions in the private sector may also take advantages of these provisions of merger. The Government's policy is that the viable bank and financial institutions should survive and the financial sector regains its confidence of the depositors. The provision in respect of amalgamation has been inserted in the Ordinance for the first time but it is restricted to the finance sector only. Although the merger of the companies registered under the CO is taking place and has become normal process particularly among the multinational companies in Pakistan. The process of merger has further been accelerated as a result of globalization and entry of Pakistan into WTO. But the Ordinance has no provision to suggest the treatment of the problems arise as a consequent to merger of the companies. The definition of the amalgamation in the Ordinance even not provides for the shareholders of the amalgamating company that at what ratio will be required to become shareholder of the amalgamated company by virtue of the amalgamation whereas the Indian tax law has recognized the concept of merger over three decades ago and has provided for in the Income Tax Act, 1961 of various issues arising under the process of merger of the companies. In the circumstances we have no choice except to seek guidance from the Indian tax laws on amalgamation of the companies which will be helpful and guidance to the taxation officers in Pakistan who are bound to follow the ruling of the Supreme Court of Pakistan who has held in a case that the analogous provisions, fundamental concepts and general principles are unaffected by the specialities of other, the tax authorities may take help from them. The Assessing Officers normally dispute the valuation of the fixed assets transferred by the amalgamating company to the amalgamated company. They insist to value the assets taken over by an amalgamated company at fair market value as provided under section 68, which defines it as the prices which the assets would ordinarily fetch on sale in the open market at a particular time. Though the said section clearly state that the fair market value will be the price that these assets would fetch if sold in the open market whereas in case of merger the assets of an amalgamating company are taken over by the amalgamated company; thus the transaction does not constitute sale. Hence the value of these assets to the amalgamated company is the book value of these assets as of date of amalgamation. The Indian Tax Law provides to value the assets in the assessment of the amalgamated company at book value as appearing in the account of the amalgamating company on the date of amalgamation. Moreover the Assessing Officers. apply the concept of fair market values to the assets taken over by the amalgamated company without applying their mind. In one of the case Assessing Officer has determined the value of the assets on the basis of surplus on re-valuation of assets appearing in the balance-sheet of the amalgamating company on the date of amalgamation. Not only that but such revaluation reserves have been assessed as deemed income under section 12(12). It shows how the Assessing Officers are exercising their discretionary powers at their sweet will. Because the Ordinance does not provide for their accountability. This imbalance in their discretionary powers versus accountability has made the taxation system oppressive for the taxpayers. The other most important issue confronting to the amalgamated companies relates to the carry forward and set-off of losses of amalgamating company: Though the merger process among the companies registered under the CO other than banking companies or DFI's has been accelerated but the Ordinance has not made any provision on the issue as it provides for in case of financial sector in respect to carry forward of accumulated business losses and set-off of unabsorbed depreciation of the amalgamating company against the profit of amalgamated companies. The Assessing Officers do not allow the benefit of carry forward and set-off of business loss as provided under sections 57 and 56 respectively to the amalgamated company on the ground that this concession is available to the business who originally has sustained it and who is continued to be carried on by it, the successor, in business cannot claim to carry forward the loss incurred by or un-absorb depreciation allowance of its predecessor. This interpretation is arised, as there is no specific provision to that effect in the Ordinance similar to such provision as provided under section 57A for financial sector. The Indian Tax Laws has inserted a specific provision relating to carry forward and set-off of accumulated losses and unabsorbed depreciation allowance in cases of amalgamation. These provisions have been relaxed in cases of amalgamation through Finance Act 1977 whereby the scope of these provisions have been extended with a view to facilitate the merger of sick industrial units with sound one. Their departmental circular of August 1977 has elaborated these provisions in case of amalgamation that where there has been amalgamation of a company with another one and the Central Government on the recommendation of the specified authority, is satisfied that certain conditions as specified are fulfilled, it may make a declaration of that effect and thereupon, the accumulated loss and unabsorbed depreciation of the amalgamating company is deemed to be the loss or allowance -of depreciation of the amalgamated company for the previous year in which the amalgamation was affected. Thereby the amalgamated company will have the right to carry forward the loss for a period of eight accounting years. The conditions which an amalgamated company is required to be fulfilled is that the amalgamating company will be carried on by the amalgamated company without or with modification as may be approved by the Central Government. Further a certificate from specified authority is required to be furnished by the amalgamated company alongwith its return of income that adequate steps have been taken by the company for the rehabilitation or revival of the business of the amalgamating company. The Indian tax law also allows the amalgamated company to amortize the intangible assets acquired by it on merger from the amalgamating company against its profit in a manner as provided in the Act. Further it provides that there no capital gain or loss will be computed in the assessment of amalgamating company in respect of the capital assets transferred by it to the amalgamated company. In Pakistan the Scheme of merger is approved by the High Court as required under the CO. The merger shall be effective from the date the High Court has issued the order of merger under the CO. The amalgamating company shall loose its existence as from that date and it ceased to be liable as a non-existent person to file any return. The liability for payment of tax passes on to the amalgamated company as from that date as has been held in a case by the Lahore High Court. In fact the Government of India as its policy to revival and rehabilitation of sick industries has provided facilities and tax incentives on merger so as to encourage them to merge with sound one. Contrary to our Government who has created multiple institutions who allow the sponsors of sick units relief in repayment of their debts offering written-off or waiver in billion of rupees at their dictated terms; despite of it a fraction of sick units or defaulters have come forward to accept the relief. The Government should review its policy and tax incentives for revival and rehabilitation of sick units be made in the Ordinance to encourage sick or small units for amalgamation. In order to revive sick subsidiary industrial units, the incentives were provided under section 34A of the Income Tax Ordinance, 1979 (repealed) though there is no corresponding provisions in the Ordinance. The IMF has also stressed the need to save the exchequer from annual loss of about Rs.100 billion by reviving or privatizing the money losing the public sector enterprises. The merger of companies should be formed a part of strategy by the Government for revival of economy. The Government should evolve objective guidelines and prepare a scheme amalgamation and taxation to be used as an instrument for revival of sick units whether it may be industrial or financial sector. This scheme should be part of Industrial Policy emphasizing the role to be played by merger of potential viable sick units with healthy one. Which are capable of managing the sick units and restoring their viability. For this purpose the taxation policy be made an instrumental allowing liberal tax incentives which will serve the purpose to turn the sick units into sound one. One of the major conditions of amalgamation is non-viability of amalgamating company. The term sick units or non-viability, therefore, be defined for the eligibility of tax relieves. The factors responsible for non-viability, may include such as (i) any industrial unit set-up has not been completed or has not commenced its operations (ii) it has not been operating smoothly or its performance has so deteriorated that it has incurred losses since last three years and its accumulated losses exceeds its paid-up capital (iii) debt equity ratio has been deteriorated beyond 9:1 (iv) the company has made default in repayment of debt for last three years (v) any industrial unit which is not in operation for over a period of two years. The revival and rehabilitation scheme should provide to deal with effectively the real cause of the non-viability of sick unit. The amalgamated company should identify the real causes of the non-viability of the sick unit and determine whether it is suffering, from non-availability of working capital or needs upgradation of plant and machineries or suffering from technological or managerial deficiency or lacks marketing network and other such related factors. Accordingly it should formulate a Scheme for the rehabilitation and revival for such undertaking indicating how each of the cause will be resolved and the resources found. The Scheme so prepare should be approved by the SEC. Obviously the amalgamated company who has accepted to undertake to provide the necessary financial and managerial resources to execute the revival and rehabilitation Scheme expects tax benefits to supplement for meeting its cost of revival of sick units. The Ordinance should provide tax incentives to the amalgamated company in respect of (i) valuation of assets of the amalgamating company to be taken by amalgamated company at book value (ii) to allow carry forward and set-off of accumulated losses and unabsorbed depreciation of the amalgamating company to the amalgamated company (iii) conditions be prescribed to be fulfilled by the amalgamated company to avail the benefit of incentives. Such as to furnish by it alongwith its return of income for the assessment year for which such benefits are claimed a certificate from their statutory auditor to the effect that adequate measures have been taken by the amalgamated company for the rehabilitation or revival of the sick undertaking. The Assessing Officer after examining the rehabilitation scheme and ensuring that all the prescribed conditions are fulfilled may allow the benefit of the tax concessions to be provided in Ordinance. In order to revival of sick or small industrial units, tax incentives are necessary to the healthy companies to acquire companies owning such units which will create employment opportunities and will revive economy.