Chapter-10 Special Provisions for Entities

52. Principles of taxation applicable in respect of entities

Interest in an entity refers, in the case of a partnership firm, to the partner's right in the profit and asset of the firm. In the case of a limited liability company, the term refers to the right of a shareholder to a return on investment in the company as well as the contingent right upon liquidation of the company. In the case of a retirement fund, it refers to the amount invested and the return thereon by the beneficiary. Interest in an entity specifically refers to the right to participate in the capital and income of that entity. In a partnership firm, the partners have an interest. In a company, the shareholders have an interest, and in a trust, the beneficiaries have an interest. In a joint venture, each member's interest corresponds to the proportion of investment or mutual agreement.

Example 13.2.2: Suppose Dinas Company Ltd. and Dinesh Company Ltd. submitted a bid to the Department of Roads for the contract to build a bridge over Roshi Khola as a joint venture with 60:40 joint ownership. In such case, those companies are said to have an interest in the Dinas-Dinesh joint venture in those respective proportions.

The right of an natural person or an entity without an natural person's interest over the assets and income of an entity, whether held directly or through intermediary entities, is called underlying ownership of that entity.

Example 13.3.1: Suppose Komal and Company Pvt. Ltd. and Shital Investment Pvt. Ltd. are shareholders in Himal Byapar Pvt. Ltd. Komal and Company Pvt. Ltd. purchased 60 percent of the shares and Shital Investment Pvt. Ltd. purchased the remaining 40 percent. This investment creates direct ownership of Komal and Company Pvt. Ltd. and Shital Investment Pvt. Ltd. in Himal Byapar Pvt. Ltd. If 80 percent of the shares in Shital Investment Pvt. Ltd. are purchased by Sharmili Pvt. Ltd. and the remaining 20 percent by Dinakar Pvt. Ltd., then Sharmili Pvt. Ltd. and Dinakar Pvt. Ltd. are said to have indirect underlying ownership in Himal Byapar Pvt. Ltd. of 32 percent (80% x 40%) and 8 percent (20% x 40%) respectively, created through an intermediary entity.

Example 13.3.2: Suppose a company named Kasmic Byapar Pvt. Ltd. has 60 percent shares held by Dineshman and 40 percent held by Ramesh Mall. The company has an investment of Rs. 1 crore in a company named Sunam Byapar Nirman. In this case, Dineshman and Ramesh Mall are said to have underlying ownership in that company's investment in Nirman in the same proportions.

(1) For purposes of payment of tax, any entity shall be responsible distinctly from its beneficiaries.

Example 13.4.1: Suppose that Shital Investment Pvt. Ltd. has two shareholders:

• One shareholder holds 60% of the shares, and

• The other holds 40% of the shares.

In the fiscal year 2067/68, the company earned a profit of Rs. 50 lakh. From the profit after tax, the company distributed dividends at the rate of 10%.

In this case, the tax applicable on the dividend must be deducted (withheld) before making payment to the beneficiaries (shareholders).

Although the company pays tax on its income (profit), it does not mean that the beneficiaries are exempt from tax on the distribution they receive from the company. In other words:

• The tax liability on the company’s income lies with the company itself, and

• The tax liability on the income received by the beneficiaries (dividends) lies with the beneficiaries.

Thus, the entity (company) also acts as a withholding agent on behalf of the beneficiaries. However, in the case of dividend income, since tax is already deducted at source while distributing the dividend, the beneficiaries are not required to pay any additional tax separately on that income.

(2) Distributions to be made by an entity shall be as mentioned in Section 53, and in distribution to be so made, tax shall be imposed on its beneficiaries pursuant to Section 54.

(3) The amounts derived by and expenses borne by an entity shall be deemed to have been received or borne by the entity irrespective of whether or not the entity has derived the same or borne expenses for another person.

(4) A asset under ownership of an entity and the liability borne by it shall be deemed to be under ownership or burden of the entity. Such asset under ownership and liability borne shall not be deemed to be under the ownership or burden of any other person.

(5) Foreign income tax paid by the manager, beneficiary of an entity or the entity, whosoever, for the income of the entity shall be deemed to have been paid by the entity.

(6) Transactions between any entity and its managers and beneficiaries shall be recognized subject to Chapter-7 and Section 45.

Entity taxation principles (Sec 52): an entity (any person other than a natural person) is a separate taxable person - it pays tax on its own income; beneficiaries pay tax on distributions they receive.

INTEREST in an entity = right to its capital & income (partner's share, shareholder's shares, beneficiary's interest).

UNDERLYING OWNERSHIP = a natural person's direct or indirect (through intermediary entities) ownership of the entity's assets/income.

The entity's income/expenses and assets/liabilities are the entity's alone (52(3)/(4)); foreign tax paid by the entity, manager or beneficiary on entity income is treated as paid by the entity (52(5)); entity-manager-beneficiary transactions are recognised subject to Ch 7 & Sec 45 (52(6))

53. Distribution by entity

(1) The following matters shall be included in the distribution to be made by an entity:-

(a) Payment made by the entity to any of its beneficiaries in any capacity, or

(b) Capitalization of profits.

If an entity's accumulated profits or other reserves are distributed to its beneficiaries not as a cash dividend but in the form of bonus shares, or by increasing the face value of shares, or by crediting amounts to the share premium account, this is considered capitalisation of profit.

(2) Notwithstanding anything contained in sub-section (1), any payment referred to in clause (a) of that sub-section shall be deemed to have been distributed only in the following circumstances:-

(a) Where the payment exceeds the amount paid by a beneficiary to the entity in exchange for a consideration likely to be obtained from the entity, and

(b) Where the following amounts are not included in the payment:-

(1) The amounts included in computing the income of the beneficiary,

(2) The payments from which tax has been deducted finally except for reason of distribution.

Sub-section (2) excludes the following payments from being distributions: a payment from an entity to a beneficiary that is required to be included in the beneficiary's taxable income computation; and a payment from which tax has been withheld finally, other than by reason of the distribution.

Example 13.5.1: If Raju Sharma, a beneficiary of Surya Pvt. Ltd., provides consultancy services to the entity and receives a service fee of Rs. 1 lakh, the entity must withhold advance tax on such payment under Section 88 of the Act. However, that amount is not a distribution from the entity. Such amount must be included in the beneficiary's taxable income. Similarly, if Raju Sharma, who has no other business, receives rental income from the entity for using his personal vehicle, advance tax must be withheld under Section 88, but that amount is not a distribution from the entity either. It falls under payments from which tax is withheld finally.

Example 13.5.2: Suppose Chheting Dorje is a shareholder and managing director of Shital Garment Pvt. Ltd. He provided Rs. 5 lakh as working capital to the company. When the company refunded this amount, even though the payment was made to a beneficiary, since it is a refund of the amount paid by the beneficiary, it is not a distribution.

Example 13.5.3: Suppose Sampoorna Bank Ltd. has employed Jamal. Jamal is also a shareholder of the bank. In income year 2080/81, Sampoorna Bank Ltd. deposited Rs. 5 lakh salary into Jamal's account at the bank. In that year, the bank credited Rs. 20,000 as interest (after tax withholding) on the amount in that account. In the same year, Jamal took a loan of Rs. 10 lakh from the same bank for purchasing a private home at the same interest rate applicable to other persons and under the same conditions, and the bank directly paid the loan amount to the home seller. The bank declared a 10 percent dividend in that year, and accordingly Jamal received Rs. 5,000 as dividend from the bank after tax withholding, based on his investment. In this case, the salary received by Jamal for working at the bank, the interest received for maintaining a deposit, and the loan facility received at market interest rates are not treated as distributions. Only the dividend received by Jamal in that year is treated as a distribution.

(3) Only if the distribution of any entity reduces the value of asset or liability of that entity, such distribution shall be deemed to be a distribution of profits or return of capital.

Example 13.5.4: Suppose the balance sheet of ABC Co. Pvt. Ltd. is (amounts in Rs. lakhs):

Suppose the company declared a 10 percent dividend distribution in this income year. The company's assets and accumulated profit decrease, so Rs. 2 lakh is treated as a distribution.

(4) In any of the following circumstances, a distribution of any entity shall be deemed to be a distribution of profits, subject to Section 55:-

(a) Where the distribution is of a type referred to in sub-section (3) and the amount as per the market value of the asset exceeds the total amount of the capital contribution consisting of the market value of the liability of the entity at the time of distribution and of capitalized profits, as well, and

(b) Where profits are capitalized.

Example 13.5.5: Suppose Jumbo Feed Pvt. Ltd. has assets of Rs. 10 lakh. Share capital is Rs. 9 lakh, reserve is Rs. 50,000, and other liabilities are Rs. 50,000. The market value of the company's assets is Rs. 12 lakh and the market value of liabilities is Rs. 50,000. The total of share capital and liabilities is Rs. 9.5 lakh, while market value of assets is Rs. 12 lakh.

A payment of up to Rs. 2.5 lakh is treated as a profit distribution, and any payment beyond that is treated as a return of capital.

Suppose the shareholder takes Rs. 3,00,000:

• Distribution = Market value of assets less market value of liabilities less paid-up capital = Rs. 12,00,000 - Rs. 50,000 - Rs. 9,00,000 = Rs. 2,50,000.

• Since payment is Rs. 3,00,000, Rs. 2,50,000 is treated as a distribution (profit-first) and the excess Rs. 50,000 as a return of capital.

Capitalisation of profit refers to the process by which an entity, instead of distributing its earned profits or similar amounts as cash dividends, distributes to its shareholders in the form of bonus shares.

Example 13.5.6: Suppose Jumbo Feed Pvt. Ltd. has net assets of Rs. 1,000,000 and share capital of Rs. 950,000. A shareholder named Hari has purchased shares of the company worth Rs. 400,000. In addition, Hari has been lent Rs. 200,000 by the company, which amount has been included in the company’s net assets.

If the company waives (forgives) this loan of Rs. 200,000, the amount waived is treated as a distribution under Section 53, because the company’s net assets are reduced by that amount.

As a result of this distribution, the company’s net assets decrease from Rs. 1,000,000 to Rs. 800,000.

In this case, the market value profit is only Rs. 50,000 (i.e., the difference between net assets of Rs. 1,000,000 and share capital of Rs. 950,000). Therefore:

• Rs. 50,000 is treated as distribution of profit, and

• The remaining Rs. 150,000 is treated as return of capital.

The profit portion of Rs. 50,000 is subject to final withholding tax on dividend under Section 92.

If Hari had purchased shares of only Rs. 90,000, then after adjusting:

• Loan waived = Rs. 200,000

• Profit distribution = Rs. 50,000

• Return of capital = Rs. 150,000

Since the return of capital exceeds the investment, the excess amount is treated as income exceeding outgoings under Section 40(3)(b). Accordingly, a gain of Rs. 60,000 is included in his income under Section 37.

Example 13.5.7: Suppose Jumbo Feed Pvt. Ltd. has accumulated reserves of Rs. 50 lakh in its balance sheet. The company’s share capital consists of 200,000 shares of face value Rs. 100 each, totaling Rs. 20 crore. In the current income year, the company decides to issue bonus shares at the ratio of 1:5. Such a situation is considered as capitalization of profit.

For capitalization of profit, the following accounting entry is passed:

Reserve A/C Dr. Rs. 40,00,000

To Share Capital A/C Rs. 40,00,000

Thus, capitalization of profit is also treated as a distribution made by the entity.

Example 13.5.8: Suppose Jumbo Feed Pvt. Ltd. has:

• Accumulated profit of Rs. 50 lakh, and

• Share premium of Rs. 90 lakh in its balance sheet.

The company’s share capital consists of 200,000 shares of face value Rs. 100 each, totaling Rs. 2 crore.

In the current income year, the company decides to issue:

• Bonus shares at the ratio of 1 : 5 from accumulated profits, and

• Bonus shares at the ratio of 2 : 5 from the share premium account.

The bonus shares issued equal to such capitalization of profits are treated as a distribution.

For the purpose of capitalization, the following accounting entries are passed:

Accumulated Profit A/C Dr Rs. 40,00,000

Securities Premium A/C Dr Rs. 80,00,000

To Share Capital A/C Rs. 1,20,00,000

Thus, capitalization of profit in this manner is treated as a distribution made by the entity.

(5) The distribution referred to in sub-section (3) shall be deemed to be a return of capital to the extent of non-distribution of profits.

(6) The distribution of any entity shall be deemed to be a dividend of that entity to the extent of non-return of capital.

Explanation: For the purposes of this Section, "capitalization of profits" means and includes any capitalization made by issuing bonus share or similar other interest or increasing the paid-up sum of the interest of that entity or crediting the profits to the premium and capital account of that entity.

Distribution by an entity (Sec 53): a distribution = (a) any payment by the entity to a beneficiary in any capacity + (b) capitalisation of profit (bonus shares, raising face value, crediting share premium).

NOT a distribution: amounts already included in the beneficiary's income, final-WHT payments (other than the distribution itself), or a refund of what the beneficiary paid in (53(2)).

A payment counts as profit/capital only if it reduces the entity's net assets (53(3)).

Profit-first rule: (market value of net assets – (paid-up capital+liabilities)) is dividend first, the excess is a return of capital (53(4)/(5)/(6))

54. Tax on dividend

(1) On the dividend distributed by a resident entity, it shall be as follows:-

(a) If dividend is distributed to the shareholder of any company or partner of any partnership firm, tax shall be imposed as per the mode of final tax deduction, and

Example 13.6.1: Suppose Jahir Miyan is a shareholder of Jumbo Feed Pvt. Ltd. with an investment of Rs. 1 lakh. The company declared dividends at 10 percent in income year 2080/81. When paying Rs. 10,000 (10 percent of Jahir Miyan's investment) as dividend, Rs. 500 (5 percent under Section 88 of the Act) must be withheld as dividend tax and Rs. 9,500 paid. Such dividend paid after tax withholding is a payment from which tax is withheld finally under Section 92 of the Act.

Example 13.6.2: Suppose XY is a partnership firm with partners X and Y. The partnership deed provides for profit and loss distribution in the ratio 2:1. In income year 2080/81, the entity's post-tax profit is Rs. 60,000 and per the partnership deed, the entity distributed Rs. 40,000 to X (two-thirds) and Rs. 20,000 to Y (one-third). Dividend tax is levied on such distributed dividends.

(b) No tax shall be imposed on distribution, if any, made by other entities.

(2) The dividend distributed by any non-resident entity to any resident beneficiary shall be included in the income of the beneficiary and tax imposed accordingly.

Example 13.6.3: Suppose Dabur India Ltd. is a company established in India. A Nepali resident of Indian nationality, Kamal Srivastava, has an investment of Rs. 2 crore in that company but the entity is not a controlled foreign entity in relation to Kamal Srivastava. If Dabur India Ltd. declares dividends at 20 percent, the dividend of Rs. 40 lakh received by Kamal must be included in his investment income when computing income.

Example 13.6.4: Suppose Pankaj Jalan, an Indian national residing in Nepal, has a partnership firm in India with an Indian. Pankaj received Rs. 4 lakh from that partnership in the current year. Pankaj must include his share of the partnership in his investment income when computing income.

However, dividends distributed by a controlled foreign entity under Section 69 of the Act need not be included in income per the provisions of this section.

(3) Notwithstanding anything contained in sub-section (1), no tax shall be levied on the dividend received after tax deduction if it is distributed.

If dividends received after final tax withholding are further distributed as dividends, no dividend tax withholding is required on such distribution up to the amount of that previously taxed dividend.

Example 13.6.5: Suppose Kamal & Sons Pvt. Ltd. receives a dividend of Rs. 1,000,000 from a resident company named Lobo & Co. Ltd., after deduction of dividend tax. Before including this dividend income, the profit of Kamal & Sons Pvt. Ltd. was Rs. 9,000,000. After adding the dividend income of Rs. 1,000,000, the total amount available for distribution becomes Rs. 10,000,000. In the same income year, Kamal & Sons Pvt. Ltd. declares and distributes a cash dividend of Rs. 10,000,000 to its shareholders. One of the shareholders of Kamal & Sons Pvt. Ltd. is Bimal Thapa. Bimal Thapa receives a dividend of Rs. 500,000.

While making this payment, the company must deduct dividend tax of Rs. 22,500 and pay the net amount of Rs. 477,500 to Bimal Thapa.

Calculation:

• Total profit distributed as dividend: Rs. 10,000,000

• Dividend income received by the company (after tax): Rs. 1,000,000

• Portion of dividend income in total profit = 1,000,000 / 10,000,000 = 10%

• Dividend payable to Bimal Thapa: Rs. 500,000

• Portion not subject to tax (10%): Rs. 50,000

• Portion subject to tax (90%): Rs. 450,000

• Dividend tax @ 5% on taxable portion= 5% × 450,000 = Rs. 22,500

• Net dividend paid to Bimal Thapa= 500,000 − 22,500 = Rs. 477,500

A company with dividend income that further distributes dividends must keep separate accounts of each year's dividend income received and the dividend amounts distributed from such income, since no dividend tax is required when re-distributing the previously taxed dividend income to beneficiaries.

(4) ......

(5) The incomes referred to in Chapter-8 receivable for the interest of a beneficiary of an entity shall include the amount for capital return made by any entity for that interest.

Provided that the dividend distributed by the entity is not required to be included.

Tax on dividend (Sec 54): dividend from a RESIDENT company/partnership to shareholders/partners = FINAL withholding tax (5% u/s 88, then no further tax and not in the income return). Distributions by other entities = no tax (54(1)(b)).

Dividend from a NON-RESIDENT entity to a resident = included in the resident's investment income and taxed (54(2)), except dividends already taxed as a controlled foreign entity under Sec 69.

Re-distribution of an already-final-taxed dividend = no further dividend tax up to that amount (54(3); keep separate year-wise records)

55. Dissolution/Liquidation of entity

When computing payments made by an entity on the grounds of dissolution, the amount up to the market-value profit (net worth at market price less paid-up capital) is treated as a distribution. However, in the case of payments made to beneficiaries through changes in share structure (buyback, forfeit, surrender, internal reconstruction, redemption, and so on), a return of paid-up capital may still be treated as a distribution. In payments to beneficiaries, the profit-first approach applies, but in payments made through restructuring of share structure, a capital-first approach is applied. "Change in share structure" refers to a change in the number of shares (in entities with enumerable shares) or in the share amount (such as joint ventures). Even if the change in share structure is partial, this Act treats it as dissolution of the entity in the case of joint ventures. However, in the case of complete dissolution and final payment, the profit-first approach always applies.

Example 13.7.1: Suppose Lalitpur Company Ltd. has a paid-up capital of Rs. 6 crore. The firm was completely dissolved. Upon such dissolution, the firm's assets were disposed of and Rs. 7 crore was received. In the case of complete dissolution, the distribution is computed on a profit-first basis, and of the payment amount, the first Rs. 1 crore is treated as a distribution and the remaining Rs. 6 crore as a return of capital.

However, if only Rs. 3 crore out of that amount is distributed, the payment is treated as partial return of capital and partial distribution under Section 55(1), using the capital-first approach. If the pre-distribution market value of assets is Rs. 7 crore, the Rs. 3 crore distributed is allocated as: return of capital (600/700 = 85.71% of Rs. 3 crore) Rs. 2,57,13,000; distribution Rs. 42,87,000. Dividend tax applies on the distribution of Rs. 42,87,000.

Example 13.7.2: Suppose in the above example, the total value of assets realized is only Rs. 4 crore. In this case:

"Distribution"="Market value of net assets"-"Paid-up capital"=4-0-6=(-2)" crore (negative capital return)". Since the paid up capital is Rs. 6 crore and the actual payment available is only Rs. 4 crore, the entire amount of Rs. 4 crore is treated as return of capital.

(1) A distribution made in proportion to the portion of profit earned by and that of capital contributed by any beneficiary in disposing the interests in the course of dissolution of any entity shall be deemed to be the payment of partial dividend and partial capital of that entity, if all of the following conditions are fulfilled:-

(a) Where any distribution has been made by such entity in respect of cancellation, release or acceptance of the interest in that entity because of, inter alia, purchase by the entity of its interest or dissolution of the entity by following the process of law in force,

(b) Where, except in cases of full dissolution, the rights of the beneficiaries in the portion of profits of that entity have not been computed in proper proportion or could not be computed reasonably, and

(c) Where the beneficiary who gets that distribution is not an associated person with the entity after the disposal.

This rule is about how to classify money received by a beneficiary when an entity returns money during dissolution or cancellation of ownership interest. It prevents people from treating the whole amount as only capital return and avoiding dividend tax.

Simple meaning

When an entity gives money to a beneficiary (shareholder/partner/member) because the beneficiary's interest is cancelled, bought back, released, or the entity is dissolved, the payment may be treated as:

→ Part dividend (profit distribution) + Part capital return (return of invested amount)

This happens only if all three conditions are satisfied.

Conditions explained:

(2) Notwithstanding anything contained in sub-section (1), the provisions contained in that sub-section and Section 53 shall not be applicable if any entity purchases the interest of any beneficiary in the entity through the securities market recognized under the law in force and makes distribution to that beneficiary.

Example 13.7.3: Nepal Danphe Company Ltd. purchased 1,000 shares of Rs. 100 face value owned by its shareholders at Rs. 500 each through the Nepal Securities Exchange Market. This is treated as the company investing in its own shares (treasury stock investment). The Rs. 5,00,000 (1,000 shares at Rs. 500) received by the selling shareholder is not treated as a profit distribution or return of capital under Section 53 but only as an investment in another company. Since Section 53 is not attracted, the gain computed under Section 36 shall be subject to tax.

Dissolution of an entity (Sec 55): on COMPLETE dissolution / final payment, the profit-first approach applies - (market value of net assets − paid-up capital) is dividend (taxed), the rest is return of capital.

On a PARTIAL change in share structure (buyback, forfeiture, surrender, redemption, internal reconstruction), a capital-first approach applies. Treasury-stock purchase through the recognised securities market = NOT a distribution or return of capital; instead the gain is taxed under Sec 36 (55(2))

56. Transaction between entity and beneficiary

(1) Subject to Section 45, if a asset is disposed through transfer of ownership over the asset in any manner of distribution between an entity and its beneficiary or in any other manner, it shall be as follows:-

(a) The transferor of the asset shall be deemed to have received, from the disposal, an amount equal to the market value of the asset immediately before the disposal, and

(b) The transferee of the asset shall be deemed to have incurred cost in a sum equal to that mentioned in clause (a) in acquiring the asset.

(2) Subject to Section 45, if any liability is disposed through transfer of the liability between any entity and its beneficiary, it shall be as follows:-

(a) The transferor of the liability shall be deemed to have incurred cost, in disposing the liability, in a sum equal to the market value of the liability immediately before the disposal, and

(b) The transferee of the liability shall be deemed to have received an amount equal to that mentioned in clause (a) in assuming the liability.

If the transfer meets the conditions of Section 45(6), assets at net cost and liabilities at net income; if the transfer does not meet the conditions of Section 45(6), the transfer is deemed to have occurred at market value, and the entity making the disposal must include the gain on disposal in income.

Example 13.8.1: Suppose Danphe Company Ltd. is a car dealer. Lakpa Sherpa holds 40 percent of the shares in that company. The company sold a car worth Rs. 15 lakh to Lakpa Sherpa at Rs. 8 lakh. The company must include Rs. 15 lakh in income when computing business income. Since this transfer does not satisfy the conditions of Section 45(6), the quantification of the transfer is treated as having occurred at market value, Rs. 15 lakh. For purposes of Section 53, the difference of Rs. 7 lakh is treated as a distribution.

Example 13.8.2: Suppose Chheting Dorje is a shareholder and managing director of Shital Garment Pvt. Ltd. The company has been engaged in manufacturing garments. He purchased garments worth Rs. 500 from the company at Rs. 100. Since he is both managing director and beneficiary of the company, if he does not include the difference of Rs. 400 in his own income, that Rs. 400 is included in the company's income and treated as a distribution of Rs. 400 from the company to him.

(3) If any entity distributes dividends other than profits as dividends to any beneficiary, the amount of such dividends shall be included in computing the income of the entity.

Provided that provisions may be made to exclude the matters contained in this sub-section in any circumstance as prescribed.

Rule 18(1): For purposes of the proviso clause of Sub-section (3) of Section 56 of the Act, in cases where any entity distributes dividends except profits to any beneficiary for the following acts, for any other reason except in the course of carrying on the business of that entity, the dividends need not be included in computing the income:

(a) the service provided by that entity to the beneficiary; or

(b) the asset under ownership of that entity, which has been provided for the use of the beneficiary.

Rule 18(2): In the cases as referred to in Sub-rule (1), no expenses including depreciation deduction shall be deducted in respect of such service or asset.

Under the above provisions of the Act and Regulations, if any entity distributes as dividends any profit, gain, or income amount not reflected in its profit and loss account, such distributed amount must also be included in the income of that entity for the income year in which the distribution occurred.

Transaction between entity & beneficiary (Sec 56): on transfer of an asset/liability between an entity and its beneficiary - if it meets the Sec 45(6) group-rollover conditions: at net cost / net income (no gain). If NOT: deemed at MARKET VALUE, and the shortfall is also treated as a distribution u/s 53 (e.g. company sells a Rs. 15 lakh car to a 40% shareholder for Rs. 8 lakh → Rs. 15 lakh in income, Rs. 7 lakh a distribution).

56(3): if an entity pays dividends out of non-profit amounts, that amount is included in the entity's income (Rule 18 exception: services/assets the entity provides to a beneficiary outside its business are excluded, but then no related expense or depreciation may be claimed)

57. Change in control

(1) If the ownership of any entity changes by fifty percent or more as compared to its ownership until before the last three years, the entity shall be deemed to have disposed of the property under its ownership or the liability borne by it.

Provided that this section shall not apply in the following circumstances:

(a) where, in a startup venture capital fund or private equity fund, the number of shares and capital held by the existing shareholders or partners remain unchanged, and additional shareholders or partners are admitted resulting in an increase in capital; or

(b) where, due to the death of a beneficiary (interest holder) of an entity, the interest held in that entity is transferred to the lawful heir through succession; or

(c) where there is a change in the ownership of a resident entity solely because of a change in ownership of another resident entity holding an interest in that entity.

(1a) For the purpose of computing the change in ownership of fifty percent or more of any entity referred to in sub-section (1), only the following ownership of such entity shall be included:-

(a) Ownership held by a shareholder or partner holding one percent or more of the total ownership, and

(b) Ownership held by the associated person of a shareholder or partner holding less than one percent of the total ownership, among shareholders or partners holding more than one percent of the total ownership.

Example 13.10.1: Suppose Company "C" distributed shares on Baishakh 1, 2078. Company "A" holds 30 percent and Company "B" holds 35 percent in that company. At the end of Chaitra 2079, Company "A" sold all its 30 percent shares in Company "C" to Company "D". Since the ownership change is only 30 percent, Section 57 of the Act is not attracted. On Chaitra 15, 2080, Company "B" also sold all its 35 percent shares in Company "C" to Company "E". The period from the end of Chaitra 2079 when Company "A" and Company "B" sold their shares falls within three years. Within 3 years, Company "A" sold 30 percent and Company "B" sold 35 percent, totalling 65 percent. Since ownership in the entity changed by more than 50 percent, Section 57 is attracted in relation to the ownership change of Company "C" Pvt. Ltd. on Chaitra 15, 2080.

Example 13.10.1A: Suppose Kedar Pant is the sole owner of Aayusha Company Pvt. Ltd. with a paid-up capital of Rs. 40 lakh. Due to lack of capital, in income year 2080/81, approval was obtained from the Company Registrar's Office to increase the capital by Rs. 60 lakh, bringing the total capital to Rs. 1 crore. This additional capital was invested by Kedar Pant himself. Even though the company's capital increased, ownership was 100 percent with Kedar Pant before and remains 100 percent with him after the capital addition, so there is no change in ownership and Section 57 is not attracted.

Example 13.10.3: Suppose Danphe Company Pvt. Ltd. was established on Baishakh 2, 2078 with share capital of 2,000 shares at Rs. 1,000 each. The shareholders include Mr. B holding 30 shares (1.5%) and Mrs. B holding 5 shares (0.25%). If Mr. B and Mrs. B are husband and wife, so, they are associated persons. Even though Mrs. B's 0.25 percent is less than one percent, since Mr. B holds 1.5 percent, if Mrs. B sells her shares, that transfer must be included in the computation for ownership change purposes. However, if a shareholder Mr. D holding 5 shares (0.25%) is not associated with any other shareholder, when Mr. D sells his shares, his 0.25 percent need not be included in the ownership change computation.

If the ownership of an entity changes by fifty percent or more within the three-year period, the entity is deemed to have disposed of assets in its ownership and liabilities it assumed. This provision is clarified in the following example:

Example 13.10.4: Suppose the ownership of Danphe Company Pvt. Ltd. changed by 50 percent on Chaitra 15, 2078. On that date, the assets and liabilities of Danphe Company Pvt. Ltd. are as follows:

Description of Assets and Liabilities as at Chaitra 15, 2078

Since Section 57 ownership change is deemed to have occurred for Danphe Company Pvt. Ltd. on Chaitra 15, 2078, on that date the trading stock, depreciable assets, and business assets and liabilities of the company are deemed to have been disposed of at market value, and the resulting gain or loss is included in taxable income.

Example 13.10.5: Suppose the tax-basis balance sheet position of Dahal Limited as at Magh 15 is as follows, and 55 percent ownership was transferred. In such a case, all assets and liabilities are deemed to have been disposed of at market value under Section 41.

Here:

1. When computing the aggregate group of depreciable assets, the remaining depreciation basis of Rs. 5,000 at the end is treated as terminal depreciation expense.

2. The net gain of Rs. 10,000 on disposal of business assets and liabilities is computed under Section 36 and included in amounts that form part of business income.

After such deemed disposal of assets and liabilities, the company must recognise the following income and expenditure from the disposal. Since assets and liabilities are deemed to have been disposed of while still held by the entity, this is called disposal with retention. Whenever an asset or liability is disposed of or deemed to have been disposed of, the resulting gain or loss from such disposal must be computed for income tax purposes. Under Section 40, if incomings from disposal exceed outgoings, it is a gain; if outgoings exceed incomings, it is a loss.

Since this is a special deemed disposal (disposal with retention), the outgoings of assets or liabilities remain with the entity up to the time of disposal, but since no actual income is received from the disposal, Section 41 provides special rules to determine what income to recognise.

1. 1. Trading stock: the market value of closing stock at the time of disposal must be included in income under Section 7(2)(b), while the cost (book value) of closing stock must be deducted as an expense under Section 15.

2. 2. Depreciable assets: the gain or loss from disposal of depreciable assets must be computed under Schedule-2, Section 4 of the Act. The market value of each group of depreciable assets remaining with the entity is treated as incomings; subtracting the remaining depreciation basis for that group, if the remainder is higher, the excess (balancing charge) must be included in income; if lower, that amount is a terminal depreciation expense deduction.

3. 3. Business assets: the market value of business assets held by the entity is treated as incomings and the actual cost as outgoings. If incomings exceed outgoings, it is a gain; if outgoings exceed incomings, it is a loss. If one business asset shows a gain and another shows a loss, the losses are offset against gains and the net gain or net loss is determined.

(2) If the ownership of any entity is changed as mentioned in sub-section (1), the entity shall not be allowed to carry out the following acts after such change:-

(a) To deduct interest incurred by that entity prior to the change in ownership and carried forward pursuant to sub-section (3) of Section 14,

(b) To deduct the loss suffered by that entity prior to the change in ownership pursuant to Section 20,

(c) To carry back a loss suffered after the change in ownership in any income year before such change pursuant to sub-section (4) of Section 20,

(d) To make adjustment pursuant to sub-section (4) of Section 24, if it has been calculated for any amount or expenses prior to the change in ownership and correction has been made on that amount or expenses pursuant to sub-section (4) of Section 24 after the change in ownership,

(e) To make adjustment pursuant to sub-section (1) of Section 25, if any amount has been calculated pursuant to clause (b) of sub-section (1) of Section 25 prior to the change in ownership and the right to receive that amount has been relinquished or in the event of that being a debt claim, such person has written off such amount as a bad debt after the change in ownership,

(f) To subtract pursuant to Section 36 the loss suffered in disposing any property or liability prior to the change in ownership from the income earned from the disposal of the property or liability after the change in ownership,

(g) If premium has been calculated pursuant to sub-clause (1) of clause (b) of sub-section (2) of Section 60 prior to the change in ownership and such premium has been returned to the insured after the change in ownership, to claim for credit accordingly, or

(h) To carry forward in the forthcoming year the tax paid in respect of a foreign income prior to the change in ownership pursuant to sub-section (3) of Section 71.

If the entity whose ownership changed is engaged in general insurance business and had accounted for premium as insurer before the ownership change, if such premium is refunded to the insured after the ownership change, such premium amount cannot be claimed as an expense deduction when computing taxable income after the ownership change. If an entity with foreign source income experiences an ownership change and had paid more foreign tax than domestic tax before the ownership change, such excess foreign tax cannot be offset against domestic tax payable after the ownership change.

(3) If the ownership of any entity changes in any income year in any manner mentioned in sub-section (1), the parts before and after the change in ownership in that income year shall be treated as separate income years.

If an entity's ownership changes per Section 57, the periods before and after the ownership change in the income year of the change must be treated as separate income years. Separate income returns must be filed for the period before and after the date. When preparing income returns for the post-ownership-change period, assets and liabilities must be valued at the market value at the time of the ownership change. The income return for the period before the ownership change must be filed within three months from the date of ownership change.

Example 13.10.7: Suppose the ownership of Danphe Company Pvt. Ltd. changed on Chaitra 15, 2079. The company must file the income return for the pre-ownership-change period (Shrawan 1, 2079 to Chaitra 15, 2079) within 3 months from that date, by Ashadh 14, 2080. The income return for the period from Chaitra 16, 2079 to the end of Ashadh 2080 must be filed by the end of Ashwin 2080.

Example 13.10.6: Suppose the assets and liabilities of Danfe Company Pvt. Ltd. are as follows on Chaitra 2, 2078 (BS) on the date of change of ownership:

Based on the above details, the following amounts from deemed disposal of assets and liabilities must be included in income:

A. Assets:

Trading Stock: The market value of closing stock at the time of disposal is Rs. 6,00,000 (representing the company's selling price at the time of ownership change). This must be included in income under Section 7(2)(b). The book value (cost) of closing stock, Rs. 5,00,000, must be deducted as an expense under Section 15.

Depreciable Assets: The remaining depreciation base (after depreciation) is Rs. 4,00,000 and the market value at time of disposal is Rs. 6,00,000. Therefore: Incomings (market value) Rs. 6,00,000 minus remaining depreciation base Rs. 4,00,000 (outgoings) = Balancing Charge of Rs. 2,00,000, which must be included in income under Section 7(2)(d).

Business Assets: Land, investments, cash balance, bank balance, and foreign currency bank balance are all business assets for the company. Gains and losses are calculated separately for each:

The net gain of Rs. 40,50,000 (= Rs. 50,00,000 + Rs. 50,000 - Rs. 10,00,000) from business assets must be included in income under Section 7(2)(ga).

B. Liabilities:

In the above example, the share capital and accumulated liabilities (post-tax) shown have market values always equal to their book values, so no gain or loss arises from deemed disposal of these liabilities. The other liabilities also have market values equal to book values, so no adjustment is required. However, if any liability's deemed disposal produces a gain or loss, the same netting approach as applied to business assets is followed, and the net gain is included in income under Section 7(2)(ga).

Change in control (Sec 57): if an entity's ownership changes by 50% or more compared to 3 years earlier, the entity is DEEMED to dispose of all its assets & liabilities at market value (gains/losses realised and taxed under Sec 41), AND tax attributes from the previous owners' period (loss carry-forwards etc.) cannot be carried forward. Measure the change over a rolling 3-year window (a single transfer or cumulative transfers).

57(1a): count only owners holding 1% or more - but a sub-1% holder who is an associated person of a 1%+ holder is also counted.

Exceptions: a pure capital increase by the same owner (no ownership change); and adding new investors to a startup venture-capital / private-equity fund where the old shareholders' shares & capital stay unchanged

58. Provision restricting reduction of dividend tax

An entity may distribute profits earned to its beneficiaries. Such distributions are generally called dividend distributions. Dividends may be distributed in cash, as bonus shares, or in any other form. Sometimes, arrangements between entities and beneficiaries may be made with the intent to evade dividend tax. Section 58 of the Act provides for the following provisions to ensure dividend tax is paid in such circumstances. If all the provisions of this Section are attracted, dividend misappropriation is deemed to have occurred and dividend tax is collected.

(1) An arrangement made by any entity upon maintaining all of the following conditions shall be deemed to be an arrangement made for reducing dividend tax:-

(a) Where profit of such entity is reserved, current or expected,

(b) Where any person who acquires an interest of the entity and the recipient of the interest or his or her associated person makes any payment to the present or previous beneficiary of the entity or his or her associated person irrespective of whether or not it is related to the acquisition of interest and whether or not it is made at the time of acquisition of interest,

(c) Where the payment is fully or partly reflected in the profits of the entity, and

(d) Where the entity distributes dividends to the recipient of interest and the profits cover the dividends fully or partly.

(2) If dividends are distributed by any entity under an arrangement reducing dividend tax made pursuant to sub-section (1), the arrangement shall be deemed to be as follows:-

(a) Payment made by the recipient of interest or his or her associated person shall not be deemed as payment made by that person but as distribution by that entity of dividends to the previous or present beneficiary referred to in clause (b).

(b) Dividends distributed by that entity to the recipient of interest shall be deemed as equal to a sum to be set by subtracting the amount of payment said to have been made from the dividends referred to in clause (a).

Authors Explanation

Mr. A acquires 90% shares of Sunrise Manufacturing Pvt. Ltd. The company has accumulated reserves and expected annual profits of NPR 15 million. Instead of investing entirely as equity, Mr. A structures NPR 40 million as a shareholder loan. During the year, the company earns NPR 15 million operating profit and pays NPR 12 million interest to Mr. A on the shareholder loan. After deducting the interest expense, remaining profit is NPR 3 million, which is distributed as dividend.

Section 58(1) applies because:

(a) the company has reserved/current/expected profits;

(b) Mr. A acquired interest in the company and payments are connected with that acquisition;

(c) the interest payment reduced company profits since it was claimed as expense; and

(d) the company still distributed dividend from remaining profits.

Under Section 58(2)(a), the NPR 12 million interest payment is not treated as interest but deemed to be dividend distributed by the company to Mr. A. Under Section 58(2)(b), the actual dividend of NPR 3 million is adjusted against the deemed dividend already recognized through the interest payment. Therefore, the arrangement is recharacterized so that the economic distribution of profits is treated as dividend rather than deductible interest.

In substance, although the arrangement was legally structured as:

Interest: NPR 12 million

Dividend: NPR 3 million

the tax authority may treat the entire extraction of profits as dividend distribution to prevent reduction of dividend tax.

Example 13.11.1: Danfe Company Pvt. Ltd. is a resident person of Nepal. Donald Inc., a non-resident company, purchased 100% of its shares. Danfe Company Pvt. Ltd. has been earning profits every year. However, instead of distributing those profits to Donald Inc. (its beneficiary), the company has been accumulating them. Suppose the accumulated profit reached Rs. 1,00,000. Sky Company Pvt. Ltd. is another company incorporated in Nepal. Sky Company Pvt. Ltd. purchased all shares of Danfe Company Pvt. Ltd. from Donald Inc. for Rs. 1,60,000. After purchasing the shares, Danfe Company Pvt. Ltd. declared dividends of Rs. 70,000 and distributed them to Sky Company Pvt. Ltd. (now the shareholder).

In this case, out of the Rs. 1,00,000 paid by Sky Company to Donald Inc. for the shares, the Rs. 70,000 that has now been distributed as dividends is not treated as dividends received by Sky Company. Instead, it is deemed to be dividends distributed by Danfe Company Pvt. Ltd. to Donald Inc.

Suppose the applicable withholding tax rate for resident shareholders on dividends in the year of distribution was 5%, and the applicable rate for Donald Inc. (a non-resident) in the year it sold its shares was 10%. In such a case, the dividend deemed to be received by Donald Inc. should have been withheld at the non-resident rate of 10% at the time of actual payment.

Because this amount is deemed to have been distributed to Donald Inc., interest under Section 119 of the Act shall also apply, calculated from the actual year in which the distribution occurred.

Continuing the above example: if Company later distributes dividends of Rs. 1,10,000 (including profits earned from its own business operations) in some year, the situation is treated as follows:

Even though Sky Company physically receives all Rs. 1,10,000, only Rs. 10,000 is treated as Sky Company's dividend; the Rs. 1,00,000 is treated as Donald Inc.'s dividend for tax purposes.

Restriction on reducing dividend tax / dividend stripping (Sec 58): an arrangement is treated as dividend-tax avoidance if ALL apply - (a) the entity has reserved, current or expected profit + (b) the buyer of an interest (or associate) pays the previous/present beneficiary (or associate) + (c) the payment is reflected in the entity's profits + (d) the entity then distributes dividends to the buyer, covered by those profits. Effect (58(2)): the buyer's payment is re-characterised as a DIVIDEND distributed by the entity to the OLD beneficiary (taxed at the old beneficiary's rate, with Sec 119 interest), and the buyer's later dividend is reduced by that amount