CONCEPT OF SLUMP SALE & TAXATION ISSUES IN INDIA

Parth Semwal Trainee June-July 2011 INDEX

• Introduction• Undertaking in a slump sale• Computation of capital gains & Net

worth

• Case Law Study on direct tax liability on slump sale issues

4.1 Issues relted to direct tax attraction in slump sale

(i)Whether slump price is attributable to the stock in trade? (ii)Whether transfer of business or undertaking by way of slump sale constitutes transfer of capital asset and whether there was any cost of acquisition of such business or undertaking or division.(iii) Whether sale of the assets of an assessee effected for the purpose of closing down the business would be covered by that proviso and would be assessable as profit?

• Overall analysis of slump sale taxation

Introduction:The term slump sale is used when an undertaking or a business is sold withoutattributing separate values to each of the assets which are sold. In other terms, if there is asale of an undertaking or a business for a lump sum price it is considered to be a slumpsale. In the contemporary world the most fashionable form of such deals falls under theless-than-glamorous term of “slump sale” its defined under the section 2(42C) of IncomeTax Act, 1961- it says “slump sale” means the transfer of one or more businessundertakings as a result of the sale for a lump-sum consideration without assigning valuesto individual assets and liabilities in sale.The law expressly provides that “undertaking” shall have the meaning assigned to it inexplanation 1 to clause (19AA) specifically clarify that for the purposes of this clause,“undertaking” shall include any part of an undertaking, or a unit or division of an

undertaking or a business activity taken as a whole, but does not include individual assetsor liabilities or any combination thereof not constituting a business activity.Under Sec.293(1) (a) Companies Act, 1956 (CA) defines that sell, lease or otherwisedispose of the whole, or substantially the whole, of the undertaking of the company, orwhere the company owns more than one undertaking, of the whole, or substantially thewhole, of any such undertaking. The seller company can undertake a slump sale afterobtaining its share holder approval under Sec. 293(1) (a) of CA. Approval requires simplemajority of votes even for the entire undertaking of the company. A slump sale of anundertaking can be affected with the shareholders approval. It should be ensured that theMemorandum and Articles of Association of the transferor company contain enablingprovisions to affect such a sale.Vinati points out the main elements of a slump sale aretherefore (a) sale of an undertaking; (b) lump

sum consideration; and (c) no separate valuesare assigned to individual assets and liabilities. One of the major criteria under thedefinition is that the assessee should own the undertaking and should transfer theundertaking by way of sale. Singhania & Singhania in there book says that “Undertaking”for the purpose of the definition if the assets/ liabilities of the specific part of theundertaking cannot by themselves constitute a business activity. Likewise, transfer of assetswhich exclude a few significant assets without which the business cannot be carried oneffectively, may not be considered as a transfer of business. Moreover, they clarified thattransfer by any other mode (like compulsory acquisition) is not covered by the definition ofslump sale under section 2(42C).“Undertaking in a slump sale”As discussed above Income Tax Act (ITA) defines “undertaking” to include anypart of an undertaking, or a unit or division of an undertaking or a business activity taken asa whole, but does not include individual assets

or liabilities or any combination thereof notconstituting a business activity. (Explanation 1 to section 2(19AA) of the ITA). Until now,interpretation of this term has been at the center of substantial debateIn contemporary day’s debate over definition of “slump sale” as given in Sec. 2(42C) andalso to definition of the word “undertaking” the major issue is whether a particular businessactivity of an undertaking can be transferred on slump sale basis.To elaborate further on the above issue let us examine with the help of recent case whichcame before income tax appellate tribunal (ITAT) in Rohan Software Pvt. Ltd. v. IncomeTax Officer Background of the Case; M/s Rohan Software Pvt. Ltd (The Taxpayer) anIndian company which was engaged in the business of software development and relatedactivities. The taxpayer transferred assets and property in its business including intellectualproperty, codes, formulae and designs; the business along with all the rights to IPRs(intangible assets) developed was taken over

by M/s ICICI Infotech Services Ltd. (“IISL”)in 1999 for a lump sum consideration. However, the taxpayer did not transfer anybuildings, vehicles or other assets and liabilities pertaining to income tax matters. Thetaxpayer treated the transaction as a transfer of an “undertaking” by way of a slump saleand characterized the gains from the sale as long-term capital gains because theundertaking was owned and held for more than 36 months. The tax authorities took theposition that the transfer of intellectual property, codes, formulae and designs, did not, inand of itself, constitute the transfer of an “undertaking” as a going concern because thetaxpayer had not transferred certain assets of the undertaking. Also, it was alleged that thetransfer had been effectuated only for a period of three years. Accordingly, the taxauthorities treated the gains arising from the transfer as “business income.” In this tribunalclarified the definition “undertaking” shall have the meaning assigned to the undertaking.

Explanation 1 to Sec. 2(19AA) was introduced with effect from 01.04.2000 by the FinanceAct, 1999. “Undertaking” includes, as per the definition, any part of an undertaking, or aunit or division of an undertaking or a business activity taken as a whole, but does notinclude individual assets or liabilities or any combination thereof not constituting abusiness activity. Moreover, tribunal further elaborated that in the instant case of theassessee, though in the purchaser's books of account the individual assets have been priced independently, assessee had not assigned separate values and consequently sold the itemsfor independent price. It is not the revenue's case also those individual assets had the pricefixed separately and charged. “Undertaking” is explained in explanation 1 to section2(19AA). According to this Explanation, as we noted already above, includes any part ofan undertaking or a unit or division of an undertaking or a business activity as a whole.Therefore in light of abovementioned facts

tribunal decided that Sec.50B of the ITA, longterm capital gain on the slump sale was worked out and deduction under Sec. 54EA wasvalid to be claimed.The expression transfer as defined in Section 2(47) of the Act, includes several forms oftransfer; and sale is only one such form of transfer. Under Section 50-B any profits ongains arising from the slump sale affected in the previous year shall be chargeable toincome tax as capital gains.In case of calculate method of accounting from transfer of undertaking by slump transitionsSupreme Court of India in PNB Finance Ltd v. Commissioner of Income Tax-I, NewDelhi, had led down three important tests to find out whether it attracts rise to taxablecapital gains under Sec. 45 of Act. Whereas the second test which needs to be applied is thetest of allocation/attribution. This test is spelt out in the judgment of this Court in CIT v.Mugneeram Bangur & Co. this test applies to

a slump transaction. S.C clarifies that theobject behind this test is to find out whether the slump price was capable of being attributable to individual assets, which is also known as item-wise earmarking.15 Inaddition to the above laid test SC also lead down third test which distinguishes conceptualdifference between an undertaking and its components. Plant, machinery and dead stockare individual items of an Undertaking. Business Undertaking can consists of not onlytangible items but also intangible items like, goodwill, man power, tenancy rights and valueof banking licence. However, the cost of such items (intangibles) is not determinable. In thecase of CIT v. B.C. Srinivasa Settyreported16 in this Court held that sec. 45 charges surpluswhich arises on the transfer of a capital asset in terms of appreciation of capital value ofthat asset. In the said judgment, SC also held that the “asset” must be one which fallswithin the contemplation of Sec. 45.

Computation of capital gains & Net worth:Under Sec. 50B of the Income-tax Act, 1961,

introduced by Finance Act 1999 with effectfrom Assessment Year (AY) 2000-01, governs taxability of capital gains pursuant totransfer of an undertaking17 in a slump sale. It provide that any profits or gains arising fromthe slump sale effected in the previous year shall be chargeable to income-tax as capitalgains arising from the transfer of long-term capital assets and shall be deemed to be theincome of the previous year in which the transfer took place: Bare provision provided thatany profits or gains arising from the transfer under the slump sale of any capital asset beingone or more undertakings owned and held by an assessee for not more than thirty-sixmonths immediately preceding the date of its transfer shall be deemed to be the capitalgains arising from the transfer of short-term capital assets. sub sec 2 to sec. 50 B says thatcapital assets being an undertaking or division transferred by way of such sale, the “networth”18 of the undertaking or the division, as the case may be, shall be deemed to be thecost of acquisition and the cost of

improvement for the purposes of § 48 and 49 no regardshall be given to the provisions contained in the second proviso to sec. 48.Moreover under sub section 3 to sec. 50 B provides that every assessee, in the caseof slump sale, shall furnish in the prescribed form along with the return of income, a reportof an accountant as defined in the explanation below sub-section (2) of sec.28819 indicatingthe computation of the net worth of the undertaking or division, as the case may be, andcertifying that the net worth of the undertaking or division, as the case may be, has beencorrectly arrived at in accordance with the provisions of this section.Clause (g-a) of Sub-Section (1) of Sec.3 of the Sick Industrial Companies (SpecialProvision) Act, 1985 defines “net worth” means the Sum of total paid up capital and freereserve”20. Under the recent amendments to the SEBI (Disclosure and Investor Protection)[DIP] Guidelines, 2000: in clause 1.2.1, the

existing sub-clause (xixa) shall be substitutedby the following: “(xixa) “net worth” means aggregate of value of the paid up equitycapital and free reserves (excluding reserves created out of revaluation) reduced by theaggregate value of accumulated losses and deferred expenditure not written off (includingmiscellaneous expenses not written of) as per the audited balance sheet.”21 Under ITAexplanation 1of Sec.50 B defines “net worth” which shall be the aggregate value of totalassets of the undertaking or division as reduced by the value of liabilities of suchundertaking or division as appearing in its books of account: provided that any change inthe value of assets on account of revaluation of assets shall be ignored for the purposes ofcomputing the net worth. In addition explanation 2.-For computing the net worth, theaggregate value of total assets shall be, - (a) in the case of depreciable assets, the writtendown value of the block of assets determined in accordance with the provisions containedin sub-item (C) of item (i) of sub-clause (c) of

clause (6) of sec 43; and (b) in the case ofother assets, the book value of such assets.“Case Law Study on tax liability on slump sale issues”This chapter focuses on major tricky issues related tax attraction in slump sale Firstly,Whether the slump price is attributable to the stock in trade?CIT v. Mugneeram Bangur & Co.22 the Supreme Court was concerned with a problemarising on the sale of going concern. The firm had sold the business as a going concernwith its goodwill and all stock in trade, etc., to a company for a lump sum price. Sikri.J.,held that the sale was of a whole concern and no part of the price paid was attributable tothe cost of land and no part of the price was taxable. Sikri.J., quoted Lord Phillimoreobservation “If a business be one of purely buying and selling, like the present, a profitmade by the sale of the whole of the stock, if it stood by itself, might well be assessable toincome tax; but their view of the facts (if it be open to them to consider the facts) is thesame as that of Stout C.J. - that is, that this

was a slump transaction”.23 Ulitmely court heldthat the sale was the sale of the whole concern and no part of the slump price is attributableto the cost of land. Secondly, whether transfer of business or an undertaking by way ofslump sale constituted transfer of capital asset and whether there was any cost ofacquisition of such business or undertaking or division.In response to these issues Zuari Industries Ltd.v. ACIT24, the assessee was engaged in thebusiness of manufacture and sale of chemicals, fertilisers and allied products as well ascement and furniture. It sold its cement division located in Andhra Pradesh to Zuari inwhich 50 per cent stake was held by the assessee against lump-sum consideration. Thisscheme was effective from April 1, 2000. In the return filed for the assessment year 200102,it stated that the net worth of the cement division, as per computation done underSection 50-B of the Act. The claim of the

assessee was rejected by the assessing officer(AO). He computed the capital gains at Rs 226.443 crore. This was upheld by theCommissioner After insertion of Section 50B in the Act, profits on transfer of such asset ischargeable to tax under the head "Capital Gains" and cost of acquisition for the purpose ofSection 48 would be the net worth as computed under the provisions of Section 50B. Inview of this legal position, the Learned Counsel for the Assessee, perhaps, has not seriouslychallenged this aspect of the matter though raised before the lower authorities.Accordingly, we hold and proceed on the footing that profit arising on the transfer ofcement division by way of slump sale is chargeable to tax under the head “Capital Gain”.25In paragraph 9 of tribunal decision it was said that the value of assets as per books ofaccounts is much more than the value of liabilities. No prudent person would have

acquiredthe unit unless the value of assets or benefits attached to the division is more than theliability. The division was purchased since value of assets was more than the liabilities. It isbecause of written down value of assets Under sec 43(6)(c) of the Act, that value ofdepreciable assets had to be computed at substantially low figure which resulted in thevalue of assets lesser than liabilities but on that account net worth cannot be reduced belowthe “Nil” account since such process would be contrary to the scheme of the section itself.Therefore, in view of the above discussion, it is held that “net worth” of the cementdivision would be taken as “Nil” which shall be deemed to be the cost of acquisition for thepurpose of computing capital gain under Sec. 48 of the Act.26Thirdly, Whether sale of the assets of an assessee effected for the purpose of closing downthe business would be covered by that proviso

and would be assessable as profit?Commissioner of Income-tax, Kerala v. B. Kalikutty and Anr27 the facts are that theassessee was running the business of plying buses. He plied the buses for some time in theprevious year and sold them in that year. The question was whether the amount realised byhim in excess of their WDV up to their original cost was taxable under the second provisoto Section 10(2) (vii). The SC held that even on the assumption that the sale of businesswas a closing down sale or realistation sale the amount was nonetheless taxable since thesale was made after the amendment of the second proviso to Section 10(2)(vii) by Act No.67 of 1949. In that case their Lordships held that in CIT v. Ajax Products Ltd.28 the SCclarified the position about the effect of the amendment made in 1949 in the proviso andthey have also explained the impact of the amendment made in the second proviso on thethree conditions laid down by the Hon'ble SC in CIT v. Express Newspapers Ltd.29. Then

their Lordships of the Supreme Court observed as follows: The words 'whether during thecontinuance of the business or after the cessation thereof were not present in theunamended proviso. In the two decisions cited earlier, in the absence of such words, thisCourt held that to attract the said proviso the machinery shall have been sold before thebusiness was closed down. This clause omits that condition for the eligibility of the tax.Following the above decision the later decision of the SC in K.B. Kalikutty's case (supra)held that the amending words in the proviso eliminated the third condition which had beenlaid down for its applicability in the previous decision, vis., that the machinery shall havebeen sold when the business was being carried on and not for the purpose of closing itdown or winding it up.

Conclusion/Overall analysis of slump sale taxation It is an eye-catching selection for a business

entity desire for selling an undertaking, knowing the involvedness drawn in grit of the costs and taxes on any such arrangement designed for the transfer of business, it is wise for parties to settle and commercially concur on the cost burden of each party at the very outset. If we look to the S. 50B overrides the Sec. which provide the mode of computation of capital gains on sale of an asset, S. 50C, providing for substitution of sale consideration of land/building by its value as per valuation of stamp valuation authority, is not applicable where land/building is part of the undertaking. On the hand disadvantages is there is no indexation benefit is available.