The Insolvency and Bankruptcy Code ('IBC') was passed by the Parliament in the year 2016. It is well acknowledged that with IBC, Mergers and Acquisitions ('M&A') activity has seen an uptick in the country with Associated Chambers of Commerce and Industry ('ASSOCHAM') predicting almost USD 50 Billion worth of deals on back of stressed assets¹. With a time-bound process to resolve insolvency applications, the IBC has materially contributed to a staggering 30 place jump for India in 2018's 'ease of doing business' ranking². With domestic and foreign participation in these deals³, it has become imperative that we examine the Income-tax Act, 1961 ('IT Act') in detail to assess the direct tax impact of these deals on the Corporate Debtor ('CD') and the potential purchaser. For this purpose, this Article envisages a Resolution Plan ('RP') with the most common attributes.

In this regard, following steps may be considered:

- Debt waiver;

- Capital Reduction - Aiming to provide the Purchaser with major equity share capital of the CD;

- Conversion of debt into convertible instruments - Optionally Convertible Redeemable Preference Shares ('OCRPS'), etc.;

The above transaction steps and the associated tax liability have been analysed in detail herein below:

Part A: Debt Waiver

In absence of a specific provisions under the IT Act dealing with waiver of loans, the issue of waiver has been subject of prolonged litigation under Indian Courts. The Revenue Authorities have litigated the issue under two broad provisions - Section 28(iv) and 41(1) of the IT Act. Section 28(iv) is the computation provision for the head of income - Profits and gains of business and profession and sub-section (iv) thereof, specifically, states "value of any benefit or perquisite, whether convertible to money or not, arising from business or exercise of a profession" and Section 41(1) of the IT Act applies to a Tax Payer who has received some benefit by way of 'remission or cessation' of trading liability. Recently, the Hon'ble Supreme Court of India in Commissioner v. Mahindra and Mahindra⁴  made it amply clear Section 28(iv) shall not apply for waiver of loans - whether on capital or revenue account, since 'cash benefit' cannot be taxed as a business perquisite. Therefore, scope of this part is reduced to examining Section 41(1) of the IT Act and consequently, examining the scope of 'remission or cessation' of trading liability.

The term 'remission' may denote a positive or a voluntary act on part of the creditor to give up his claim on whole or part of the debt⁵. 'Cessation' on the other hand implies that the liability has ceased to exist in the eyes of law. Therefore, while remission necessarily flows from the creditor, cessation may flow otherwise. In the facts and circumstances of our case, there is no positive act on the part of the creditor and therefore, remission is ruled out. Cessation on the other hand is where it gets trickier - 'cessation' implies that for the CD the impugned liability does not exists anymore. There may be difference between enforceability of such right⁶, however to invoke Section 41(1) what needs to be satisfied is the extinguishment of such liability in the hands of the CD, and further, such liability is in the nature of trading liability and the CD has claimed a deduction under Section 36(1)(iii) qua the interest accrued thereto. Where the Tax Payer is able to prove otherwise, they may have a case to defend qua cessation of liability.

Part B: Capital Reduction

Section 2(22)(d) of the IT Act provides that any distribution by a company to its shareholders on, on reduction of capital, to the extent of the accumulated profits in the entity, whether capitalized or not, shall be treated as deemed dividend and is taxable as such.

Legislative Intent - Distribution qua accumulated profits

The Hon'ble Supreme Court in Punjab Distilling Industries Ltd.⁷, has explained the meaning of the expression 'distribution' as under:

"...The expression 'distribution' connotes something actual and not notional. It can be physical; it can also be constructive. One may distribute amounts between different shareholders either by crediting the amount due to each one of them in their respective accounts or by actually paying to each one of them the amount due to him.." (sic)

Therefore, distribution may be actual or notional, however there should be 'distribution' qua the accumulated profits.  In the facts and circumstances of our case, where the CD is under IBC proceedings it may be safe to assume absence of distribution and/or accumulated profits in the entity. Otherwise, selective capital reduction of the shares may be treated as 'transfer' under section 2(47) of the IT Act resulting in capital gain liability in the hands of the individual shareholders, and given the facts of the case, the shareholder may claim capital loss⁸  for the particular transaction. However, this view may be prone to litigation by the Revenue Authorities.

Section 56(2)(x) vis-à-vis Section 2(22)(d) of the IT Act

Section 56(2)(x) is a deeming fiction under the head of income - 'Income from other sources' ('IFOS'), which deems the difference between the Fair Market Value⁹  ('FMV') of any property (including shares) and the actual consideration discharged as 'Income' of the person receiving such property. The Revenue Authorities may argue that since the CD received shares (though for cancellation) for a consideration less than the FMV the same may be taxed as IFOS in the hands of the CD.

To mitigate the risk on this account it is advisable that the NCLT order itself provides for cancellation of equity share capital and the CD is not expected to 'receive' such share for cancellation purposes; however, if this may not be feasible it may be tenable to argue that any receipt for purposes of mere cancellation (for the purposes of Capital Reduction as mandated under the Companies Act, 2013) does not tantamount to any 'value' in the commercial sense¹⁰.

Part C: Conversion of debt into convertible instruments

Of the part of debt which is not waived, some part thereto is converted into convertible instruments like OCRPS etc. In this regard, the loan amount has been converted into a convertible instrument for discharge of such liability. Section 269T of the IT Act enunciates the mode of repayment of loans and deposits and read with Section 271E of the IT Act imposes penalty on any loan or deposit repaid by any other means except by an account payee cheque/ bank draft or by use of electronic clearing system.

In the facts of our case, loan liability has been converted into an instrument for Banks and other creditors. Second proviso to Section 269T of the IT Act specifically exempts Banks and as such this provision shall not apply to the Banks. On its application to other creditors, reference is invited to Triumph International¹¹, in which the Hon'ble High Court of Bombay interpreted the provision to imply that set-off of corresponding liabilities between two parties through accounting entries is in contravention of Section 269T. However, the Hon'ble High Court did not impose penalty under the provision since it held that the transaction was admittedly genuine. In present case, since such conversion shall be affected by the NCLT the Tax Payer will have a good case to defend the genuineness of the transaction and the commercial necessities that existed to convert the loan liability into a convertible instrument.

Additionally, since the said loan liability is merely converted into a 'convertible instrument' this shall not satisfy the 'receive' test for the purposes of Section 56(2)(x) of the IT Act and such the same may not be successfully invoked by the Revenue (if at all). Further, even in the hands of the creditor whose debt is converted, it is converted to the extent of the loan obligation vis-à-vis the FMV of the convertible instrument, and therefore, chance of successful invocation of Section 56(2)(x) of the IT Act in the hands of creditor (also) seems unjustified.

1. 2018 may see M&A worth $50 billion on back of stressed assets, https://www.livemint.com/Money/wFzzBnEfhAZLT23Mxb0sjO/2018-may-see-MAs-worth-50-billion-on-back-of-stressed-asse.html, last accessed 1 October 2018

2. India jump up 30 places in World Bank's Ease of doing Business Report and Reforms 2018, http://hindustan360.in/india-jump-up-30-places-in-world-banks-ease-of-doing-business-report-and-reforms-2018/, last accessed 1 October 2018

3. Our Bid for Essar Steel, https://corporate.arcelormittal.com/our-bid-essar-steel, last accessed 1 October 2018

4. Civil Appeal No. 6949-6950 of 2004, Supreme Court of India

5. See, Liquidator, Mysore Agencies Ltd. v. CIT, [1978] 114 ITR 853] = [TS-5475-HC-1978(Karnataka)-O]. This view has been upheld by various State High Courts.

6. Ibid

7. [(1965) 57 ITR 1] = [TS-5001-SC-1965-O]

8. Kartikeya Sarabhai v. CIT, [(1997) 228 ITR 163] = [TS-24-SC-1997-O]; G. Narasimhan, [(1999) 236 ITR 327] = [TS-5067-SC-1998-O]

9. Calculated as per prescribed rules under the (Indian) Income-tax Rules, 1962 ('IT Rules')

10. CTO v. SBI, Civil Appeal No. 1798 of 2005] = [TS-5272-SC-2016-O] - An analogy may be drawn wherein the Hon'ble Supreme Court of India held that since the intent and the purpose of the license was not to purchase it but to nullify it, the ownership never gets transferred. In the present case, it may be argued by the Revenue Authorities that 'ownership' has no co-relation with receipt, and therefore, CTO v. SBI (supra) case is not applicable to the facts of the present case. On the other hand, the Tax Payer may argue that the deeming fiction only gets attracted once the receipt is accompanied by 'economic vesting' of such property and therefore in absence of 'ownership' fulfilment of Section 56(2)(x) is not satisfied. This may be contentious.

11. 345 ITR 270] = [TS-400-HC-2012(Bombay)-O]