Carry Forward of Business Losses – The Story Within

Every startup entrepreneur who brings forth a business of his own, among all other thought processes, come across a possibility called loss. For any business, the most common issue to face at the brink is business loss. And only a handful of entrepreneurs can think of using these business losses in the years when the business bear fruits, if some of the conditions are met by the concern. We had been awaring our readers on one such condition, which is timely income tax return filing of the company as a requisite for carry forward and set-ff of losses with future profits.  Now the other big condition needs to be put under the limelight, what we call ” Carry Forward of Business Losses – The Story Within”   Let us bring this into a structured discussion. Section 79 of the Income tax Act, 1961 (‘the Act’) provides for restriction on carry forward of loss in case of a company, not being a company in which public are substantially interested, on account of change of ownership in the company. Unabsorbed loss of closely held companies relating to earlier previous years will not be set off in a previous year where a change in shareholding has taken place unless in the said previous year, shares carrying at least 51% of voting power are beneficially held on the last day thereof by the persons who held shares to the similar extent in the previous year in which the unabsorbed loss was incurred. However, change in shareholding in a previous year consequent to the death of a shareholder or transfer of shares by way of gift made by a shareholder to his relative, will not be taken into account for this purpose. Let us understand this with an example :   Shareholding pattern of XYZ Private Limited [25% of shares held by each shareholder] FY ended                                                                                                                Profit/Loss 31-03-2012                  A                     B                     C                     D                – 1.62 lacs 31-03-2013                  A                     B                     C                     X                – 0.78 lacs 31-03-2014                  A                     B                     Y                     X                  3.24 lacs State whether losses of FY 2011-12 and FY 2012-13 can be c/f and set-off against profits in FY 2013-14? Verdict: Loss of Rs 1.62 lacs of FY 2011-12 will not be allowed to be set-off against profits of FY 2013-14, since only A & B holding stake of 50% remains the shareholders in FY 2013-14. However, loss of Rs 0.78 lacs can be set-off against profits of FY 2013-14, since A, B & X holding stake of 75% remains the shareholders in FY 2013-14. Therefore, the net taxable profits after set-off in FY 2013-14 come to Rs 2.46 lacs. Another interesting observation to bring into discussion is that the over-riding provisions of Section 79 do not effect the set off of unabsorbed depreciation which is governed by Sec 32(2). Till 1989, before clause (b) was deleted from Section 79, there was the possibility for a genuine loss making company to take on a majority partner/ shareholder and still claim set off of losses in subsequent years so as to mitigate some of the hardship suffered earlier. The object of clause (b) was to ensure that the assessee was not deprived of the benefit of carry forward of losses unless the change in shareholding had been made with a view to avoid or reduce the tax liability. However, as the section stands to day, there is no discretionary power in the hands of the assessing officer to do anything in the matter and in all cases where there is a 51% or greater transfer of beneficial shareholding the right to carry forward and set-off previous years’ genuine losses is lost. This is downright unfair, and hard, on genuine entrepreneurs who have, firstly, lost a lot of their money in the venture and have to now doubly suffer on account of this stricture of law. M/s Tainwala Trading and Investments Company Limited (‘the taxpayer’) claimed a set off of the brought forward business loss of Rs 6.41 million incurred during the Financial Year (‘FY’) 1997-98 against its income for the FY 2005-06. Based on the shareholding pattern, the Revenue authorities (‘RA’) observed that M/s Concept Reality and Securities Limited (‘Original Shareholder’) held 58.12 percent of the shares of the taxpayer as on March 31, 1998 (i.e., the last day of the FY in which the loss was incurred) but did not own these shares as on March 31, 2006 (i.e., the last day of the FY in which the tax payer claimed the set-off of the brought forward losses).The regulatory authority accordingly, disallowed the set-off of brought forward business loss in relation to FY 1997-98 against the income of FY 2005-06.The CIT(A) also upheld the order of the RA on this issue. Now let us focus on what the tax payer had to say. At the time of assessment proceedings, the taxpayer stated that the change in shareholding was only on account of rationalization of holding of Mr D Ramesh Tainwala (‘Current Shareholder’), being the director on board of the Original Shareholder. It was emphasized that the beneficial owner of the shares in the taxpayer as on March 31, 1998 was the Current Shareholder though these shares were held in the name of the Original Shareholder then, and that this shareholding pattern continued as is as on March 31, 2006, since the Current Shareholder held these shares in his own name at such later date. Based on this argument, the taxpayer claimed that there has been no change in the shareholding pattern and hence, there should be no disallowance under section 79 of the Act. During the course of the assessment proceedings, it was further argued that the shares of the taxpayer were exchanged between the members of the Tainwala family through cross gifts and hence, it would be covered within the exception carved out (from the applicability of section 79 in case the change in shareholding is on account of gift to any relative of the shareholder making such gift) under the proviso to section 79 of the Act. However, the tax payer failed to substantiate these arguments by appropriate documentary evidence which were requested for by the RA. The Mumbai Tribunal in its ruling highlighted that section 79 of the Act is enacted to disallow the set-off of brought forward business loss against the income of a later year if there is change in the shareholding of more than the prescribed percentage. The transfer of shares from the Original Shareholder to the Current Shareholder, being canvassed as not leading to any change in the beneficial ownership of shares (since the Current Shareholder initially held these shares through the Original Shareholder  and later partly transferred these shares to him in his individual name) was not considered favourably by the Mumbai Tribunal. The Mumbai Tribunal pointed out that a company is a separate legal entity distinct from its shareholders and that the assets of a company are not to be considered as assets of the shareholders, except in the case of liquidation and that too, to the extent of the amount remaining after the discharge of the outside liabilities. If the shareholders of the company and the company itself are treated as one and the same person, then the concept of separate legal entity would not have any meaning. It just goes to show the lack of trust that the government has in its own administrative machinery and instead of trying to plug the loopholes for the misuse of Section 79, it has simply taken the easy way out and done away with the discretionary powers given to its officers, in the process putting all genuine business owners at loss. Looking at it in the context of the overall direct tax collection of the government, we do not think this kind of set off would have had any material impact on the same, however, from the company’s point of view the impact is huge on each such company that is put to a genuine hardship (loss) on this account.