Tax implication in case of liquidation of a company

What is Liquidation of a company?

In law, liquidation is the process by which a company is brought to an end, and the assets and property of the company redistributed. Liquidation is also sometimes referred to as windingup or dissolution, although dissolution technically refers to the last stage of liquidation.The main purpose of a liquidation where the company is insolvent is to collect in the company’s assets, determine the outstanding claims against the company, and satisfy those claims in the manner and order prescribed by law.Tax implication in case of liquidation of a company

This article deals with the tax implication on liquidation of a company.

 What are the tax implicationonLiquidation of a company?

When a liquidator is making a distribution to shareholders, they needto consider whether a distribution of funds is income or capital in nature.The liquidator makes this allocation based on the records maintained by the company or the accountant.

  • Income-if a distribution to members is from income generated by the company through trading activities or operation activities, then it will be deemed to be a dividend paid to members out of profits derived from the company.
  • To determine the CGT consequences that arises for the shareholders as a result of liquidation.  Because the liquidation of a company gives rise to the cancellation of the shares in the company, a capital gain or loss could arise.  In simple terms, a capital gain would arise for the shareholders if the capital proceeds from the cancellation of the shares exceed the cost base of the shares.  The time the capital gain arises is when the shares are cancelled (i.e. at the time the company is dissolved).

Capital proceeds on cancelations of shares:

The capital proceeds for the cancellation of shares on liquidation of a company consists of the full amount of the distribution made by the liquidator on the winding up of the company.  However, if the liquidator makes an interim distribution more than 18 months before the shares cease to exist, the interim distribution is not included in the capital proceeds for the cancellation of the shares.  Instead such an interim liquidator’s distribution will be treated as the capital proceeds on ownership of shares; the effect of this is that these capital proceeds reduce the cost base of the shares. If there is any excess capital proceeds after the reduction of the cost base the excess is a taxable capital gain for the shareholder (i.e. the cost of acquisition reduces for such shares).

When does the Capital Gain/Loss arise?

According to the Tax office the capital gain or loss arises at the time of liquidation of the company.
However the time of liquidation of a company s determined as under:

  • where the company is wound up by an order of a court and the liquidator has obtained from the court an order that the company be dissolved – the date of the order;
  • where the company is wound up voluntarily – three months after the lodging of the return of the final meeting of members and/or creditors, or on such other date as the court may order;
  • where a defunct company’s registration is cancelled – on the date of the Government Gazette in which notice of the deregistration is published.

Case Study

Mr. A held shares in Y ltd. which went into liquidation. The liquidator gave a plant (cost Rs. 10 lakhs, WDV 6 lakhs, FMV 9 lakhs) to the shareholder being surplus. Dividend u/s 2(22) (C) i.e. deemed dividend was determined to be 4 lakhs.

The Cost of Acquisition (COA) of the plant when the shareholder sells the plant in future would be equal to the Fair Market Value (FMV) of the plant on the date of acquisition i.e. Rs. 9 lakhs.

Again if the deemed dividend worked out to be 9 lakhs the entire value of the plant would get assessed under Income from Other Sources (IFOS)  as dividend not exempt. No part of the machinery would be assessed under Capital Gain.

Supreme Court in case of Vijay Kumar Budhia observed that sec 55(2)(b)(iii) which provides to treat the FMV as cost in hands of the shareholder would operate only if the asset was assessed under the head Capital Gain. In situation like this the provision of section 49(1) will apply and the cost in the hands of the shareholder shall be the cost to the previous owner being Rs. 6 lakhs (WDV).

For reading the full ruling click here.

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