Business losses of group companies

In order to arrest the growing trend of sick industrial units, a provision u/s 34A was inserted in the Income Tax Ordinance 1979 through the Finance Act 1980.Whereby the healthy companies were encouraged to acquire the sick units for their revival allowing them an incentive to set off current losses of a subsidiary company against its current year's profits for three years.
According to the scheme a listed holding company on a registered stock exchange in Pakistan owning the entire share capital of subsidiary company was entitled to set-off the loss of the subsidiary company against its business income for three consecutive years.
This facility of set-off of losses was conditional, among others, upon submission of a plan for the revival of such unit by the holding company and approval of it by the DFI's.
The holding company was subsequently required to submit a progress report to the DFI to satisfy that the steps have been taken as laid down in the approval plan for the revival of the subsidiary unit. This provision was in line with such provision available in the Indian Income Tax Act 1961.
The Income Tax Ordinance 2001 did not contain any such provision, however, the Finance Act 2004 inserted section 59B introducing the concept of group relief whereby assessed loss surrendered by a subsidiary company can be claimed against the income of the holding company.
The holding company was required to be a public company listed on stock exchange in Pakistan, holding 75% or more of the share capital of the subsidiary company owning and managing an industrial undertaking with such other conditions.
Subsequently through the Finance Act 2005, the service sector was also included to avail the benefit of group relief along with an industrial undertaking. However, none of the holding and subsidiary companies in Pakistan availed benefit of group relief up to the year 2006.
It upset the government which has adopted several policy initiatives to encourage corporatization in the country. The Central Board of Revenue, therefore, constituted a Task Force in August 2006 to examine the issue.
The Task Force, considered as the need of the time, is to consolidate corporate sector for emergence of financially and technically strong groups compatible with international corporations so as to enable it to effectively play in the competitive environment of international market, contrary to business groups in Pakistan being managed by families or individuals and do not reflect consolidated ownership.
In order to achieve the desired objective, it was considered necessary to promote the concept of Holding Companies structure in Pakistan. It, therefore, recommended enforcement of the concept of Group Taxation and Group Relief in Pakistan which emerged in the shape of group relief provisions u/s 59B which has been substituted through Finance Act 2007-08.
The scheme u/s 59B envisages that a subsidiary of a holding company may surrender its assessed loss, excluding capital loss and brought forward losses, to its holding company or a subsidiary company may surrender such losses to another subsidiary company of the holding company.
The conditions imposed for the purposes are that (i) the holding company shall be listed on a registered stock exchange in Pakistan and shall hold 55% or more of the share capital of the subsidiary company.
In case holding company is not listed on stock exchange or is a private company, it shall hold 75% or more of the share capital of the subsidiary company provided it shall get itself listed within three years from the year in which loss is claimed.
This specified shareholding shall continue for five years. In case this ceiling of holding shares is reduced by disposal of share by the holding company during five years, the holding company is required to offer for tax the amount of profit on which taxes have not been paid due to set off losses surrendered by the subsidiary company; (ii) a company within the group engaged in trading business shall not be entitled to avail group relief; (iii) the group companies are locally incorporated under the Companies Ordinance 1984; (CO); (iv) The directors of the respective companies shall approve the surrender of the losses claimed for adjustment; (v) the subsidiary company shall continue the same business for three years; (vi) all the group companies shall comply with corporate governance requirement specified by the Securities and Exchange Commission of Pakistan (SEC) and are designated as companies entitled to avail group relief.
It has been provided that the subsidiary company is not entitled to surrender its assessed losses for set off against the income of the holding company for more than three tax years; in case of the unadjusted losses within three years, it has option to carry forward the unadjusted losses in accordance with provisions of the section 57.
It also requires a holding or a subsidiary company who claims set off of losses to inject cash, with the Board's approval, equal to tax effect of the losses surrendered to the loss surrendering subsidiary company. This transfer of cash would not be taken as a taxable event in either of the two companies.
Further, in order to encourage the sponsors to avail the benefit of the group relief, it has made a provision that no loss or gain be taken as taxable event in respect of transfer of shares held by the common directors between the group companies to acquire share capital for formation of the group.
However, such transfer of share shall be subject to approval by the SEC or State Bank of Pakistan. It restricts sale and purchase of shares from third party, which would be taken as taxable event so that misuse of this concession is avoided.
Although the above substituted provisions of section 59B are improvement and is extensive in its scope over the existing provisions made in 2004, yet it has many omissions and commissions such as a subsidiary company may surrender the losses to another subsidiary of the holding company, based on the shareholding of the holding company and does not require the subsidiary companies to hold share capital between themselves.
Similarly treatment of losses surrendered by the subsidiary company to holding company are specified in sub-sections (3) and (4) but no provision is made in case of losses surrendered in between the subsidiary companies. Besides, the provision is made in respect of the consequences arising as a result of disposal of shares by holding company, but the section is silent on such consequence in case of losses are surrendered between the subsidiary companies.
Comparative study of the similar provisions u/s 34A of the repealed Ordinance with the aforesaid section 59B, indicates that u/s 34A, the subsidiary company was required to be wholly owned by the holding company against holding of 55% or 75% conditioned u/s 59B.
Further, the losses of subsidiary company eligible for set-off were business losses excluding deprecation allowance and speculation loss. Furthermore, the facility of set-off was conditional upon submission of a plan for the revival by the holding company of such unit and approval thereof by the DFI's.
Moreover, holding company was required to submit subsequently a progress report to the said institutions to satisfy that the steps have been taken as laid down in the approved plan for the revival of the subsidiary unit.
It has been a universal practice that where tax concessions are allowed, the legislature imposes certain conditions to ensure that the beneficiaries do not take unfair advantage of the scheme. The repealed Ordinance put the aforesaid conditions so as to the objective set by the government is achieved without adverse consequences.
Whereas section 59B is the free lunch for the group companies in availing the tax concessions without any limit. The Indian Income Tax Act 1961 provides for carry forward and set-off of earlier years' business loss and of unabsorbed depreciation which are relaxed as an incentive to the healthy companies to amalgamate with sick units for their revival.
The conditions imposed to avail the benefit of the concession, among other, includes that the amalgamated company furnishes along with its return of income for the assessment year for which such set-off is claimed, a certificate from the specified authority to the effect that adequate steps have been taken by that company for the rehabilitation or revival of the business of the amalgamating company.
Besides, it requires that the Central Government shall declare on its satisfaction that the amalgamation is in the public interest and that the conditions as laid down are fulfilled.
The conditions include to scrutinise the factors in respect of accumulated losses on the date of amalgamation as compared to the paid up capital, reserves and surpluses, repayment of term loan and interest thereon, status of cash credit and excess drawings, if any, during three years preceding amalgamation, extent and nature of liabilities in relation to the value and composition of assets on the date of amalgamation and projected future profits in case of undertaking which have commenced production during the five years preceding amalgamation.
Further, the amalgamated company is required to submit rehabilitation plan signed by the managing director of the company and should be accompanied by a certificate from the statutory auditors of the company on the prescribed form.
The scheme group relief u/s 59B if examined in international perspective, the condition for eligibility for group relief to hold 55% share capital of the subsidiary company by the holding company is too low compared to the prevailing practice world over.
In Korea it is 80%, Singapore 75%, Japan 100%, USA 80%, and UK 75% to avail group taxation. The rational behind such condition for holding company is to protect the minority interest that effectively loses the right in potential assets and profits of their holding company.
Moreover, group relief for the purpose of consolidation, in a large number of countries is not permissible viz. India, Indonesia, France, China, Mauritius, South Africa, Sweden. Further, group relief world over is confined to domestic companies only except in UK where relief for losses of companies outside UK is allowed in very restricted circumstances.
The section 3 of the CO requires a holding company to hold more than 50% of voting securities or has power to elect more than 50% of director of a company is subsidiary company. The condition to hold 55% or more share capital of a subsidiary company by holding company to surrender its losses, deprives the 49% minority shareholders of the holding company from the benefit of the profit of their holding company may have earned.
Additionally it will face liquidity crunch being the cash equal to the amount of tax effect of losses set-off will be transferred to the subsidiary company. It may be noted that the losses of a subsidiary company are accepted by the holding company for set-off and further transfer of cash to loss surrendering company are not subject to approval of the shareholders of the holding company; thus all these actions are without the consent of the minority shareholders of the holding company.
The directors are empowered to approve the scheme. In a corporate culture of our country where it is influenced with the family domination, the benefit of the concession in taxation allowed under the cover of group relief would naturally result in family relief. Moreover, the concept of transfer of cash will open the doors to defeat the provisions of the CO in respect of financing to associate companies.
In the case of holding company, being private company, it needs to hold 75% share capital of the subsidiary company with a condition to get itself listed within 3 years from the year in which loss is claimed; that is by the time the limitation of adjustment of losses for three years will expired.
In a nutshell the group relief in the present form may serve to the group families at the cost of the honest taxpayers rather in national/public interest. The scheme is free from any restriction and accountability of a subsidiary or holding company.
It does not provide to look into the causes of the losses sustained by a subsidiary company nor for any plan by the holding company to take the steps for revival of the subsidiary company to overcome such losses. Thus the prescription of the task force will not achieve the desired objective of consolidation of corporate sector.
Here some safeguards are necessary for compliance with by the group companies such as (i) that the holding company should be required to get approved by its shareholders in the general meeting of the company the loss transferred by its subsidiary company for set-off against its business profit, identifying the causes of losses incurred with the proposed concrete measures for rectifying them within specified time (ii) the loss transferred by a subsidiary company should be based on the audited accounts by special auditors identifying the causes of the losses (iii) the share holding of the directors and their relatives in the loss surrendering company be specified, they should not hold more than 10/15% shares in loss making company (iii) the loss surrendered, in case of private or unlisted subsidiary company, should have been approved through special resolution by at least three fourth of their shareholders (iv) the holding company should submit a revival plan of the loss making company to the CBR and SEC duly audited by special auditors before accepting it for adjustment (v) similarly a loss making subsidiary company should submit an independent rehabilitation plan of the company to FBR and SEC within specified period before availing the facility which should identify the causes for losses incurred.
The audit/revival plan should propose concrete measures for rectifying the loss making causes in the company. These safeguards are necessary for effective implementation of the scheme of group relief. Therefore, SEC should impress upon and the Federal Board of Revenue to consider them to incorporate them in the section 59B.