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Tax Entailments in Liquidation of Company

Shubham Chauhan

| Updated: Dec 04, 2019 | Category: Startup, Taxation

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There comes a time when a private limited company decides to shut down the business. In this case, the business owner may think about liquidating the company to turn the assets of the company into cash. Although people generally assume that a company goes into liquidation process only when it becomes officially insolvent. However, this is not the case; liquidation process works for both solvent and insolvent companies. There are three main categories of the process of liquidation of a Company, i.e. solvent, insolvent and compulsory liquidation.

What is solvent liquidation?

A company whose assets exceeds its liabilities and can pay all its creditors within 12 months of a debt falling due is considered a Solvent Company. However, there are cases when even a solvent company decides to liquidate its business to transfer assets and cash to themselves personally. Solvent Liquidation is known as Members Voluntary Liquidation (MVL).Some of the circumstances when company directors choose to liquidate the company are:

  • If a company has no plans to continue the business any further or has no purpose left
  • Director or Shareholder of the company decides to retire and transfer assets and cash to themselves.
  • If the Directors decide to start with a new business and gain assets and cash out the liquidation.

What is Insolvent liquidation?

A company whose liabilities exceeds its assets and cannot pay its creditors their due amount is considered an Insolvent Company. Insolvent Liquidation is known as Creditors Voluntary Liquidation (CVL). CVL is a formal liquidation process that is used to close down the business affairs of an insolvent company. It is initiated by the Directors or shareholders of the company to sell the assets of the Company to make a timely return to the creditors. This process of liquidation requires an Insolvency Practitioner to be appointed as liquidator to manage the whole process accordingly.

What is Compulsory liquidation?

A Creditor generally initiates this process of liquidation through a court order known as Winding Up Petition (WUP). This petition notifies the Company regarding the petition lodged to close the business and liquidation of its assets.

Liquidator’s Role in the Process of Liquidation of Company

The main role of a Liquidator is to manage the process of the liquidation of the company. Liquidator investigates all company affairs and looks for the assets that were sold by the Company at a price lower than the actual market value. Liquidators have the liberty to reverse these transactions, which caused a loss to the company.

Tax Implications in Liquidity of Company

Various tax issues arise during the process of liquidation of the Company. When a business owner decides to sell the assets of the company, it may result in a taxable gain. In such cases, the liquidator needs to pay the tax implied on the amount gained during the liquidation process. This payment of tax needs to be done before distributing any cash or assets to shareholders or creditors. Some of the tax implications of the process of liquidity of a Company are as follows:

Tax Implications on Deemed Dividend Distributed

  • If a company distributes its profits to its shareholders from the income generated by company’s trading and operation activities, such distribution is deemed to be a dividend paid to members out of benefits gained from the Company. For deemed dividend distributed, the company is liable to distribution tax at the rate of 15% under Section 115-O of the Income Tax Act. When a Company is in liquidation process there arises a possibility that the Company has no accumulated profits available. In such a case company is not liable to pay dividend distribution tax. Also, distribution by a liquidator itself does not require any tax to be paid on dividend income unless the company had gained profits before it went into liquidation.

Tax Implications on Shareholder Returns during the Process of Liquidity of Company

The process of liquidation of a Company gives rise to the cancellation of shares in the company, which may lead to capital gain or a capital loss. The capital gain in the process of liquidation of a company is liable to tax under the Income Tax Act. A capital gain arises for the shareholders if the capital proceeds from the cancellation of shares exceed the cost base of the shares. The capital proceeds consist of the full amount of distribution made by the liquidator during the process of liquidity of the Company.

Tax Implications on Foreign Investor during the Process of Liquidity of Company

Shareholder of a Company can also be a non-resident who receives assets of the Company during the process of liquidation of Company. As per section 9 of the Income Tax Act, “any dividend paid by an Indian Company outside India is income deemed to accrue and arise in India”. Provisions of section 46 of the Income Tax Act is equally applicable to the foreign shareholder as well.

Conclusion

Liquidation of a Company offers great benefits to the shareholders. However, the distribution made to shareholders is liable to tax if the funds are not managed properly during and before the liquidation. The process of Liquidation of a Company offers various advantages such as large tax benefits, reduction of ongoing compliance costs etc.

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Shubham Chauhan

A passionate legal content writer, a nature enthusiast, an avid reader, and a part-time thinker. By means of conducting in-depth research on industry related topics, Shubham often builds flawless and intelligible legal content for populace from all walks of life.

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