[Opinion] Cost of Acquisition Liquidation – FMV Prevails on Assets

Suvira Agarwal & Surabhi Singhal – [2025] 174 taxmann.com 740 (Article)

1. Introduction

There are two practices commonly followed by companies in liquidation either

(i) transfer of assets to third parties and distribution of consequent sales proceeds (net of labilities) to the shareholders, or

(ii) distribution of net assets directly to the shareholders pursuant to the liquidation event.

Provisions of section 46 read with section 2(22)(c) of the Income tax Act, 1961 (‘IT Act’) govern the taxability of liquidation in the hands of the shareholders. Under the applicable tax provisions, distribution of surplus cash or assets to the shareholders is tax-exempt in the hands of the Company undergoing liquidation. However, the liquidation proceeds (in the form of cash/assets)are taxable in the hands of the shareholders as under:

• Amount of cash/fair market value (FMV) of assets distributed on liquidation taxable as dividend income to the extent of accumulated profits available with the Company;
• Excess of the amount of cash/FMV of assets distributed on liquidation over the amount assessed as dividend income is deemed to be the consideration value for the purposes of determining capital gains income in the hands of the shareholders.

Accordingly, in the first scenario, the Company is liable to pay tax on capital gains on transfer of such assets and subsequently, the shareholders are liable to pay tax on the cash proceeds received on liquidation as dividend income and/or capital gains tax depending on the availability of accumulated profits with the Company. In the second scenario, tax on distribution of cash/assets on liquidation arises in the hands of the shareholders and the FMV of assets on the date of distribution is taxable as dividend income to the extent of accumulated profits available with the Company and residual excess FMV, if any, is deemed to be the consideration for the purposes of determining capital gains income for the shareholders as per the applicable provisions of the IT Act.

In case of liquidation involving distribution of assets, there isan ambiguity with respect to determining the cost of acquisition of such assets in the event of a further sale of such asset by the recipient shareholder. There are two provisions under the IT Act i.e. section 55(2)(b)(iii) and 49(1)(ii)(c), which govern the determination of cost of acquisition of assets received in liquidation.

As per section 55(2)(b)(iii), where the capital asset is received pursuant to distribution of capital assets by a company on its liquidation and the assessee has been assessed to income-tax under the head “Capital gains” in respect of that asset under section 46, the cost of acquisition is the fair market value (FMV) of the asset on the date of distribution.

However, as per section 49(1)(ii)(c), where the capital asset becomes the property of the assessee on any distribution of assets on the liquidation of a company, the cost of acquisition of the asset shall be deemed to be the cost of acquisition (as increased by the cost of improvement, if any) incurred by the previous owner of the property.

Thus, both the provisions are contradictory in nature especially in situations where both may simultaneously apply, for instance, where the liquidation event and transfer of assets received on liquidation takes place in the same financial year such that assessment to tax under section 46 cannot be clearly established in the hands of the recipient shareholder.

The Madras High Court recently in the case of T.R. Balasubramanium has provided the requisite clarity in such situations where the aforesaid two conflicting provisions may be simultaneously applicable for determining cost of assets received pursuant to liquidation in the hands of the assessee.

2. Facts of the Case

• The appellants were three shareholders in a company under liquidation and had purchased 120 shares each at INR21,000 per share in the Company.
• The Company went into liquidation and the value of immovable property ~ INR 1,36,51,000 (i.e. FMV) held by the Company was distributed to the appellants proportionately ~ INR 27,302 per sharei.e. INR 32,76,240 each.
• Accordingly, the appellants declared capital gains of INR7,56,240 each pursuant to transfer of the asset after considering the cost of acquisition of the asset at FMV in accordance with the provisions of section 55(2)(b)(iii) of the IT Act.
• However, the Assessing Officer (AO) initiated the reassessment proceedings under section 48 and recomputed the cost of acquisition of the asset at INR 32,69,795 as per the provisions of section 49(1)(iii)(c) of the IT Act.
• The appellants filed an appeal before the Commissioner of Income-tax (Appeals) [CIT(A)], which allowed the appeal and ruled in their favour. The Revenue filed an appeal against the order of the CIT(A)before the Income-tax Appellate Tribunal (ITAT).
• The Tribunal though agreed with the contentions of the appellants, followed the co-ordinate bench ruling (adverse) in the case of other two appellants and ruled in favour of the Revenue. Aggrieved, the appellant filed an appeal before the High Court (HC).

3. Issue Under Consideration

Whether the cost of acquisition of assets received on liquidation of a Company would be determined basis the provisions of section 55(2)(b)(iii) or as per provisions of section 49(1)(ii)(c) of the IT Act?

4. HC Ruling

• The HC observed that the unique facts in the case is the co-existence and simultaneous applicability of both the rival provisions since the extinguishment of shares pursuant to liquidation (i.e. Transaction 1) and transfer of assets received on liquidation (Transaction 2) has taken place in the same financial year.
• The HC concurred with the view of the ITAT that since in the instant case, both the transactions took place in the same financial year, the appropriate interpretation is that Transaction 2 occurred after Transaction 1 and hence, the tax computation methodology would be to first compute tax liability for Transaction 1 followed by computing tax liability for Transaction 2.
• In the present case, the assessee has not postponed the taxability of capital gains but is offering it for tax in the same year in which the gains have accrued. Therefore, the interpretation that income under section 46 was not assessed to tax since both the transactions fell in the same financial year and hence, section 49(1)(ii)(c) should apply, would result in unnecessarily burdening the assessee with a higher tax liability.
• The HC also highlighted that the ITAT was not bound by the earlier conclusions of the coordinate bench of the ITAT that had decided adversely for the other two Appellants and noted that the ITAT could have referred the matter for the constitution of a Larger Bench.
• The HC therefore ruled in favour of the appellants (common order passed for all the three appeals) and allowed the cost of acquisition of assets to be computed on the basis of section 55(2)(b)(iii).

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