Personal income tax filing season: a few principles to be considered on determining transfer value in sales of unlisted shares
Several courts have pronounced on the special pricing rule for transfers of unlisted shares and in particular on how to apply the rule to transfers of shares in dormant or newly created companies. They have also pronounced on the burden of proof in relation to market value and on whether a limited review is a valid procedure for examining these transactions.
With the personal income tax filing season in full swing, and in view of recent decisions and judgments, this is a good time to recall the personal income tax treatment of transfers for a consideration of unlisted shares.
Under article 34 of the Personal Income Tax Law, in transfers for a consideration the capital gain or loss is determined by reference to the difference between the assets’ acquisition costs and transfer prices. As a general rule, the transfer price is the actual value at which the transaction was performed, less any expenses and taxes incurred on it. In relation to transfers for a consideration, however, article 37 provides a special valuation rule for shares.
Under that rule, the transfer value cannot go below the higher of the following two amounts (unless it can be substantiated that the paid sum is equal to the amount that would have been agreed between independent parties on an arm’s length basis):
- The net equity figure disclosed on the balance sheet for the latest fiscal year-end before the due date for the tax.
- The figure obtained by capitalizing at 20% (multiplying by 5 in other words) the average earnings figure for the latest three fiscal to end before the due date for the tax, and computing any paid dividends and allocations to reserves as income (excluding amounts recorded in respect of asset revaluation).
A host of doubts have arisen over application of these special rules, and a few have been resolved in recent decisions and judgment:
a. Newly created companies and dormant companies
In a decision delivered on April 26, 2022 (Principle 1 and Principle 2), TEAC examined how to calculate the capitalization of earnings where the entity was created in either of the two years that ended before the due date for the tax, in other words, where on the due date, the earnings figures for the company’s three fiscal years preceding the due date referred to in the law are not available. The tribunal concluded that in these cases the capitalization rule does not apply. In other words, the minimum transfer value will be the net equity figure for the latest year to end before the due date for the tax.
The tribunal clarified however that the rule is applicable by contrast where the owned company had been dormant, and not obtained either a loss or income in any of the three fiscal year-ends preceding the due date. In these cases the earnings figures for those years must be considered to be “0” and the average figure must be calculated for those three years.
b. Proof of adequacy of the price paid and of the market value
The Galician High Court recalled, in a judgment delivered on April 4, 2022, that for the purposes of undermining the presumed price under the law, the burden of proving that the paid price matches market value lies with the interested party rather than with the tax authorities.
The taxpayer may therefore question the value that the authorities calculated using the company's balance sheets, for example, by showing that the company's accounting records do not reflect its actual economic circumstances. If this is so and can be substantiated by the taxpayer, it should be possible to correct the value calculated by the tax authorities.
Furthermore, if the taxpayer produces an expert report proving these points, its validity cannot be rejected by the tax authorities without justification. In this specific case, the court accepted the credibility of the produced report (evidencing that the company's actual value is close to “0”), even though the calculations made by the expert were based on data produced by the taxpayer.
Lastly, several judgments have been published by the high courts for Castilla-La Mancha (March 29 , April 6, March 29 and April 25, 2022) and Castilla y León (April 13, 2022) in which the use of a limited review procedure to modify the gain reported by the taxpayer on the transfer of unlisted shares is questioned.
As noted by these courts, a modification of the transfer value by applying that special rule necessarily requires an analysis of the investee's accounting records, which is prohibited in this type of procedure. This conclusion is not altered by the fact of the taxpayer not questioning the accounting data in the course of the procedure. In other words, “it is not correct to set the scope of the prohibition on examining the company's accounts and, as a result, make the validity of a tax management procedure conditional on the very specific defense or excuse strategy employed in each case by the interested party since clearly that approach … does not appear to respect the principle of legal certainty, without prejudice to whether the taxpayer reporting a transfer value as a market value that differed from the carrying or listed amount, entailed or implied a denial or questioning of the accounting data …” (Castilla y León high court judgment of April 13).
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