Synopsis
Introduced by Finance Act, 2012 and effective from 1st April, 2013, Section 56(2)(viib) of the Income Tax Act, 1961, provides for a specific category of income that shall be chargeable to tax under the head “Income from other sources”.
The article gives an in-depth analysis of the said section and Rule 11UA that prescribes certain modes of valuation. The author suggests that a literal interpretation of the provision may result in it failing to achieve its objective. Section 56(2)(viib) { introduced by Finance Act 2012 w.e.f 01-04-2013 } r.w.s. 2(24)(xvi), of the Income tax Act (‘the Act’) provides that where a closely held company issues shares to a resident, for an amount received in excess of the fair market value of the shares, then the said excess portion will be regarded as income of the Company and charged to tax under the head ‘Income from other sources’. The said fair market value is defined as higher of the value arrived at on the basis of the method prescribed under Rule 11UA of the Income-tax Rules, 1962 (‘the Rules’) or the value as substantiated by the Company to the satisfaction of the Assessing Officer under Explanation to section 56(2)(viib). The Company can substantiate the fair market value based on the value of the tangible and intangible assets and various types of commercial rights as stated in the section. The fair market value which may be determined under Rule 11UA and the determination of date of fair market value for the purpose of valuation is discussed separately in the ensuing paragraphs below. However, this provision will not apply to amounts received by a venture capital undertaking from a venture capital fund or a venture capital company, which terms have been defined in section 10(23FB) . Further, this provision will also not apply to amount received for issue of shares from a non-resident, a foreign company or from a class of persons as may be notified by the Government.
A better understanding of the aforesaid provisions a reference should be made to the Budget Speechby the Hon’ble Finance Minister and Notes on Clauses and Memorandum Explaining the provisions. which are reproduced at Annexure 1 separately. For section 56(2)(viib) to apply, the following conditions will have to be fulfilled:
• Recipient of consideration for issue of shares should be a closely held company i.e. a company in which the public are not substantially interested, referred to u/s. 2(18) of the Act;
• Consideration received for issue of shares should be only from a person, who is resident and the consideration so received should exceed the face value of shares issued;
• Recipient must ‘receive’ income i.e. consideration in excess of fair market value for issue of shares in the previous year [i.e. relevant financial year]; and
• The share premium received (i.e. consideration received for value of shares issued which exceeds the fair market value of the shares), is charged as income and subjected to tax accordingly; Section 56(2)(viib) is one of the charging sections under the Act. The sections which provide for levy or charge should be strictly construed. The rule of construction of a charging section is that before taxing any person, it must be shown that he falls within the ambit of the charging section by clear words in the section. No one can be taxed by implication. Further, the word ‘receives’ as referred to in section 56(2)(viib) has been interpreted to mean: “The words ‘receives’ implies two persons – the person who receives and the person from whom he receives.”
However, it is equally true that mere receipt of money is not sufficient to attract tax. It is only on receipt of ‘income’ which would attract tax. Every receipt is not necessarily income. So, until the Company receives income as referred to in section 56(2) (viib) r.w.s. 2(24)(xvi), it cannot be taxed. In addition to above, it would be necessary to highlight the following exceptions and certain limitations, :
1. As regard to determination of the date as on which fair market value of the shares issued needs to be determined, the provisions of section 56(2)(viib) and Rule 11UA provide as under: Three modes of valuation are prescribed for determination of fair market value of shares for section 56(2)(viib), with each of them providing for different valuation dates i.e. the dates as on which the fair market value of the shares needs to be decided. While two modes of valuation are prescribed under Rule 11UA, one mode of valuation, which is generally subjective in nature, is prescribed under Explanation to section 56(2)(viib) of the Act: a. The subjective mode of valuation as prescribed under Explanation to section 56(2)(viib), provides for determination of fair market value of shares on the date of issue of shares. The said mode of valuation provides for applicability of any method to determine the fair market value of shares, as may be relevant, however it categorically requires satisfaction of the Assessing Officer to said determination of fair market value of shares; or b. Rule 11UA as mentioned above provides for two modes of valuation to determine fair market value of shares issued by the closely held company as on the valuation date. Recently, Rule 11UA(2) has been inserted and the term ‘valuation date’ was amended vide Notification No. 52 under Income-tax (Fifteenth Amendment) Rules, 2012 w.e.f. from 29th November 2012, which provides for the present two modes of valuation.
The term ‘valuation date’ is now defined under Rule 11U(j) as the date on which the consideration is received by the assessee for issue of shares. Rule 11UA(2) is specifically inserted to provide for determination of fair market value of shares u/s. 56(2)(viib) of the Act. Prior to the aforesaid amendment, Rule 11UA only provided for one method of valuation and the term ‘valuation date’ was also not defined to provide for cases covered u/s. 56(2) (viib). Further, Rule 11UA(2) provides for option to the Company to select for either mode of valuation as provided under Rule 11UA(2)(a) or Rule 11UA(2) (b) of the Rules. The said modes of valuation are explained in brief below and for better understanding :
(a) The said mode of valuation is generally based on the book value of the shares as on the latest audited balance sheet of the Company, subject to adjustments as provided for assets and liabilities of the Company. In other words, the fair market value (‘FMV’) of the shares of the Company are defined as under: FMV of unquoted equity shares = (Assets – Liabilities) x PV PE The term ‘assets’ and ‘liabilities’ as required to be considered with necessary adjustments are defined under the Rules, while PV stands for Paid up value of such equity shares and PE stands for total amount of paid up equity share capital of the Company as shown in the latest Audited balance sheet of the Company. So, the FMV of the shares under this method which is to be determined as on the valuation date, provides for consideration of values as on the latest Audited Balance sheet of the Company;
(b) The second mode of valuation provides for FMV of the shares to be undertaken by Merchant banker or Fellow Chartered Accountant of ICAI as per the Discounted Free Cash Flow method. The second method is silent as regard to values based on which FMV needs to be computed. However, considering FMV of the shares needs to be computed as on the valua- tion date, therefore, Discounted Free Cash Flow Method will have to be determined as on valuation date i.e. date on which consideration is received by the Company for issue of shares.
So, in the light of the above discussions, it appears that the Legislature has provided for selection of either modes of valuation under Rule 11UA and selection of the highest FMV on comparison with the mode of valuation prescribed under Explanation to section 56(2)(VIib), based on which FMV of the shares issued by the Company are to be determined. However, the modes of valuation so prescribed are subject to various limitations and subjectiveness, some of which are referred above.
2. Secondly, one finds that the taxable event of the income under discussion is based on receipt of consideration for issue of shares in the given financial year. So, it is imperative to understand the terms ‘consideration’ and ‘issue of shares’ as referred to in the section. However, the said terms are not defined under the Act.
The concept of ‘issue of shares’ could be better understood under the Indian Companies Act, 1956 (‘the 1956 Act’) with the help of the legal precedents under the 1956 Act which are referred in ensuing paragraphs who have explained the concept of ‘issue of shares’ in context of ‘allotment of shares’ as under:
“Under the Act [author’s note – i.e. Companies Act], a company having share capital is required to state in its memorandum the amount of capital and the division thereof into shares of a fixed amount. see Section 13(4). This is what is called the authorised share capital of the company. Then the Company proceeds to issue the shares depending on the condition of the market. That only means inviting applications for these shares. When the applications are received, it accepts them and this is what is generally called allotment…..
……The words ‘creation’, ‘issue’ and ‘allot- ment’ are used with the three different meanings familiar to business people as well as to lawyers. There are three steps with regard to new capital, firstly it is created, till it is created the capital does not exist. When it is created it may remain unissued for years, as indeed it was here, the market did not allow of favourable opportunity of placing it. When it is issued it may be issued on such terms as appear for moment expedient. Next comes allotment…
…Allotment means the appropriation out of the previously unappropriated capital of a company, of a certain number of shares to a person. Till such allotment, the shares do not exist as such. It is on allotment in this sense that the shares come into existence.”
The aforesaid legal proposition explaining the different stages of share capital of the Company are approved in the following legal precedents:
• Florence Land and Public Works Company (1885)
L.R. 29 Ch.D. 421;
• Mosely vs. Koffyfontain Mines Limited (1911) I.L.R. Ch. 73.84.;
• Sri Gopal Jalan and Company vs. Calcutta Stock Exchange Association Ltd. (AIR 1964 SC 250); and
• Shree Gopal Paper Mills Ltd vs. CIT (77 ITR 543) (SC);
Further, the Income tax Act, 1961 has been using the terms ‘issue of shares’ and ‘allotment of shares’ independently in different provisions at different points in time. So, the Legislature is aware of the differences between ‘issue of shares’ vis-a-vis ‘allotment of shares’ and their meanings and respective stages thereof in the share capital of the Company.
The word ‘consideration’, is defined under the Indian Contract Act, 1872 (‘the 1872 Act’) and could be considered for the purpose of understanding the meaning of the term, on account of absence of specific definition for under the Act. The word ‘consideration’ is defined u/s. 2(D) of 1872 Act as under:
“When at the desire of the promisor, the promise or any other person has done or abstained from doing, or does or abstains from doing, or promises to do or to abstain from doing, something, such act or abstinence or promise is called a consideration of the promise.”
So, existence of promisor-promisee relationship is sine qua non for ‘consideration’ under the 1872 Act. In context of share transactions relating to the companies particularly on issue of shares, the determination of promisor-promisee relationship could be explained as under:
A share is a right to a specified amount of the share capital of a company with it certain rights and liabilities, while the company is a going concern and in the winding up. The promisor- promisee relationship shall not come into existence until the offer and acceptance of offer thereof in completed in a contract. So, in context of contract of shares of the Company with the proposed shareholders, the following steps take place:
• Step 1: Initially, the Company makes an invitation of offer to the public in general for subscription of shares at a given price for the share and other relevant conditions. This stage is referred to as ‘issue of shares’ under the legal precedents above;
• Step 2: Out of the said invitation of offer to public, the proposed shareholders upon having accepted the terms of conditions of issue of shares of the Company makes an offer to the Company for al- lotment of shares on payment of price referred in step 1; and
• Step 3: The Company through its Board of Directors on receipt of offer from the proposed share- holders decide in their meeting for acceptance of said offers and thereby pass resolution and undertake other compliances viz. filing of return of allotment in favour of shareholders, who are selected from the list of proposed shareholders. This stage is referred to as ‘allotment of shares’ and it is at this stage, the relationship of promisor-promisee comes into existence and simultaneously definition of ‘consideration’ under the 1872 Act is satisfied.
So, at the time of issue of shares, the receipt of money from the proposed shareholders by the Company cannot partake the nature of consid- eration, since no promisor-promisee relationship exists between the proposed shareholders and the Company. The promisor-promisee relationship comes into existence at the time of ‘allotment of shares’ by the Company; which is a stage anterior to ‘issue of shares’.
In light of above averments, it may be possible to urge that the charging provisions of section 56(2) (viib) of the Act may fail to satisfy the taxable event provided therein at the time of ‘issue of shares’, because the receipt of money at the time of ‘issue of share’ fails to satisfy the definition of ‘consideration’ under the 1872 Act. Further, the condition of ‘consideration’ is satisfied only at the time of allotment of shares because the shares also come into existence at the said stage of share capital and accordingly the incidence of share premium [which is sought to be taxed u/s. 56(2)(Viib)] is also established at that stage and not at ‘issue of shares’.
Alternatively, one may want to debate that in light of the intention of the Legislature to tax the share premium received at the time of issue of share above the fair market value, the averments as referred in above paras may require reconsideration. One may want to dispute the above understanding of the ‘issue of shares’ and distinguish it for want of relevance restricted to Companies Act, 1956 and thereby giving the term ‘issue of shares’ as a general meaning instead. In light of said understanding, one may argue that charging provisions of section 56(2)(VIIB) are satisfied and share premium shall be taxed accordingly in the hands of the Company at the time of issue of shares.
So, until the Courts of India decide upon the issue and/or clarification on the above contrary interpretation of the provision is given by the Legislature, it would be difficult to reach to any conclusions. As a way forward until any clarity is received, on a conservative basis, one may want to suggest that advance tax and/or self assessment tax, as the case may be, be paid considering the alternative interpretation as discussed later [i.e. in the immediately preceding para above] for the income under consideration be taxed u/s. 56(2)(VIIB) and at the time of filing the return of income, one may take an aggressive position of not subjecting the income under consideration to tax and a suitable note substantiating the said position be disclosed in the return of income. With this there may be limited chances of penalty and interest provisions being attracted to the transaction at the time of assessment of the company in the income-tax proceedings.
Annexure 1
Relevant extracts of Budget Speech of Finance Bill, 2012
“Para 155. I propose a series of mea- sures to deter the generation and use of unaccounted money. To this end, I propose:
(i) ……,
(ii) ……,
(iii) Increasing the onus of proof on closely held companies for funds received from sharehold- ers as well as taxing share premium in excess of fair market value.”
Relevant extracts of Budget Speech while moving in amendments to Finance Bill, 2012 “It has been proposed in the Finance Bill, 2012 that any consideration received by closely held company in excess of fair market value would be taxable. Exemption is provided to angel investors who invest in start-up company”
Memorandum explaining the provisions of Finance Bill, 2012
“Share premium in excess of the fair market value to be treated as income…….Section 56(2) provides for the specific category of incomes that shall be chargeable to income- tax under the head “Income from other sources”…. The new clause will apply where a company, not being a company in which the public are substantially interested, receives, in any previous year, from any person being a resident, any consideration for issue of shares. This amendment will take effect from 1st April 2013 and will accordingly apply in relation to AY 2013-14 and subsequent AYs”
Supplementary Circular explaining the amendments to the provisions of Finance Bill, 2012
“Company which receives any consideration for issue of shares and the consideration for issue of such shares exceed the fair market value of the share then the aggregate consideration received for such shares as exceeds the fair market value of the share shall be chargeable to tax”
Notes on Clauses to Finance Bill, 2012 “….Company receiving the consideration for issue of shares shall be provided an opportunity to substantiate its claim regarding the fair market value of shares”.
