In a conflict between law and equity, it is the law which prevails as per the Latin maxim dura lex sed lex, meaning ‘the law is hard, but it is the law’. Equity can only supplement law, it cannot supplant or override it. However, in
CIT vs. J.H. Gotla (1985) 156 ITR 323 SC, it is held that an attempt should be made to see whether these two can meet.
In the realm of taxes, the tax collector always has an upper hand. When this upper hand is used to convey ‘heads I win, tails you lose’, the taxpayer has to suffer this one-upmanship till all taxpayers collectively voice their grievance loud and clear and the same is heard and acted upon. In this article, the authors would be throwing light on certain unfair provisions of the Income-tax Act.
Case 1: Differential valuation in Rule 11UA for unquoted equity shares, section 56(2)(x)(c) vs. section 56(2)(viib); section 56(2)(x)(c) read with Rule 11UA(1)(c)(b)
Section 56(2)(x)(c) provides for taxation under ‘income from other sources’ (IFOS), where a person receives, in any previous year, any property, other than immovable property, without consideration or for inadequate consideration. ‘Property’, as per Explanation to section 56(2)(x) read with Explanation (d) to section 56(2)(vii), includes ‘shares and securities’.
Section 56(2)(x)(c)(A) provides that where a person receives any property, other than immovable property without consideration, the aggregate Fair Market Value (FMV) of which exceeds Rs. 50,000, the aggregate FMV of such property shall be chargeable to tax as IFOS. Section 56(2)(x)(c)(B) provides that where a person receives any property, other than immovable property, for consideration which is less than the aggregate FMV of the property by an amount exceeding Rs. 50,000, the aggregate FMV of such property as exceeds such consideration shall be chargeable to tax.
The FMV of a property, as per the Explanation to section 56(2)(x) read with Explanation (b) to section 56(2)(vii) means the value determined in accordance with a prescribed method.
Rule 11UA(1)(c)(b) provides for determination of FMV of unquoted equity shares. Under this Rule, the book value of all the assets (other than jewellery, artistic work, shares, securities and immovable property) in the balance sheet is taken into consideration. In case of the assets mentioned within brackets, the following values are considered:
a) Jewellery and artistic work – Price which it would fetch if sold in the open market (OMV) on the basis of a valuation report obtained from a registered valuer;
b) Shares and securities – FMV as determined under Rule 11UA;
c) Immovable property – Stamp Duty Value (SDV) adopted or assessed or assessable by any authority of the Government.
SECTION 56(2)(viib) READ WITH RULE 11UA(2)(a)
Section 56(2)(viib) provides for taxation of excess of aggregate consideration received by certain companies from residents over the FMV of shares issued by it, when such consideration exceeds the face value of such shares [angel tax].
Explanation (a) to the said section provides that the FMV of shares shall be a value that is the higher of the value
a) As determined in accordance with the prescribed method; or
b) As substantiated by the company to the satisfaction of the Assessing Officer based on the value of its assets, including intangible assets.
Rule 11UA(2)(a) provides for the manner of computation of the FMV on the basis of the book value of assets less the book value of liabilities.
DISPARITY BETWEEN RULES 11UA(1)(c)(b) AND 11UA(2)(a)
Section 56(2)(x)(c) deals with taxability in case of receipt of movable property for no consideration or inadequate consideration. Thus, the higher the FMV of the property, the higher would be the income taxable u/s 56(2)(x). Hence, Rule 11UA(1)(c)(b) takes into consideration the book value, or the OMV or FMV or SDV, depending on the nature of the asset.
Section 56(2)(viib) brings to tax the delta between the actual consideration received for issue of shares and the FMV. Therefore, the lower the FMV, the higher would be the delta and hence the higher would be the income taxable under the said section. Rule 11UA(2) provides for the determination of the FMV on the basis of the book value of assets and liabilities irrespective of the nature of the same.
One may note the disparity between the two Rules in the valuation of unquoted shares. Valuation for section 56(2)(x)(c) adopts FMV or OMV, so that higher income is charged to tax thereunder. Valuation for section 56(2)(viib) adopts only book value so that a higher delta would emerge to recover higher angel tax.
The levy of angel tax is itself arbitrary, because such tax is levied even if the share issue has passed the trinity of tests, i.e., genuineness, identity and creditworthiness of section 68. No Government can invite investment as it wields this nasty weapon of angel tax. Adding salt to the wound, the NAV of unlisted equity shares is determined by insisting on adopting the book value of the assets irrespective of their real worth.
It is time the Government takes a bold move and drops section 56(2)(viib). Any mischief which the Government seeks to remedy may be addressed by more efficiently exercising the powers under sections 68 to 69C. In the meanwhile, the aforesaid disparity in the valuation should be immediately removed by executive action.
Case 2: Indirect transfer – Rule 11UB(8)
Explanation 5 to section 9(1)(i) provides that an asset or a capital asset being any share or interest in a company or entity registered or incorporated outside India shall be deemed to be, and shall always be deemed to have been, situated in India if the share or interest derives, directly or indirectly, its value substantially from the assets located in India (underlying asset).
Explanation 6(a) to section 9(1)(i) provides that the share or interest, referred to in Explanation 5, shall be deemed to derive its value substantially from the assets (whether tangible or intangible) located in India if, on the specified date, the value of such assets
a) Exceeds Rs. 10 crores; and
b) Represents at least 50% of the value of all the assets owned by the company or entity, as the case may be.
Explanation 6(b) to section 9(1)(i) provides that the value of an asset shall be its FMV on the specified date without reduction of liabilities, if any, determined in the manner as prescribed.
Rule 11UB provides the manner of determination of the FMV of an asset for the purposes of section 9(1)(i). Sub-rules (1) to (4) of Rule 11UB provide for the valuation of an asset located in India, being a share of an Indian company or interest in a partnership firm or association of persons.
Rule 11UB(8) provides that for determining the FMV of any asset located in India, being a share of an Indian company or interest in a partnership firm or association of persons, all the assets and business operations of the said company or partnership firm or association of persons are taken into account irrespective of whether the assets or business operations are located in India or outside India. Thus, even though some assets or business operations are not located in India, their value would be taken into account, thereby resulting in a higher FMV of the underlying asset in India and hence a higher chance of attracting Explanation 5 to section 9(1)(i).
This is contrary to the scheme of section 9(1)(i) read with Explanation 5 which seeks to tax income from indirect transfer of underlying assets in India. Explanation 5 codifies the economic concept of location of the asset. Such being the case, Rule 11UB(8) which mandates valuation of the Indian asset ignoring the downstream overseas investments by the Indian entity, is ultra vires of Explanation 5. It offends the very economic concept embedded in Explanation 5.
Take the case of a foreign company [FC], holding shares in an investment company in India [IC] which has step-down operating subsidiaries located outside India [SOS]. It is necessary to determine the situs of the shares of the FC in terms of Explanation 5.
Applying Explanation 6, the value of the shares of IC needs to be determined to see whether the same would exceed Rs. 10 crores and whether its proportion in the total assets of FC exceeds 50%.
Shares in FC derive their value not only from assets in India [shares of IC] but also from assets outside India [shares of the SOS]. However, Rule 11UB(8) mandates that while valuing the shares of the IC, the value of the shares of the SOS cannot be excluded. It seeks to ignore the fact that the shares of IC directly derive their value from the shares of the SOS, and thus the shares of FC indirectly derive their value from the shares of the SOS. This is unfair inasmuch as it goes beyond the scope of Explanation 5 and seeks to tax gains which have no economic nexus with India.
This is a classic case of executive overreach. By tweaking the rule, it is sought to bring to tax the gains which may have no nexus with India, whether territorial or economic. It is beyond the jurisdiction of the taxman to levy tax on gains on the transfer of the shares of a foreign company which derive their value indirectly from the assets located outside India.
Taxation of indirect transfer invariably results in double taxation. Mitigation of such double taxation is subject to the niceties associated with complex FTC rules. Such being the case, it is unfortunate that the scope of taxation of indirect transfer is extended by executive overreach. Before this unfair and illegal action is challenged, it would be good for the Government to suo motu recall the same.
