The Finance Bill, 2010 witnessed the introduction of a new provision in the Income-tax Act, 1961 (IT Act), being the insertion of clause (viia) to sub-section (2) of section 56 of the IT Act, with effect from 1st day of June 2010.
Until such time, only individuals and Hindu Undivided Families (HUF) were covered within the provisions of section 56(2). As explained in the Memorandum to the Finance Bill 2010, clause (viia) was inserted in section 56(2) to prevent the practice of transferring shares of an unlisted company without consideration or at a price lower than the Fair Market Value (FMV) and to bring it under the tax net.
The legislative intent behind introduction of this provision was to prevent laundering of unaccounted income under the pretext of gifts, especially after abolition of the Gift Tax Act. Hence, these provisions are in the nature of anti-abuse provisions.
These provisions apply only if the recipient of shares is a company and in which public are not substantially interested or a firm. The term ‘firm’ has now been inclusively defined u/s.2(23)(i) to include a Limited Liability Partnership as defined (LLP), under the LLP Act, 2008.
We reproduce below the relevant extract of section 56(2)(viia) of the IT Act:
“(viia) where a firm or a company not being a company in which the public are substantially interested, receives, in any previous year, from any person or persons, on or after the 1st day of June, 2010, any property, being shares of a company not being a company in which the public are substantially interested, —
(i) without consideration, the aggregate fair market value of which exceeds fifty thousand rupees, the whole of the aggregate fair market value of such property;
(ii) for a consideration which is less than the aggregate fair market value of the property by an amount exceeding fifty thousand rupees, the aggregate fair market value of such property as exceeds such consideration:
Provided that this clause shall not apply to any such property received by way of a transaction not regarded as transfer under clause (via) or clause (vic) or clause (vicb) or clause (vid) or clause (vii) of section 47.
Explanation — For the purposes of this clause, ‘fair market value’ of a property, being shares of a company not being a company in which the public are substantially interested, shall have the meaning assigned to it in the Explanation to clause (vii);”
The provisions of section 56(2)(viia) of the IT Act are therefore, attracted upon fulfilling of the following conditions:
(a) Recipient is a firm or a company not being a company in which the public are substantially interested, as defined u/s.2(18) of the IT Act closely held company;
(b) Transferor can be any person;
(c) Recipient must ‘receive’ shares of a closely-held company; and
(d) Shares should be received without consideration or for inadequate consideration.
Therefore any receipt of shares of a closely-held company, without consideration or for inadequate consideration, is taxable in the hands of the recipient.
For the purposes of this section, consideration would be deemed to be inadequate, if the difference between the actual consideration and the FMV (to be determined as per prescribed Valuation Rules) of the property exceeds Rs.50,000.
As per Rule 11UA of the Income-tax Rules, 1962, the FMV of unquoted shares is to be determined as under:
(a) Equity shares: Book value of the shares to be computed as follows:
(A – L) x (PV)
—————-
(PE)
Where,
A = Book value of the assets in balance sheet as reduced by any amount paid as advance tax under the Income-tax Act and any amount shown in the balance sheet including the debit balance of the profit and loss account or the profit and loss appropriation account which does not represent the value of any asset.
L = Book value of liabilities shown in the balance sheet but not including the following amounts —
(i) the paid-up capital in respect of equity shares;
(ii) the amount set apart for payment of dividends on preference shares and equity shares where such dividends have not been declared before the date of transfer at a general body meeting of the company;
(iii) reserves, by whatever name called, other than those set apart towards depreciation;
(iv) credit balance of the profit and loss account;
(v) any amount representing provision for taxation, other than amount paid as advance tax under the Income-tax Act, to the extent of the excess over the tax payable with reference to the book profits in accordance with the law applicable thereto;
(vi) any amount representing provisions made for meeting liabilities, other than ascertained liabilities;
(vii) any amount representing contingent liabilities other than arrears of dividends payable in respect of cumulative preference shares.
PE = Total amount of paid-up equity share capital as shown in balance sheet.
PV = the paid-up value of such equity shares.
Please note, here FMV does not imply the actual market value of the shares at which shares may be transacted between parties. It is the value of shares as determined based on book value of the assets and liabilities of the company.
(b) Other than equity shares: Price which the shares will fetch in the open market, to be determined by a valuation report of a Merchant Banker or a Chartered Accountant.
If, in case the company has issued Compulsory Convertible Preference Shares (CCPS), then unless it has been actually converted to equity shares, it would be regarded as ‘other shares’. Thus, on any transfer of CCPS before its conversion, one will have to consider its market value, as stated above, to ascertain the implications u/s.56(2)(viia).
The tax officer is given the power to refer the questions of FMV of equity shares and other shares, to a valuation officer. For this purpose, necessary changes have been made u/s.142A(1) of the IT Act, with effect from 1st July 2010.
In order to avoid hardships in genuine cases, certain exceptions have been provided in the said provision as listed below:
(a) Receipt of shares in an Indian company by amalgamating foreign company from the amalgamated foreign company, in a scheme of amalgamation;
(b) Receipt of shares in an Indian company by resulting foreign company from the demerged foreign company, in a scheme of demerger;
(c) Receipt of shares in case of business reorganisations of a co-operative bank;
(d) Receipt of shares in the resulting company by the shareholders of the demerged company, under a scheme of demerger; and
(e) Receipt of shares in the amalgamated company by the shareholders of the amalgamating company, under a scheme of amalgamation.
Thus, the receipt of shares of a closely-held company, for reasons, other than as mentioned above, would attract the provisions of section 56(2)(viia) of the IT Act.
It is pertinent to note that corresponding amendments to section 49 by insertion of sub-section (4) have been incorporated, so as to provide that if provisions of section 56(2)(viia) are invoked, then the FMV of the shares so determined would be regarded as the ‘cost of acquisition’ in the hands of the recipient. This is to ensure that once the recipient is taxed on the differential value of the consideration, i.e., difference between FMV and the actual consideration, then such recipient is entitled to add such value towards its cost of acquisition of the shares.
The applicability of these provisions to certain transactions which are not specifically included in the list of exceptions will have to be judged by interpretation of the provisions as they read vis-à-vis the actual legislative intent. A strict interpretation may lead to absurd results while digging the legislative intent may lead to a liberal interpretation.
In this article, we have dealt with certain peculiar situations which may arise in corporate restructuring.
1. Receipt of shares pursuant to fresh issue of shares at a price less than FMV or issue of bonus shares by the company
In case, where a closely-held company restructures its capital base, it may consider the option of further issue/rights issue to new/existing shareholders. Unlike listed companies which are subject to pricing guidelines on preferential allotment, closely-held companies are free to issue shares at a price as decided by its board of directors.
Thus, legally a closely-held company is entitled to issue shares at less than the book value of its existing shares, being the FMV for the purposes of section 56(2). Now, whether such an issue of shares at less than FMV can be covered within the ambit of section 56(2)(viia)? Also, would there be any taxability u/s.56(2)(viia) in case of bonus issue by a company which due to its very nature would always be received by the shareholders without any consideration?
The application of section 56(2)(viia) to allotment of bonus does not seem to be the legislative intent. This is supported by the Memorandum to the Finance Bill, 2010 which indicates that section 56(2)(viia) ought to apply only in case of ‘transfer’ of shares. In case of allotment of shares, there is no ‘transfer’ of shares. Further, even the meaning of the words ‘receives any property’ contemplates that the property should be in existence before it can be received. Whereas, in case of issue of shares by a company, shares come into existence only at the time of allotment.
Additionally, in case of bonus issue, it is a case of capitalisation of reserves which in any case belong to the shareholders. Therefore, the shareholders do not receive shares without consideration, rather what they receive is in lieu of an existing right in the profits of the company. Hence, 56(2)(viia) ought not to apply to a bonus issue.
2. Conversion of debentures into equity shares at a pre-agreed value
Similar to issue of equity shares, it is common for companies to issue debentures which are convertible into equity shares of the company at a later date. At the time of issue of such instrument, the subscriber would have paid the entire value of the debenture and would have agreed to the terms and conditions regarding the conversion ratio of debentures into equity shares.
A question that arises is at the time of actual conversion of debentures, if the FMV of the equity shares is higher than the price paid by the debenture holders to acquire the debentures, would section 56(2)(viia) apply?
Similar to the issue of equity shares for cash, on conversion of debentures, the company would issue equity shares to debenture-holder in consideration of the value of the debentures being surrendered to the company. On allotment of shares by the company at the time of conversion of debenture, new shares are brought into existence at such point of time and hence section 56(2)(viia) ought not to apply on conversion of debentures into equity shares.
3. Implications for non-resident recipients
Section 56(2)(viia) does not make any distinction between resident and non-resident companies/ firms. Therefore, receipt of any shares of a closely held company by a non-resident without consideration or for an inadequate consideration would be taxable as ‘Income from other sources’ under the IT Act.
However, if the non-resident is a resident of a foreign country with which India has entered into a Double Tax Avoidance Agreement (DTAA), his taxability in India would depend on the relevant DTAA. Under the DTAA, the said income may be governed by the Article dealing with ‘Other Income’. It may be noted that the DTAAs entered by India with countries like Czech Republic, Germany, Hungary, Mauritius, etc., provide that ‘Other Income’ earned by a resident of a Contracting State shall be taxable only in the Contracting State where the taxpayer is resident, except if the tax-payer carries on business in the other Contracting State through a permanent establishment (PE) or the person provides independent personal services from a fixed base situated therein. In other words, section 56(2)(viia) may not apply to a non-resident, if he does not have a PE or fixed base in India.
If the non-resident is a resident of a foreign country with which India has not entered into a DTAA, then the provision of section 56(2)(viia) of the IT Act would apply and income earned by such non-resident would be subject to tax in India.
4. Sale of an undertaking comprising of shares on a slump-sale basis
When a closely-held company acquires an ‘undertaking’ by way of a ‘slump sale’ and the undertaking, inter alia, comprises of shares of a company in which public are not substantially interested, whether it can be said that provisions of section 56(2)(viia) get attracted.
In such a case, can it be said that the transfer is of certain assets and liabilities as a whole for a lump sum consideration and that it would not be possible to artificially allocate consideration towards the shares, which form part of the undertaking?
Even if one were to ignore the practical difficulty, section 56(2)(viia) should not apply to sale of an undertaking, because the words used in section 56(2)(viia) are ‘receives any property, being shares of a company …….’ which means that the property being transferred/received should be shares of a company. In case of sale of an undertaking, the property being transferred would be an ‘undertaking’ and not ‘shares’ per se. To attract section 56(2)(viia), the subject matter of receipt should be ‘property being shares’ and not property being an undertaking which may include shares of a company in which public are not substantially interested. Several Court decisions have recognised ‘undertaking’ as a distinct capital asset or a distinct property. If sale of an undertaking on a slump sale is viewed as a sale of individual assets like plant and machinery, shares, etc. and subjected to section 56(2)(viia), it would go to diluting the meaning of slump sale.
However, the above argument may be looked at differently by the Revenue authorities, in case of transfer of an undertaking where the undertaking comprises only of shares of a company, i.e., an Investment Division.
5. Capital reduction/Buyback of shares
Amongst others, companies resort to capital reduction u/s.100-103 of the Companies Act as part of their corporate restructuring. One of the ways of doing capital reduction is by way of cancellation of shares either partially or fully (in case a class of shares is being cancelled). Depending on the purpose of capital reduction and the liquidity in the company, the board of directors may decide to pay the shareholders certain amount of consideration per share. In case of closely-held companies, the FMV as defined for the purpose of section 56(2)(viia) of the shares may or may not be relevant in deciding the consideration on cancellation of shares. Post introduction of section 56(2)(viia), the issue is whether this section will get attracted in the hands of a company if the consideration paid is less than the FMV of the shares cancelled.
On the same lines, can it be said that a buyback of shares by a closely-held company u/s.77A of the Companies Act, 1956 will attract the provisions of 56(2)(viia) of the IT Act?
The key issue here is whether the meaning of the words ‘receives’ as used in the provision can extend to buyback or capital reduction for mere cancellation purposes? As the word ‘receives’ is not defined under the IT Act, it gives room to varied interpretations.
While the ‘transfer’ of shares pursuant to capital reduction/buyback are taxable transfers in the hands of the transferor, the tax authorities may contend that these would constitute ‘receipt’ in the hands of the company cancelling or buying back the shares and therefore should be subjected to section 56(2)(viia) if the consideration paid to the shareholders is less than the FMV.
A relevant point, that the company does not receive its shares, but only cancels its share capital pursuant to the powers conferred on it under the Companies Act. In fact, the Companies Act does not permit a company to hold its own shares. Even if one were to say that a company receives its own shares on buyback or cancellation of shares, it is for the limited purpose of cancellation of those shares and therefore the company does not actually ‘receive’ any property, in the nature of shares.
However, litigation on applicability of section 56(2)(viia) to buyback or reduction cannot be ruled out.
6. Transfer of shares by a partner of a firm/LLP
When a partner of a firm/LLP transfers shares of a closely-held company by way of capital contribution to a firm/LLP, section 45(3) of the IT Act would apply. As per section 45(3), the amount recorded in the books of accounts is deemed to be the full value of the consideration for computing the capital gain in the hands the partner.
If, the value so recorded in the books of the firm/ LLP is less than the FMV as determined under the valuation rules, then it may be possible that the difference between the FMV and the price at which transfer is made by the partner, may be considered as income of the firm/LLP u/s. 56(2)(viia) of the IT Act.
While undertaking any business reorganisation, a closely-held company will have to evaluate the applicability and the possible implications u/s.56(2) (viia) of the IT Act. Since this is a recently introduced provision, various interpretations can emerge.
