ISSUE FOR CONSIDERATION
Receipt of consideration for issue of shares by a company, not being a company in which the public are substantially interested, in excess of the face value of such shares, is taxable in the year of receipt, to the extent of the amount that exceeds the fair market value of the shares, as per the provisions of clause (viib) of sub-section (2) of s.56 of the Income-tax Act, 1961.
This provision does not apply to the receipts by a venture capital undertaking from a venture capital company or a fund or a specified firm besides the receipts by a company from a class of notified persons, for example a start-up company.
Rules 11U and 11UA provide for the method of determining the fair market value of the shares by following the Net Asset Value method or the Discounted Cash Flow method. In the alternative, the fair market value shall be such value as is substantiated by the company to the satisfaction of the AO based on the value of its assets.
An interesting issue has arisen in respect of applicability of S.56(2)(viib) of the Act, where shares are issued by a closely held company at a premium on conversion of loans into share capital.
The Chandigarh Bench of the Income Tax Appellate Tribunal held that such a conversion of a loan into share capital does not attract the provisions of S.56(2)(viib). In contrast, the Ahmedabad Bench of the Tribunal recently held that the provisions do apply following the decisions of the Kolkata and Mumbai Benches of the Tribunal.
I. A. HYDRO ENERGY’S CASE
The issue arose in the case of CIT vs. I.A Hydro Energy (T) Ltd., before the Chandigarh Bench of the Tribunal in ITA No. 548/CHD/2022 dt. 11.10.2023 for assessment year 2018-19. In that case, the assessee, an Indian company, engaged in the business of generation and distribution of electricity, owned a Hydro Electric Project in Chanju, Himachal Pradesh. For the relevant year, the assessee filed the return of income on 18.10.2018 under section 139(1) of the Act declaring a loss of ₹67,15,30,280. The assessment in the case of the assessee was completed vide order dated 12.04.2021 passed under section 143(3) read with sections 143(3A) & 143(3B) assessing the total income of the assessee at ₹135,36,85,457/- after making addition of ₹202,50,00,000/- u/s 56(2)(viib) of the Act. The AO noted that the assessee company had issued equity shares at a premium, which was in excess of the fair market value of the shares issued. On appeal, the CIT(A) deleted the addition made by the assessing officer. Aggrieved, the Income-tax Department filed an appeal before the Tribunal.
In appeal, it was pointed out by the Revenue that the assessee company was incorporated on 23.03.2017 and prior to that, business was carried out in the status of a partnership firm, namely M/s. I A Energy, which was constituted on 18.06.2010. On conversion of the partnership firm into a company, all the partners of the firm became shareholders. Later on, unsecured loans given by the erstwhile partners were converted into equity shares, which were issued at a premium. The assessee had, during the year, allotted 2,25,00,000 shares of face value ₹10 each at a premium of ₹90 each while the market value of the shares as per the Net Asset Value (NAV) method and Rule 11UA of the Income Tax Rules was far less than the value at which the shares had been allotted. The assessee had submitted that the value of the shares had been determined at ₹106 per share by the Discounted Cash Flow (DCF) method and had submitted the CA certificate in support of the same. The CA certificate mentioned that all the values of variables in the DCF method had been taken as per figures provided by the management of assessee company. The assessee failed to produce any valid justification in respect of projection of financial statements, which were baseless, unsubstantiated and far removed from the actual business and financial realities of the assessee company.
The Revenue, on the above facts, requested the Tribunal to consider the following grounds :
1. The Ld CIT (A) erred in deleting the addition of ₹202.50 Crores under the Head “Income from Other Sources” u/s 56(2)(viib) of the Act on account of excess amount per share paid as premium.
2. The Ld CIT (A) erred in holding that there is no case of application of Section 56(2)(viib) to the facts of appellant’s case where pre-existing unsecured loans of partners / shareholders were converted into equity shares at premium and the facts of the assessment order do not indicate any case of tax abuse involved in such share conversion.
3. The Ld CIT (A) erred in deleting the addition as the DCF (Discounted Cash Flow) valuation used by the assessee was done with fictitious figures having no correlation with actual affairs of the assessee company.
The Revenue challenging the impugned order, contended that the CIT (A) erred in deleting the addition of ₹202.50 Crores made by the AO u/s 56(2)(viib) of the Act under the head “Income from Other Sources” on account of excess of fair market value per share paid as premium; that the CIT (A) erred in holding that there was no case for application of Section 56(2)( viib) to the facts of appellant’s case, where pre-existing unsecured loans of partners / shareholders were converted into equity shares at a premium and the facts of the assessment order did not indicate any case of tax abuse involved in such share conversion; that the CIT (A) erred in deleting the addition based on DCF (Discounted Cash Flow) valuation used by the assessee which was done with fictitious figures having no correlation with actual affairs of the assessee company;
In response, on behalf of the assessee company, it was contended that no money/consideration was actually received by the assessee on conversion of loans to shares, after a conversion of the partnership firm to the assessee company, and that thereby, the provisions of Section 56(2)(viib) of the Act were not applicable. It was further submitted that Section 56(2)(viib) of the Act provided for taxation, where the company received any consideration in excess of fair market value of shares; that the assessee had not received any money/ consideration on issuance of shares; the shares had been issued in lieu of already outstanding loans received from existing shareholders itself.
It was reiterated that the assessee company came into existence on 23.03.2017 by conversion of the Firm. All the partners of the Firm became shareholders of the company. The Firm was also enjoying substantial amount of loan facility from its partners, who granted loans from time to time vide loan agreement(s) of 2010. It was upon conversion of the firm to a Company that the existing loans were converted into equity shares, and thereby the assessee issued 2,25,00,000 equity shares of ₹10 each at a premium of ₹90 in lieu of outstanding loans. It was submitted that the aforesaid unsecured loans received from the partners, starting from the year 2010, had always been accepted as genuine in the hands of the Firm in as much as no doubt/addition/ disallowance in respect of such loans had been made in completed scrutiny assessment(s) for AYs 2013-14, 2014-15, 2016-17 and 2017-18.
It was submitted that it was apparently clear that no fresh consideration/ money had flown to the assessee company on issue of shares during the relevant year. In effect, the loans were received in preceding years and were outstanding and had merely changed form during the relevant year, i.e., from ‘loan’ to ‘equity share capital’; there was no consideration received by the assessee company during the year in lieu of shares allotted, warranting application of section 56(2)(viib) of the Act.
It was mentioned that clause (viib) of sub section (2) of section 56 was inserted vide Finance Act, 2012 with a view to curb the practice of closely held companies introducing undisclosed money of promoters / directors by issuing shares at high premium, over and above the book value of shares of the company, to escape the rigours of section 68 of the Act.
Attention had been drawn to the Budget Speech, 2012 wherein the object behind the introduction of Section 56(2)(viib) in the Act besides the Circular No. 1 /2011 dated 6th April, 2011 issued by the Board.
The decision of the CIT(A) was reproduced in para 12 of its order by the Chandigarh bench to support the case for no addition. The relevant parts of the said decision were:
In view of the aforesaid, considering that section 56(2)(viib) of the Act is aimed at curbing practice of routing unaccounted/ black money, the said provisions would not, in our respectful submission, apply in case of bona-fide transaction of conversion of existing loans, accepted as genuine in the year of receipt, to share capital, that, too, related to existing shareholders refer PCIT vs. Cinestaan Entertainment Pvt Ltd. : ITA No. 1007/2019 (Del HQ; C/earview Healthcare (P.) Ltd. vs. ITO: 181 ITD 141 (Del Trib.); Vaani Estates (P.) Ltd. vs. ITO: 172 ITD 629 (Chennai Trib.).
28. Further, Circular No.1/201I dated 6 April, 2011 issued by the CBDT explaining the provision of section 56(2)(vii) of the Act specifically states that the section was inserted as a counter evasion mechanism to prevent money laundering of unaccounted income. In paragraph 13.4 thereof, it is stated that “the intention was not to tax transactions carried out in the normal course of business or trade, the profit of which are taxable under the specific head of income”. The said circular, it is respectfully submitted, further fortifies the contention of the assessee that the provision of section 56(2)(viib) of the Act are not applicable to genuine business transaction without there being any evidence stating otherwise.
29. In view of the aforesaid, in absence of any money/ consideration flowing to the assessee company on issue of shares and keeping in mind the avowed objective behind introduction of section 56(2)(viib) of the Act, the said section has no application. In that view of the matter, addition made by the assessing officer under section 56(2)(viib) of the Act is liable to be deleted at the threshold, on the said ground itself.
30. It is further submitted that once the transaction is tested by the tax department and the assessing officer is satisfied that the transaction is a genuine business transaction, i.e., without any element of tax avoidance, then, there is no requirement to further test FMV of issue of shares at premium, applying provisions of section 56(2)(viib) of the Act.
The Tribunal reiterated that in pursuance of the aforesaid loan agreement(s), the pre-incorporation loan given by the erstwhile partners (now shareholders) were converted into shares of the assessee company, by issue of fresh equity shares of ₹10 each at premium of ₹90 per share (total ₹100 per shares) during the relevant year. A copy of the Valuation Report obtained by the assessee from its Chartered Accountant has been filed.
The Tribunal noted that the CIT(A), while deleting the addition made by the AO, had observed as follows :
(ii) The appellant has referred to the objective behind provision of Section 56(2)(viib) introduced by Finance Act, 2012 by relying on the Budget Speech 2012 and contended that section was introduced as an anti-abuse provision to arrest circulation of unaccounted y in the economy. Reference to Hon’ble Supreme Court decision in the case of K.P. Verghese Vs. lTO, 131 ITR 597 was also made wherein the Hon’ble Apex Court held that the h of Finance Minister while Introducing Finance Bill, carries considerable weightage to determine the intent behind the provisions inserted/amended. It was thus, contended that bonafide transaction of conversion of existing loans accepted as genuine in the year of receipt to share capital and that too for existing shareholders will not fall under the purview of Section 56(2)(viib) of the Act.
(iii) It was also contended that once the transaction is tested by the tax department and found genuine without any element of tax avoidance, there cannot be any requirement to test FMV of issue of shares at premium applying the provision of Section 56(2)(viib) of the Act. The appellant has relied on the decision in Clearview Healthcare Pvt. Ltd. Vs. ITQ 181 ITD 141 (Delhi bench). Cinestaan Entertainment Pvt. Ltd., 170 ITD 809 (Delhi bench) and similar other decisions to support this contention.
(iv) As regards the rejection of appellant’s valuation of DCF method, it is contended that the choice of valuation method is available to the assessee (NAV or DCF) as per provision of Rule 11UA of IT. Rules and the AO substituting the method of valuation by NAV is completely beyond jurisdiction and invalid. The appellant relied on the decision of Bombay High Court in the case of Vodafone M-Pera Ltd. Vs. DCIT, 164 ITR 257, wherein the Hon’ble Court held that the AO cannot change the method adopted by the assessee for share valuation by DFC method which was violation of Rule 11UA. The appellant has referred to similar decision of Mumbai ITAT, Bangalore, ITAT Delhi ITAT to emphasize that the AO could not have substituted the- assessee’s choice of method of valuation as mandated by Rule 11UA of IT. Rules.
v) The appellant has referred to the decision of CIT Vs. WA Hotels Pvt. Ltd., 276 Taxmann 330 (MAD) to support its contention that variation between projection and actual results cannot be the ground for rejection of DCF method to value shares. In the case of VVA Hotels, Hon’ble Madras High Court held that unless the AO is able to bring out any evidence of abuse of benevolent provision with an intention to defraud the revenue, the option given to the assessee shall be held to be absolute as regards DCF method of share valuation. The appellant also referred to similar other decisions to support this view point. In the case of Creditapha Alternative Investment Advisors Pvt. Ltd., 134 Taxmann.com 223, Hon’ble Mumbai ITAT held that the Assessing Officer has no authority to pick and choose the valuation method and make addition as it was the assessee who has option to choose the method of valuation.
vi) Appellant contended that the AO cannot on his “ipse dixit” reject the valuation report of an expert and supported this contention by referring to relevant decisions of various Courts / tribunals . The appellant relied on the decision in the case of Urmin marketing Pvt ltd 122 Taxmann.cm.40 (Aha; wherein it was held that the valuation report prepared by technical expert cannot be disturbed by the AO without taking opinion of the technical person. vii) The appellant contended that even the observations of the AO as regards variation in projected figures and actual figures were duly explained through detailed charts and reasonable assumptions made.
After considering the AO’s findings in the assessment order and appellant’ submission, following facts emerge
i) It is undisputed fact that the appellant did not receive any consideration for allotment of shares in the previous year relevant to current assessment year. The AO has not discussed this fact neither countered this contention of the appellant. It is a clear fact that the erstwhile partners of the erstwhile Firm (converted into appellant company) had given loans to the said firm which was converted into share capital of those partners becoming the shareholders. The AO has mentioned in the assessment order that the loans outstanding as on 01.04.2017 were converted into share capital. The shares were issued at Rs.10 per share face value and premium of Rs.90 per share. After plain reading of S.56(2)(viib), there is no doubt that this provisions is applicable to the considerations received in the previous year under consideration for taxing the excess premium charged over and above fair market value of shares determined as per prescribed method under Rule 11UA. In the current facts of the case, the appellant did not receive any consideration in the current assessment year and the outstanding loans of existing partners of erstwhile firm was converted into the shares of the appellant company. Thus, prima facie, there is no justification for the AO to apply Section 56(2)(viib) of the Act in the appellant’s case. The said consideration in the form of unsecured loans were received from the partner of the erstwhile firm in the year 2010 (as evidenced from loan agreement) and the AO could not bring out any material facts to show that such conversion of loans to equity shares was a ploy to defraud revenue of the tax on such transaction. In fact, the loans received in earlier years also got tested through scrutiny assessments completed for assessment year 2013-14, 2014-15, 2016-17 and 2017-18 in the case of the erstwhile firm. Thus, it can be concluded that the AO has not made out any case that the share conversion by the appellant led to defrauding revenue of its due taxes. Thus, firstly ,the amount is not received in the relevant previous year makes the applicability of S.56(2)(viib) invalid in the case of the appellant and secondly, the legislative intent to arrest abuse of tax laws to defraud revenue is also not available in the current facts of the case as the receipt of loans in the earlier years were from the existing partners of the erstwhile firm which got duly verified in the scrutiny of various assessment years after loans receipt”.
The Tribunal noted that the ld. CIT(A) had observed that it was an undisputed fact that the appellant did not receive any consideration for allotment of shares in the previous year relevant to the current assessment year; that the AO had not discussed that fact nor countered that contention of the appellant; it was a clear fact that the erstwhile partners of the erstwhile Firm (converted into appellant company) had given loans to the said firm, which were converted into share capital of those partners, who became the shareholders; the AO had mentioned in the assessment order that the loans outstanding as on 01.04.2017 were converted into share capital; the shares were issued at ₹10 per share face value and premium of ₹90 per share.
The Tribunal observed that on a plain reading of S.56(2)(viib), there was no doubt that the provision was applicable to the consideration received in the previous year under consideration for taxing the excess premium charged over and above fair market value of shares determined as per prescribed method under Rule 11UA. In the current facts of the case, the appellant did not receive any consideration in the current assessment year, and only the outstanding loans of existing partners of erstwhile firm was converted into the shares of the appellant company. Thus, prima facie, there was no justification for the AO to apply Section 56(2)(viib) of the Act in the appellant’s case. The said consideration in the form of unsecured loans was received from the partners of the erstwhile firm in the year 2010, as evidenced from loan agreements, and the AO could not bring out any material facts to show that such conversion of loans into equity shares was a ploy to defraud revenue of the tax on such transaction.
In fact, the loans received in earlier years also got tested through scrutiny assessments completed for assessment year 2013-14, 2014-15, 2016-17 and 2017-18 in the case of the erstwhile firm. Thus, it could be concluded that the AO had not made out any case that the share conversion by the appellant led to defrauding revenue of its due taxes. Thus, firstly, the fact that the amount is not received in the relevant previous year made the applicability of S.56(2)(viib) invalid in the case of the appellant and secondly, the legislative intent to arrest abuse of tax laws to defraud revenue was also not available in the current facts of the case, as the receipt of loans in the earlier years were from the existing partners of the erstwhile firm, which got duly verified in the scrutiny of various assessment years after receipt of the loans.
In PCIT vs. Cinestaan Entertainment Pvt. Ltd., 433 ITR 82 ( Del), it was contended on behalf of the Assessee-Respondent before the High Court, inter alia, that section 56(2)(viib) of the Act was not applicable to genuine business transactions; that the genuineness and creditworthiness of the strategic investors was not doubted by either the AO, or the CIT(A); that sub-clause (ii) of clause (a) of the Explanation to section 56(2)(viib) was not applicable to the case of the Respondent-Assessee and the Assessee was not required to satisfy the Assessing Officer about the valuation done; and that in accordance with sub-clause (i) of clause (a) of the Explanation to section 56(2)(viib). the Respondent-Assessee had an option to carry out a valuation and determine the fair market value of the shares only on the Discounted Cash Flow Method (the DCF Method), which was appropriately followed by the Respondent-Assessee.
In view of the above facts and discussion, it was apparent to the Chandigarh bench that there was no case of application of Section 56(2)(viib) to the facts of the appellant’s case where pre-existing unsecured loans of partners/shareholders were converted into equity shares at a premium, and the facts of the assessment order did not indicate any case of tax abuse involved in such share conversion. Even the AO’s decision to substitute DCF method of share valuation by NAV method was not in accordance with Rule 11UA of the IT Rules. Accordingly, the addition of ₹202,50,00,000 u/s. 56(2)(viib) of the Act was deleted.
PARASMANI GEMS’S CASE
The issue was again recently examined by the Ahmedabad Bench of the Tribunal in the case of Parasmani Gems (P) Ltd., vs. DCIT, 210 ITD 215, for assessment year 2013-14. In that case, the assessee company was engaged in the business of manufacturing and trading of gold and diamond jewellery. In assessing the total income for A.Y. 2013-14, the AO found that the assessee had issued shares of face value of ₹10 with a premium on two occasions during the financial year under consideration, first on 03.11.2012 at a premium of ₹90 per share, and again on 26.03.2013 at a premium of ₹31.67 per share only to three persons namely, Daxesh Manharlal Soni, Kunal Manharlal Soni & Nirav Manharlal Soni, against the loans received from such persons in the past.
It was explained to the AO that the shares allotted on 03.11.2012 were on the basis of fair market value of the shares as determined under Discounted Cash Flow method, supported by a report of the Accountant that was filed. The AO was not satisfied with the working of the FMV of the shares as per the DCF method of valuation adopted by the assessee and instead, he worked out the value of the shares as per Net Asset Value method, which worked out to ₹34.55 share only. Accordingly, the AO held that the premium charged to the extent of ₹55.45 (90-34.55) per share was excessive and accordingly a part of the share premium of ₹94,26,500 was added u/s.56(2)(viib) of the Act, which was, subsequently on rectification, reduced to ₹27,72,500 only.
Aggrieved with the order of the AO, the assessee had filed an appeal before the First Appellate Authority, which had been dismissed by the FAA. The assessee in the second appeal, before the Tribunal, raised the following relevant grounds of appeal, besides a few others:
(1) That on facts and in law, the learned CIT(A) has grievously erred in confirming the addition of ₹27,72,500/- made u/s 56(2)(viib) of the Act.
(2) That on facts, evidence on record, and in law, the learned CIT (A) ought to have accepted the valuation done by appellant’s C.A. and ought to have held that the provisions of section 56(2)(viib) of the Act are not applicable and the entire addition ought to have been deleted, as prayed for.”
For the assessee, besides a few other contentions not considered here for the sake of brevity, it was submitted on the issue under consideration herein that there was no fresh introduction of capital during the year; that the assessee had taken loans from the three shareholders, which were converted into share capital during the year and thus, no fresh consideration towards issue of shares was received during the year. The assessee relied upon the decision of the Chandigarh bench of the Tribunal in the case of ACIT vs. I.A. Hydro Energy Pvt. Ltd. [IT Appeal No. 548 (Chd.) of 2022, dated 11-10-2023, and submitted that when no amount was received during the year towards share capital, the applicability of Section 56(2)(viib) of the Act was invalid. The Tribunal was further informed that the decision of the Chandigarh bench was confirmed by the High Court of Himachal Pradesh in ITA No.4 of 2024 dated 31.05.2024/Principal Commissioner of Income-tax vs. I.A. Hydro Energy (P.) Ltd., 299 Taxman 304 (HP).
On behalf of the Revenue, on the issue under consideration herein, besides a few other submissions not considered here, it was submitted that Section 56(2)(viib) of the Act prescribed “any consideration for issue of shares” and that the word “consideration” had a much wider implication. In this regard, reliance was placed on the decision of ITAT Mumbai in the case of Keep Learning Resources Pvt. Ltd. vs. ITO [IT Appeal No. 1692 (Mum.) of 2023, dated 31-8-2023, wherein an identical issue of conversion of loan advanced in the past into equity shares with share premium was involved, and the Mumbai bench had held that the transaction was covered by the provisions of Section 56(2)(viib) of the Act. Reliance was placed also upon the decision of the Kolkata bench of the Tribunal in the case of Milk Mantra Dairy (P.) Ltd. vs. Deputy Commissioner of Income-tax 196 ITD 333 (Kol.). It was also submitted that the assessee had issued shares on two occasions i.e. on 03.11.2012 and again on 26.03.2013, both during the same financial year. While shares on 03.11.2012 were issued at a premium of ₹90/- per share, the shares allotted next on 26.03.2013 were issued at a premium of ₹31.67 per share only. The assessee had not explained the huge difference in the fair market value of the shares in the two allotments made during the same financial year; the premium of ₹31.67 charged by the assessee in the second allotment on 26.03.2013 itself proved that the premium of ₹90 charged earlier in the first allotment was not as per the correct FMV.
The Tribunal examined the facts and the ratio of the decision of coordinate bench of ITAT, Chandigarh, in the case of I.A. Hydro Energy Pvt. Ltd. (supra) on the contention of the assessee that that there was no fresh inflow of funds in respect of allotment of shares, and that it was only an accounting entry for conversion of loans into share capital and therefore, the provisions of Section 56(2)(viib) of the Act were not at all attracted.
The Ahmedabad bench of the Tribunal noted that the coordinate bench of Chandigarh Tribunal, in that case, did hold that in the case of conversion of loan into share capital, no consideration was received; that such conversion of loan into share capital did not lead to defrauding the Revenue of its due taxes; that the said decision of Chandigarh Bench of Tribunal was upheld by the Himachal Pradesh High Court; that the Hon’ble High Court, on the basis of the finding recorded by the Tribunal held that no substantial question of law was involved in the appeal before the court, and that the issue of whether provision of section 56(2)(viib) of the Act was applicable in the case of conversion of loan into share capital, was not independently examined by the Court. The relevant part of the order of the High Court was reproduced by the Tribunal:
“18. We are of the opinion that the orders passed by the Income Tax Appellate Tribunal as well as the CIT(Appeals), are fairly comprehensive. Both of them have concurrently found that no consideration was received by the assessee-firm for allotment of the shares, therefore Section 56(2)(viib) of the Act would not apply, and that it would have applied only if consideration was received for such a transaction.
19. Also, both the Tribunal and the CIT(Appeals) have held that the Assessing Officer had no jurisdiction to substitute the NAV method of assessing the valuation of shares, once the assessee had exercised option of a DCF valuation method as per Rule 11UA(2) of the Income Tax Rules.
20. We agree with the reasoning adopted by the CIT(Appeals) confirmed by the ITAT on all aspects and find that no substantial questions of law arise in this appeal for consideration by this Court.
21. Accordingly, the appeal fails and is dismissed.”
The Tribunal disagreed with the contention of the assessee that the decision of the Himachal Pradesh High Court in the case of I.A. Hydro Energy Pvt. Ltd. (supra) should be followed to maintain the judicial discipline and that the views expressed by even a non-jurisdictional High Court deserved utmost respect and reverence, that had the unquestionable binding force of law. The Tribunal instead held that a mere declaration by the court that no substantial question of law was involved, on the basis of findings of the lower authorities, could not be considered as a binding precedent. The Tribunal incidentally observed that in the case before the Himachal Pradesh High Court, the AO had no jurisdiction to substitute NAV method of valuation of shares when the assessee had opted DCF method of valuation. In contrast, noted the Tribunal, in the case before them, the assessee had not explained as to why the first allotment of shares was at a premium of ₹90 per share, whereas the second subsequent allotment, after a gap of 5 months, was made at a premium of ₹31.80 per share only. Thus, the facts of the case were found to be totally different and, therefore, the ratio of the decision of Himachal Pradesh High Court was not followed in view of the peculiar facts of the case before them. Further, the Tribunal observed that the judgement of the non-jurisdictional High Court, in any event, did not constitute unquestionably binding judicial precedent.
The provision of the Act as well as the Memorandum for introduction of this provision, the Tribunal noted, made it explicit that if the consideration was received for issue of shares that exceeded the fair value of such shares, then the consideration received for such shares, as exceeding the fair market value of the shares, shall be chargeable to tax under the head income from other sources. It noted that there was no stipulation in section 56(2)(viib) that it would be applicable only in the case of receipt of any ‘amount’ or ‘money’ on account of share application money. Rather the words used in the section were ‘any consideration for issue of shares’ which had a very wide implication. The Ahmedabad bench noted with approval the decision of the co-ordinate bench of Kolkata in the case of Milk Mantra Dairy (P.) Ltd. (supra).
The Ahmedabad bench again noted that the co-ordinate bench of Mumbai in the case of Keep Learning Resources Pvt. Ltd. (supra) had categorically held that the conversion of loan amount into equity shares would not exonerate the assessee from application of provisions of section 56(2)(viib) of the Act.
Keeping in view the language of the section, which used the term ‘consideration’, which was of wider import when compared with the word ‘amounts’, the Tribunal was inclined to agree with the decisions of Mumbai and Kolkata benches on the issue. As a result, the contention of the assessee that provisions of section 56(2)(viib) of the Act were not attracted in the case of conversion of loan amount into share capital was rejected. In the considered opinion of the Ahmedabad bench, the provisions of Section 56(2)(viib) of the Act did apply in the case of conversion of loan into share capital. It observed that the view adopted by the Chandigarh Bench would make the provisions of section 56(2)(viib) otiose for all such transactions of conversion of securities, which was not desirable. It therefore, upheld the order passed by the CIT(A), and the appeal filed by the assessee was dismissed.
OBSERVATIONS
The relevant part of s.56(2)(viib),introduced by Finance Act, 2012 reads as under;
where a company, not being a company in which the public are substantially interested, receives, in any previous year, from any person, any consideration for issue of shares that exceeds the Face value of such shares, the aggregate consideration received for such shares as exceeds the fair market value of the shares:
Provided that this clause shall not apply where the consideration for
issue of shares is received—
(i) by a venture capital undertaking from a venture capital company or a venture capital fund [or a specified fund]; or
(ii) by a company from a class or classes of persons as may be notified by the Central Government in this behalf:
The legislative intent behind the introduction of the deeming fiction was explained by the Finance Minister in the Budget Speech and in the Explanatory Memorandum.
On a composite reading of the provision and the background documents the following emerge;
- The provision represents a deeming fiction,
- It seeks to tax a receipt of consideration on issue of shares in given circumstances,
- The charge of the tax is in the year of receipt of consideration,
- The provision is an anti-avoidance measure that seeks to bring to book such cases which are intended to avoid tax by adopting such measures that are undesirable.
It is said that bad facts make for bad law, and the decision of the Ahmedabad bench, with respect, is a case that goes on to prove the same. In that case, the company, during the same year, had issued shares on two occasions, first at a premium of ₹90 per share and then later on at a paltry value of premium of ₹31.57 per share, providing a serious suspicion about the intentions of the company, more so when no material change had happened in the financials of the company between the two issues. This fact itself perhaps led the bench to overlook or keep aside the other relevant consideration of the need for actual receipt during the year and the motive behind the transaction, and also the fact that the valuation based on DCF supported the valuation.
The overwhelming urge to bring to book an errant company might have led the bench to disregard the fact that there was no apparent intention to avoid taxes and further led the bench to disregard the ratio of the decision of the High Court, which had, in clear terms with specific findings, approved the decisions of the CIT(A) and the Tribunal. To hold that the said decision of the High Court was delivered only on the lack of substantial question of law with respect to the case was not correct. Also, not correct was to hold that the decision of non-jurisdictional High Court was not binding on the bench more, so where there was no contrary decision of the Court on the subject nor was any such decision cited by the bench. The Himachal Pradesh High Court, in the decision, had considered the important facts, and on due consideration, had held that the appeal of the Revenue did not involve the substantial question of law. The decision of the Court therefore was delivered on the due consideration of the facts and the law, as was clear from the relevant part of the order reproduced by the bench itself in the body of the order.
The CIT(A) and the Tribunal, in the case of I.A. Hydro Energy Ltd., gave due consideration and the weightage demanded of the case before them to the Budget speech and the Explanatory Memorandum and a few other decisions of the Delhi High court, to hold that the deeming fiction of s.56(2)(viib) had no application in cases where there was no intention to avoid tax and that there was no proof of such intention.
The decision of the Chandigarh Bench in I.A.Hydro Energy’s case has been recently confirmed on the ground that no substantial question of law arose out of the decision of the Tribunal. This decision of the Court is reported in 339 CTR (HP) at page 375. This decision of the Court was cited before the Ahmedabad Bench but was not followed by the Bench in as much as the Bench found the case to be distinguishable on the reasonings discussed above.
The provision was first introduced by the Finance Act, 2012 w.e.f. 01.04.2013 and was originally restricted in its scope to receipts by a company from a resident. The scope, however, was enlarged by the Finance Act, 2023 to encompass receipts from any person, resident or non-resident, w.e.f 01.04.2024. At the time of introduction, specific methodology was not provided for computation of the fair market value but later on, rules were prescribed for valuation. The rules for valuation have been notified w.e.f 29.11.2012. This provision has ceased to apply w.e.f. 01.04.2025 as per the amendment by the Finance (No.2) Act, 2024.
The important issue that remains to be examined is whether a conversion of a loan into share capital could be considered as a “receipt” for attracting the provision. Alternatively, can a receipt of an amount classified as a loan in a different year be construed as a “receipt” on passing of an accounting entry, in a subsequent year for recording the conversion or treatment of a loan into a share capital. Can it be contended that there was no receipt of any amount in the year of issue of share capital?
For attracting a charge of taxation under the relevant provision, twin conditions, besides a few more conditions, are required to be satisfied; one such condition is a receipt in a previous year, and the other condition is that the receipt must represent a consideration for issue of shares. Apparently, the year of receipt of the amount is different than the year of issue of shares and, in any case, these two events are different, even if they fall in the same year, unless the receipt in the first place itself was for issue of shares. In the circumstances, unless the act of passing an accounting entry is considered or classified as an act of receipt representing the consideration for issue of shares, the charge of tax in the year of conversion may fail, as no express provision to that effect is ingrained in the law. Even on the count that the provision in question is a deeming provision and seeks to bring to tax an ordinary transaction of the issue of share capital, which is otherwise on capital account, as an income, it therefore requires a strict interpretation.
Obviously, the loan, when received was refundable, and such a receipt cannot be classified as a receipt of consideration for issue of shares and surely not a receipt that could be taxed in the absence of the applicability of provisions of s. 68 of the Act. This section too would seek to tax the receipt in the year of actual receipt of loan, and not in the year of passing the accounting entry. A small, related issue, not inconsequential, could also be about the year of determination of the fair market value of the shares; should the valuation be in the year of receipt of loan or the year of passing an accounting entry.
The relevant part of the order of the CIT(A), passed in the appeal by I.A.Hydro Energy Ltd. and confirmed by the Chandigarh bench succinctly explains the reason behind not attracting the deeming fiction;
“It is undisputed fact that the appellant did not receive any consideration for allotment of shares in the previous year relevant to current assessment year. The AO has not discussed this fact neither countered this contention of the appellant. It is a clear fact that the erstwhile partners of the erstwhile Firm (converted into appellant company) had given loans to the said firm which was converted into share capital of those partners becoming the shareholders. The AO has mentioned in the assessment order that the loans outstanding as on 01.04.2017 were converted into share capital. The shares were issued at ₹10 per share face value and premium of ₹90 per share. After plain reading of S.56(2)(viib), there is no doubt that this provisions is applicable to the considerations received in the previous year under consideration for taxing the excess premium charged over and above fair market value of shares determined as per prescribed method under Rule 11UA. In the current facts of the case, the appellant did not receive any consideration in the current assessment year and the outstanding loans of existing partners of erstwhile firm was converted into the shares of the appellant company. Thus, prima facie, there is no justification for the AO to apply Section 56(2)(viib) of the Act in the appellant’s case. The said consideration in the form of unsecured loans were received from the partner of the erstwhile firm in the year 2010 (as evidenced from loan agreement) and the AO could not bring out any material facts to show that such conversion of loans to equity shares was a ploy to defraud revenue of the tax on such transaction. In fact, the loans received in earlier years also got tested through scrutiny assessments completed for assessment year 2013-14 2014-15, 2016-17 and 2017-18 in the case of the erstwhile firm. Thus, it can be concluded that the AO has not made out any case that the share conversion by the appellant led to defrauding revenue of its due taxes. Thus, firstly, the amount is not received in the relevant previous year makes the applicability of S.56(2)(viib) invalid in the case of the appellant and secondly, the legislative intent to arrest abuse of tax laws to defraud revenue is also not available in the current facts of the case as the receipt of loans in the earlier years were from the existing partners of the erstwhile firm which got duly verified in the scrutiny of various assessment years after loans receipt”.
Circular No.1/2011 dated 6th April, 2011 issued by the CBDT explaining the provisions of section 56(2)(vii) of the Act specifically states that the section was inserted as a counter evasion mechanism to prevent money laundering of unaccounted income. In paragraph 13.4 thereof, it is stated that “the intention was not to tax transactions carried out in the normal course of business or trade, the profits of which are taxable under the specific head of income”. The said circular, it is respectfully submitted, further fortifies the contention of the assessee that the provisions of section 56(2)(viib) of the Act are not applicable to genuine business transactions without there being any evidence to the contrary.
The better view, supported by the decisions of the High Courts, is that unless a case is made out for tax evasion, the deeming fiction should not be activated.
