JANUARY 25, 2019

By Hiral Raja

GOVERNMENT of India has from time to time introduced various anti-abuse provisions in the Income Tax Act, 1961. Two anti abuse provisions are introduced with respect to fresh issuance of shares by the Private Limited Companies.

(i)  Section 56(2)(viib): Under this provision, in case a private limited company receives from any person resident in India, any consideration for issue of shares that exceeds the fair market value of such shares, then the aggregate consideration received for issuance of such shares exceeding the fair market value of shares is included in the income of the Company as 'Income from other sources'.

Hence under this provision, any excess premium received by a private limited company on issuance of equity shares is taxed in the hands of the Company (Investee Company). This provision was specifically introduced to ensure that private limited companies do not issue shares at an unjustifiably higher premium to shareholders/prospective shareholders and thereby take excess funds into the Company by issuing disproportionate shares, considering the valuation of equity shares of the Company. The intent of the Government is well appreciated.

The fair market value of shares u/s. 56(2)(viib) has to be taken as the value:

(a) As may be determined in accordance with the Rule 11UA (2) of the Income Tax Rules, 1962; or

(b) As substantiated to the Assessing Officer, based on the value on the date of shares, its assets, including intangible assets or any other rights.

Hence as can be seen from the above, in a normal scenario, the computation of fair market value has to be done more or less as per Rule 11UA (2). Rule 11UA (2) prescribes that the valuation of unquoted equity shares can be done in one of the following approaches, at the option of the assessee:-

(i) Book Value of Net assets per share, subject to certain inclusions and exclusions;

(ii) Fair market value of unquoted equity shares determined by Merchant Banker as per Discounted Cash Flow Method (DCF).

It needs to be noted that the Investee Company can choose any of the above two options to compute the fair value of unquoted equity shares.

(ii)  Section 56(2)(x)(c): Under this provision, where any person receives shares for a consideration, less than the fair market value (by an amount exceeding rupees fifty thousand), then the fair market value of such shares exceeding the consideration amount is taxed as 'income from other sources' in the hands of such person.

Hence under this provision, any person (including a listed Company), receives shares for a consideration which is less than the fair value of such shares, then the excess of fair market value over the consideration amount is taxed as 'income from other sources' in the hands of the Investor. This provision is wide enough to cover any assets procured by any person at value lower than the fair market value of such assets.

The computation methodology of fair market value of unquoted equity shares for this purpose is prescribed at Rule 11UA(1)(c)(b) and is different from the computation methodology laid down u/s. 56(2)(vii)(b) r.w.r. Rule 11UA (2).

Under Section 56(2) (x)(c), fair market value of unquoted equity shares has to be computed u/r 11UA(1)(c)(b) on valuation date as under:

Fair market value of unquoted equity shares = (A+B+C+D-L) X (PV)/ (PE), wherein

A = book value of assets (other than jewellery, artistic work, shares and securities and immovable properties), subject to certain reductions;

B = Valuation of jewellery and artistic work based on valuation report obtained from registered valuer;

C = fair market value of shares and securities as computed under Rule 11UA;

D = Value adopted or assessed/assessable by the stamp duty authority with respect to immovable property

L = book value of liabilities, subject to certain exclusions.

PV = paid up value of such equity shares

PE = Total amount of paid up share capital

Interplay between Section 56(2)(viib) and Section 56(2)(x)(c):

As can be seen from the above, on equity infusion by a investor into a private limited company, to ensure that neither the investor nor the investee falls into the trap of taxation under section 56(2)(x)(c) or section 56(2)(viib), as the case may be, the investor as well as investee Company needs to be satisfy the following:

(a) Investor: Consideration paid for receipt of unquoted equity shares is equal to or higher than the fair market value of such unquoted equity shares:

(b) Investee Company: Consideration received for issuance of unquoted equity shares is lower than or equal to the fair market value of such unquoted equity shares.

Also the valuation methodology to be applied for computation of fair market value of the unquoted same equity shares of private limited company is different for Investee Company [Section 56(2) (viib)] and Investor [Section 56(2)(x)(c)].

If the investor as well as the Investee Company wants to take a holistic view, then inspite of the other methods provided, only DCF carried out by the Investee Company might help both investor and investee company escape the rigour of tax under section 56(2)(viib) as well as 56(2)(x)(c), as the case may be, provided the DCF method computation is higher than the valuation computation u/s. 56(2)(x)(c) r.w.r. 11UA(1)(c)(b).

My view is that once the investee company has gone through the rigour of anti abuse provisions u/s. Section 56(2)(viib) by justifying that the shares have been issued at a value not higher than the fair market value of such shares, there is no need for the investor to once again pass through another anti abuse provision u/s. 56(2)(x)(c) to justify that the shares have been received at value equal to or higher than the fair market value (in compliance with a different methodology for valuation). This simply adds to the confusion and a different methodology to justify the fair market value of unquoted equity shares for the same investment, as far as income tax Act is concerned.

It would be appropriate that the Government issues a clarification confirming that provisions of section 56(2)(x)(c) of the Income Tax Act, 1961 would not apply to fresh issuance of equity shares of a private limited company. Alternatively CBDT can align the valuation methodology for both the sections and ensure that this chaotic valuation disorder does not continue...

(The views expressed are strictly personal)