Discussion on the issues on the strength of the available precedence

Welcome back…..lets continue the journey from Part I and let us discuss the issues involved U/s 56(2)(viib) in the light of the available precedents!

1. Is section 56(2)(viib) applicable where preference shares are allotted by the company?

The relevant extract of the bare text of section 56(2)(viib) is reproduced herein below for better understanding

56. (1) xxxxxxxx

(2) In particular, and without prejudice to the generality of the provisions of sub-section (1), the following incomes, shall be chargeable to income-tax under the head "Income from other sources", namely:-

(viib) 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 that exceeds the face value of such shares, the aggregate consideration received for such shares as exceeds the fair market value of the shares:

Thus, from the perusal of Section 56(2)(viib) of the Act, one can fairly conclude that that all types of shares are covered by this Section. The argument that the preference shares are quasi-debt and that it was not the intention of the legislature to bring such instruments within the ambit of this Section, is not acceptable. - Dcit, Cir-8(1), Kolkata, Kolkata vs M/S Microfirm Capital Pvt. Ltd, [TS-8051-ITAT-2017(Kolkata)-O], Kolkota ITAT

It is quite pertinent to note here that equity shares and preference shares stand on different footing. While the equity shareholders are the real owners of the company, the preference shareholders are not in fact, the owners of the company, they get preference over the equity shareholders on certain aspects. Hence the Net asset value of the company really represents the value of Equity shares and not "Preference shares" - As held by Hon'ble ITAT, Mumbai in case of ACIT 16(1) Vs. M/s. Golden Line Studio Pvt. Ltd, [TS-8635-ITAT-2018(Mumbai)-O].

Further, Rule 11UA(2), which is specifically applicable for the valuation of shares for the purpose of section 56(2)(viib) covers only unquoted equity shares within its ambit and there in no reference to the preference shares.

Thus, the only method for determining the FMV of the preference shares is Rule 11UA(1)(c)(c), which is reproduced herein below:

"the fair market value of unquoted shares and securities other than equity shares in a company which are not listed in any recognized stock exchange shall be estimated to be price it would fetch if sold in the open market on the valuation date and the assessee may obtain a report from a merchant banker or an accountant in respect of which such valuation."

Now, the price of the preference shares of a private limited company, which would fetch if sold in the open market as on the date of valuation is another controversial aspect.

2. Can the assessing officer compare the revenue/profit projected under DCF method vis a vis actual revenue/profit of the company and reject the valuation report?

When the law has specifically provided a method of valuation and the assessee exercised an option by choosing a particular method, changing the method or adopting a different method would be beyond the powers of the revenue authorities. DCF Method, is essentially based on the projections (estimations) and hence these projections cannot be compared with the actuals to expect the same figures as were projected - As held by Hon'ble ITAT, Jaipur Bench on case of M/s. Rameshwaram Strong Glass (P) Ltd. V/s The ITO, Ward 2(1), Ajmer, [TS-8114-ITAT-2018(Jaipur)-O]

This issue, however, depends upon the facts and circumstances of the cases and difficult to generalize. There is a contrary decision of Hon'ble ITAT, Delhi in case of Agro Portfolio Private Ltd vs. ITO, [TS-7311-ITAT-2018(Delhi)-O], wherein it has been held that in case the valuation under DCF is done on the projections provided by the management and the valuer (under DCF method) has categorically mentioned in the report as a disclaimer that the truthfulness, accuracy and completeness of the information and financial data has been provided by the company and the valuer has relied on the same, the assessing officer can reject the DCF method and go by NAV method to determine the FMV of the shares.

3. Can the provisions of section 56(2)(viib) be invoked in spite of the fact that satisfactory explanation has been provided under section 68 of the Act?

Section 56 falls under the Chapter "Computation of Income". Section 68 under "Aggregation of Income and Set Off or Carry Forward of Loss". The provisions of 56(2) (viib) of the Act, cannot be controlled by the provisions of Section 68 of the Act. - As held by Hon'ble High Court of Kerala in case of Sunrise Academy of Medical 56 Specialities (India) Private Limited vs. Income Tax Officer, Corporate Ward 2(1), Range-2, Kochi-682018, [TS-5655-HC-2018(Kerala)-O].

Thus, the provisions of section 56(2)(viib) can be invoked irrespective of the fact that satisfactory explanation of the nature and source of funds is provided to the assessing authorities.

4. Can the book value method prescribed under Rule 11UA be taken as a base to establish Arm's Length Price for transfer pricing purposes?

Rule 11UA prescribes a book value method for determination of fair market value of a property other than immovable property for the purpose of sec.56 of the Act and cannot be taken as a basis for valuation in a transfer pricing matter. Though DCF methodology is a preferred methodology for determination of arm's length price for sale of shares, yet net asset value as per Rule 11UA is only intended for application of section 56 and never intended for arriving at a fair market value for comparing an international transaction. - As held by Hon'ble ITAT of Chennai in case of Ascendas (India) Private Ltd. vs DCIT, [TS-5000-ITAT-2013(Chennai)-O]

5. Whether the residential status of the payee is to be checked at the time of receipt of consideration for shares or during the previous year in which the shares are allotted?

Before we answer this, let us have one more closer look at relevant extract of section 56(2)(viib), as reproduced herein below:

"(viib) 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, ------------".

Going by the literal interpretation of section 56(2)(viib) of the Act, it appears that the residential status of the payee is relevant for the year in which the company receives the consideration for the issue of shares.

We will continue with more interesting discussion in Part III of this Article.

Click here to read Part-I of the Article Series titled “Section 56(2)(viib) of Income Tax Act, 1961 - a Legal Conundrum”