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2018-12-20
Introduction to the section, its literal understanding and the issues involved
The recipe for a successful business is one brilliant idea, strong enthusiasm and initial capital!! Mr. X had one such idea, strong enthusiasm and was able to get the funding for his newly incorporated company from few investors. To his irony, however, what Mr. X thought of doing was already done by ten others in the market….
oppps., the business idea some have didn’t work and the revenue/profit from the company was not as expected. Mr. X was having a cup of tea in his office in disgust and disappointment and the next logical step on the road of Mr. X was try and convince the investors that his idea is somewhat different than the others and to get more funding. In the meanwhile, the tax consultant of Mr. X called him up and said that the during the course of assessment proceedings of the company the income tax authorities are proposing to treat part of funding from the investors as the income of the company U/s 56(2)(viib) of Income Tax Act, 1961 and are proposing to levy income tax on the same.
What?? This was a shocker to Mr. X and with the feeling of fear and anxiety, he asked his consultant, “Sir, what is section 56(2)(viib)?”
Well, you are not aware of section 56(2)(viib)? Than fasten your seat belts and enjoy this roller coaster ride.
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The central government has been time and again taking various initiative to curb the menace of black money circulation and there has been dramatic changes in the recent past in the income tax law in this regard. Action against black money is an on-going process. Such actions include policy-level initiatives, effective enforcement action on the ground, putting in place robust legislative and administrative frameworks, systems and processes.
One of such initiatives taken by the central government is the introduction of section 56(2)(viib) to the Income Tax Act, 1961, via Finance Act, 2012. The objective of introducing section 56(2)(viib) was to discourage the generation and use of unaccounted money done through subscription of shares of a closely held company, at a value which is higher than the Fair Market Value (FMV) of shares of such company.
By virtue of section 56(2)(viib) of the Act, 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 shall be deemed to be the income of the concerned company chargeable to tax under the head Income from other Sources for the relevant financial year. There are, however, certain exceptions, which are provided in the proviso to the said section.
Before we proceed further, let us understand the applicability or otherwise of section 56(2)(viib) in a simple language, as captured in the below table, without going into the bare text of the law.
|
Sl.No |
Particulars |
Remarks |
|
1 |
Applicable to whom |
Private limited Company which receives, in any previous year, from any person being a resident, any consideration for issue of shares for a value which exceeds the FMV of such shares. |
|
2 |
How to determine the FMV of the shares? |
The FMV of the shares shall be higher of the following: 1. The value as determined in accordance with the Rule 11U and 11UA of the Income Tax, Rules, 1962 or, 2. any other value as may be substantiated by the company to the satisfaction of the Assessing Officer, based on the value, on the date of issue of shares, of its assets, including intangible assets being goodwill, know-how, patents, copyrights, trademarks, licences, franchises or any other business or commercial rights of similar nature. |
|
3 |
What are the exceptions to section 56(2)(viib)? |
The provisions of section 56(2)(viib) are not applicable where the consideration for the issue of shares is received: 1. by a venture capital undertaking from a venture capital company or a venture capital fund. 2. by a company from a class or classes of persons as may be notified by the Central Government in this behalf. |
|
4 |
What do you mean by venture capital undertaking, venture capital company and venture capital fund |
venture capital company", "venture capital fund" and "venture capital undertaking" shall have the meanings respectively assigned to them in Explanation to clause (23FB) of section 10 |
|
5 |
What is the impact if the value of the shares issued by the company is more than the FMV of the shares as determined under the specified method? |
The aggregate consideration received for such shares as exceeds the FMV of the shares shall be deemed to be the income of the issuer company chargeable to tax under the head Income from Other Sources. |
|
6 |
Which are the prescribed methods for determination of FMV of shares? |
As per Rule 11UA(2), the FMV can be determined under Net asset value Method(as specified under Rule 11UA(2)(a)) or under Discounted cashflow method, at the option of the assessee. |
|
6 |
Is there any central government notification stating that the provisions of section 56(2)(viib) are not applicable to any particular class/classes of the companies? |
Notification 24/2018 dated 24th May, 2018, read with notification G.S.R. 364(E), subject to the fulfilment of specified conditions. |
|
7 |
Who is authorized to issue the valuation report under DCF method for the purpose of section 56(2)(viib)? |
As per Rule 11UA(2)(b) of Income Tax Rules, read with Notification No.23/2018, dated 24th May, 2018, only Merchant Bankers are now authorized to issue valuation reports as per DCF method for the purpose of section 56(2)(viib) |
…………, and the Enigma revolving around.
Though the intent of the law is fair, there are certain aspects due to which there is a controversy revolving around. It is quite imperative to note at this juncture that a new company, particularly in the service sector does not have sufficient capital base at the inception and hence NAV method sometimes becomes impractical to apply. Due to this reason, lot of companies adopt DCF method which requires lot of subjective analysis in terms of revenue projections, adoption of discounting factor, risk free rate of interest, inflation rate, etc. Though there are some decisions of the appellate authorities on section 56(2)(viib), yet there is a lot of confusion in the minds of the taxpayers, some of which are enumerated below.
| 1. | Does the assessee has the option to adopt either NAV or DCF method for valuation of shares? |
| 2. | Can the assessing officer change the method adopted by the assessee to determine the FMV? |
| 3. | Is section 56(2)(viib) applicable where preference shares are allotted by the company? |
| 4. | 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? |
| 5. | 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? |
| 6. | Can the valuation report under DCF method be taken as a base to establish Arm's Length Price for specified domestic transactions referred to U/s 92BA? |
| 7. | Can the assessing officer reject the method adopted by the assessee and the valuation himself or can he refer the case to the valuation expert? |
| 8. | 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? |
There is obviously a tax litigation on some of the aspects, but let us try to address each of the above concerns based on the interpretation of the law and available precedents on the subject matter:
Does the assessee have the option to adopt either NAV or DCF method for valuation of shares? Can the assessing officer change the method adopted by the assessee to determine the FMV?
Section 56 allows the assessees to adopt one of the methods of their choice. It is beyond the jurisdiction of the AO to insist upon a particular system, especially when the Act allows to choose one of the two methods. Until and unless the legislature amends the provision of the Act and prescribes only one method for valuation of the shares, the assessees are free to adopt any one of the methods – Held by Mumbai Bench of ITAT, in case of DCIT vs. M/s. Ozoneland Agro Pvt.Ltd. in [TS-6963-ITAT-2018(MUMBAI)-O]
We will continue with more interesting discussion on the above in the light of the cases decided at various appellate forum in Part II of this Article.
Click here to read Part-II of the Article Series titled “Section 56(2)(viib) of Income Tax Act, 1961 - a Legal Conundrum”
