Direct Tax Alert

Background

Section 56(2)(viib) of the Income-tax Act, 1961 (IT Act) before Finance Act 2023 provided that if a closely held company receives any consideration, in excess of face value, for the issue of shares (equity or preference) from any resident investors exceeding the “fair market value” (FMV) of such shares, then such excess amount shall be taxed as Income from Other Sources in the hands of such company. There are certain exemptions on the applicability of the provision viz., investment by notified class of persons etc.

The Finance Act 2023 amended section 56(2)(viib) of the IT Act to make it applicable even in cases where shares are issued to a non-resident with effect from 1 April 2023. Therefore, from 1 April 2023, provisions of section 56(2)(viib) of the IT Act are applicable to investments made by a resident/ non-resident in a closely held company.

 Rule 11UA(2) of the Income-tax Rules, 1962 (IT Rules) outlines the methodologies¹ for determining the fair value for the purpose of section 56(2)(viib) of the IT Act. After the amendment, concerns were raised by various stakeholders pertaining to the structuring of investments in India by foreign investors and issues that may arise in the valuation of shares. In order to address this concern, the Central Board of Direct Taxes (CBDT) issued a notification specifying (i) a class of persons², and investments from which would not attract angel tax provisions and (ii) a draft³ of modified Rule 11UA of the IT Rules for public comments. In this regard, recently the CBDT has issued amended Rule 11UA⁴ of the IT Rules. We, at BDO in India, have hereunder analysed and summarised key provisions of the said notification:

Equity Share

• The existing Rule 11UA(2) of the IT Rules provides that for the purpose of Section 56(2)(viib) of the IT Act, the valuation of unquoted equity shares on the valuation date⁵ should be determined by the taxpayer either as per prescribed formula or method based on the net asset value (NAV) or the discounted cash flow method (DCF) as determined by the merchant banker.
• The amended Rule 11UA(2) of the IT Rules provides that for Section 56(2)(viib) of the IT Act, the valuation of unquoted equity shares on the valuation date should be determined by the taxpayer (i.e. closely held company issuing shares) by any of the below methods, at the option of the taxpayer:
  • In cases where consideration is received from a resident or non-resident:
    • a. NAV; or
    • b. DCF; or
    • c. In the case of a taxpayer, being a venture capital undertaking⁶ who has received consideration from the issue of unquoted equity shares to a venture capital fund, venture capital company⁷ or any specified fund⁸, the price of such equity shares corresponding to such consideration be taken as the FMV of the equity shares for resident and non-resident investors subject to the following:

• To the extent, the consideration from such FMV does not exceed the aggregate consideration that is received from a venture capital fund or a venture capital company or any specified fund; and

• The consideration has been received by the undertaking from a venture capital fund a venture capital company or any specified fund, within a period of 90 days before or after the date of issue of shares which are subject matter of valuation.

• By way of illustration, if an undertaking receives consideration of INR 5 lakhs from a venture capital company for issue of 1000 shares at the rate of INR 500 per share, then such an undertaking can issue 1000 shares at this rate to any investor within a period of 90 days before or after the receipt of consideration from venture capital company.

d. In the case of a closely held company, which has received consideration from the issue of unquoted equity shares to any non-resident entity notified by the Central Government⁹, the price of such equity shares corresponding to such consideration be taken as the FMV of the equity shares for resident and non-resident investors subject to the following:

• To the extent, the consideration from such FMV does not exceed the aggregate consideration that is received from the notified entity; and

• The consideration has been received by the closely held company from the notified entity, within a period of 90 days before or after the date of issue of shares which are subject matter of valuation.

e. In case consideration is received from a non-resident, in addition to above valuation methods discussed in (a) to (d) above, the value is determined by a merchant banker under the following methods:

• Comparable Company Multiple Method;

• Probability Weighted Expected Return Method;

• Option Pricing Method;

• Milestone Analysis Method;

• Replacement Cost Methods

Compulsorily Convertible Preference Shares

• In a case where consideration is received from a resident, the FMV shall be the value on the valuation date in accordance with pointers (b), (c), or (d) above or based on the FMV of unquoted equity shares determined in accordance with pointers (a), (b), (c), or (d) above, at the option of the taxpayer.

• In the case where consideration is received from a non-resident, the FMV shall be the value on the valuation date in accordance with pointers (b) to (e) above or based on the FMV of unquoted equity shares determined in accordance with pointers (a) to (e) above, at the option of the taxpayer.

Rule 11UA(3) of the IT Rules- Deemed Valuation Date

Where the date of the merchant banker’s valuation report (required for DCF and 5 new methods mentioned in point (e), above) is not more than 90 days prior to the date of issue of shares which are subject matter of valuation, then such date at the option of the taxpayer shall be deemed to be the valuation date. Further, where such an option is exercised, the provisions of Rule 11U(j)¹⁰ of the IT Rules shall not apply.

Rule 11UA(4) of the IT Rules- Safe harbour 

• Investment by residents- A 10% safe harbour is applicable on valuation arrived at by NAV or DCF methods where the issue price of the shares exceeds the value of shares. In such case, the issue price shall be deemed to be FMV.

• Investment by non-residents- A 10% safe harbour is applicable on valuation arrived at by NAV or DCF or 5 new methods (pointer e above) where the issue price of the shares exceeds the value of shares. In such case, the issue price shall be deemed to be FMV.

This rule shall be effective from 25 September 2023.   

BDO in India Comments

The changes made by the CBDT are a welcome move as it will provide additional methods for valuation to investors. The amended Rules are more or less in line with the draft Rules except that the draft rule did not propose any change in the valuation of preference shares. It is pertinent to note that Section 56(2)(viib) of the IT Act is applicable to the consideration received from non-residents on or after 1 April 2023 whereas the amended Rules are made applicable from 25 September 2023. Hence, further clarity is required with respect to the valuation of shares issued in the interim period.

 

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¹ Section 56(2)(viib) of the IT Act provides that the FMV of the shares shall be- (i) as may be determined in accordance with Rule 11UA(2) of the IT Rules; or (ii) as may be substantiated by the company to the satisfaction of the tax officer.

² Notification No. 29 and 30/2023, dated 24 May 2023. Please refer our tax alert.

³ CBDT Press release dated 19 May 2023

⁴ Notification No. 81/2023, dated 25 September 2023

⁵ As per Rule 11U(j) of the IT Rules, valuation date means the date on which the property or consideration, as the case may be, is received by the taxpayer.

⁶ As per clause (b) of Explanation to section 56(2)(viib) of the IT Act

⁷ As per clause (b) of Explanation to section 56(2)(viib) of the IT Act

⁸ As per clause (aa) of Explanation to section 56(2)(viib) of the IT Act

⁹ Notification No. 29/2023, dated 24 May 2023.

¹⁰ Rule 11U(j) of the IT Rules defines valuation date means the date on which the property or consideration, as the case may be, is received by the taxpayer.