Direct Tax Alert - Share premium in excess of the Fair Market Value to be taxed as income in the year of share allotment

Background

In order to discourage the generation and use of unaccounted money done through the subscription of shares of a closely held company, the Finance Act, 2012 introduced clause (viib) to section 56(2) of the Income-tax Act, 1961 (IT Act). As per this clause, where shares are issued for a consideration in excess of FMV, the excess shall be taxed as Income from Other Sources. The rules for determining FMV is contained in Rule 11UA of the Income-tax Rules, 1962 (IT Rules).

Generally, in case of share issue, the share allotment is preceded by the receipt of the share application money. A situation may arise where the share application money is received in one fiscal year (FY) but the shares are allotted in a subsequent FY. In such a situation, a question may arise on  the year in which section 56(2)(viib) of the IT Act is applicable.

Recently, the Mumbai Tax Tribunal¹ (Tax Tribunal) had an occasion to examine this issue i.e. whether the provisions of Section 56(2)(viib) of the IT Act were applicable on the receipt of advance money or on allotment of shares.

We, at BDO in India, have summarised the ruling of Tax Tribunal and provided our comments on the impact of this decision hereunder:

Facts of the case

The taxpayer, an investment holding company, is a wholly owned subsidiary of ICSPL. The taxpayer had invested in various unlisted companies including TMSL, which is its wholly owned subsidiary. In the initial years of its business, TMSL incurred huge losses which led the taxpayer to revalue its investment in Fiscal Year (FY) 2010-11 and reduce the value of investment in TMSL. As a result, the taxpayer’s net worth became nil or negative. ICSPL provided the taxpayer with financial assistance in order to immerse the same in TMSL. Accordingly, till FY 2011-12, the taxpayer received unsecured loans from its holding company. In FY 2011-12, the taxpayer converted the unsecured loan as advance towards share capital through journal entry. Owing to significant improvement in the financial position of TMSL by the end of FY 2012-13, the taxpayer wrote back the provision created in FY 2010-11.

The taxpayer received money towards the issue of shares in FY 2012-13. However, the taxpayer did not issue any shares in FY 2012-13 but issued the shares in FY 2013-14.

The tax officer observed that the taxpayer had received the final tranche of advances on 30 March 2013 and had treated the entire advance as liability in its balance sheet. As the taxpayer had issued shares at premium in the subsequent FY (i.e. FY 2013-14), the tax officer treating advance against share capital as other income invoked section 56(2)(viib) of the IT Act by observing that the FMV as on 30 March 2013 was much less than the consideration. The Tax Officer rejected the event of actual issue of shares in the subsequent FY. The First-Appellate Authority concurred with the order of tax officer. Aggrieved, the taxpayer appealed before the Tax Tribunal:

Tax Tribunal’s Ruling

The Tax Tribunal held that section 56(2)(viib) of the IT Act applies only in the year in which the taxpayer issues actual share capital. As the taxpayer had issued the shares in FY 2013-14, no addition can be made in FY 2012-13. While coming to this conclusion, the Tax Tribunal made following observations:

• The tax officer invoked section 56(2)(viib) of the IT Act as the taxpayer’s net worth was nil or negative until the final tranche of receipt of advance towards share capital. The tax officer not only brought to tax the share premium but also the face value of the share capital. The Tax Tribunal opined it to be a bizarre situation in which the company with the eroded capital can never receive any investment from its holding company nor planned to receive any investment. While it agreed with the view of tax authorities that no prudent investor will invest more than FMV, it stated that a prudent businessman will invest in order to safeguard the investment in the subsidiary or to revive the subsidiary company.
• It is evident from the resolution passed by ICSPL in FY 2010-11 and the pattern of transfer of funds that the amount so received from ICSPL was an unsecured loan and later converted into advance towards share capital. ICSPL accepted the terms of issuing shares at premium of INR 2990 per share and accordingly, the taxpayer issued the shares at INR 3000 per share based on the actual valuation of shares after write back of the provision created to reduce the investment made in TMSL. All these activities were preferably within the legal framework of the Companies Act and other related allied laws and procedures.
• The receipt of consideration for issue of shares to mean the proceeds for exchange of ownership for the value. The term consideration means “something in return” i.e., Quid Pro Quo”. The receipt is exchanged with the ownership in the company. ICSPL passed the resolution to finance TMSL through the taxpayer and the funds intended for TMSL, which is a step-down subsidiary and the funds were remitted to the taxpayer as an advance towards share capital during this FY. The consideration means the promise of the taxpayer to issue shares against the advances received. The receipt of advances is a liability and will never take the character of the ownership until it is converted into share capital. The taxpayer can never enjoy the receipt of money from the investor until the ownership for the money received is not passed on i.e., by allotment of shares. The receipt of consideration during the previous year means the year in which the ownership or allotment of shares are passed on to the allottee in exchange for the investment of money.   
• Unless and until the event of allotment of shares takes place, the taxpayer cannot become the owner of the funds invested in the company. The event of allotment will change the colour of funds received by the taxpayer from liability to the ownership. Placing reliance on the Bombay High Court ruling in the case of Sesa Goa Ltd², the Tax Tribunal opined that Section 56(2)(viib) of the IT Act is attracted only in the year of allotment of shares      
• Section 56(2)(viib) of the IT Act was introduced by the legislature in order to curb the practice of generation and circulation of unaccounted money. However, the revenue authorities invoked the provisions of Section 56(2)(viib) of the IT Act without bringing on record whether the investment received by the taxpayer  is genuine or not. Rather, they acknowledged that the funds were invested by the ICSPL and received by the taxpayer as advance towards share capital. Further, there is no dispute that the net worth of the taxpayer is NIL because of investment in step-down subsidiary, the funds were moved from ICSPL and were re-invested in the TMSL in order to revive it.
• Mere transfer of funds as unsecured loan or advances towards share capital will not trigger the deeming provision under section 56(2)(viib) of the IT Act. The legislature must have not intended to tax such legitimate investment under section 56(2)(viib) of the IT Act. Tax Tribunal relied on several decisions³ and stated that revenue authorities have mechanically invoked the deeming provision without actually investigating whether the taxpayer has actually indulged in any money laundering activities.

BDO comments

This Ruling reaffirms that the relevant point for checking whether section 56(2)(viib) of the IT Act is the year in which the shares are allotted. Earlier, in case of Taaq Music Pvt. Ltd. Vs ITO (ITA No. 161/Bang/2020), the Bangalore Tax Tribunal held that even though the application money is received before section 56(2)(viib) of the IT Act was inserted, the provision will still be attracted since the shares were allotted when section 56(2)(viib) of the IT Act was effective. However, one should not lose the sight of Kolkata Tribunal’s Ruling in case of ACIT vs. M/s Diach Chemicals & Pigments Pvt. Ltd. (ITA No. 546/Kol/2017) wherein it has been held that the applicability of section 56(2)(viib) of the IT Act should be seen at the time of receipt of share application money. Considering that the judiciary is divided on this matter, the taxpayer (in light of its own facts) should seek professional advice on the applicability of this ruling before placing reliance on this Ruling.

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