“Consideration” for the issue of shares for the purpose of section 56(2)(viib) of the IT Act encompasses the conversion of CCD

 

BACKGROUND

Section 56(2)(viib) of the Income-tax Act 1961 (IT Act) is attracted when a closely held company issues shares at a premium and the consideration exceeds Fair Market Value (FMV). It provides that the difference between the actual consideration and the FMV of the shares or Face value of shares (in case FMV is lower than Face Value) shall be deemed to be the income of such a closely held company and accordingly taxable under the head ‘Income from other Sources’. Apart from the issue of equity shares, the Company can also raise funds through the issue of Preference Shares, hybrid instruments such as Compulsorily Convertible Debentures (CCDs), Compulsorily Convertible Preference Shares (CCPS), Non-Convertible Debentures (NCDs) etc. Whether section 56(2)(viib) of the IT Act gets attracted when the funds are raised through hybrid instruments like CCDs is open to interpretation.

In this regard, recently, the Kolkata Tax Tribunal1 had an occasion to examine the applicability of section 56(2)(viib) of the IT Act to the conversion of CCD into equity shares. We, at BDO in India, have summarized the ruling of the Kolkata Tax Tribunal and provided our comments on the impact of this decision hereunder:

FACTS OF THE CASE

Taxpayer, a private limited company, is engaged in manufacturing and selling dairy products like pasteurized milk, cottage cheese, curd, flavoured milkshake etc. During the Fiscal Year (FY) 2010-11 and 2011-12, it entered into an agreement with its investors (including non-resident and venture capital funds) for the issuance of CCDs over various tranches. In FY 2012-13 (i.e., the relevant year under consideration), the taxpayer issued equity shares and also converted the CCDs into equity shares. The shares were issued to various parties including Venture Capital Funds (VCF), non-residents and other angel investors at a premium. With respect to CCD, the entire consideration was received at the time of issuing CCDs i.e. in FY 2010-11 and FY 2011-12 and hence no amount was to be paid by the CCD holders at the time of conversion. The taxpayer obtained two valuation reports on 29 December 2016 - FMV of equity share was arrived at INR 144.21 per share by taking the date of valuation of 18 December 2012 and in the second report the date of valuation was taken as 08 March 2013. The FMV of equity share arrived at was INR 144.27 per share. For purpose of valuation, Discounted Cash Flow (DCF) method was applied. However, the Tax Officer by applying the Net Asset Value (NAV) method to the Audited Balance Sheet as on 31 March 2022 computed negative FMV and thereby treated the entire consideration to be taxable under section 56(2)(viib) of the IT Act. Aggrieved, the Taxpayer filed an appeal before the First Appellate Authority [CIT(A)] who granted partial relief in respect of shares issued to a non-resident by holding that the provisions of section 56(2)(viib) of the IT Act are applicable only on proceeds received from residents. CIT(A) also gave relief by deleting the addition pertaining to the receipt of the face value of shares by holding that provisions of section 56(2)(viib) of the IT Act are applicable only on the “consideration for issue of shares that exceeds the face value of share” i.e. only in case of share premium and not to the face value of the shares. However, the CIT(A) upheld the addition with respect to the premium on the issue of equity shares on conversion of CCD  Hence, the taxpayer filed an appeal before the Kolkata Tax Tribunal. Apart from challenging the applicability of section 56(2)(viib) of the IT Act, the taxpayer also challenged the NAV method applied by the Tax Officer.

KOLKATA TRIBUNAL RULING

While upholding the applicability of section 56(2)(viib) of the IT Act to equity shares issued on account of conversion, the Kolkata Tax Tribunal made the following observations

a. Re.: Applicability of section 56(2)(viib) of the IT Act on the transaction of conversion of CCDs into equity shares.

• It is uncontroverted and undisputed that the provisions of section 56(2)(viib) of the IT Act having been introduced w.e.f. 1 April 2012 are applicable to FY 2012-13 i.e. the year under consideration. In the present case, CCDs have been converted into equity shares in FY 2012-13.
• The term “consideration” needs to be pondered upon before deciding whether conversion entails any consideration. In the context of section 56(2)(viib) of the IT Act, the term “consideration” is of wider import when compared with the words “amounts” or “money”. Receipt of money is one of the several modes for receipt of  consideration in a transaction. Consideration can partake in many forms viz. tangible or intangible, pecuniary or non-pecuniary, direct or indirect. Section 56(2)(viib) of the IT Act contains the words “receives any consideration” which encompasses consideration in all forms and is not limited to only receipt of money.
• Some of the “considerations” that the taxpayer “receives” on the conversion of its CCDs into equity shares are:
  • The debt obligation on the taxpayer to repay is extinguished.
  • The charge created on the assets/properties of the taxpayer to secure the debt obligation is released.
  • The cost of servicing the debt obligation by paying periodic interest is mitigated.
  • The capital based in the form of own fund gets widened to leverage on the capital/stock markets.
  • The debt-equity ratio becomes favourable to various stakeholders of the taxpayer making it more lucrative for investors.
  • The risk of getting into the claim of insolvency resolution from the debt creditors in case of default in servicing their debt obligation is mitigated.
• As per the terms and conditions, warranties and other covenants relating to the issuance of CCDs and their subsequent conversion into equity shares records and corroborates a few of the considerations listed above relating to the discharge of an obligation, release of encumbrance, interest obligation, pari passu ranking of rights of equity shareholders, etc. Thus, when looking at these aspects, section 56(2)(viib) of the Act envisages a much wider outlook to the “receipt of any consideration” which cannot be limited to the receipt of money only.
• The conversion of CCDs into equity shares in FY 2012-13 entails receipt of consideration which is translated into the total issue price including share premium. Hence, section 56(2)(viib) of the IT Act applies to the issuance of shares on conversion of CCDs.
• Further, decisions2 relied upon by the taxpayer are distinguishable on facts since the transactions dealt therein were not that of conversion of securities but receipt of share application money.

b. Re. Exclusion clauses of section 56(2)(viib) of the IT Act on certain transactions

• The transaction of issue of equity shares to one of the taxpayer’s investors is covered by clause (i) in the first proviso to section 56(2)(viib) of the IT Act which states that section shall not apply where the consideration for issue of shares is received by a Venture Capital Undertaking from a Venture Capital Company or a VCF.
• On perusing the Form FC-GPR filed with the Reserve Bank of India for the issue of shares to non-residents and drawing force from the co-ordinate bench ruling3, it is held that provisions of section 56(2)(viib) of the IT Act shall not apply to the consideration received from a non-resident angel investors.

c. Re. Applicability of Rule 11UA of the IT Rules for valuation of equity shares

• It is trite law that “when a statute requires a thing to be done in a certain manner, it shall be done in that manner alone and not otherwise”. This doctrine was dealt with by the Delhi Tax Tribunal in the case of SPL’s Siddhartha Ltd4.
• Explanation (a)(ii) to section 56(2)(viib) of the IT Act specifically provides that valuation is to be substantiated to the satisfaction of the Tax Officer whereas such provision is not specified in Explanation (a)(i) of section 56(2)(viib) of the IT Act as opted by the taxpayer. Hence, on the facts of the case, the Tax Officer was not empowered to disregard the DCF valuation as carried out by the valuer.
• The DCF method is essentially based on projection only and hence, this projection cannot be compared with the actual results to expect the same figures as projected.
• Rule 11UA(2) of the Income-tax Rules, 1962 (IT Rules) gives an option to the taxpayer to opt and adopt either the NAV method or the DCF method. Referring to the Bombay High Court’s ruling in the case of Vodafone M-Pesa Ltd5, the Tax Officer has no right to change the method of valuation adopted by the taxpayer who has opted for the DCF method for valuation of equity shares.
• Thus, in the instant case, the basis for valuation of equity shares should be the DCF method opted by the taxpayer as prescribed under Rule 11UA(2) of the IT Rules.
• As the taxpayer has not supplied the MIS data which was given to the valuer for the purpose of valuation of shares and also the details on the assumptions to conclusively establish that the projections used for DCF valuation were prepared scientifically, the matter is remitted to the Tax Officer for the limited purpose of verification and satisfaction on the scientific basis of valuation and rationality of assumptions made. For this purpose, reference is made to the Bangalore Tax Tribunal in the case of Innoviti Payment Solutions Pvt. Ltd.6
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•  COMMENTS

While this Ruling is with respect to CCDs conversion, the principle laid down can be applied to other hybrid instruments as well. As the CCDs were issued at a time when section 56(2)(viib) of the IT Act was not in existence, the Kolkata Tribunal is silent on its applicability at the time of issuance of CCDs. Further, it is silent on whether the FMV on the date of issue of CCDs (when the conversion price is decided upfront based on the valuation done while issuing CCD) should be considered or at the time of conversion. While this decision involved only two years, the hybrid instrument could be issued for more than two years. In such a situation, the valuation date would play an important role.