Friday, 29 January 2021

Angel Tax – An Analysis

 

 The consideration received by a company for issue of its shares constitutes a capital receipt and thus should not be liable to income-tax in the hands of the issuer company. However, there are certain provisions in the (Indian) Income-tax Act, 1961 (‘Act’) which deem the same, either fully or a part of the same, as income liable to tax under the head ‘Income from Other Sources’. This may so happen where the assessing officer considers the transaction as not genuine or where the shares are issued at a premium and the issue price is in excess of the fair market value of those shares.

 

 Position prior to the changes made by the Finance Act, 2012

 

Section 68 of the Act provides that where any sum is credited in the books of accounts and the assessee offers no explanation about the nature and source thereof or the explanation offered by the assessee is not, in the opinion of the assessing officer, satisfactory, the sum so credited may be charged to income-tax as income of the assessee for that tax year. This will include crediting of money as share capital by an issuer company. Clearly, the objective seems to be to tax black money introduced in the books of accounts of the issuer company by way of share capital, as income of the issuer company. There have been numerous judicial precedents as to how and under what circumstances the assessing officer can tax the consideration received for issue of shares as the income of the issuer company. A significant amendment in section 68, in this regard, was made by the Finance Act, 2012.

 

 Position after the changes made by the Finance Act, 2012

 

 Enlarging the scope of issuer company’s obligations

 

The Finance Act, 2012 inserted a proviso in section 68 of the Act regarding issue of shares by a company in which the public are not substantially interested, that is, very broadly, a closely held company.

 

The above referred proviso provided that the explanation offered by the issuer closely held company regarding identity, creditworthiness and genuineness etc. of the investment by an investor who is ‘resident’ of India (except certain funds) shall be deemed to be not satisfactory unless the investor also offers an explanation about the nature and source of the amount invested and the assessing officer finds the same satisfactory.

 

The rationale for the above amendment was explained in the Memorandum explaining the provisions of the Finance Bill, 2012 in the following words:

 

“The onus of satisfactorily explaining such credits remains on the person in whose books such sum is credited. If such person fails to offer an explanation or the explanation is not found to be satisfactory then the sum is added to the total income of the person. Certain judicial pronouncements have created doubts about the onus of proof and the requirements of this section, particularly, in cases where the sum which is credited as share capital, share premium etc.

 

Judicial pronouncements, while recognizing that the pernicious practice of conversion of unaccounted money through masquerade of investment in the share capital of a company needs to be prevented, have advised a balance to be maintained regarding onus of proof to be placed on the company. The Courts have drawn a distinction and emphasized that in case of private placement of shares the legal regime should be different from that which is followed in case of a company seeking share capital from the public at large.

 

In the case of closely held companies, investments are made by known persons. Therefore, a higher onus is required to be placed on such companies besides the general onus to establish identity and credit worthiness of creditor and genuineness of transaction. This additional onus, needs to be placed on such companies to also prove the source of money in the hands of such shareholder or persons making payment towards issue of shares before such sum is accepted as genuine credit. If the company fails to discharge the additional onus, the sum shall be treated as income of the company and added to its income. It is, therefore, proposed to amend section 68 of the Act to provide that the nature and source of any sum credited, as share capital, share premium etc., in the books of a closely held company shall be treated as explained only if the source of funds is also explained by the assessee company in the hands of the resident shareholder. However, even in the case of closely held companies, it is proposed that this additional onus of satisfactorily explaining the source in the hands of the shareholder, would not apply if the shareholder is a well-regulated entity, i.e., a Venture Capital Fund, Venture Capital Company registered with the Securities Exchange Board of India (SEBI).”

 

 Issue leading to insertion of section 56(2)(viib) of the Act

 

It may appear from the discussion above that the scope of section 68 was enlarged to tax the non-genuine transactions of investments by way of share capital, and the matter should have ended there only...

 

However, visualize a situation where the relevant shareholder is identified, is an income-tax assessee, has capacity to make investment and subscribes to the shares of the closely held company through banking channels, but the tax department is not convinced about the genuineness of the transaction particularly where the subscription has been made at a disproportionate premium. It seems that probably to address this kind of situation (where apparently it may be difficult for the tax department to levy tax under section 68), section 56(2)(viib) was inserted in the Act by the same Finance Act, 2012.

 

As regards the stated legislative intent of introducing section 56(2)(viib) in the Act, paragraph 155 of the Finance Minister Speech includes only the following:

 

Increasing the onus of proof on closely held companies for funds received from shareholders as well as taxing share premium in excess of fair market value.”

 

The Memorandum explaining the provisions of the Finance Bill, 2012 does not throw any light on the legislative intend except stating that “It is proposed to insert a new clause in section 56(2). The new clause will apply 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. In such a case if the consideration received for issue of shares 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 chargeable to income-tax under the head “Income from other sources”.

 

 Section 56(2)(viib) of the Act

 

Section 56(2)(viib) provides that in certain cases where a closely held company issues its shares at premium, a part of the issue price may be taxable as income in the hands of the issuer closely held company. Before we discuss the issue, let us first take a note of the following relevant aspects:

 

1.    Section 56(2)(viib) applies only where the shares are issued at premium. It has no applicability where the shares are issued ‘at par’.

 

2.    Section 56(2)(viib) applies only on issue of ‘shares’ (i.e. whether equity or preference), and not to issue of convertible debentures.

 

3.    Section 56(2)(viib) applies only on shares issued to persons resident in India. It has no applicability on issue of shares to non-residents.

 

4.    Section 56(2)(viib) does not apply to a few categories of persons (certain funds or class of persons notified by the Central Government).

 

The scheme of section 56(2)(viib) is that where a closely held company issues its shares at premium to persons resident in India, then, the excess of fair market value (‘FMV’) of shares over the issue price (i.e. par value plus premium) is taxable as income of the issuer closely held company under the head ‘Income from Other Sources’. As the consideration received by a company for issue of its shares constitutes a capital receipt and not any ‘income’, simultaneous with the insertion of section 56(2)(viib), the definition of ‘income’ as contained in section 2(24) was expanded to deem the above referred excess of FMV over the issue price as income of the issuer closely held company.

 

Key issue – determination of FMV

 

The key issue which arises in implementation of section 56(2)(viib) of the Act is the determination of FMV. It has been provided in section 56(2)(viib) read with Rule 11UA(2) of the Income Tax Rules, 1962 that FMV shall be the higher of the following:

 

(a)  the value as may be determined in accordance with either of the following methods at the option of the issuer closely held company (i) book net asset value (‘Book NAV’) method, or (ii) value determined by a merchant banker as per discounted free cash flow (‘DCF’) method; or

 

(b)  the 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, licenses, franchises or any other business or commercial rights of similar nature.

 

The above may indicate that the expression FMV, for the purposes of section 56(2)(viib) of the Act, has been defined very widely and should address the concerns, if any, of the issuer companies in genuine infusion of capital by the investors. However, it is relevant to keep in mind that the technology driven companies, start-ups and other similar companies including service companies which are in the phase of scaling up of operations and have no or little track record of profitability, the valuation of businesses is largely based on ‘value’ proposition. The investors and the issuer companies may agree for a particular valuation based on such ‘value’ proposition which may certainly not be supported by Book NAV and thus for the purposes of section 56(2)(viib) they generally end up following DCF method of valuation. While the Government has exempted certain start-ups from the applicability of section 56(2)(viib) but the issue still remains regarding the issuer closely held companies which are not eligible for the said exemption.

 

It is well recognized that the valuation of shares of a company is not an exact science and the DCF method of valuation is essentially based on projections given by the management at the relevant point of time, and the valuer carries out the valuation based on certain assumptions and upon exercise of judgment. In other words, there cannot be any straight forward arithmetic formula for determining value of shares of a company which is acceptable to all.

 

In such a case, in a genuine transaction, where the investment is made in the shares of a closely held company at a particular valuation which is duly supported by the valuation report of a merchant banker but the same is not acceptable to the assessing officer later on who taxes a part of the issue price as income of the issuer closely held company, a question arises as to whether such taxing of a part of the issue price achieves any ‘objective’? In other words, whether the deeming provision of 56(2)(viib) (by deeming a part of capital receipt as ‘income’) is an objective in itself or it is a mean to achieve an objective?

 

Ever since the tax assessments for the financial year 2012-13 onwards came up for tax assessment, there have been several instances that the tax department has challenged the determination of FMV for various reasons where the FMV is determined on the basis of DCF method. There have been instances where the assessing officers have compared the projections versus actual numbers to reject the FMV determined by the issuer companies as per DCF method. The purpose of this write-up is not to go into the details of such instances and instead the moot point being raised is as to whether at all we should tax a part of the issue price as income in genuine cases of investments.

 

There is no dispute with the fact that section 56(2)(viib) of the Act is a legal fiction. Section 56(2)(viib), as it stands today, does not require the assessing officer to record any finding regarding any tax evasion or non-genuineness of the transaction. Any suggestion to put an onus on the assessing officer to record a finding in this regard before proceeding to add anything to income under section 56(2)(viib), will, effectively, make section 56(2)(viib) redundant.

 

Ideally, the Government should withdraw section 56(2)(viib) from the Act, and instead strengthen the provisions of section 68 to achieve the objective of taxing non-genuine transactions. However, if this does not work at this juncture, the CBDT should consider issuing a circular laying down the scope of enquiry by the assessing officers and steps to be followed by them where they are not convinced with the valuation report. Further, the assessees may also be well advised to carefully document and preserve the background papers regarding valuation of shares as per DCF method.


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