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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