Businesses are facing unprecedented financial and economic challenges due to the COVID-19 crisis and the economic slowdown. In these circumstances, it is imperative that companies be able to raise funds to survive and grow their business. However, there are certain tax provisions designed as anti-abuse safeguards that act as major barriers to fundraising.
In general, the issue of Shares or transfer of Shares will be deemed to be a capital transaction and not subject to taxation except in the case of capital gains on the sale of Shares.
Taxation when issuing shares with premium
- If the shares are issued by an unlisted company at a price in excess of the fair value for residents, then the amount in excess of the issue price over the fair value is income in the hands of the issuing company in accordance with Section 56( 2)(viib) of the Income Tax Act 1961 (IT Act). The fair value is determined based on the book value of the company or the discounted cash flow method, at the discretion of the issuing company.
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- In several instances, the issuance of shares would be at a premium to book value or DCF (discounted cash flow) due to industry prospects, investor interest and other business factors. For example, digital companies, healthcare and life science companies, e-commerce companies, etc. attract a significant amount of investment at a significant premium. While the DCF valuation method offers some flexibility for the valuation, it can lead to different views due to the underlying assumptions. In addition, tax assessments are subject to time lags and some of the valuation assumptions may not correspond to actual results.
- In the case of Karmic Labs Pvt. Ltd vs. ITO (ITAT Mumbai) it was found that the assessee has the option to choose a prescribed method of determining the market value of the transferred shares. If the assessee has chosen an assessment method under Rule 11UA (ie DCF method), the AO (Assessment Officer) has no authority or authority to switch this method to another method. Section 56 permits the assessee to use any method of his choice. However, the AO considered that the beneficiary should have used only one method to determine the value of the shares. In our opinion, it was outside the jurisdiction of the AO to insist on any particular system, especially when the law allows for the choice of either method. Until and unless the legislature changes the provision of the law and requires only one method of valuing the shares, the assessee is free to adopt either method.
While this court ruling may grant a certain amount of time, in practice tax authorities often question the basis of the assumption and underlying assumptions, leading to unjustified tax disputes.
- In principle, the issue of shares as a capital transaction should not give rise to any taxation. This provision is unprecedented and it is difficult to find similar provisions in any other country in the world.
Taxation on issue or transfer of shares below book value
- In the case of receiving shares for a consideration below market value, the difference is deemed to be income in the hands of the recipient pursuant to Section 56(2)(x) of the IT Act. For this purpose, the fair value valuation methodology is based on the adjusted book value method (book value of shares adjusted for real estate appreciation, etc.). In several cases, the enterprise value is lower than the book value of the shares. This may be due to the industry outlook, investor appetite, regulatory developments or even the COVID-19 crisis.
- Section 50CA of the IT Act states that if the consideration received or accrued as a result of the transfer of a capital property by a person, the participation in an unlisted company is less than the fair market value of that stock, determined by any means required , the value so determined shall be deemed to be the full value of the consideration received or accruing as a result of such a transfer for the purposes of section 48:
Pursuant to that Section 50CA, the fair market value of Shares is to be taken into account for the purpose of calculating capital gains, while the consideration for sale may be less than fair market value.
In such event, deemed capital gains may be imposed on the seller under Section 50CA as well as deemed taxes on the buyer under the provisions of Section 56(2)(x) of the IT Act as a result of the receipt of Shares for insufficient account.
- The above provisions provide for a fictitious taxation that contradicts the basic principle of taxing real income. These fictitious tax proposals are separated from business reality. These regulations were introduced primarily as anti-abuse regulations to prevent unscrupulous transactions involving the issue or transfer of shares at ridiculous valuations, but in practice the said regulations prevent real companies from raising capital. There are several mechanisms to deal with abuse of the provisions through targeted investigation and verification of the commercial reasons.
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The fact is that company valuations are driven by a variety of economic, geopolitical, regulatory and financial factors and do not fit into the straitjacket of mathematical formulas.
In order for India to promote itself as an investment-friendly country and facilitate the revitalization of the economy, it is imperative that such provisions (ie Section 56(2)(viib), 56(2)(x) and Section 50CA) be removed from notional taxation.
(The author is Founder, RSM India.)