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Compliance issues under Section 56(2)(viib): A Legal and Commercial Analysis* 


The tax on capital gains directly affects investment decisions, the mobility and flow of risk capital from static to more dynamic situations, the ease or difficulty experienced by new ventures in obtaining capital, and thereby the strength and potential for growth in the economy.

– John F. Kennedy

The issuance of shares has remained a constant feature in news headlines, whether it iis Facebook’s acquisition of a 9.99% equity stake in Reliance Jio, the widely-discussed Vodafone case, Adani’s “hostile takeover” attempt on NDTV, or the tumultuous events surrounding the Hindenburg report and the subsequent drop in Adani’s stocks. Even figures like Warren Buffett, one of the wealthiest individuals globally, have amassed their fortunes through the buying and selling of shares.

The instances above highlight the significance and abundance of share transactions in any economy. Consequently, the regulation of shares is a task overseen by a multitude of laws including the Income Tax Act, 1961 (hereinafter, “IT Act”), the Companies Act, 2013 (hereinafter, “CA, 2013”) along with its associated rules; Foreign Exchange Management Act, 1999 (hereinafter, “FEMA”) and along with its related rules; and SEBI regulations governing shares traded on stock exchanges.

While the presence of specialized bodies and laws dedicated to various facets of share issuance appears logical, it also introduces a significant compliance burden for investors. Moreover, the plethora of laws increases the likelihood of legislative conflicts. A poignant example of such conflicts emerges in section 56(2)(viib) where FEMA, and CA, 2013 clash with the IT Act, leaving stakeholders grappling for clarity amidst ambiguity.

Furthermore, while FEMA and the CA, 2013 maintain flexibility regarding valuation methods, as long as they are legitimate and possess global acceptance, the Income Tax Act imposes specific valuation criteria like Net Asset Value and Discounted Cash Flow. Thus, section 56(2)(viiib) presents a myriad of unresolved issues warranting thorough analysis.

Conflict of Laws

The average judge, when confronted by a problem in conflict of laws, feels almost completely lost and like a drowning man will grasp at a straw.

– Justice Cardozo

Section 2(18) of the IT Act[1] defines a company where public is substantially interested and by necessary implication, the companies falling outside this definition would be where public is not substantially interested. It is the latter that concerns section 56(2)(viib).[2] Private Companies are excluded from the ambit of section 2(18) except for specific circumstances outlined in its sub-clauses. These circumstances include being a company with 40% shares held by the government or Reserve Bank of India (section 2(18)(a)[3]), declared by the board to have substantial public interest (section 2(18)(ab)[4]), operating for charitable purposes (section 2(18)(aa)[5]), and others.

Under rule 11U(i)[6] of the Income Tax Rule, 1962 (hereinafter, “IT Rules”) unquoted shares are defined as “shares and securities which is not a quoted shares or securities” i.e., shares which are not listed on any stock exchange.[7] Given that we are dealing with a private company, the shares are unlisted, thereby classified as unquoted shares. Issuance of unlisted shares are dealt by following laws.

A. Emergence of Conflict

1. Companies Act, 2013

Private placement

Section 42[8] permits a private company to issue its securities and according to Rule 14[9] it necessitates a report from a valuer justifying the price at which the offer is made. This requirement is implied by Rule 14(d), which mandates that the valuer’s name and address be included in the explanatory note attached with the notice seeking approval of shareholders.

Compliance Issues Under Section 56(2)(viiib) A Legal And Commercial Analysis

Preferential allotment of shares

In the landmark case of Mrs. Proddaturi Malathi v. Srp Logistice Pvt. Ltd.,[10] it was ruled that Section 62 applies to private companies. Section 62(1)(c) stipulates that when a company seeks to increase its subscribed capital through the issuance of further capital, valuation report is necessary to determine the price of such shares. Furthermore, Rule 13[11] of the Companies Rules, 2014, specifies that the basis for the price, along with the registered valuer’s report, must be explained under Rule 13(1)(d)(iv). The explanation to the rule mentions that “the price of shares or other securities to be issued on preferential basis shall not be less than the price determined on the basis of valuation report of a registered valuer.”[12]

The rationale behind this is to prevent companies from undervaluing their securities. However, there is there is no prohibition on a company to issue such securities at a price exceeding such valuation.

2. Foreign Exchange Management Act, 1999

Rule 21 of FEMA (Non-Debt Instruments) Rules, 2019[13] mandates that “the price of equity instruments issued by an Indian company to a person resident outside India must shall not be less than the valuation of such instruments determined by any internationally accepted pricing methodology.”

The rationale behind mandating that the valuation of equity instruments should not be lower than the Fair Market Value (hereinafter, “FMV”) is rooted in the necessity to maintain a steady inflow of foreign currency into India. Undervaluing shares could impede this inflow, potentially diminishing forex reserves. Conversely, exceeding the Fair Market Value is desirable as it leads to greater foreign exchange inflows.

3. Income Tax Act, 1961

Section 56(2)(viib)[14] stipulates that “the aggregate consideration received for such shares as exceeds the fair market value of the shares” is taxable.

This provision serves multiple objectives: Firstly, it aims to tax excessive share premiums received unjustifiably by private companies, thereby curbing the issuance of shares lacking underlying value. Secondly, it functions as an anti-abuse measure, thwarting the generation and circulation of unaccounted money disguised as share premiums.

Therefore, what is the floor in CA, 2013 and FEMA, forms the ceiling under the IT Act. 

Commercial Impact of the Contact

This dual restriction, comprising both a floor and a ceiling, constricts the company’s issuance of shares to align precisely with the fair market value. While the “floor” stipulated by CA/FEMA safeguards against undervaluation, thus shielding the company and its current shareholders, the “ceiling” enforced by the IT Act curtails the company’s capacity to establish a higher share price. This limitation impedes strategic financial manoeuvres, such as attracting foreign investment or ability to generate more capital.

Section 56(2)(viib) [“Angel Tax”] continues to affect various categories of investors in start-ups. While start-ups can seek exemption under section 80IAC,[15] obtaining this exemption is not automatic and requires a separate application process. Additionally, the application of this clause only to investments made by residents seems illogical[16] and consequently, the 2023 amendment[17] does away with this, but then it conflicts with FEMA as explained above.

In the book, “The Law and Practice of Income Tax,” Kanga & Palkhivala argue that when the origin of share application funds cannot be explained by the assessee, section 68 is applicable. Even if the source is explained, the Department retains the authority to tax the amounts under section 56(2)(viib). Consequently, they content that if a company is closely held with all shareholders qualifying as “relatives” as per Explanation (d) to clause (vii), then the new shares issued to another “relative,” at any excessive premium should on a holistic view of the transaction amount to a gift between relatives and should therefore be exempt under s 56(2)(x).[18]

Furthermore, the 2023 amendment to Rule 11UA, recognizes these commercial implications and therefore, Rule11UA(4)[19] provides some relief by permitting a deviation of up to 10% from the fair market value in the issue price of shares, while still categorizing it as fair market value.

Issue of Convertible Instruments

Considering that section 56 relates to income from other sources, its jurisprudence is under constant evolution, its sub-section(2)(viib) also faces a similar fate. While numerous cases have delineated the circumstances in which it applies, they have primarily focused on share issuance, consequently it is essential to shed light on whether convertible instruments like convertible debentures and share warrants fall within its ambit.

Under CA, 2013 and FEMA, the terminology used is “securities”[20] and “equity instruments,” [which under its definition provided in Rule 2(k) of FEMA (Non-Debt Instruments) Rules, 2019[21]], respectively and are broad enough to include share warrants and convertible debentures. However, section 56(2)(viib) specifically refers to “issue of shares,” so while it includes equity shares, preference shares and compulsorily convertible preference shares, whether it includes convertible instruments remains a subject of debate.

There have been conflicting views taken by Income Tax Appellate Tribunals (hereinafter, “ITATs”) on the same. In Milk Mantra Dairy Pvt. Ltd. v. DCIT,[22] the Kolkata ITAT ruled that Section 56(2)(viib) applies to the conversion of compulsorily convertible debentures (CCDs) into equity shares. This decision was based on the rationale that the provision targets any excess consideration received by a closely held company upon issuing its shares, regardless of the form that consideration takes, whether cash or otherwise. The tribunal highlighted that this consideration can encompass non-monetary benefits such as the settlement of debt obligations or an enhanced debt-equity ratio.

In contrast, the ITAT Mumbai Bench, in the case of DCIT v. M/S Rankin Infrastructure Pvt. Ltd.,[23] clarified that Section 56(2)(viib) should be applied in the year the share consideration is received, not merely upon the issuance of shares. This interpretation was based on the reasoning that the language of the section indicates both the issuance of shares and the receipt of consideration must occur within the same assessment year for the provision to apply. Since the consideration for the OFCDs was received in years prior to their conversion into shares, the tribunal concluded that Section 56(2)(viib) did not apply.

In taxation, the rule of strict interpretation applies, and any gaps in the statute are construed in favour of the taxpayer. Following this rule of strict interpretation, convertible instruments should logically fall outside the purview of section 56(2)(viib). Additionally, during the amendment of Rule 11AU and the section itself, the legislature had the opportunity to encompass convertible instruments within the scope, especially considering its awareness of convertible preference shares. However, it deliberately refrained from doing so, indicating that extending the section to cover convertible instruments would deviate from the legislature’s original intent.

Moreover, the practical application of such an extension poses challenges. Under FEMA regulations, convertible instruments cannot be converted at a price lower than the initial subscription price paid by the non-resident investor.[24] Similarly, under the Companies Act, the price of the converted shares may be determined based on the valuation provided at the time of the offer.[25] As a result, even if the fair market value experiences a significant decline from the initial price due to a decrease in the company’s valuation at the time of conversion, tax liabilities would still ensue which is evidently unjust. Furthermore, the non-application of section 56(2)(viib) would also enable companies to circumvent tax payment by channeling share issuance through convertible instruments, thus escaping the adverse commercial consequences associated with it as explained above.


India’s taxation policy has always been one of the main obstacles to its ease of doing business. Much limelight is taken up by retrospective tax, and deeming provisions – which create liability through the legal fiction of a profit, in the hope that this legal fiction matches reality. Section 56(2), which creates a tax liability for a company attempting to raise funds by starting with the assumption that such fundraising exercise may be a colourable device for evasion purposes, has also been a topic of discussion of late due to the extension of its applicability to foreign investors, but what gets overlooked is the significant obstacle it poses for companies to issue shares to resident investors as well.

The trouble with the opposing compliance regime under IT Act when read with FEMA and/or the CA, 2013 is not merely the multiplicity of compliances itself, but the clear lack of policy direction displayed by creating a conflicting compliance regime under some of India’s most stringent acts – in a manner that all but ensures that a resident company must fall afoul of one or the other. Despite constant assurances by successive governments about the ease of business in India – such policy changes (including the recent extension of section 56(2)(viib) to non-resident investors as well) make apparent a suffocating and paranoid regulatory regime that investors would be justified in being wary of.

* Siddhart Kumar and Varsha Agarwal, Final Year B.A.,LL.B. (Honours) students at National Law University, Jodhpur.

[1] Income Tax Act, 1961, § 2(18), No. 43, Acts of Parliament 1961 (India). [hereinafter, IT Act]

[2] Id. at § 56(2)(viib).

[3] Id. at § 2(18)(a).

[4] Id. at § 2(18)(ab).

[5] Id. at § 2(18)(aa).

[6] Income Tax Rule, 1962, Rule 11U(i).

[7] Id. at Rule 11U(d).

[8] The Companies Act, 2013, § 42, No. 18, Acts of Parliament 2013 (India).

[9] The Companies (Prospectus and Allotment of Securities) Rules 2014, Rule 14.

[10] Proddaturi Malathi v. SRP Logistics Pvt. Ltd., 2017 SCC OnLine NCLAT 331.

[11] The Companies (Share Capital and Debentures) Rules 2014, Rule 13.

[12] Id. at Explanation to Rule 13.

[13] Foreign Exchange Management Act (Non-Debt Instruments) Rules, 2019, Rule 21.

[14] Income Tax Act, 1961, § 56(2)(viib), No. 43, Acts of Parliament 1961 (India).

[15] Exemption to Start-ups, Income Tax Notification 30 of 2023, S.O. 2275 (E) dated May 24, 2023.

[16] Kanga & Palkhivala, The Law and Practice of Income Tax (Arvind Datar eds., 11th ed. 2020).

[17] Kanga & Palkhivala, The Law and Practice of Income Tax (Arvind Datar eds., 11th ed. 2020).

[18] Income-tax (Twenty-first Amendment), Rules, 2023, G.S.R. 685(E) dated September 25, 2023.

[19] Income Tax Rules, 1962, Rule 11UA(4).

[20] Companies Act, 2013§ 42, No. 18, Acts of Parliament 2013 (India).

[21] The Foreign Exchange Management Act (Non-Debt Instruments) Rules, 2019, Rule 2(k).

[22] ITA No.413/Kol/2020.

[23] ITA No. 7288/MUM/2019.

[24] Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017, Explanation to Regulation 11(1).

[25] Companies (Share Capital and Debentures) Rules, 2014, Rule 13.



i. Sidhart Kumar, Final year B.A.,LL.B. (International Trade Law Hons.) student at National Law University, Jodhpur.

ii. Varsha Agarwal, Final Year B.A.,LL.B (Business Law Hons.) student at National Law University, Jodhpur.



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July 2024