Section 56(2)(viib) & Rule 11UA(2) : Decoding amendment & draft rule

Deciphering the amendments to Section 56(2)(viib) & Rule 11UA(2) of the Income Tax Act post-Finance Bill 2023, impacting FDI and startup ecosystems. Explore the key provisions and valuation methodologies for unquoted equity shares received from residents and non-residents. Stay informed about the impact on closely held companies and exemptions for startups.

Section 56(2)(viib) & Rule 11UA(2) : Decoding the amendment in section 56(2)(viib) of the Income Tax Act and draft sub rule 2 of rule 11UA of the income tax Rules

In Finance bill 2023, the government of India has bite the bullet with the amendment in section 56(2)(viib) by cementing the provisions for resident as well as non-resident investor for the purpose of issue of shares. This amendment has direct impact on FDI inflow to India as in year 2022 as India was ranked 7^th in the terms of Global Economy for FDI and ranked 3^rd in startup ecosystem. Thus, it was the need of the hour was to assess the impact on FDI inflow and startups ecosystem. Post consultation with stakeholder, government has come-up with the amendment in Section 56(2)(viib) and the rules for valuation of share of the companies in which public are not substantially interest. Let’s unfold the provision after amendment in law:

Section 56(2)(viib): “Where a company, not being a company in which the public are substantially interested, receives, in any previous year, from any person, any consideration for issue of shares that exceeds the face value of such shares, the aggregate consideration received for such shares as exceeds the fair market value of the shares” than consideration to the extent exceeding fair market value shall be chargeable to tax under the head Income From Other Source.

Provided that above provision shall not apply where the consideration for issue of shares is received from :

1. by a venture capital undertaking from a venture capital company or a venture capital fund or a specified fund; or

2. by a company from a class or classes of persons as may be notified by the Central Government in this behalf:

• Government and Government related investors such as central banks, sovereign wealth funds, international or multilateral organizations or agencies including entities controlled by the Government or where direct or indirect ownership of the Government is seventy-five percent or more;
• Banks or Entities involved in Insurance Business where such entity is subject to applicable regulations in the country where it is established or incorporated or is a resident;
• Any of the following entities, which is a resident of any country or specified territory listed in ANNEXURE*, and such entity is subject to applicable regulations in the country where it is established or incorporated or is a resident: ––
• entities registered with Securities and Exchange Board of India as Category-I Foreign Portfolio Investors;
• endowment funds associated with a university, hospitals or charities;
• pension funds created or established under the law of the foreign country or specified territory;
• Broad Based Pooled Investment Vehicle or fund where the number of investors in such vehicle or fund is more than fifty and such fund is not a hedge fund or a fund which employs diverse or complex trading strategies.

*ANNEXURE

List of Notified Countries/Territories

Analysis of Provision: Finance Act 2023 has cemented the difference between resident as well as non-resident for applicability of section 56(2)(viib). Now any amount received by the company (in which public is not substantially interested) exceeding the fair market value for issue of shares will be chargeable to tax under the head income from other sources. Further, The following category of person has been notified in case which the provision of the section 56(2)(viib) will not be applicable:

• Received by Venture Capital Undertaking: The provision of section 56(2)(viib) will not be applicable on the consideration received by Venture Capital Undertaking from venture capital company or venture capital fund or specified fund.
• Government & Government related Investor: If a closely held company receives any consideration for issue of its shares to Government and Government related Investor and the consideration received is more than FMV of shares of the company then there will be no tax implication of issue of shares in the hands of the company. Here, Government related entities means:
• central banks
• Sovern sovereign wealth funds
• international or multilateral organizations or agencies including entities controlled by the Government or where direct or indirect ownership of the Government is seventy-five percent or more.
• Banks & Insurance Companies: Banks or Entities involved in Insurance Business where such entity is subject to applicable regulations in the country where it is established or incorporated or is a resident.

• Notified Entities from Specified countries/territories: The provision of section 56(2)(viib) is not applicable if the consideration has been paid by the notified institution from specified territory to the closely held company for issue of shares. To understand easily, I have tried to make a simplified matrix as hereunder:

• Startup: The MOF has allowed exemption to startups in order to provide relief from Angel Tax subject to fulfilment of following condition:
• It should be DIPP reconised startup and
• The amount of Paid-up share capital and security premium after the proposed issue should not exceed INR. 25 Crore.

Apart from above, The Ministry of Finance has issued draft amendment to amend Rule 11UA of the Income tax rules via notification no F. No. 370142/9/2023-TPL(part-I) dated 26 May 2023 to in line the valuation methodologies with provisions of Section 56(2)(viib). Broadly the guidelines for valuation of share as per draft rule is as hereunder:

Some further notable points of draft amendments of Rule 11UA is as follows:

• For the purpose of subrule 2 of rule 11UA, any report issued by merchant banker not more than 90 days prior to the proposed issue may have option to adopt as deemed FMV.
• Safe harbour rule for 10% variation has been proposed.

Since, it is news in transition, therefore we should expect some change in final position of law for valuation of shares under subrule 2 of Rule 11UA for the purpose of Section 56(2)(viib).

Disclaimer: All information & views expressed above are my own and not representing any legal opinion. It would be better if you write to me on [email protected] for any further inquiries. You can also reach me +91-8882214254.

1. S.O. 2274(E).

2. S.O. 2275(E).

3. F. No. 370142/9/2023-TPL(part-I)