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Tax Implications of Optionally Convertible Preference Shares

Introduction

XYZ Pvt Ltd (“the Issuer”) proposes to issue Optionally Convertible Preference Shares (OCPS) to ABC Pvt Ltd (“the Subscriber”). The issue involves a subscription amount of Rs. 1 Crores, with a dividend rate of 0.10% over a tenure of 20 years. This brief examines the tax implications and regulatory considerations under the Indian Income Tax Act associated with this transaction.

Sections attracted

  1. Section 56(2)(vii)(b): If unquoted shares are issued at premium by a closely held company, the excess of premium over the fair market value of the shares shall be taxable in the hands of the issuer company under the head income from other sources.
  2. Section 56(2)(x): Pertains to the receipt of property (including shares) for a consideration less than the FMV where the difference exceeds Rs 50,000. This amount is treated as income from other sources.
  3. Section 56: More broadly addresses incomes that are taxable under “Income from Other Sources,” including dividends on shares.
  4. Section 194: This section deals with the requirement to deduct tax at source (TDS) on dividend payments, especially relevant since the dividend distribution tax (DDT) has been abolished.
  5. Section 2(22)(e): Mentioned to clarify that the provision of deemed dividends does not apply in the case of OCPS issuance as it pertains to loans and advances to shareholders, which is not the scenario here.
  6. Rule 11UA: It details the methods for valuing unquoted shares for the purposes of Section 56(2)(viib), including optionally convertible preference shares and other unquoted shares.
  7. Section 68: Addresses unexplained cash credits, which could be relevant if the subscription amount received is not properly justified in terms of FMV or issuance terms.
  8. Section 115BBE: Tax rates and conditions for taxing income deemed under Section 68 where explanations about the nature and source of credits are unsatisfactory.
  9. Section 115QA: Discusses the tax implications for the company on the distribution of amounts following the buy-back of shares, which may also apply to the redemption of preference shares as a buy-back.

Let us understand all the above sections keeping in mind the proposed transaction:-

Issue Price and Fair Market Value (FMV) [Section 56(2)(vii)(b)]: section 56(2)(viib) of the Income-tax Act, 1961 (Act) as an anti-abuse provision to prevent generation and circulation of unaccounted money through share premium received from resident investors in a closely held company in excess of its fair market value. It taxed the consideration or premium above fair market value (FMV) on issue of shares in the hands of the closely held company. In other words, the difference in the consideration received and the FMV of the closed held company was subject to income-tax as ‘income from other sources’ in the hands of the closely held company (recipient).

As per Section 56(2)(viib), any excess premium received by a company is chargeable to tax under the head income from other sources if the following conditions are satisfied:

(a) Shares (equity or preference shares) are issued by a closely held company;

(b) The consideration for issue of shares is received from any person;

(c) The consideration received for issue of shares exceeds the face value and fair market value of shares.

  • Thresholds for determining chargeability to tax:
Issue of shares by Indian company Result
At face value of shares No tax
Between face value and fair market value (assuming FMV > FV) Still no tax
Above fair market value (assuming Issue Price > FMV) Tax on difference between subscription price (Issue) and FMV

If above conditions are satisfied, the consideration received exceeding the fair market value of the share shall be taxable in the hands of the issuer company. This provision does not apply if quoted shares are issued at premium by a domestic company.

The fair market value of the following shares shall be determined in accordance with the provisions laid down in Rule 11UA:

(a) Valuation of unquoted equity shares;

(b) Valuation of compulsorily convertible preference shares (‘CCPS’); and

(c) Valuation of other unquoted shares.

Valuation of other unquoted shares

For the purpose of Section 56(2)(viib), the fair market value of unquoted shares (other than equity shares and CCPS) of a company shall be estimated to be the price it would fetch if sold in the open market on the valuation date, and the assessee may obtain a report from a merchant banker or an accountant in respect of such valuation.

Rule 11UA(1)(c)(c)

Valuation of unquoted shares and securities other than equity shares which are not listed on any recognized stock exchange:

FMV

  • Price it would fetch if sold in the open market on the valuation date
  • The assessee may obtain a report from a merchant banker or an accountant in respect of such valuation

IF THE ISSUE/SUBSCRIPTION PRICE IS BETWEEN FACE VALUE AND FAIR MARKET VALUE

Under Section 68 of the Indian Income Tax Act, any sum found credited in the books of an assessee, for which he offers no explanation about the nature and source, or the explanation offered is not satisfactory, may be charged to income tax as the income of the assessee.

  • The proviso applies specifically to closely held companies;
  • The credited sum includes share application money, share capital, share premium, or any similar amount;
  • 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.
  • The primary onus of satisfactory explanation of such credits is on the assessee-company.

Tax Implications: If the explanation is deemed unsatisfactory by the tax authorities, the amount credited (or part of it) could be taxed as income of the company under “Income from Other Sources.” This would lead to a significant tax liability.

Tax rate under section 115BBE:

  1. The effective tax rate will be 78% (60% tax rate + 25% surcharge + 4% cess) on such income,
  2. No deduction in respect of any expenditure/allowance/setoff of any loss shall be allowed to assessee in computing income under section 115BBE(1).

Dividend Income [Section 56]: Dividend income received by ABC Pvt Ltd would be taxable under “Income from Other Sources.” With the dividend rate being 0.10%, this income should be taxed on an accrual basis annually. It’s also worth noting that, as per the Finance Act, 2020, the dividend distribution tax (DDT) regime has been abolished, and dividends are now taxable in the hands of the shareholders at their applicable income tax rates.

Tax Deducted at Source (TDS) [Section 194]: With the removal of the DDT, the entity distributing the dividend (XYZ Pvt Ltd) is required to deduct tax at source at the rate of 10% if the dividend amount exceeds Rs. 5,000 in a financial year.

Capital Gains on Maturity/Redemption: Upon conversion or redemption of the OCPS, any gains arising to ABC Pvt Ltd would be subject to capital gains tax. If the holding period of these shares is more than 24 months, the gains would be considered long-term and taxed at 20% with indexation benefits. If the holding period is less than 24 months, the gains would be short-term and taxed according to the slab rates applicable to the corporate.

Another key area requiring clarification is whether the provisions of Section 115QA would apply on redemption of preference shares. As per the provisions of section 115QA, any amount distributed by a Company pursuant to buy-back of its shares is subject to tax in the hands of the Company @ 20%. The said buyback of shares is not restricted to a buyback covered under section 68 of the Companies Act and hence, a redemption of preference shares may be considered as a buyback of preference shares by the Company. In such a case, the tax implications will arise in the hands of the Company u/s 115QA while such gains on redemption would be exempt in the hands of the shareholders u/s 10(34A). In absence of any clarity on the taxability of redemption of preference shares i.e. whether tax is to be borne by the Company as buyback of shares or as capital gains tax is on the shareholders, such event is likely to result in tax uncertainty for the investors. The tax rate applicable on the buyback of shares is same as the LTCG rate applicable in the hands of the shareholders i.e. 20%. Hence, to avoid any ambiguities, it may be considered to cover the redemption of preference shares as a capital gains tax event only, taxable in the hands of the shareholders.

Provision of Deemed Dividend [Section 2(22)(e)]: This provision is not applicable in the context of the transaction, as it pertains to loans and advances by a company to its shareholders holding a substantial interest, or to any concern in which such shareholder has a substantial interest. Since this transaction involves the issuance of OCPS and not a loan or advance, Section 2(22)(e) is not triggered.

Anti Abuse Provisions – Section 56(2)(x)

  • Section 56(2)(x)(c) provides situations where any person receives, any property other than any immovable property from any person or persons on or after 1st day of April 2017.
  • The term Property inter alia includes “Shares and securities”
  • In case of an inadequate consideration wherein the difference between FMV & consideration > Rs 50,000/-, then, FMV less consideration received will be treated as income for the recipient and chargeable under the head “ Income from other sources”.
  • section 56(2)(x)(c) requires the Investors to acquire shares at a value equal to or higher than the Fair Market Value (FMV) of such shares,
Sr. No. Events Applicability under section 56(2)(x)
1 Issues of equity shares, CCPS, CCDs, RPS, OCDs, OCPS If the issue price is < FMV & the difference is > 50,000/-

Tax Implication on Conversion of Preference Share into Equity Shares

Section 47(xb): Any transfer by way of conversion of preference shares of a company into equity shares of that company is not liable to capital gains as per this clause.

Clause (xb) of Section 47 was added w.e.f. 1st April, 2018. Even Prior to insertion of this clause, conversion of PreferenceShares into Equity Shares was not considered as a transfer, in the case of Periar Trading Co. (P.) Ltd. v. ITO [2018] 100 taxmann.com 263/[2019] 174 ITD 137 (Mum.). Reference, in the said decision, was made to CBDT circular dated 12.05.1984 vide F No. 12/1/64-IT (A) which read as under: “Where one type of shares is converted into another type of share (including conversion of debentures into equity shares), there is, in fact, no ‘transfer’ of a capital asset within the meaning of Section 2(47) of the Income-tax Act, 1961.”

The circular was found to be entirely consistent with both the legislative objective and the capital gain taxation scheme. Further it was held that Section 55(2)(b)(v)(e) states that where the capital asset being share of company, became property of the assessee on conversion of any kind of shares of the company into another kind, the cost of acquisition for the purpose of computing capital gain would be the cost of acquisition calculated with reference to the cost of acquisition of shares from which such asset is derived. Thus, it was made clear that the legislature itself had chosen to ignore the intermediate event of conversion for taxation purposes. Accordingly, conversion of preference shares into equity shares was held to be a non-taxable event.

  1. As per clause (xb) of section 47, conversion of preference shares of a company into equity shares of that company is not treated as transfer, hence no capital gains arises on the same.
  2. Section 49(2AE) has been inserted to provide that cost of acquisition of preference shares shall be treated as cost of acquisition for equity shares (received on conversion).
  3. Further, to find out whether such equity shares received on conversion are long term capital assets or not, the period of holding shall be determined from the date of acquisition of preference shares of such company – Explanation 1 to section 2(42A).
  4. The benefit of indexation will start from the date of acquisition of preference shares of the company.
  5. The difference between the market value of the equity shares issued and the subscription price paid for the preference shares is taxable u/s 56(2)(x) of the Income Tax Act.

Conclusion

It is advisable to issue the OCPS at fair market value only by taking a valuation report from a merchant banker. If the OCPS are issued at a price significantly different from the fair market value (FMV), especially if lower, it might be scrutinized under GAAR. The authorities might investigate whether the pricing strategy was designed to shift profits, create artificial losses, or achieve a similar tax-incentive result.

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