Tax on Excess Consideration for Shares Issued at Premium

Introduction:

Navigating the intricate landscape of Indian taxation is essential, particularly when it involves understanding the tax implications of receiving excess consideration for shares issued at a premium. This comprehensive article delves into the nuances of Section 56(2)(viib) of the Income Tax Act, which dictates the taxation of such excess premiums. We’ll explore the criteria, exemptions, and the methodology for calculating the fair market value of shares in detail.

Taxability of excess consideration received on shares issued at a premium

• Any excess premium received by a company is chargeable to tax under the head income from other sources if the following conditions are satisfied:
• Shares (equity or preference shares) are issued by a closely held company;
• The consideration for the issue of shares is received from any person (resident or non­resident);
• The consideration received for the issue of shares exceeds the face value and fair market value of shares.
• If the 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.
• A closely held company is a company in which the public is not substantially interested.
• In the following cases, this provision shall not apply:
• The consideration is received by a Venture Capital Undertaking from a Venture Capital Company, Venture Capital Fund, Category-I or Category-II Alternative Investment Fund (AIF); or
• The company is an eligible start-up fulfilling conditions as prescribed in Notification No. GSR 127 (E) [F.NO.5 (4)/2018-SI], Dated 19-2-2019.

Exemption to a start-up company

• A start-up recognised by DPIIT gets immunity from the provisions of Section 56(2)(viib) if it fulfils the conditions specified below.
• The aggregate amount of paid-up share capital and share premium of the start-up, after the issue or proposed issue of shares, should not exceed Rs. 25 crores. While calculating this threshold limit, the issue of shares to the following persons shall not be included:

(a) A non-resident person;

(b) Venture Capital Company;

(c) Venture Capital Fund; and

(d) A company whose shares are frequently traded within the meaning of SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 and whose net worth exceeds Rs. 100 crore or turnover exceeds Rs. 250 crores for the financial year preceding the year in which shares are issued.

• The eligible start-up should not invest in any of the following assets for a period of 7 years from the end of the latest financial year in which the shares are issued at a premium:

(a) Land or building, being a residential house, other than that used for the purposes of renting or held as stock-in-trade in the ordinary course of business;

(b) Land or building, not being a residential house, other than that occupied by the start-up for its business or renting purposes or held as stock-in-trade in the ordinary course of business;

(c) Loans and advances if the start-up is not engaged in the ordinary business of lending money;

(d) Capital contributions to any other entity;

(e) Shares and securities;

(f) Motor vehicle, aircraft, yacht or any other mode of transport, if the cost of such an asset exceeds Rs. 10 lakhs other than that held by the Start-up for the purpose of plying, hiring, leasing or as stock-in-trade in the ordinary course of business;

(g) Jewellery held otherwise than as stock in trade; and

(h) Archaeological collections, drawings, paintings, sculptures, any work of art or bullion.

• To claim this exemption, the start-up has to file a declaration in Form 2 with the DPIIT along with the details of the company.
• The DPIIT shall forward the self-declaration form to the CBDT for approval. On successful submission of a self-declaration form, the start-up can issue the shares. The CBDT, thereafter, shall assess the application, and it can either accept it or reject it after giving it an opportunity of being heard.
• In case of failure to comply with these conditions, the consideration received from the issue of shares as exceeding the fair market value of such shares shall be deemed to be the income of the company chargeable to tax for the previous year in which such failure takes place.
• When the exemption is withdrawn, it shall be deemed that the company has underreported the income as a consequence of the misreporting, and a penalty shall be levied as per Section 270A.

Computation of the fair market value

• The fair market value of the shares shall be the higher of the following:

(a) Value determined in accordance with the book value method or DCF method prescribed in Rule 11UA; or

(b) Value substantiated by the company to the satisfaction of the Assessing Officer, based on the value of its assets, including intangible assets being goodwill, know-how, patents, copyrights, trademarks, licences, franchises or any other business or commercial rights of similar nature on the date of issue of shares.

• The Discounted Cash Flow (DCF) methodology expresses the present value of a business as a function of its future cash earnings capacity. In this method, future cash flows of a business are discounted at an appropriate discount rate on a going concern assumption.
• The book value of the unquoted equity shares shall be determined in accordance with the following formula:

• The book value of assets shall not include the following:

(a) Amount of prepaid taxes, as reduced by the amount of Income-tax refund claimed;

(b) Any amount shown in the balance sheet as an asset, including the unamortised amount of deferred expenditure, which does not represent the value of any asset;

• The book value of assets in the balance sheet shall be determined as per the following:

(a) The price which the jewellery and artistic work would fetch if sold in the open market on the basis of the valuation report obtained from a registered valuer;

(b) The value of shares and securities as determined in the manner provided in this Rule 11UA;

(c) The value adopted or assessed or assessable by any authority of the Government for the purpose of payment of stamp duty in respect of the immovable property.

• The book value of liabilities shall not include the following:

(a) Paid up capital in respect of equity shares;

(b) Amount set aside for payment of dividends on preference shares and equity shares if such dividends have not been declared (before the date of transfer) at a general body meeting of the company;

(c) Reserves and surplus (even if the resulting figure is negative) other than those set apart towards depreciation;

(d) Excess provision for tax (including deferred tax liability);

(e) Provisions for unascertained liabilities;

(f) Contingent Liabilities.

• For the purposes of determination of the fair market value of unquoted shares for Section 56(2)(viib), the balance sheet of the closely held company shall mean the balance sheet (including the notes annexed thereto and forming part of the accounts) as drawn up on the valuation date which has been audited by the auditor of the company appointed under the law relating to companies in force. Where the balance sheet on the valuation date is not drawn up, the balance sheet drawn up as on a date immediately preceding the valuation date, which has been approved and adopted in the annual general meeting of the shareholders of the company.
• The fair market value of unquoted shares and securities (other than equity shares) in 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.

Taxability of excess consideration received on shares issued at a premium:  Important Points

1. Any excess premium received by a company is chargeable to tax under the head income from other sources if the Shares (equity or preference shares) are issued by a closely held company.

2. Any excess premium received by a company is chargeable to tax under the head income from other sources if the consideration for the issue of shares is received from any person (resident or non-resident);

3.  Section 56(2)(viib) shall not apply where:

(a) The consideration is received by a Venture Capital Undertaking from a Venture Capital Company, Venture Capital Fund, Category-I or Category-II Alternative Investment Fund (AIF); or

(b) The company is an eligible start-up fulfilling conditions as prescribed in Notification No. GSR 127 (E) [F.NO.5 (4)/2018-SI], Dated 19-2-2019.

4. The aggregate amount of paid-up share capital and share premium of the start­up, after the issue or proposed issue of shares, should not exceed Rs. 25 crores.

5. To claim the exemption under section 56(2)(viib), the start-up has to file a declaration in Form 2 with the DPIIT along with the details of the company.

6. The Discounted Cash Flow (DCF) methodology expresses the present value of a business as a function of its future cash earnings capacity. In this method, future cash flows of a business are discounted at an appropriate discount rate on a going concern assumption.

Conclusion: In conclusion, the taxability of excess consideration for shares issued at a premium involves a careful examination of specific conditions and compliance with the law. It’s crucial for both closely held companies and start-ups to be aware of these provisions and exemptions, as well as to follow the right methodology for determining the fair market value of shares. Understanding these aspects ensures that businesses can navigate the tax landscape with confidence and in compliance with the law.