“Unlock the complexities of Income Tax Act’s Section 56(2)(viib). Dive into the tax implications for closely-held companies issuing shares above fair market value. Explore applicability, covered transactions, tax incidence, fair valuation methods, and the legislation’s rationale. Stay compliant, understand the rules, and ensure transparent transactions.”
Section 56(2)(viib) of the Income Tax Act encompasses a provision that pertains to closely-held companies issuing shares to resident investors at a value exceeding the “fair market value” of those shares. In such cases, the surplus amount of the issue price over the fair value is subject to taxation as the income of the company issuing the shares. The computation of the fair market value of unquoted equity shares for the purpose of this section is governed by Rule 11UA of the Income-tax Rules, which provides a formula for valuation.
To gain a clearer understanding of the tax implications, let’s break down the key components of this section:
(a) Applicability: This section applies to companies that are not considered “companies in which the public are substantially interested.” The definition of “company in which the public are substantially interested” can be found in section 2(18) of the Income Tax Act. Generally, it includes public companies listed on stock exchanges or subsidiaries of listed public companies.
(b) Covered transactions: The section applies to the issuance of shares by the aforementioned companies at a value higher than the fair market value of the shares. It is important to note that the section refers to “shares” rather than specifically “equity shares.” Therefore, all types of shares, including equity and preference shares, are covered. Additionally, the section currently applies only to issuances made to residents.
(c) Tax incidence: The tax liability arises at the time of share issuance. Although debatable, it has been held that the section applies only when the issuance of shares and receipt of consideration occur in the same assessment year (AY). Consequently, for convertible preference shares, the tax incidence can be considered to be solely on the issuance of such shares, without any further tax implication for the issuer upon conversion into equity. The tax is payable on the amount received against the share issuance, to the extent that it exceeds the fair value of the shares.
(d) Fair valuation of shares: Rule 11UA(2) of the Income Tax Rules outlines the methodologies for fair valuation. For unlisted equity shares, there are two options:
(i) NAV method: This method involves valuing equity based on the net asset value, considering the company’s book value of assets and liabilities as per its last audited financial statements. The valuation can be performed by a practicing Chartered Accountant or a Merchant Banker.
(ii) Discounted cash flow method: This method permits companies to value equity shares using discounted cash flow techniques, but the valuation must be conducted by Merchant Bankers exclusively. Regarding the valuation of preference shares, the Rule does not prescribe any specific method; instead, internationally accepted valuation techniques can be utilized.
(e) Rationale and purpose: Section 56(2)(viib) of the Income Tax Act aims to prevent the misuse of shares issued by closely-held companies at inflated prices. By taxing the excess amount as income, the legislation discourages the practice of artificially inflating share values to facilitate undisclosed transactions, money laundering, or tax evasion.
The provision promotes transparency and fairness in transactions involving closely-held companies and ensures that the valuation of shares is based on genuine market value. By taxing the surplus amount, the government aims to collect revenue and maintain the integrity of the tax system.
Conclusion: Section 56(2)(viib) of the Income Tax Act plays a crucial role in curbing tax avoidance and ensuring equitable taxation in relation to the issuance of shares by closely-held companies. By taxing the excess of the issue price over the fair value, the legislation discourages the manipulation of share values and promotes transparency in transactions.
It is important for companies and investors to understand the provisions of this section, including its applicability, covered transactions, tax incidence, and the methods for determining fair valuation. Adhering to the rules and guidelines outlined in Rule 11UA of the Income-tax Rules will help companies accurately assess the fair market value of unquoted equity shares.
By complying with the provisions of Section 56(2)(viib), companies can avoid potential tax liabilities and legal consequences. Investors, on the other hand, can ensure that their investments are made at fair valuations and in accordance with the tax laws.
Overall, Section 56(2)(viib) serves as an important mechanism in maintaining the integrity of the income tax system and promoting transparency in transactions involving closely-held companies.
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what would be the tax implication, if
1.FMV=100, Face value =110 and consideration received is 105
2. FMV=100, Face value= 105 and consideration= 110