[Analysis] Income Tax Implications on Issue of Securities

Table of Contents

1. Applicability of Tax Provisions
2. Angel Tax Provisions Section 56(2)(viib)
3. Cash Credit – Section 68
4. Transfer Pricing Applicability
5. Anti Abuse Provisions – Section 56(2)(x)
6. Double Tax Avoidance Agreement Implications

1. Applicability of Tax Provisions

2. Angel Tax Provisions Section 56(2)(viib)

• Section 56(2)(viib) was introduced in the year 2012 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.
• Section 56(2)(viib) provide that where a closely held Indian company receives any consideration for issue of shares that exceeds the face value of such shares as well as the fair market value of the shares, then the excess consideration received over the fair market value of the shares would become chargeable to income-tax for the Indian company under the head ‘Income from other sources’.
• Rule 11UA of the Income Tax Rules, 1962 provides the formula for computation of FMV of unquoted equity shares for the purposes of the Section 56(2)(viib).
• Exemption from this section:

1. 1. Investments made by Venture Capital Company or Venture Capital Fund or Category I & II AIFs regulated by SEBI/IFSC.
   2. Start-ups registered with DPIIT and satisfying conditions such as total share capital and share premium after issuance < INR 25 crores; prohibition from making purchase of investment assets such as land/building/residential house/jewellery, shares etc.

• FinanceAct 2023: “Being a Resident” omitted with effect from 04.2024 and extends the applicability to consideration received from non-resident shareholders too.
• Thresholds for determining chargeability to tax:

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 (resident or non-resident), any consideration for the issue of share that exceeds the fair value of such shares, the aggregate consideration received for such shares as exceeds the fair market value of the shares
• However this clause has certain exceptions for companies where the consideration for the issue of shares is received by

1. 1. A venture capital undertaking from a venture capital company or a venture capital fund or a specified fund; or
   2. A company from a class or classes of persons as may be notified by the central government in this behalf

Note: when such class or class of person as may be notified by the central government fails to comply with the conditions specified in the prescribed notification, the consequence referred to it in the next slide will be imposed upon if it does not meet the conditions.

Both the Consequences will be imposed to such class or class of persons:

1. When any consideration is received for the issue of a share that exceeds the fair market value of such shares it shall be deemed to be the income of that company chargeable to income tax for the previous year in which such failure has taken place
2. It shall also be deemed that the company has under-reported, such income as the consequence of the misreporting referred to in the section 270A for the said previous year

Rule 11UA(2) of the Income Tax Rules, 1962 (“the rules”) provides the method for computation of the fair market value of unquoted equity shares for this section

• Valuation exercise u/s 56(2)(viib) needs to be carried out at the time of issuance of
  equity shares or CCPS.
• Does it need to carried out at the time of conversion of CCPS/CCDs into equity shares?
• Further, valuation report would now be required under three different laws for investment received from non-residents and it would lead to disparity as shown below unless the shares are issued exactly at fair value arrived commonly under all laws:

Principles emerging from judicial decisions on Sec. 56/ Rule 11UA

• AO has no right to change the method of valuation adopted by the assessee.
• AO can scrutinize the valuation report and if not satisfied with assessee’s explanation, AO has to record the reasons and basis for not accepting the valuation report. Only thereafter, he can go for own valuation or to obtain the fresh valuation report from an independent valuer and confront the same to the assessee; though under the same valuation method.
• For scrutinizing the valuation report, facts and data available only on the date of valuation to be considered and actual result of future cannot be a basis to decide about reliability of the projections.
• The primary onus to prove the correctness of the valuation report is on the assessee.
• Assessee has to satisfy about the correctness of the projections, discounting factor, terminal value, etc. with the help of empirical data or industry norms, if any, and/or scientific data, scientific method, scientific study and applicable guidelines regarding DCF method of valuation since assessee is privy to the facts of the company.

2.1 Notified Classes of Persons

[Notification No. 29/2023/F. No. 370142/9/2023-TPL (Part-I) dated 24th May 2023]

• 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/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;
• Resident of any country or specified territory (listed in next slide), and such entity is subject to applicable regulations in the country where it is established or incorporated or is a resident:––

1. 1. Entities registered with SEBI as Category-I FPI;
   2. Endowment funds associated with a university, hospitals or charities;
   3. Pension funds created or established under the law of the foreign country or
      specified territory;
   4. 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.

List of Country/Territory

2.2 Start-up Company Exemption

[Notification No. 30/2023/F. No. 370142/9/2023-TPL (Part-I dated 24th May 2023]

Provisions of Section 56(2)(viib) will not be applicable if:

• Consideration has been received from any person, by a company which fulfills the conditions specified in para 4 of the notification number G.S.R. 127(E), dated 19th Feb 2019 issued by the Ministry of Commerce and Industry, DPIIT.

2.3 Start-up Eligibility Conditions

[Notification No. G.S.R. 127(E) dated 19th February 2019]

• Eligible for 56(2)(viib) exemption if (i) Recognised by DPIIT; (ii) Aggregate amount of paid-up share capital + share premium after issue or proposed issue < 25 crore rupees (shares issued to non-resident or VCC/VCF or specified company not to be included in 25 crore limit)
• Should not have invested in (if shares issued at a premium not to invest for 7 years):

1. 1. Residential building or land appurtenant thereto, other than that used for renting or held as stock-in-trade;
   2. Land/building not being a residential house, other than occupied for business or
      used for renting or held as stock-in-trade;
   3. Loans & advances other than loans or advances extended in the ordinary course;
   4. Capital contribution made to any other entity; Shares & securities;
   5. Motor vehicle/aircraft/yacht/any other mode of transport, the actual cost > 10 lakh INR, other than held for plying, hiring, leasing or as stock-in-trade;
   6. Jewellery other than that held as stock-in-trade;
   7. Any other asset – sub-clauses (iv) to (ix) of clause (d) of explanation to 56(2)(vii)

2.4 Rule 11UA(2) – Types of Methods applicable to Resident

[Notification No. 81/2023/F.No. 37-142/9/2023-TPL Part (1)] 

• Net Asset Value
• Discounted Free Cash Flow
• Price Matching – Venture Capital Fund (‘VCF’) or a Venture Capital Company (‘VCC’) or a Specified Fund (‘SF’)
• Price Matching – Notified Entity

2.5 Rule 11UA(2) – Types of Methods applicable to Non-resident

[Notification No. 81/2023/F.No. 37-142/9/2023-TPL Part (1)]

• Net Asset Value
• Price Matching – VCF or VCC or SF
• Discounted Free Cash Flow
• Probability Weighted Expected Return
• Milestone Analysis
• Comparable Company Multiple
• Option Pricing
• Replacement Cost
• Price Matching – Notified Entity

2.6 Net Asset Value Method

The fair market value of unquoted equity share = (A-L) x ( PV/PE), where

A = Book value of the assets in the balance sheet as reduced by any amount of tax paid as deduction or collection at source or as advance tax payment as reduced by the amount of tax claimed as refund under the Income-tax Act and any amount shown in the balance sheet as asset including the unamortised amount of deferred expenditure which does not represent the value of any asset;

L= book value of liabilities shown in the balance sheet, but not including the following amounts, namely:—

• the paid-up capital in respect of equity shares;
• the amount set apart for payment of dividends on preference shares and equity shares where such dividends have not been declared before the date of transfer at a general body meeting of the company;
• reserves and surplus, by whatever name called, even if the resulting figure is
  negative, other than those set apart towards depreciation;
• any amount representing provision for taxation, other than amount of tax paid as deduction or collection at source or as advance tax payment as reduced by the amount of tax claimed as refund under the Income-tax Act, to the extent of the excess over the tax payable with reference to the book profits in accordance with the law applicable thereto;
• any amount representing provisions made for meeting liabilities, other than ascertained liabilities;
• any amount representing contingent liabilities other than arrears of dividends payable in respect of cumulative preference shares

PE= total amount of paid up equity share capital as shown in the balance sheet;

PV= the paid up value of such equity shares

2.7 Discounted Free Cash Flow Method (DCF)

• The most popular method for valuing start-ups and emerging companies is the DCF method.
• FMV is calculated by forecasting the company’s future cash flows and using a discount rate to reduce them to their present value while accounting for investment risk and time value of money. DCF method requires a lot of estimation and assumptions.
• This method gives a thorough understanding of the company’s worth by taking its anticipated future performance into account.
• The fair market value of unquoted equity shares as per the Discounted Free Cash Flow method should be determined by a merchant banker only.

2.8 5 Optional Valuations Method available for NR investments

Valuation can also be conducted following below-mentioned methods only in case of investments received from non-resident investors;

1. 1. Comparable Company Multiple Method
   2. Probability Weighted Expected Return Method
   3. Option Pricing Method
   4. Milestone Analysis Method
   5. Replacement Cost Method

• Comparable Company Multiple Method (CCMM): The guideline publicly- traded technique uses information on publicly-traded comparables that are either similar to or equal to the subject asset in order to calculate an indication of value. The observable valuation metrics could include price multiples or enterprise value multiples which would applied to the financial parameters of the subject company. Few examples of common price multiples such as Price-to-earnings, Price-to-Book Value, Price-to-Sales, and Price-to-Cash Flow. Typically, enterprise multiples used are Enterprise Value-to-EBITDA, Enterprise Value-to-EBIT, Enterprise Value-to-Free Cash Flow, and Enterprise Value-to-Sales.
• Probability Weighted Expected Return Method (PWERM): By determining potential exit strategies, such as IPO, acquisition, or staying private, the PWERM determines a company’s FMV. Post which, it assigns probabilities to each scenario and estimates its expected future values. An expected return that is weighted average is calculated using these values and probabilities.
• Option Pricing Method (OPM): This method evaluates an option’s value, or the right to purchase or sell something at a later time, like company shares. It does so by taking into account variables like the market price at the time of assessment, the exercise price, the time till maturity, volatility, and risk-free interest rates. Companies with complex capital structures and a variety of securities classes are valued using OPM.
• Milestone Analysis Method (MAM): Company’s FMV is determined based on the fulfillment of particular benchmarks or performance targets. This approach entails determining a series of benchmarks, such as product development, revenue targets, or regulatory approvals, that the business is anticipated to meet over a specific time frame. Company’s estimated FMV is then determined using the expected values and probabilities for each milestone.
• Replacement Cost Method (RCM): The cost of substituting equivalent assets for an asset is the basis of the RCM valuation method. It entails calculating the price of purchasing or building new assets while taking into account the labor, materials, technology, and resources required for duplication. This approach makes the assumption that a buyer won’t pay more for a business than it would cost to replace it with a comparable business.

2.9 Price Matching- VCF or VCC or SF

• Where any consideration is received by a VCC for the issue of unquoted equity shares, from a VCC/VCF/SF, the price of the equity shares corresponding to such consideration, may at the option of such undertaking, be taken as the FMV of the equity shares to the extent the consideration from such FMV does not exceed aggregate consideration that is received from a VCC/VCF/SF.
• If, within a period of 90 days before or after the date of issue of the shares subject to valuation, the undertaking has received the consideration from a VCF, VCC, or SF.
• The terms VCF, VCC, and SF shall have the same meaning assigned to them in section 56.

Illustration: If a VC undertaking receives a consideration of Rs. 80,000/- from a VCC for the issue of 50 shares at the rate of Rs. 160/- per share, then such an undertaking can issue 50 shares at this rate to any other investor within a period of 90 days before or after the receipt of consideration from VCC.

2.10 Price Matching – Notified Entity

The price of the equity shares which correspond to any consideration received for the issuance of shares from any entity that the Central Government notifies may be regarded as the FMV of the equity shares for both resident and non-resident investors, subject to the following:

• To the extent that the total consideration received from the notified entity is not greater than the consideration from such FMV,
• If, within a period of 90 days before or after the date of issue of the shares subject to valuation, the business has received the consideration from the notified entity

2.11 Compulsory Convertible Preference Share Valuation

2.12 Date of Valuation Report

• The date of the valuation report as determined by the merchant banker (DCF or any of the 5 methods as applicable) can be considered the valuation date if it is within 90 days before the share issue date
• However, the clause (j) of rule 11U shall not apply if the assessee exercises this option

2.13 Safe Harbour

3. Cash Credit – Section 68

3.1 Understanding the concept of unexplained cash credit

Section 68 of the Income Tax Act

Provision to tax unexplained cash credits as income of the taxpayer

The objective of Section 68

To discourage the use of unaccounted money in the economy

Unexplained cash credit

Cash Credit that cannot be explained by the taxpayer’s known sources of income

3.2 Section 68 – Cash Credit

“Where any sum is found credited in the books of an assessee maintained for any previous year, and the assessee offers no explanation about the nature and source thereof or the explanation offered by him is not, in the opinion of the Assessing Officer, satisfactory, the sum so credited may be charged to income-tax as the income of the assessee of that previous year”

In essence, Section 68 aims to prevent the inclusion of unexplained or unaccounted money in an assessee’s books and ensures transparency in financial transactions by requiring a satisfactory explanation to the assessing officer for any sum credited. The primary onus of satisfactory explanation of such credits is on the assessee.

Finance Act 2012 inserted Proviso

• The proviso applies specifically to closely held companies;
• The credited sum includes share application money, share capital, share premium, or any similar amount;
• The amendment establishes that any explanation offered by the assessee company regarding the sum credited shall be deemed to be not satisfactory unless either of the specified conditions are met. The following slide deals with the conditions for this.

Condition for Satisfactory Explanation

• The person, being a resident in whose name such credit is recorded in the books of such company also offers an explanation about the nature and source of such sum so credited
• The Assessing Officer must find the explanation provided by the resident person to be satisfactory
• The aforementioned clause will not be applicable if the person, in whose name the sum is recorded is a venture capital fund or venture capital company as defined by section 10(23FB).
• The term VCC/VCF is defined as under:

1. 1. Venture Capital Fund” means such fund, operating under a trust deed registered under the provision of the Registration Act,1908 (16 of 1908), established to raise monies by the trustees for investments mainly by way of acquiring equity shares of a venture capital undertaking in accordance with the prescribed guidelines
   2. Venture Capital company” means such company as has made investments by way of acquiring equity shares of venture capital undertakings in accordance with the prescribed guidelines

Tax treatment for the amount covered under section 68 :

• Taxation of unexplained cash credits: If the assessing officer deems that the sum credited under section 68 represents undisclosed income or unexplained money, it will be added to the total income of the assessee and chargeable to tax under the head ‘Income from Other Sources’.
• Tax rate under section 115BBE:

1. 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 against that specified

Principles emerging from judicial decisions on Sec 68:

1. Identity: Keeping track of documents like PAN, address, certificate of incorporation, that can help prove identity
2. Creditworthiness: Keeping track of records including ITR of share allottee, audited financial statements, proof of credits received through banking channel etc.
3. Genuineness: Keeping a record of ITR of share allottee and may furnish confirmation from shareholder to prove that transactions are genuine.

• AO can ask to explain the ‘source of credit’ as well as ‘source of source’ of such sum credited.

4. Transfer Pricing Applicability

• As per section 92 of the Income Tax Act, 1961, any income arising from an international transaction shall be computed having regard to the arm’s length price.
• International transaction as defined in Section 92B inter alia include:

“capital financing, including any type of long-term or short-term borrowing, lending or guarantee, purchase or sale of marketable securities or any type of advance, payments or deferred payment or receivable or any other debt arising during the course of business;”.

• Under clause 16 of Form 3CEB, the Assessee has to furnish details about transactions that are in nature of purchase or sale or marketable securities.
• However, the question here emerges whether upon issuance of shares, any income arises in the hands of the assessee and thus, reporting is required.
• Decision of the High Court of Bombay in the case of Vodafone India Services (P.) Ltd. v. Union of India [2014] 50 taxmann.com 300/228 Taxman 25/368 ITR 1 (Bom.) – The premium arising on the issue of shares is a capital account transaction and does not give rise to income and, hence not liable to transfer pricing adjustment.
• Government of India, Ministry of Finance – Instruction No. 2/2015 dated 29.01.2015.
• Notable judgments that have followed the Vodafone judgment are: SKR BPO Services (P.) Ltd. v ITO [2015] 55 taxmann.com 84/230 Taxman 192 (Bom.); Equinox Business Parks (P.) Ltd. v. UOI [2015] 55 taxmann.com 222/230 Taxman 191 (Bom.).
• The term income has been defined under section 2 to inter-alia include, any receipt of share consideration in excess of FMV under section 56(2)(viib) of the Act.
• Since the provisions of section 56(2)(viib) of the Act did not apply to nonresident shareholders earlier, any share consideration received from them fell outside the ambit of the definition of income.
• However, after amendment vide Finance Act, 2023, TP provisions could apply to the closely held company upon receipt of excess share consideration from non-resident shareholders as per section 92(1) r.w. section 2(24)(xvi) of the Act.

5. 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”.
• This section will be applicable in certain situations like conversions of shares, bonus shares, Right shares etc.

Few exemptions to any sum received in this section:

• From any relative;
• On the occasion of the marriage of the individual;
• Under a will or by way of inheritance;
• In contemplation of the death of the payer or donor;
• From any local authority;
• From any institution referred under Section 10;
• From or by any trust registered under section 12A;
• Transaction not referred as transfer Under Section 47;
• From class of person and subject to condition as prescribed under Rule 11UAC

5.1 Class of person prescribed – Rule 11UAC

Unquoted shares, of a company, its subsidiary, and that subsidiary’s subsidiary received by a shareholder where-

• If the tribunal, upon application by the CG, suspends the BOD of the company and appoints new directors
• Share received by shareholders under a resolution plan approved by the tribunal, after providing an OOBH to the jurisdictional commissioner or commissioner

Equity shares of the reconstructed bank

• Investor or investor bank received shares that have been allotted by the reconstructed bank under the scheme at a price as prescribed

Equity shares, of a public sector company or a company

• Public sector company/CG/any state government received shares under strategic disinvestment as defined under section 72 A

Shares/unit/Interest in the resultant fund

• Shares/units/interest is received by the fund management entity
• Two conditions must be met for the relocation to be valid

Conditions to be met for relocation to be valid for resultant fund:

90% ownership continuity in the fund management entity

• Same entity or person
• Same proportion as held in original fund

90% ownership continuity in the investment manager entity of the original fund

• Same entity or person

5.2 Rule 11UA(1)(c)(a)

Valuation of quoted shares and securities

5.3 Rule 11UA(1)(c)(b)

The fair market value of unquoted equity share = (A+B+C+D-L) x (PV/PE), where;

A = Book value of all the assets(other than jewellery, artistic work, shares, securities,
and immovable property) in the balance sheet as reduced by

• any amount of income tax paid if any is less the amount of income tax refund claimed, if any;
• any amount shown as asset including the unamortised amount of deferred expenditure which does not represent the value of any asset;

B = 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;

C = Fair market value of shares and securities as determined in the manner provided in this rule

D = 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

L =Book value of liabilities shown in the balance sheet, but not including the following amounts, namely:—

• the paid-up capital in respect of equity shares;
• the amount set apart for payment of dividends on preference shares and equity shares where such dividends have not been declared before the date of transfer at a general body meeting of the company;
• reserves and surplus, by whatever name called, even if the resulting figure is negative, other than those set apart towards depreciation;
• any amount representing provision for taxation, other than amount of tax paid, if any, less the amount of income tax claimed as refund, if any to the extent of the excess over the tax payable with reference to the book profit in accordance with the law applicable thereto;
• any amount representing provisions made for meeting liabilities, other than ascertained liabilities;
• any amount representing contingent liabilities other than arrears of dividends
  payable in respect of cumulative preference shares

PE = Total amount of paid-up equity share capital as shown in the balance sheet;

PV = The paid up value of such equity shares

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

Valuation of unquoted shares and securities other than equity shares which are not listed in 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 which such valuation

6. Double Tax Avoidance Agreement Implications

• Income taxed u/s 56(2)(x) taxable under other income article?
• Other income article is a residuary article that provides for the allocation of taxing rights in relation to income not dealt with in any of the other articles of DTAA.
• Many of the DTAAs that India has signed provide for taxing rights allocation between the resident state as well as the source state.
• Few DTAAs India have signed provide for taxing rights only to the resident state. E.g.:

1. 1. India – Albania DTAA (barring gambling/ betting income);
   2. India – UAE DTAA;
   3. India – Nepal DTAA (barring gambling/ betting income);
   4. India – Saudi Arabia DTAA;
   5. India – Korea DTAA;
   6. India – Kuwait DTAA.