Issue of shares at less than FMV- NO Income Tax Implications for investors

Issue of shares at less than Fair Market Value(FMV)- No Income Tax Implications for investor.

Based on prevalent language of Section 56(2)(viia), doubt is expressed in many circles that if unlisted company issues shares at less than FMV to company or Firm, then excess of FMV over issue price will be taxable in the hand of investors as Income from other sources.

I think that said apprehension is not correct because if section 56(2)(viia) is interpreted in way as mentioned afore-said, then it will lead to incongruity in application of other explicit provisions of Income Tax Act.

Attempt is being made hereunder to understand that how such interpretation of section 56(2)(viia) will lead to inconsistency.

Analysis of Section 56(2)(viia)

Said section provides as under:-

1.       When Firm or company, not being a company in which public are substantially interest (Unlisted) receives

2.       Any shares of company, not being a company in which public are substantially interest (Unlisted)

3.       Without consideration and FMV of such shares are more than Rs. 50,000, then entire FMV will be taxable in the hands of Firm or Company

4.       For a  consideration and where difference between consideration and FMV is more than Rs. 50,000, then FMV less consideration will be taxable in the hands of firm or company

The whole controversy revolves around the use of words “Receives” in section 56(2)(viia). Since the word “Receive” is not defined in the Act, one may argue that “Receive” means receipt of shares on account of transfer by transferor or on account of fresh issue of shares.

The apprehension on taxability in the hands of Investor, when unlisted company issues shares at less than FMV is blown out of proportion and it appears not to be intention of law to bring within the ambit of taxation this aspect, analysed as under:-

The reasoning is as under:-

1.       Section 56(2)(vii)

a)      Said section was introduced upon abolition of Gift Tax Act and thereupon, the value of gift was made taxable in the hands of Donee.

b)      Said section is applicable on Individual and HUF.

c)       Among other things, this section provides that where individual/HUF receives any Property (Shares & Securities {listed and unlisted), jewellery, etc) without consideration or for consideration, the FMV or FMV less consideration will be taxable in the hands of Individual/HUF, as the case may be.

d)      In this section also, the words use is “Receive”

e)      Now consider that case where Listed company comes with the Right Issue

i)        In case of listed shares, the FMV of shares is prevailing Market Price as per rule 11U of Income Tax Rules

ii)                   Right issue is generally less than FMV.

iii)        This implies that  only Individual/HUF investor will be taxable for difference between FMV and consideration. Moreover individual/HUF retail investors do not have any say in pricing of right issue of listed companies

iv)       Company/firm will not be taxable, since section 56(2)(vii) covers only Individual and HUF and under section 56(2)(viia) where company/firm is covered, no tax implication is called where shares of listed company are involved.

v)       Had the intention of law is to bring right issue within the ambit of taxation in the hands of Individual/HUF investor and to create such differentiation in taxability between Individual/HUF and Company/firm, it could have provided the same explicitly as provided in section 56(2)(viib), wherein upon issue of shares by unlisted company at premium, excess consideration on allotment over FMV of shares, will be taxable in the hands of Company.

f)       If from afore-said, it can be concluded that section 56(2)(vii) is not intended to tax the right issue in the hands of individual/HUF investors on account of  use of words “Receive”, similar conclusion can be drawn that word “Receive” used in section 56(2)(viia) is not intended to cover the fresh allotment shares by company within its purview.

 

2.       Bonus shares

a.       If words “receives” as used in section 56(2)(vii) & 56(2)(viia) is interpreted to cover allotment of shares, then every bonus shares will be taxable in the hands of investors as under:-

i)        In case of individual/HUF, value of bonus shares issue by every company, whether listed or unlisted, will be taxable in the hands of them.

ii)    In case of Company/firm, value of Bonus shares issued by unlisted company will be taxable in the hands of them.

b.      As per Section 49(4), where assessee is subject to tax u/s 56(2)(vii) or 56(2)(viia), then cost of acquisition of shares, in the instant case, in the hands of assessee will be FMV of shares on the date of receipt.

c.       Further as per section 55(2)(aa)(iiia), cost of acquisition of bonus shares in the hands of investor will be NIL

d.      If words “receive” is interpreted to cover allotment of shares, then further ambiguity will develop to determine the cost if acquisition of bonus shares in the hands of investors as under:-

i)     If cost of bonus shares is taken as per section 49(4), then it will render section 55(2)(aa) (iiia) otiose.  It would never have been intention of law to make one section ineffective in interpretation of other section i.e 56(2)(viia)

ii)    If cost of bonus shares is taken as per section 55(2)(iiia), then assessee will be subject to double taxation, once at the time of receipt of bonus shares u/s 56(2)(vii)/(viia) and secondly at the time of sale of bonus shares, since cost of bonus share is taken at NIL. Unless otherwise provided specifically, sections cannot be interpreted to provide for double taxation of same income.

e.      Based on afore-said explanations, further conclusion can be taken that words “Receive” used in section56(2)(viia) is not intended to cover allotment of shares by company.

 

3.       Issue of Bonus Shares to Preference shareholders

a)      As per Section 2(22)(b) any issue of bonus shares to preference shareholder is dividend, subject to Dividend Distribution tax u/s 115O

b)      As per section 10(34), dividend income subjected to dividend distribution tax u/s 115O is exempt in the hands of shareholders.

c)       Now if section 56(2)(vii)/(viia) is interpreted to cover allotment of shares within its grab, then upon issue of bonus shares to preference shares holders, its value will be taxable in their hands, whereas 10(34) exempt value of such bonus shares in the hands of investor

d)      Thus such interpretation of section 56(2)(vii)/(viia) will lead to direct conflict with explicit provision of section 10(34).

From afore-said it can be gathered that to cover allotment of shares at less than FMV within the purview of section 56(2)(viia) will not only lead to double taxation on certain occasion but will also cripple the utility of other express provision of the Act

Thus in my view no tax implications are involve in the hands of investors when company issues shares at less than FMV.

Gift Provision Under Income Tax Act - Codified

Gifts Provisions under Income Tax Act - Codified

Gift of CAPITAL ASSET by an individual to other Individual

1.       Capital Gain on transferor

There is no capital gain in the hands of transferor on gift of capital asset. – Section 47(iii).

2.       Taxability in the hands of Transferee- If asset is treated as Capital asset by Transferee.

a)      Transferee is not liable to any tax on receipt of gift, if transferee is relative within the meaning of Clause (e) of Explanation to section 56(2) (vii).

b)      Transferee is Not a Relative-The value of Gift, if it exceeds Rs. 50,000, is liable to be included in taxable income of Transferee, provided capital assets is among the following (Here in after referred to as Prescribed Capital Asset):- (Section 56(2)(vii))

i)                    Immovable property, being land or building or both

ii)                   Shares & Securities

iii)                 Jewellery

iv)                 Archaeological collections

v)                  Drawings

vi)                 Paintings

vii)               Sculptures

viii)              Any work of art

ix)                 Bullion

In case, capital asset does not fall in above category, nothing is taxable in the hands of Transferee on receipt of gift.

3.       Taxability in the hands of Transferee- If asset is Stock in trade for Transferee.

In this case, nothing would be taxable in the hands of Transferee on value of gift received, since section 56(2)(vii) will not be applicable. Said section is applicable, where assets is capital asset in the hands of Transferee.

4.       Cost of Acquisition in the hands of Transferee- asset is capital asset for transferee.

a)      Transferee is Relative – Cost of acquisition in the hands of Transferee will be aggregate of Cost of acquisition and cost of improvement in the hands of transferor – Section 49(1)

b)      Transferee is Non Relative

a)      Capital asset is other than Prescribed Capital Asset -  Cost of acquisition in the hands of Transferee will be aggregate of Cost of acquisition and cost of improvement in the hands of transferor – Section 49(1).

b)      Capital assets is Prescribed Capital Asset -  Cost of acquisition will be fair market value of capital asset on the date of gift – section 49(4).

5.       Cost in the hands of Transferee- Asset is stock in trade for Transferee.

In case gifted asset is treated as Stock in Trade by Transferee, the cost of such asset would be aggregate of Cost of acquisition, cost of improvement and expenditure incurred wholly and exclusively in connection with transfer, in the hands of Transferor – Section 43C.

6.       Period of Holding of capital asset in the hands of Transferee- Section 2(42A)

At the time of sale of capital asset by transferee, acquired by way of gift, the period of holding in the hands of transferee will include the period for which asset was held  by transferor, irrespective of following:-

a)      Whether Transferee is relative or not.

b)      Nature of capital asset

c)       Whether value of gift is taxable in the hands of transferee or not.

7.       Capital assets is Depreciable assets – Reduction in WDV of Block of asset of Transferor

Section 43(6)(c) provides the method of computation of Value of block of assets for purpose of calculating depreciation us/ 32. The method is as under:-

a)      Opening WDV of Block of asset

b)      Add: Actual cost of asset purchased which is falling within the block.

c)       Less: Moneys Payable in respect of asset, falling in the block, which is sold or discarded or demolished or destroyed during the previous year.

For reduction in block of asset, it is essential that money should be payable in respect of asset discarded.

Since on Gift of depreciable asset, there is no moneys payable in respect of asset transferred, so nothing will be reduced from Block of assets on gift of depreciable asset.

8.       Capital Asset is Depreciable Asset- WDV in the hands of Transferee, where asset is treated as capital depreciable asset by transferee.

a.       The Mode of computation of value of Block of asset is stated above. The addition to block of assets is actual cost of asset acquired.

b.      Explanation 2 to section 43(1) governs the provision relating to Actual cost, in the hands of recipient, of assets acquired by Gift. The Actual cost will be computed as under:-

i)                    Actual Cost in the hands of Transferor

ii)                   Less: Depreciation actually allowable as if the said asset was only assets in the block.

Gift of Stock in Trade by an individual to other Individual

1.       Taxation in the hands of Transferor

a)      There is no express provision in the Act on this aspect, except where stock in trade is land or Building or both. Gift of stock in trade by Individual will amount to his drawings from the business and going by the decision of Supreme Court in Kikabhai Premchand, nothing would be taxable in the hands of transferor on value of gift of stock in Trade.

b)      In case of stock in trade, being land or building or both, stamp duty value of asset will be deemed sales consideration in the hands of Transferor and will be taxed accordingly.- (Section 43CA)

2.       Taxation in the hands of Transferee

a)      If the transferee is relative and treat the gifted asset as capital asset, nothing will be taxable in the hand of transferee on account of value of gift.

b)      If Transferee, being non-relative, treat the gifted assets as Capital asset, which is prescribed capital asset, then value of gift, in excess of Rs. 50,000 will be taxable in the hands of Transferee- Section 56(2)(vii), read with Clause (d) of Explanation to said section. As per said explanation, “Property means the Following CAPITAL ASSET of the assessee---“

(Note: In this scenario, in case of gift of land or building or both, there will be double taxation of same income, once in the hand of Transferor (u/s 43CA) and second, in hand of Transferee (u/s 56(2)(vii))

c)       If Transferee, being non-relative, treat he gifted asset as capital asset, which is not a prescribed capital asset, then, nothing will be taxable in the hand of transferee on account of value of gift.

d)      If transferee treat the gifted asset as Stock in Trade, nothing would be taxable in the hands of Transferee on value of gift received, since section 56(2)(vii) will not be applicable.

3.       Cost of Acquisition in the hands of Transferee- asset is capital asset for transferee

a)      Transferee is Relative –

i)                    Cost of acquisition in the hands of Transferee will be aggregate of Cost of acquisition and cost of improvement in the hands of transferor – Section 49(1)

ii)                  However there will be practical problems to determine the cost of acquisition in the hands of Transferor, unless transferor is following specific identification method for valuation of Stock. For Example a jeweller give a gift of jewellery, being stock in trade, to his relative. Generally jeweller follows either FIFO, LIFO or average cost method for stock valuation. So in the instant case it would be difficult to work out the actual cost of acquisition of asset gifted, it may be valued on the basis stock valuation method followed.

b)        Transferee is Non Relative

i)                    Capital asset is other than Prescribed Capital Asset- Cost of acquisition in the hands of Transferee will be aggregate of Cost of acquisition and cost of improvement in the hands of transferor – Section 49(1).

ii)                  Capital asset is  Prescribed Capital asset -  Cost of acquisition will be fair market value of capital asset on the date of gift – section 49(4)

4.       Cost in the hands of Transferee- Asset is stock in trade for Transferee

a)      In case gifted asset is treated as Stock in Trade by Transferee, the cost of such asset in the hands of Transferee would be cost of acquisition in the hands of Transferor- Section 43C.

b)      In case of Gifted asset, being land or building or both, Transferor has paid tax deemed consideration, being stamp duty value of property, but the cost in the hands of Transferee will be the Cost of Acquisition in the hands of Transferor u/s 43C, since there is no corresponding provision for enhancement of cost in the hands of Transferee, where transferor has subjected to tax by virtue of provision of section 43CA.

5.       Period of Holding of capital asset in the hands of Transferee- Section 2(42A)

a)      At the time of sale of capital asset by transferee, acquired by way of gift, the period of holding in the hands of transferee will include the period for which asset was held  by transferor, irrespective of following:-

i)      Whether Transferee is relative or not.

ii)     Nature of capital asset

iii)   Whether value of gift is taxable in the hands of transferee or not.

b)      However, there will be practical problems in working out the period of holding of asset in the hands of Transferor, for whom gifted asset was stock in trade.

6.        Asset is Depreciable Asset for transferee- WDV in the hands of Transferee.     

a)      Same as stated at point no. 8 under the heading “ Gift of Capital Asset by Individual to other Individual

b)      One will encounter the practical problem in arriving at actual cost in the hands of Transferor.

Section 43CA (Income Tax Act) vs Demerger

Section 43CA (Income Tax Act) vs Demerger

Herein attempt is made to understand, whether Section 43CA of Income Tax Act can be a dampener in Demerger Process?

Section 2(19AA) defines demerger, which is summarised as under:-

1.       Transfer, pursuant to scheme of arrangement u/s 391 to 394 of the Companies Act.

2.       Of Undertaking.

3.       From Demerged Company to Resulting company

4.       Properties and liabilities of the undertaking , being transferred, are transferred at values appearing in its books of accounts immediately before demerger

5.       Resulting company issues, in consideration, of the demerger, it shares to the shareholders of demerged company.

Undertaking is defined as combination of assets and liabilities constituting a business activity as a whole.

Now, the issue sought to discuss hereinafter is whether UNDERTAKING as such is capital asset or components of Undertaking should be treated as a capital asset or stock in trade as per the nature of respective components and corresponding provisions of Act will apply to Capital Asset and Stock in Trade respectively.

To further elucidate the issue, considered undertaking purport to be transferred under demerger has following constituents:-

1.       Plant & Machinery

2.       Land – held as stock in trade

3.       Net Current Assets

Before we proceed further, consider summary of provision of section 43CA inserted by Finance Act, 2013

1.       Where the consideration for transfer of assets (Other than a capital asset), being land or building or both.

2.       Is less than value adopted by stamp duty authority

3.       Then value, so assessed by stamp duty authority, shall be deemed to be full value of consideration for transfer of said asset.

Under section 47 (vib) transfers of Capital asset under demerger is not treated as transfer of capital assets for the purpose of computation of Capital Gains in the hands of Demerged Company.

Now Questions for consideration are as under:-

1.       Whether Undertaking in itself is capital asset, thus transfer of the same is exempt u/s 47(vib), irrespective of nature of its components.

2.       Whether components of undertaking is to be treated separately and only transfer of capital asset is exempt u/s 47(vib) and other components should be treated as per separate provisions of Act e.g section 43CA will be applicable on transfer of land, not being capital asset in above example.

                                                                                                                               

Arguments- Against treating undertaking as Capital Asset

1.       Section 50B-

a)       The said section serves the dual purpose  relating to slump sale- Charging Section and computation mechanism.

b)      Section 50B(1) provides profits and gains from slump sale shall be chargeable to Income tax as capital gains. Slump sale is defined u/s 2(42C) as a sale of one or more undertaking without being values assigned to individual assets and liabilities. The undertaking is defined as by giving reference to section 2(19AA), which defined undertaking for demerger.

c)       Had the undertaking being capital asset, there would not have been need for separate charging section for sale of undertaking under slump sale, section 45 would  have taken care of the same, implies that law does not treat undertaking in itself as separate capital asset within the meaning of section 2(14), defining capital asset.

2.       Non- availability of Computation mechanism

a)      Transfer of Capital asset u/s 47(vib) is exempt only, if conditions specified in section 2(19AA) are satisfied.

b)      If Conditions of section 2(19AA) are not satisfied, then transfer of Capital Asset is not exempt in the hands of Demerged company.

c)       If undertaking is treated as Capital asset, there is no explicit provision for computing Cost of acquisition of Undertaking in the hands of Demerged Company.

d)      Section 50B which is treating undertaking as capital asset has also prescribed the computation mechanism to work out the cost of acquisition of undertaking.

e)      Thus had the intention of legislature to treat undertaking as capital asset, it would have provided the computation provisions for computing its cost of acquisition.

3.       Others

a)      Explanation 2B to section 43(6) separately provides for the computation of WDV of block of asset in the hands of resulting company acquired by it from demerged company under demerger. Explicit provision for computation of cost/WDV of one of the constituent of undertaking gives the impression that law does not intend to treat undertaking as separate asset in itself.

b)      Provisions of section 72A(4) provides the computation mechanism  for unabsorbed business loss & Depreciation of demerged company to be carried forward by resulting company. Computation mechanism is worked out based on  assets transferred in demerger out of Total assets of Demerged company. Here also, the use of cost of undertaking was absent, to allocate the loss between resulting and demerged company.

Implications

1.       Section 47(vib) benefits will be available to capital asset comprise in the Undertaking.

2.       If there is land or building or both, being stock in trader and forming part of undertaking, then on its transfer pursuant to demerger, AO may invoke the Provisions of section 43CA.

3.       Since in case of demerger, consideration is being received by shareholders of Demerged Company, AO may take the stand that since demerged company has not received any consideration for transfer of land, its stamp duty value, shall be deemed consideration in the hands of Demerged Company and will be taxed accordingly.

Since Demerger provisions are beneficial ones, intended to facilitate restructuring of business, unintended consequence of section 43CA should be amended appropriately to facilitate smooth transition in Demerger process.