Understanding Section 56(2)(viib) of the Income Tax Act, 1961

Introduction

Section 56(2)(viib) of the Income Tax Act, 1961, is 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.

Key Components of Section 56(2)(viib)

Applicability

This section applies to companies that are not considered "companies in which the public are substantially interested". A “company in which the public are substantially interested” is extensively defined under section 2 (18) of the Income Tax Act. Generally, it includes public companies listed on stock exchanges or subsidiaries of listed public companies. However extensive definition is reproduced as under-

“2(18) "company in which the public are substantially interested"—a company is said to be a company in which the public are substantially interested—

(a) if it is a company owned by the Government or the Reserve Bank of India or in which not less than forty per cent of the shares are held (whether singly or taken together) by the Government or the Reserve Bank of India or a corporation owned by that bank ; or

(aa) if it is a company which is registered under section 25 of the Companies Act, 1956 (1 of 1956) ; or

(ab) if it is a company having no share capital and if, having regard to its objects, the nature and composition of its membership and other relevant considerations, it is declared by order of the Board to be a company in which the public are substantially interested :

Provided that such company shall be deemed to be a company in which the public are substantially interested only for such assessment year or assessment years (whether commencing before the 1st day of April, 1971, or on or after that date) as may be specified in the declaration ; or

(ac) if it is a mutual benefit finance company, that is to say, a company which carries on, as its principal business, the business of acceptance of deposits from its members and which is declared by the Central Government under section 620A of the Companies Act, 1956 (1 of 1956), to be a Nidhi or Mutual Benefit Society ; or

(ad) if it is a company, wherein shares (not being shares entitled to a fixed rate of dividend whether with or without a further right to participate in profits) carrying not less than fifty per cent of the voting power have been allotted unconditionally to, or acquired unconditionally by, and were throughout the relevant previous year beneficially held by, one or more co-operative societies ;

(b) if it is a company which is not a private company as defined in the Companies Act, 1956 (1 of 1956), and the conditions specified either in item (A) or in item (B) are fulfilled, namely :—

(A) shares in the company (not being shares entitled to a fixed rate of dividend whether with or without a further right to participate in profits) were, as on the last day of the relevant previous year, listed in a recognised stock exchange in India in accordance with the Securities Contracts (Regulation) Act, 1956 (42 of 1956), and any rules made thereunder ;

(B) shares in the company (not being shares entitled to a fixed rate of dividend whether with or without a further right to participate in profits) carrying not less than fifty per cent of the voting power have been allotted unconditionally to, or acquired unconditionally by, and were throughout the relevant previous year beneficially held by—

(a) the Government, or

(b) a corporation established by a Central, State or Provincial Act, or

(c) any company to which this clause applies or any subsidiary company of such company if the whole of the share capital of such subsidiary company has been held by the parent company or by its nominees throughout the previous year.

Explanation.—In its application to an Indian company whose business consists mainly in the construction of ships or in the manufacture or processing of goods or in mining or in the generation or distribution of electricity or any other form of power, item (B) shall have effect as if for the words "not less than fifty per cent", the words "not less than forty per cent" had been substituted ;

Legal Provisions-

“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 being a resident, any consideration for issue of shares that exceeds the face value of such shares, the aggregate consideration received for such shares as exceeds the fair market value of the shares:

Provided that this clause shall not apply where the consideration for issue of shares is received—

(i) by a venture capital undertaking from a venture capital company or a venture capital fund or a specified fund; or

(ii) by a company from a class or classes of persons as may be notified by the Central Government in this behalf:

Provided further that where the provisions of this clause have not been applied to a company on account of fulfilment of conditions specified in the notification issued under clause (ii) of the first proviso and such company fails to comply with any of those conditions, then, any consideration received for issue of share that exceeds the fair market value of such share 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 and, it shall also be deemed that the company has under reported the said income in consequence of the misreporting referred to in sub-section (8) and sub-section (9) of section 270A for the said previous year.

Explanation.—For the purposes of this clause,—

(a) the fair market value of the shares shall be the value—

(i) as may be determined in accordance with such method as may be prescribed; or

(ii) as may be substantiated by the company to the satisfaction of the Assessing Officer, based on the value, on the date of issue of shares, 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,

whichever is higher;

(aa) "specified fund" means a fund established or incorporated in India in the form of a trust or a company or a limited liability partnership or a body corporate which has been granted a certificate of registration as a Category I or a Category II Alternative Investment Fund and is regulated under the Securities and Exchange Board of India (Alternative Investment Fund) Regulations, 2012 made under the Securities and Exchange Board of India Act, 1992 (15 of 1992) or regulated under the International Financial Services Centre Authority (Fund Management) Regulations, 2022 made under the] International Financial Services Centres Authority Act, 2019 (50 of 2019)];

(ab) "trust" means a trust established under the Indian Trusts Act, 1882 (2 of 1882) or under any other law for the time being in force;

(b) "venture capital company", "venture capital fund" and "venture capital undertaking" shall have the meanings respectively assigned to them in clause (a), clause (b) and clause (c) of Explanation to clause (23FB) of section 10;”

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.

Tax Incidence

The tax liability arises at the time of share issuance. 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.

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:

• 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.Approach: This method calculates the value of equity based on the net asset value.
  
  Process: It considers the company’s book value of assets and liabilities as per its last audited financial statements.
  
  Valuation by: A practicing Chartered Accountant or a Merchant Banker can perform this valuation

• The valuation can be performed by a practicing Merchant Banker.Approach: This method values equity shares using discounted cash flow techniques.

Process: It involves projecting future cash flows and discounting them to the present value.

Valuation by: Only Merchant Bankers are authorized to conduct this valuation.

Conclusion

Understanding Section 56(2)(viib) is crucial for closely-held companies and their investors. It helps them stay compliant, understand the rules, and ensure transparent transactions.