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Anti-abuse provisions: A curse in disguise for businesses navigating the nebula of Indian taxation system

For India to promote itself as an investment-friendly jurisdiction and to facilitate the revival of economy, it is imperative to scrap such provisions (i.e. Section 56(2)(viib), 56(2)(x) and Section 50CA ) related to notional taxation

Dr. Suresh Surana | September 17, 2020 | Updated 10:06 IST
Anti-abuse provisions: A curse in disguise for businesses navigating the nebula of Indian taxation system
Certain tax provisions that were designed to be anti-abuse arrangements are acting as major roadblocks in raising funds

Businesses are going through unprecedented financial and economic challenges due to the COVID-19 crisis and economic slowdown. Under these circumstances, it is imperative that companies are able to raise funds to survive and grow their businesses. However, there are certain tax provisions that were designed to be anti-abuse arrangements but are acting as major roadblocks in raising funds.

Generally, it would be presumed that the issue of shares or transfers of shares are transactions on capital account and would not be subject to tax except in the event of capital gains arising on the sale of shares.

Taxability in case of issue of shares at premium

  • In case, the shares are issued by an unlisted company at a price which is higher than the fair value to residents, then the amount in excess of the issue price over the fair value is deemed to be income in the hands of the issuing company as per Section 56(2)(viib) of the Income Tax Act, 1961 (IT Act).  For this purpose, the fair value is determined as per the book value of the company or as per the discounted cash flow method at the option of the issuing company.

Also Read: Has Modi's tax policy deepened govt's resource crunch? A Tamil Nadu legislator believes so

  • In several cases, the issue of shares would be at a premium to the book value or DCF (discounted cash flow) due to industry outlook, investor appetite, and other business factors. For instance, digital businesses, health care & life science businesses, e-commerce businesses, etc. attract a significant amount of investment at a substantial premium. While the DCF valuation method does provide certain flexibility for valuation but can be a matter of divergent views due to underlying assumptions. Further, the tax assessment takes place after a lag of time and some of the assumptions for valuation may not converge with the actual results.
  • In the case of Karmic Labs Pvt. Ltd vs. ITO (ITAT Mumbai), it has been held that the assessee has the choice to choose a prescribed method for ascertaining the market value of the shares transferred. If the assessee has chosen one method of valuation provided under Rule 11UA (i.e. DCF method), the AO (assessment officer) has no power or jurisdiction to change that method to another method. Section 56 allows the assessee to adopt one of the methods of his choice. But, the AO held that the assessee should have adopted only one method for determining the value of the shares. In our opinion, it was beyond the jurisdiction of the AO to insist upon a particular system, especially when the Act allows to choose one of the two methods. Until and unless the legislature amends the provision of the Act and prescribes only one method for valuation of the shares, the assessee is free to adopt any one of the methods.

While this tribunal verdict can provide some respite, but in practice, tax authorities often challenge the basis of assumption and the underlying assumptions, thereby resulting in unwarranted tax litigation.

  • Generally, the issue of shares being a capital transaction should not result in any taxability. This provision is unprecedented, and it is difficult to find similar provisions in any other country globally.

Taxability in case of issue or transfer of shares below the book value

  • In case of the receipt of shares at a consideration which is below the fair market value, the difference is deemed to be income in the hands of the recipient as per Section 56(2)(x) of the IT Act. For this purpose, the valuation methodology for fair market value is based on adjusted book value method (book value of shares as adjusted by increase in value of immovable property, etc.). In several cases, the business valuation is lower than the book value of the shares. This can be due to the sectoral outlook, investor appetite, regulatory developments, or even the COVID-19 crisis. 
  • Section 50CA of the IT Act states that where the consideration received or accruing as a result of the transfer by a person of a capital asset, being share of an unlisted company is less than the fair market value of such share determined in such manner as may be prescribed, the value so determined shall, for the purposes of section 48, be deemed to be the full value of consideration received or accruing as a result of such transfer:

Under the said section 50CA, the fair market value of shares is to be considered for the purpose of computing the capital gains whereas the sales consideration may be less than the fair market value.  

Notional capital gains can be imposed in this case in hands of the seller under Section 50CA as well as notional tax in the hands of the buyer under the provisions of Section 56(2)(x) of the IT Act on account of receipt of shares for inadequate consideration.  

  • The aforesaid provisions provide for notional taxation which is against the basic principle of taxation of real income. These notional tax propositions are divorced from the business reality. These provisions were primarily introduced as anti-abuse provisions to prevent unscrupulous transactions relating to issuing or transferring of shares at ridiculous valuation but in practice, the said provisions are hampering genuine businesses from raising capital. There are several mechanisms to deal with abuse of the provisions by focused investigation and review of commercial rationale.

Also Read: Toyota to not expand further in India; blames high taxes

It is a fact that business valuations are driven by a multitude of economic, geopolitical, regulatory, and financial factors and cannot be fitted into the straight jacket of mathematical formulae.

For India to promote itself as an investment-friendly jurisdiction and to facilitate the revival of economy, it is imperative to scrap such provisions (i.e. Section 56(2)(viib), 56(2)(x) and Section 50CA ) related to notional taxation.  

(The author is Founder, RSM India.)

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