Issue of Shares at less than FMV- Section 56(2)(vii)

Analysis of Mumbai Tribunal Judgement in Sudhir Menon HUF (ITA No. 4887/Mum/2013)- AY 2010-11- Section 56(2)(vii)

Facts:-

1. Assessee was shareholder in a company and was allotted right shares (1,94,000) at face value of Rs. 100 each on 28.01.2010

2. The book value (FMV) of shares on 31/3/2009 was Rs. 1538.

3. AO apply the provisions of section 56(2)(vii)(c) and held that since assessee receive property at less than FMV, the FMV less than consideration is taxable in the hands of assessee. Accordingly AO calculated additional income of assessee at Rs. 27.82 Cr (1,94,000 x (1538-110))

Held

1. Section 56(2)(vii) apply where company issue shares at less than FMV- Thus where existing company issues shares to new shareholders at less than FMV, then provision of section 56(2)(vii) will be attracted in the hands of shareholders.

2. Implication on Right Issue- As long as, therefore, there is no disproportionate allotment, i.e., shares are allotted pro-rata to the shareholders, based on their existing holdings, there is no scope for any property being received by them on the said allotment of shares; there being only an apportionment of the value of their existing holding over a larger number of shares. Thus on proportionate right share to existing shareholders at less than FMV, section 56 (2) (vii) will not be attracted in the hands of shareholders and based on that AO order is set aside.

3. Bonus Issue - Issue of bonus shares is by definition capitalization of its profit by the issuing-company. There is neither any increase nor decrease in the wealth of the shareholder (or of the issuing company) on account of a bonus issue, and his percentage holding therein remains constant. In other words, there is no receipt of any property by the shareholder, and what stands received by him is the split shares out of his own holding. Thus section 56(2)(vii) will not apply in case of bonus issue.

Critical comments

Section 56(2)(vii) deal with deeming income in the hands of Individual and HUF as under:

a. Where these entities receives property without consideration and FMV value of property is more than Rs. 50,000, then FMV of property will be deemed income in the hands of Recipient entities.

b. Where these entities receive property for consideration and difference between FMV and consideration is more than Rs. 50,000, then such difference will be deemed income in the hands of recipient entities.

c. Property among other things includes shares of listed and unlisted entities.

A. Section 56(2)(viia) deals with deeming income in the hands of unlisted companies and firm  where conditions as mentioned above at (a) or (b) are met but property is defined to include only shares of unlisted companies

B. Implications- From operation of above-said judgement

1. Right Issue by Listed Company –

a. Suppose upon right issue by Listed Company at less than FMV, the individual shareholders renounce the right in favour on New shareholder, being firm. As a result firm applied and was allotted shares by listed company. This has resulted in disproportionate allotment. However firm will not be taxable on receipt of property at less than FMV, since section 56(2)(vii) does not apply to firm and under section 56(2)(viia), listed company’s share are not covered.

b. Suppose in above case, individual shareholders renounce their right in favour of new shareholder, being Individual. In such case going by above said Tribunal Judgement, the new Individual shareholder, getting disproportionate allotment, will be subjected to provision of section 56(2)(vii).

c. Operation of above-said judgement will create dichotomy in taxation treatment in the hands of Individual and company & Firm.

2. Cost of shares in the hands of New Shareholder – Suppose a person in whose favour right was renounce, apply and allotted right shares. He acquired right for Rs. 5/share and amount paid for acquisition is Rs. 10/share. Book value of share is Rs. 50. Going by above Judgment, there will be inconsistency in the operation of following two provisions as under:-

a. Section 49(4) – Where FMV of property is treated as income in the hand of person u/s 56(2)(vii)/(viia), then as per section 49(4), cost of acquisition of said property in hands of said person will be FMV of property. Thus in instant example, the cost of acquisition will be Rs. 40/share (Rs. 50-10)

b. Section 55(2) – In case where person has buy the right and then apply for right share, the cost of acquisition of shares will be aggregate of amount paid for purchase of right and shares. In the instant example, it will be Rs. 15/share

c. Operation of above-said judgement will created inconsistency in the operation of section 49(4) and 55(2).

Issue of Shares at Premium, issue price being more than FMV based on DCF –

a. Section 56(2)(viib) provides that where unlisted company issues shares at premium, but the issue price is more than FMV, then excess of issue price over FMV will be taxable in the hands of company

b. Rule 11UA(2) provides that FMV will be either book value or value arrived at on the basis of DCF, at the option of assessee.

c. Suppose face value of share is Rs. 10, premium Rs. 50. Book value – Rs. 80. Valuation based on DCF – Rs. 60.

d. Investor will always prefer valuation of company based on DCF, as DCF methodology is better reflection of value of company over book value.

e. For the purpose of section 56(2)(viib), Company will considere the FMV, as its option to be Rs. 60, so that issue price is at par with FMV ( 60 = 60) and a result that nothing is taxable in its hands.

f. FMV for purpose of section 56(2)(vii)/(viia)  is book value – Rs. 80. As a result Rs. 20/share will be taxable in the hands of investor u/s 56(2)(viii)/(viia).

g. Thus investor investing on the basis of actual/potential worth of company, will be forced to pay tax in the instant case.

With due respect to afore-said judgement, I think it is not the mandate of law to cover issue of shares u/s 56(2)(vii)/(viia) on account of following:-

a. Section 56(2)(vii) was bought into the status upon repeal of Gift Tax Act, whereby on incidence of gift, the tax burden has been shifted from Donor to Donee. Erstwhile Gift Tax Act, did not contain any provision for treating the difference between FMV and Issue price as gift in the hands of Company. So on similar analogy, the said differential should not be taxable in the hands of Investor u/s 56(2)(vii)

b. Had mandate of law to treat the difference between FMV and issue price of shares as taxation incidence in the hands of investor u/s 56(2)(vii), then it would have come up with more elaborate definition of FMV, which is currently restricted to book value, as against prescribed under section 56(2)(viib). In real world, for investment perspective, valuation of company is rarely done on book value; rather it is based on discounted cash flow or Comparable Companies method.

c. On operation of section 56(2)(vii), cost in the hands of recipient of property is governed by section 49(4). Had the intention of law to cover the issue of share at less than FMV as taxable event in the hands of investor, it would have made consequential amendments in section 55 and other incidental provisions, which is not done.