Unlisted shares to be taxed only if transferred below fair value: Experts

Taxing receipt of shares of unlisted company: CBDT clarifications affect ongoing litigation

Jinesh Shah, partner- tax, KPMG in India, and Devarsh Patel, director - deal advisory, M&A tax, KPMG in India, decode the provisions in Section 56 (2) of the Income Tax Act that deals with taxation of receipt of shares of unlisted companies without adequate consideration

What are the provisions in Section 56 (2) (viia) of the Income Tax Act, 1961? What was the intent of legislature at the time of its introduction?

Section 56(2)(viia) of the Income Tax Act (Act) provides for taxation of receipt of shares of an unlisted company without consideration or for an inadequate consideration. This anti-abuse provision was introduced through the Finance Act, 2010, as a mechanism to prevent laundering of unaccounted income veiled in the form of gifts and to tax transactions that take place for inadequate consideration or an all-together lack of it. 

With effect from April 1, 2017, these provisions were replaced by the introduction of new Section 56(2)(x). Earlier provision was applicable only in case of the receipt of “unlisted shares” for inadequate consideration, whereas the new provision is made applicable to the receipt of all securities. 

As per the Memorandum to the then Finance Bill, the legislative intent for introducing such provision was “to prevent transfer of unlisted shares below its fair value”. However, the fine print of the Act had created ambiguity by using the word “receipt” instead of “transfer” as per its intent. Since then a debate has ensued on whether these provisions are applicable on the receipt of shares pursuant to fresh issue or are applicable only on the receipt of shares pursuant to transfer.

In light of the CBDT circular dated December 31, 2018, what was the clarification issued? How was it perceived?

The Central Board of Direct Taxes (CBDT) clarified that legislative intent has to be read in conjunction with the Memorandum. Hence, the provisions of Section 56(2)(viia) should be made applicable only in case of transfer of unlisted shares below fair value. The CBDT had clarified that it shall not apply to fresh issuance of shares, including by way of issue of bonus shares, rights shares and preference shares or transactions of similar nature.  

Given that the circular does not refer its applicability to Section 56(2)(x), it created perceivable confusion whether this clarification is also applicable to the aforementioned provision. The Memorandum to Finance Act, 2017, which introduced this provision, reads that “in order to prevent the practice of receiving the sum of money or property” whereas the Memorandum to Finance Bill, 2010, which introduced Section 56(2)(viia) reads that “in order to prevent the practice of transferring unlisted shares”. Although the original intent seems to be the same for both these provisions, the confusion stems from a difference in the language used in the Memorandum. 

What is the possible impact on account of withdrawal of the aforementioned circular?

The CBDT has reversed its clarification on January 4, 2019, by withdrawing the December circular, thereby withdrawing relief granted in case of receipt of shares below its fair value on primary issuance. One of the reasons cited by the CBDT for the withdrawal of this circular is pendency of matter relating to the interpretation of the term “receives” before various judicial fora. Various stakeholders have sought clarification on similar provisions in Section 56 of the Act. It is expected that the CBDT would examine the matter afresh and issue a comprehensive circular in this regard. 

From a tax assessments standpoint, this clarification and subsequent withdrawal have created confusion among firms that received demands/notices from tax authorities. This will affect all the ongoing litigation until a fresh circular is issued in this regard. However, this may give additional ground of argument during the assessment proceedings that the original intent of the provision is to make it applicable only in case of transfer of shares below its fair value. 

Does this circular provide relief to angel-funded start-ups touted as “angel tax”?

This circular is not relevant with respect to tax concerns of angel investor-funded start-ups. Their concerns have arisen on account of premium received on issue of shares. However, on January 16, the government, in an attempt to address their concerns, specified a new mechanism to smoothen availability of tax-breaks to eligible start-ups by instituting a requirement to be recognised by the Department of Industrial Policy & Promotion.