Notional income tax on issue of shares by closely held applicable not applicable under Sec.56(2) (vii a), clarifies CBDT

-Million dollar question: Can the same be extended to Sec. 56(2)(x) ?

By Yutika Lohia (yutika@vinodkothari.com)

The abolition of Gift Tax Act in the year 1998 paved way for one of the most dynamic sections of the Income Tax Act, 1961, – Section 56(2). Under this section all kinds of incomes and gains which were from sources other than the sources mentioned in the Act at that time was brought under the purview of Income Tax. Now, incomes and gains arising out of such transactions which were structured to pass on assets to some other party without any consideration or with inadequate consideration was subject to be taxed under this section.

While the Section 56(2) gave the authorities a tool to keep check on the transactions structured to merely launder unaccounted income, it also brought in many questions with itself. The CBDT has since been releasing clarification to address the questions as well as making changes to the section to cover all lose ends of laundering unaccounted incomes.

Recently Central Board of Direct Taxes (CBDT) in its circular dated 31st December, 2018 came up with a clarification to address the question –

Does the terms “receives” with regards to section 56 (2)(viia) include receiving shares of companies (where public are not substantially interested) by way of issues of shares by way of fresh issue/ bonus issue/ issue of rights shares/ transaction of similar nature?

Before we get to the clarification lets first analyse the sections – 56(2)(vii), 56(2)(viia) , 56(2)(viib) & 56(2)(x)

Analysis of Section 56(2)(vii) Section 56(2)(viia) Section 56(2)(viib) & Section 56(2)(x)

Section 56(2)(vii) Section 56(2)(viia) Section 56(2)(viib) Section

56(2)(x)

Applicable to Individual/ HUF Firm/ Company (closely held) Company (closely held) Person as per section 2(31) of the IT Act, 1961
Applicable on 1. Money

2. Immovable Property

3.Property other Immovable Property

Shares of closely held company 1.Issue of Shares 1. Money

2. Immovable Property

3.Property other Immovable Property

Applicable date From  1st October, 2009 to 31st March, 2017 From 1st June, 2010 to 31st March, 2017 From 1st April, 2013 From 1st April, 2017

 

Section 56(2)(viia) of the IT Act, 1961 was inserted by Finance Act, 2010. Referring to the memorandum of Finance Act, 2010[1] clause (viia) was incorporated in section 56 to prevent the practice of transferring unlisted shares at a price which was different from the fair market value (i.e no or inadequate consideration) of the shares and also include within its ambit transactions undertaken in shares of the company (not being a company in which public are substantially interested) either for inadequate consideration or without consideration where recipient is a firm or a company (not being a company in which public are substantially interested).

In a layman’s term the act of receiving means to receive something which was already in existence and the act of creation of the that particular thing.

Similarly receipt of shares of shares by way of fresh issue/ bonus issue/ issue of rights shares/ transaction of similar nature is an act of creation of the securities and not transfer of the same. The CBDT in its circular dated 31st December, 2018has clarified the same. section 56(2)(viia) is applicable to transactions involving subsequent transfer of the shares form the initial receiver to some third party, and not time of issuance of such shares.

It is palpable that the shares would be treated as goods only when it comes into existence and issuance of shares is the act of bringing the shares into existence. The word “receives” with respect to section 56(2)(viia) would not include issuance of shares within its ambit.

The intent of insertion of clause (viia) to section 56 was to apply anti-abuse provision i.e transfer of shares for no or inadequate consideration, it is hereby clarified by the CBDT circular that section 56(2)(viia) of the Act shall apply in cases where a company (not being a company in which public are substantially interested)  or a firm receives the shares  of the company (not being a company in which public are substantially interested) through transfer for no or inadequate consideration. Hence section 56(2)(viia) of the Act shall not be applicable on fresh issue of shares by the specified company.

Taxation of fresh issue of shares comes under the purview of section 56(2)(viib).

The Subhodh Menon case in context to Section 56

Recently the Income Tax Appellate Tribunal (ITAT) in the case of The Assistant Commissioner of Income Tax Vs. Shri Subhodh Menon[2], order dated 7th December, 2018 held that a shareholder cannot be taxed under section 56(2)(vii)(c) of the IT Act, 1961 so long as the shares are allotted to the holder on a proportionate basis (right shares), even if such shares are allotted at a value lower than the fair market value.

Drawing from the above case law, right shares issued at a value below the fair market value to individual/ HUF where allotment is disproportionate will not be taxable under section 56(2)(vii)(c) of the IT Act, 1961. Shares issued higher than proportion offered (based on shareholding) shall attract tax provisions.

Conclusion

The Union Budget 2017[3] introduced the section 56(2)(x) of the IT Act, 1961 widening the scope of Income from other sources and also clubbing section 56(2)(vii) & section 56(2)(viia).  Income Tax shall not be chargeable at normal rate for fresh issue of shares for closely held companies.

Since the offence that section 56(2)(viia) was trying to curb is the same as section 56(2)(x), the question still lies, whether the term “receives” clarified in the CBDT circular shall have the same analogy for Section 56(2)(x)? Simply put, whether section 56(2)(x) of the Act will also be limited to transfer of existing shares and not cover fresh issue of shares?


[1] https://www.indiabudget.gov.in/ub2010-11/mem/mem1.pdf

[2] http://itatonline.org/archives/wp-content/uploads/Subodh-Menon-shares.pdf

[3] https://www.indiabudget.gov.in/budget2017-2018/ub2017-18/memo/memo.pdf

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