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Gov’s Attempt to Make Slump Sale ‘Fair’

-Yutika Lohia ( finserv@vinodkothari.com )

Introduction

The income tax laws of the country has been witnessing dynamic changes over the years. The tax authorities are understanding the bottlenecks within their current tax system and proposing changes to mobilize revenue, promote investments and also to cope up with the present gaps.

On the other hand, with such dynamicity in laws, income tax or otherwise, companies often find themselves struggling to keep at par with the economy, and hence taking the restructuring route – slump sale being one option. The authorities are identifying the areas where there has been loss of revenue to the government and accordingly making changes in the tax laws.

Slump sale is one of the modes of business restructuring process and attracts capital gain under section 50B of the IT Act. Prior to Finance Act 2021, full value of consideration was the lumpsum value agreed between the buyer and seller considered while computing capital gains.  Post Finance Act 2021, a new clause was inserted in sub section 2 of section 50B of the IT Act, where “Fair market value of the capital assets as on the date of transfer, calculated in the prescribed manner, shall be deemed to be the full value of the consideration received or accruing as a result of the transfer of such capital asset.”

The IT Department has introduced new rule for computation of fair market value of capital assets which shall be the full value of consideration while computing capital gains in case of a slump sale. The rules are an anti abuse measures to restrict the practice of sale of business at under value.

In this write up, we shall discuss the changes made by Finance Act 2021 in case of a slump sale, new rule for computation of fair market value of capital asset and its implications.

Widening the scope of slump sale by Finance Act 2021

Definition of slump sale

Prior to Finance Act 2021, the Indian Tax Law defined slump sale as transfer of one or more undertaking as a result of sale for a lump sum consideration without values being assigned to individual assets and liabilities.

However, the Finance Act 2021, extended the scope of “slump sale” under section 2(42C) of the IT Act and inserted an Explanation to the said section so as to provide that the word “transfer” shall have the same meaning assigned to in section 2(47) of the IT Act.

Earlier the definition of “slump sale” considered only those transfer where there was monetary consideration and transfer like exchange with property or shares were not covered under the scope of slump sale. Therefore, to widen the definition, the Finance Act 2021 covered those transactions which were just not restricted to sale and but also covered all kinds of transfer.

Fair Market value Computation

Earlier for computing capital gains in case of a slump sale, net worth of the undertaking was reduced from full value of consideration. The Finance Act 2021, amended the capital gain computation provision and introduced the Fair Market Value approach. To say, full value of consideration shall be replaced by the fair market value of the undertaking.

Net worth Computation

For computation of net worth, a new clause has been added where cost of goodwill which has not been acquired by the taxpayer by purchase from previous owner has to be taken at NIL

Notification issued by CBDT

The Central Board of Direct Taxes vide its Notification dated 24th May, 2021 has notified a new rule i.e., Rule 11UAE of the Income Tax Rules 1962, for computation of fair market of capital assets in case of a slump sale.

Rule 11UAE has introduced two methods of fair market value calculation i.e., FMV1 and FMV2 and higher among the two shall be considered while computing capital gains for slump sale transaction.

  • FMV1 shall be the fair market value of the capital assets transferred by way of slump sale
  • FMV2 shall be the fair market value of the consideration received or accruing as a result of transfer by way of slump sale

The fair market value of the capital assets under sub-rule (2) and sub-rule (3) shall be determined on the date of slump sale and for this purpose valuation date referred to in rule 11UA shall also mean the date of slump sale

The two FMVs shall be determined in accordance with the formula discussed below.

FMV1 approach

As per sub rule (2) of Rule 11UAE, we may call it adjusted NAV approach where book value of all assets other than jewellery, artistic work, shares, securities and immovable property shall be considered.

FMV1 = A+B+C+D-L, where,

A= book value of all the assets (other than jewellery, artistic work, shares, securities and immovable property) as appearing in the books of accounts of the undertaking or the division transferred by way of slump sale as reduced by the following amount which relate to such undertaking or the division, —

  • any amount of income-tax paid, if any, less the amount of income-tax refund claimed, if any; and
  • any amount shown as asset including the unamortised amount of deferred expenditure which does not represent the value of any asset;

B = the price which the jewellery and artistic work would fetch if sold in the open market on the basis of the valuation report obtained from a registered valuer;

 C = fair market value of shares and securities as determined in the manner provided in sub-rule (1) of rule 11UA;

 D = the value adopted or assessed or assessable by any authority of the Government for the purpose of payment of stamp duty in respect of the immovable property; L= book value of liabilities as appearing in the books of accounts of the undertaking or the division transferred by way of slump sale, but not including the following amounts which relates to such undertaking or division, namely: —

  • the paid-up capital in respect of equity shares;
  • the amount set apart for payment of dividends on preference shares and equity shares where such dividends have not been declared before the date of transfer at a general body meeting of the company;
  • reserves and surplus, by whatever name called, even if the resulting figure is negative, other than those set apart towards depreciation;
  • any amount representing provision for taxation, other than amount of income-tax paid, if any, less the amount of income-tax claimed as refund, if any, to the extent of the excess over the tax payable with reference to the book profits in accordance with the law applicable thereto;
  • any amount representing provisions made for meeting liabilities, other than ascertained liabilities;
  • any amount representing contingent liabilities other than arrears of dividends payable in respect of cumulative preference shares.

FMV2 approach

As per sub rule (3) of Rule 11UAE, FMV2 i.e.  shall be the fair market value of the consideration received or accruing as a result of transfer by way of slump sale determined in accordance with the formula-

FMV2 = E+F+G+H, where,

E = value of the monetary consideration received or accruing as a result of the transfer;

F = fair market value of non-monetary consideration received or accruing as a result of the transfer represented by property referred to in sub-rule (1) of rule 11UA determined in the manner provided in sub-rule (1) of rule 11UA for the property covered in that sub-rule;

G = the price which the non-monetary consideration received or accruing as a result of the transfer represented by property, other than immovable property, which is not referred to in sub-rule (1) of rule 11UA would fetch if sold in the open market on the basis of the valuation report obtained from a registered valuer, in respect of property;

H = the value adopted or assessed or assessable by any authority of the Government for the purpose of payment of stamp duty in respect of the immovable property in case the non-monetary consideration received or accruing as a result of the transfer is represented by the immovable property.

Further the expression “registered valuer” and “securities” shall have the same meaning as per Rule 11U of the Income Tax Rules.

Conclusion

This new Rule 11UAE will not only capture monetary consideration but also non-monetary consideration received for transfer of undertaking. Also, the new rule considers revaluation of assets and liabilities made in the books.

Prior to Finance Act 2021, the consideration of slump sale was the amount agreed between the buyer and the seller. Since the consideration was not based on any mechanism, the transfer would take place at a lower price and this often resulted in tax leakage.

To curb all the tax loop holes and prevent tax leakage in merger and acquisition transactions, the income tax laws has been modified and a new concept has been introduced where fair market value for capital assets shall computed as per Rule 11UAE for consideration value in case of a slump sale.

Now the seller will have to pay tax on the fair market value as computed as per Rule 11UAE even if the actual consideration received is less than the fair market value of capital assets. Also, this rule will put a challenge where the undertaking is transferred at a true sale value.

 

 

 

 

 

 

 

 

 

 

 

 

Important Rulings -Section 56 (2) (viia), 56 (2) (x) and 56 (2) (viib) of Income Tax Act 1961

– Qasim Saif and Mahesh Jethani

finserv@vinodkothari.com

Section 56(2) (viia)

  • When shares of closely held company received without consideration or for inadequate consideration
  • Where shortfall in consideration as compared to Fair Market Value (FMV) exceeded Rs. 50,000
  • Recipient is:

(a) Firm

(b) closely held company

  • Then, FMV of such shares exceeding Rs. 50,000/- after reducing the value of consideration paid, if any, was considered as – Income from other Sources.

Section 56(2) (x)

Section 56(2)(vii)/(viia) is inoperative with effect from 1-4-2017

Clause (x) is inserted in section 56(2) to provide that the specified receipts [same as provided in Sec. 56(2)(vii)] will be taxable as income in the hands of any person, under the head ‘Income from Other Sources’

Sub-Clause (c) of Clause (x) of Section 56-Taxation of any property other than Money and Immovable Property: –

  • If received without consideration, the aggregate fair market value of which exceeds fifty thousand rupees, the whole of the aggregate fair market value of such property shall be considered Income from Other Source
  • If there is inadequate consideration whereby the difference between FMV and consideration exceeds Rs.50,000/- then difference in FMV and consideration will be considered as IFOS

Property means the following capital asset of the assessee –

(i) immovable property being land or building or both;

(ii) share and securities;

(iii) jewellery;

(iv) archaeological collections;

(v) drawings;

(vi) paintings;

(vii) sculptures; or

(viii) any work of art.

(ix) Bullion

Reason for amendments

The Memorandum to the section explains the following-

“The existing definition of property for the purpose of this section includes immovable property, jewellery, shares, paintings, etc. These anti-abuse provisions are currently applicable only in case of individual or HUF and firm or company in certain cases. Therefore, receipt of sum of money or property without consideration or for inadequate consideration does not attract these anti-abuse provisions in cases of other assessee.”

Thus, it appears that through insertion of new provision, the scope of the existing anti-abuse provision is widened to make it applicable to all assessee and also clubbing section 56(2)(vii) & section 56(2) (viia).

 

Important Rulings on Section 56(2) (viia) and 56(2) (x)

 

Taxability of the credit to the general reserve by the amalgamated company

Aamby Valley Ltd vs. ACIT (ITAT Delhi)

Date: 22nd February 2019.

Background:

Section 56(2) (viia) is an anti-abuse provision which applies only to cases of bogus capital building and money laundering. It does not apply to an amalgamation where shares are allotted at alleged undervaluation.

Increase in general reserves due to recording of assets of amalgamating company at FMV not give rise to any real income to the assessee. It is capital in nature

Judgement and conclusion:

This is an important judgement by Tribunal which deals with the taxability of the credit to the general reserve by the amalgamated company of the fair valuation of the assets received under the scheme of amalgamation. The Tribunal held that the transaction does not give rise to real income to the assessee and it thus cannot be treated as a business profit.

Provisions of Section 56 (2) (viia) will not be applicable if fair value of the shares received was not higher than the sacrifice suffered by taxpayer under the composition reorganisation scheme, as there is no incremental benefit to the shareholder.

Reserve directly credited to general reserve and not in P&L cannot be subjected to MAT.

Raising of Tax related Objection by RD when Income Tax Authority did not raise the same.

Casby Cfs Private Limited vs Casby Logistics Private Limited (Bombay High Court)

Date: 19th March 2015

Background:

In the instant case the question of law is that whether the RD could raise tax-related objections to the scheme of amalgamation though the ITA raised no objections? Whether the scheme was liable to be rejected based on the RD’s aforesaid objections?

One of the issue that was pointed out that the scheme was devised to evade capital gain tax by virtue of using the device of beneficial ownership and scheme, transferee is acquiring shares without consideration which will attract section 56 (2) (viia)

Judgement and conclusion:

Since the court was required to ensure that the scheme did not contravene any Act, the RD was not only entitled to, but was duty-bound, to bring to the HC’s notice any provision in the scheme that contravened any law. This included the Income tax law and aimed to ensure that the company did not use the HC sanction as a shield to protect itself from consequences of contravention of the law

That the ITA did not object did not prevent the RD from raising objections or making such observations with regard to the scheme as he/ she deemed fit, including those pertaining to tax laws

The HC has held that the RD is entitled to raise objections pertaining to income tax in a merger scheme, even though no objections were raised by the tax authorities.

Application of Section 56(2)(viia)/56 (2) (x) in case of Buy Back

Vora Financial Services P. Ltd vs. ACIT (ITAT Mumbai)

Date:29th June 2018

Background:

Section is a counter evasion mechanism to prevent laundering of unaccounted income under the garb of gifts. The primary condition for invoking the section is that the asset gifted should become a “capital asset” and property in the hands of recipient. If the assessee-company has purchased shares under a buyback scheme and the said shares are extinguished by writing down the share capital, the shares do not become capital asset of the assessee-company and hence s. 56(2) (viia) cannot be invoked in the hands of the assessee company

Judgement and conclusion:

A combined reading of the provisions of sec. 56(2)(viia) and the memorandum explaining the provisions show that the provisions of sec. 56(2)(viia) would be attracted when “a firm or company (not being a company in which public are substantially interested) “receives a property”, being shares in a company (not being a company in which public are substantially interested)”.

Therefore, it follows the shares should become “property” of recipient company and in that case, it should be shares of any other company and could not be its own shares. Because own shares cannot be become property of the recipient company.

Accordingly, Tribunal was of the view was that the provisions of sec. 56(2) (viia) should be applicable only in cases where the receipt of shares become property in the hands of recipient and the shares shall become property of the recipient only if it is “shares of any other company”. In the instant case, the assessee herein has purchased its own shares under buyback scheme and the same has been extinguished by reducing the capital and hence the tests of “becoming property” and also “shares of any other company” fail in this case.

The tax authorities are not justified in invoking the provisions of sec. 56(2) (viia) for buyback of own shares.

Valuation of Share to be done as per Rule 11UA

Minda SM Technocast Pvt. Ltd vs. ACIT (ITAT Delhi)

Date: 7th March 2018

Background:

Section 56(2)(viia) read with Rule 11UA, The “Fair Market Value” of shares acquired has to be determined by using the values of the underlying assets and not their market values

In the present case, the assessee has acquired shares of TEPL at Rs.5 per shares. The assessee claimed to have valued the shares of TEPL as per the provisions of Rule 11UA of the Rules. AO was of the view that the assets are to be valued at the fair market value which will increase the value of shares to 45.72 and difference Rs. 40.72 being subjected to tax.

Judgement and conclusion:

“Fair Market Value” of a property, other than an immovable property, means the value determined in accordance with the method as may be prescribed”

On the plain reading of Rule 11UA, it is revealed that while valuing the shares the book value of the assets and liabilities declared by the TEPL should be taken into consideration. There is no whisper under the provision of 11UA of the Rules to refer the Fair Market Value of the land as taken by the Assessing Officer as applicable to the year under consideration. Therefore, ITAT was of the view that the share price calculated by the assessee of TEPL for Rs. 5 per shares has been determined in accordance with the provision of Rule 11UA.

Applicability of section in case of “Gift” by one company to another.

Gagan Infraenergy Ltd vs. DCIT (ITAT Delhi)

Date: 15th May 2018

Background:

Huge volume of shares in a company were transferred by assessee to another company without any consideration and without any proper documentation being executed as per law, giving it name of “Gift”.

Question raised: Will the said transaction be covered by section 56(2)(viia) or is exempt from tax u/s 47(iii) of the Income Tax Act, 1961 (the Act)

Judgement and conclusion:

After considering all the facts and circumstances of the case, it is held that the AO has correctly observed that gift by a corporation to another corporation is a strange transaction as there cannot be a gift between artificial entities/persons. The submissions filed by the Appellant are considered and not found to be tenable.

The assessee has to establish to the hilt, the factum, genuineness and validity of the transaction, the right to enter into such transaction especially when, revenue challenges its genuineness. There is no agreement/document that has been executed between group companies forming part of family realignment. To postulate that a company can give away its assets free to another even orally, can only be aiding dubious attempts at avoidance of tax payable under the Act unless it is supported by documentary evidence

It has been vehemently contested by authorities. CIT (DR) contented that transaction has been effectuated for avoiding payment of tax and to get out of the ambit of section 56 (2) (viia) of the Act. Hence benefit of exemption under section 47 (iii) can not be granted.

 

Application of Section in case of Bonus Issue

Commissioner of Income-Tax vs Dalmia Investment Co. Ltd (Supreme Court)

Date:13th March 1964

Background

There has been a constant flip flop by the CBDT on the issue that whether the provisions of the given section would apply on fresh issue of shares. As the ambiguity prevails the highly celebrated case can be referred for determining applicability of section on Bonus Issue.

Judgement and Conclusion

The apex court in the given case while adjudicating the issue of taxability on transfer of shares held that the Bonus shares were acquired “Without Payment of price and not without consideration” hence it can be implied that Section 56(2) (viia) would not apply in case of bonus issue.

Whether it is valid in law to assess the difference between the value of the shares allotted to the taxpayer and the consideration paid by it, as the taxpayer’s income?

Sudhir Menon HUF vs. ACIT (ITAT Mumbai)

Date: 12th March 2014

Background:

Section 56(2)(vii) (c) (ii) provides that where an individual or a HUF receives any property for a consideration which is less than the FMV of the property, the difference shall be assessed as income of the recipient. The section does not apply to the issue of bonus shares because there is a mere capitalization of profit by the issuing-company and there is neither any increase nor decrease in the wealth of the shareholder as his percentage holding remains constant. Similar view can be taken while considering rights issue as well.

Judgement and conclusion:

Since Right Shares are allotted on the basis of original holding, it cannot be said that same have been allotted at a price less than the fair market value without consideration. Therefore, provisions of Section 56(2)(x) of the Act are not applicable. Moreover, in view of specific provisions of Section 55(2)(aa)(iii) cost of acquisition of these shares will be taken to be the actual price paid by the shareholder and same is not to be adjusted by the amount of deemed income in terms of section 49(4) of the Act, applicability of provisions of section 56(2)(x) is not intended. However it shall be noted that in case the right is assigned to a person the given section would apply.

Valuation of share can be done only on basis of FMV and Not Market Value:

DCIT Mumbai vs Ozoneland Agro Pvt Ltd (ITAT Mumbai)

Date: 2nd May 2018

Background

A.O. observed that two persons transferred their shares to the assessee at Rs.75.49 per share whereas, on the same day all the other shareholders transferred their shareholdings to the assessee at Re.1 per share. He observed that when the market rate is Rs.75.49/share, the assessee has purchased the shares at less than the market price i.e., Re.1 per share and therefore, the transactions attract provisions of section 56(2) (viia) of the I.T. Act.

The assessee however argued that under section 56(2)(viia) FMV as calculated under Rule 11U is to be considered and not market price. And FMV of the shares were negative and hence the section has no applicability in the given case.

Judgement and Conclusion

The Tribunal on due consideration ruled that the action of AO was outside the ambit of law and only FMV under Rule 11U can be considered and not Market price. Hence dismissing appeal by the AO.

Application of Section on acquisition of shares before 1st July 2010.

M/S Nathoo Ram Nityanand Timber vs Department of Income Tax (ITAT Lucknow)

Date: 30th August 2016

Background

In the given case the assessee had acquired shares prior to notification of section 56(2) (viia), that is before 1st July 2010 however the said case came into consideration after the notification of said section the Assessing officer, reassessed the income of assessee giving impact of section 56 (2)(viia). Which was challenged by the assessee

Judgement and Conclusion

The ITAT upheld the argument forwarded by the assessee and ruled that in case transaction had been undertaken before the notification that is to say before 1st July 2020 that income would not be readjusted based on provisions of section 56(2)(viia).

Section 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:

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

Important Ruling on Section 56(2) (viib)

 

Discretion of Assessee to choose method of Valuation

Cinestaan Entertainment P. Ltd vs. ITO (ITAT Delhi)

Date: June 27, 2019 

Background:

The assessee has the option under Rule 11UA (2) to determine the FMV by either the ‘DCF Method’ or the ‘NAV Method’. The AO has no jurisdiction to tinker with the valuation and to substitute his own value or to reject the valuation. He also cannot question the commercial wisdom of the assessee and its investors.

Judgement and Conclusion:

It is a well settled position of law with regard to the valuation, that valuation is not an exact science and can never be done with arithmetic precision.

Also, an important angle to view such cases, is that, here the shares have not been subscribed by any sister concern or closely related person, but by an outside investors like, Anand Mahindra, Rakesh Jhunjhunwala, and Radhakishan Damani who are one of the top investors and businessman of the country and if they have seen certain potential and accepted this valuation, then how AO or Ld. CIT(A) can question their wisdom.

Read our related write ups on the subject –

Section 94B: Thin capitalization rules may impede operations of NBFCs, by Nidhi Bothra & Kanishka Jain, 24th May, 2017

Genesis of the thin capitalization rules

The genesis of the thin capitalization rules lies in the distinction between tax treatment of debt and equity.  A company typically finances its projects either through equity and debt or mixture of both, equity being costly in terms of cost and ownership is less attractive than the debt financing where interest is a deductible expense. Debt is not only less expensive to service, it also reduces tax liabilities and enhances return on equity.

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