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Direct Tax Alert - Where transaction is sham, preference shares issued at face value would attract section 56(2)(viib)

24 March 2021

BACKGROUND

Finance Act, 2012 had introduced section 56(2)(viib) in the Income-tax Act, 1961 (IT Act) to bring consideration received for issue of shares in excess of Fair Market Value (FMV) of such shares within the ambit of tax. As per this section, where a closely held company (i.e., company in which public are not substantially interested) issues share at a premium, then the aggregate consideration received over and above the FMV shall be taxed in the hands of the issuing company. However, relaxation to certain type of entities have been prescribed. Considering that the section uses the term shares, a question arises as to whether this section will get attracted when preference shares are issued. Furthermore, whether this section is attracted when the shares are issued at face value even though the said face value is higher than the FMV of such shares.

Recently, the Chennai Tax Tribunal1 had an occasion to analyse applicability of Section 56(2)(viib) of the IT Act to preference shares issued at face value by a company having negative net worth. We, at BDO in India, have summarised the ruling of the Chennai Tax Tribunal and provided our comments on the impact of this decision.

FACTS OF THE CASE

The taxpayer, a closely held company, is engaged in the business of investment activities. For the relevant year under consideration, it issued 17,500 preference shares at Face Value (FV) of INR 10,000/- to its related party2. These shares were issued to repay its existing loan liability. Before the Tax Officer, the taxpayer contended that the provisions of Section 56(2)(viib) of the IT Act are not attracted as the preference shares are issued at FV. However, the Tax Officer rejected the taxpayer’s contention on account of following:

  • Even though FV of the taxpayer’s equity shares was fixed at INR 10 per share, preference shares were issued at FV of INR 10,000.
  • The FMV of the share as on date of issue was INR 4.73 (negative) which is far lower than the FV fixed by the taxpayer.  
  • The taxpayer failed to substantiate FV of preference shares at INR 10,000 per share, when the asset base of the company is not supporting such valuation.
  • Also, confirmation letter from the investor-company was not furnished and thereby genuineness of transaction was not established.

Accordingly, the tax officer applied section 56(2)(viib) of the IT Act and taxed the excess consideration above the FMV of share in the hands of the taxpayer. The First Appellate Authority upheld the order of tax officer. Aggrieved, the taxpayer filed an appeal before Chennai Tax Tribunal.

TRIBUNAL RULING

While the Tax Tribunal held that the provisions of section 56(2)(viib) of the IT Act are attracted only when the shares are issued at premium, it upheld the Tax Officer’s order by making following observations:

  • The taxpayer amended its share capital clause in Memorandum of Association to divide its share capital into equity shares and preference shares.
  • While the taxpayer retained the FV of equity shares at INR 10 per share, the FV of preference shares was fixed at INR 10,000 per share.
  • At the time of amending share capital and issuing preference shares, the taxpayer’s net-worth was negative.
  • The provisions3 of Companies Act, 2013 require the taxpayer to specify the purpose of issue of preference shares and justify its value before issuing such shares. In the present case, the taxpayer had justified purpose of issue of preference shares (i.e., to repay its existing loan liability) but the basis for fixing FV of preference shares at INR 10,000 per share had not been explained. Further, the taxpayer had neither filed any valuation report or evidence to justify value of shares, nor it had explained basis for fixing different share price for equity shares and preference shares.
  • The taxpayer had negative net-worth and there is no significant business activity except investments in equity shares of an Indian company. It had not filed any evidence to explain how a prudent businessman would invest in a company, where its net-worth is negative and book value of shares is far less than the FV of preference shares.
  • The sequence of events and manner in which preference share capital was raised, including terms of repayment, rate of return and period of shares, showed that the issue of preference shares is in the nature of sham transaction to overcome the provisions of Section 56(2)(viib) of the IT Act. In this regard, reference has been made to the ruling of the Hon’ble Supreme Court in the case of Mc. Dowell & Co.4   
  • The taxpayer failed to explain and justify issue of preference shares with a FV of INR 10,000 per share when the FMV of the shares of the company is INR 4.73 (negative) per share.               

BDO COMMENTS

While the Chennai Tribunal has held that provision of section 56(2)(viib) of the IT Act is not attracted, the said transaction should not be a sham transaction. The Chennai Tribunal has relied on the principle laid down in the case of Mc. Dowell & Co. - tax planning may be legitimate provided it is within the framework of law. It is imperative to note that with General Anti Avoidance Rule (GAAR) now in force, such transactions (i.e., shares having FV above the FMV) could be treated as impermissible transaction and thereby brought to tax. With respect to period prior to GAAR, the Tax Officer could take support of this judgement to bring to tax cases where shares (whether equity or preference), issued at FV, are issued at value more than FMV.

 

1M/s Sindya Securities and Investments Pvt. Ltd. vs ACIT (ITA No. 1816/Chny/2019)

2In this case, taxpayer and shareholder-company are related due to common directors. Further, the taxpayer and its shareholder-company are functioning in same premises.

3Section 55 of the Companies Act, 2013 and Rule 9 of Companies (Share Capital and Debentures) Rules, 2014 

4Mc. Dowell & Co Ltd. Vs. Commercial tax Officer [1985] 154 ITR 148 (Supreme Court)