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1. Section 56(2)(viib) of the Income Tax Act, 1961 – Extract from Bare Act

(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:

Provided that this clause shall not apply where the consideration for issue of shares is received –

(i) by a venture capital undertaking from a venture capital company or a venture capital fund ; or

(ii) by a company from a class or classes of persons as may be notified by the Central Government in this behalf.

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 such shares, of its assets, including intangible assets being goodwill, know-how, patents, copyrights, trademarks, licenses, franchises or any other business or commercial rights of similar nature,

whichever is higher.

(b) “venture capital company”, “venture capital fund” and “venture capital undertaking” shall have the meanings respectively assigned to them in clause (a), clause (b) and clause (c) of Explanation to Clause (23FB) of section 10;

2. Rules 11U and 11UA(2) of the Income Tax Rules, 1962.

Rule 11UA(2) Notwithstanding anything contained in sub-clause (b) of clause (c) of sub-rule (1), the fair market value of unquoted equity shares for the purpose of sub-clause (i) of clause (a) of Explanation to clause (viib) of sub-section (2) of section 56 shall be the value, on valuation date, of such unquoted equity shares as determined in the following manner under clause (a) or clause (b), at the option of the assessee, namely:-

(a) The fair market value of unquoted equity shares = (A-L) X (PV) ,

(PE)

where,

A = book value of the assets in balance-sheet as reduced by any amount of tax paid as deduction or collection at source or as advance tax payment as reduced by the amount of tax claimed as refund under the Income-tax Act and any amount shown in the balance sheet as asset including the unamortized amount of deferred expenditure which does not represent the value of any asset;

L = book value of liabilities shown in the balance-sheet, but not including the following amounts, namely:-

(i) the paid-up capital in respect of equity shares;

(ii) 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;

(iii) reserves and surplus, by whatever name called, even if the resulting figure is negative, other than those set apart towards depreciation;

(iv) any amount representing, provision for taxation, other than amount of tax paid as deduction or collection at sources or as advance tax payment as reduced by the amount of tax claimed as refund under the Income-tax Act, to the extent of the excess over the tax payable with reference to the book profits in accordance with the law applicable thereto;

(v) any amount representing provisions made for meeting liabilities, other than ascertained liabilities;

(vi) any amount representing contingent liabilities, other than arrears of dividends payable in respect of cumulative preference shares;

PE = total amount of paid up equity share capital as shown in the balance-sheet;

PV = the paid up value of such equity shares; or

(b) the fair market value of the unquoted equity shares determined by a merchant banker or an accountant as per the Discounted Free Cash Flow method.

2.1 Relevant clauses of Rule 11U

11U. For the purpose of this rule and rule 11UA, –

(a) “accountant”, –

(i) for the purpose of sub-rule (2) of rule 11UA, means a fellow of the Institute of Chartered Accountants of India within the meaning of the Chartered Accountants Act, 1949 (38 0f 1949) who is not appointed by the company as an auditor under section 44AB of the Act or under section 224 of the Companies Act, 1956 (1 of 1956); and

(ii) ***

(b) “balance-sheet”, in relation to any company, means –

(i) for the purpose of sub-rule (2) of rule 11UA, the balance-sheet of such company (including the notes annexed thereto and forming part of the accounts) as drawn up on the valuation date which has been audited by the auditor of the company appointed under section 224 of the Companies Act, 1956 (1 of 1956) and where the balance-sheet on the valuation date is not drawn up, the balance-sheet (including the notes annexed thereto and forming part of the accounts) drawn up as on a date immediately preceding the valuation date which has been approved and adopted in the annual general meeting of the shareholders of the company ; and

(ii) ***

(c) “merchant banker” means category I merchant banker registered with the Securities Exchange Board of India established under section 3 of the Securities Exchange Board of India Act, 1992 (15 of 1992);

(i) “unquoted shares and securities”, in relation to shares or securities means shares and securities which is not a quoted shares or securities;

(j) “valuation date” means the date on which the property or consideration as the case may be, is received by the assessee.

3. Share premium is the amount by which the issue price of a share exceeds the nominal value. Under The Companies Act, the value of the share premium must be credited to a securities premium account.

4. Scope of Section 56(2)(viib) of the Income Tax Act, 1961.

There are five (5) aspects (conditions) inherent in Section 56(2)(viib) – all of which must be cumulatively be satisfied – for the share premium received by a company – to be deemed as income from Other Sources of the company in a particular assessment year.

I. TYPE OF COMPANY

II. NATURE OF RECEIPTS

III. RESIDENTIAL STATUS OF PAYER

IV. AMOUNT (SHARE PREMIUM)

V. ACCRUAL (IN WHICH ASSESSMENT YEAR)

5. TYPE OF COMPANY

5.1. DEFINITION OF CLOSELY-HELD COMPANY

i. The phrase ‘closely-held company’ is not explicitly defined under the Income Tax Act, 1961 but it means a ‘company in which the public is not substantially interested’.

ii. Section 2(18) of the Income Tax Act, 1961 defines ‘a company in which the public is substantially interested’ to include :-

a. a company owned by the Government or the RBI or more than forty percent of the shares are owned by Government or the RBI or a corporation owned by the RBI.

b. a company registered under section 25 of the Companies Act, 1956.

c. a company not having share capital and declared by the Board to be such company

d. Mutual Benefit Finance Company – business of acceptance of deposits from members and notified by the Central Government u/s 620 of the Companies Act, 1956.

e. a company, whose more than 50% Equity Shares (not being Preference Shares) held by one or more Co-operative Societies throughout the previous year.

f. a company not being a Private Company as defined in the Companies Act, 1956, whose Equity Shares were listed on the 31 March of the previous year in a Recognised Stock Exchange. g. a ‘Government Company’ not being a ‘Private Company’ (both terms being defined in the Companies Act, 1956).

iii. As a corollary to the definition of ‘a company in which the public is substantially interested’, a ‘closely held company’ will include :-

a. a Private Company as defined in the Companies Act, 1956 ; and

b. a Company not being a Private Company as defined in the Companies Act, 1956 and whose Equity Share are not listed on the 31 March of the previous year in a Recognised Stock Exchange.

5.2. APPLICABILITY ON FOREIGN COMPANIES

i. Section 56(2)(viib) does not distinguish between an Indian or a Foreign Company.

ii. Section 2(17) defines “company” to include a body corporate incorporated by or under the laws of a country outside India.

6. NATURE OF RECEIPTS

6.1 Share Premium i.e., any consideration for issue of shares that exceeds the face value of such shares.

6.2 Issue of shares at face value where the fair market value is less than face value would not attract section 56(2)(viib).

7. RESIDENTIAL STATUS OF PAYER

7.1 Section 56(2)(viib) is applicable only when the payer is “any person being resident.”

8. AMOUNT (SHARE PREMIUM)

8.1 The amount of income under section 56(2)(viib) is “the aggregate consideration received for such shares as exceeds the fair market value of the shares.”

8.2 Rules 11U and 11UA(2) of the Income Tax Rules, 1962 provide the formula for determination of “fair market value” of a share.

8.3 The company may substantiate before the assessing officer based on the value, on the date of issue of such shares, of its assets, including intangible assets being goodwill, know-how, patents, copyrights, trademarks, licenses, franchises or any other business or commercial rights of similar nature.

9. ACCRUAL (IN WHICH ASSESSMENT YEAR)

9.1 The income referred to in Section 56(2)(viib) shall accrue in the previous year in which the share premium is received by the company.

9.2 Therefore, only receipts(s) during the “current year” is covered & any opening balances are to be ignored.

9.3 The assessing officer may reopen assessment proceedings u/s 147, to bring “share premium” escaping assessment to tax for the preceding assessment years.

9.4 Any share premium(s) which is received beyond the limitation period cannot be assessed to Income-tax. The limitation period is period for which the assessing officer cannot issue Notice u/s 147 for reassessment of income.

10. Exceptions

10.1 Section 56(2)(viib) shall not apply where the consideration for issues of shares has been received by a venture capital undertaking from a venture capital company or a venture capital fund.

10.2 Section 56(2)(viib) shall not apply where the consideration for issues of shares has been received by a company from a class or classes of persons as may be notified by the Central Government in this behalf.

11. Bonus & Right Issue of shares by a company

Hon’ble ITAT Mumbai bench on subject of taxation under deemed gift u/s 56(2)(vii) for concessional share allotment at less than book value (under rule 11U & 11UA) held bonus shares do not fall under the same; right shares and original first time allotment falls in the same however if new shares allotted to existing share holders pro rata as per exiting holdings no adverse inference/addition possible. (I.T.A. No. 4887/Mum/2013 on 12.03.2014)

12. Exemption to Startups from Angel Tax.