Taxation & Valuation of Share Premiums

November 2023

S. 56(2)(viib) – Issue of Shares at a Premium

Background:  The provisions of S. 56(2)(viib) apply to companies in which the public are not substantially interested when they issue shares at a premium. Thus, the prerequisite to attract the section is to issue shares (preference or equity) at a premium. Also, the issuing company should not be a company in which public are substantially interested. S. 2(18) of the IT Act defines the term ‘company in which public are substantially interested’ as a company whose shares are listed on a recognized stock exchange in India or a subsidiary or sub-subsidiary of such a company. Of course, it has to be ensured that the status of subsidiary and sub subsidiary should be maintained for the whole of the previous year.

Earlier, the provisions of the section did not apply to issuance of shares to non-resident shareholders. However, through an amendment which was brought about vide FA, 2023, the provisions of the section would now also apply to issue of shares made to non-residents. Thus, the exemption which was earlier available to non-resident investor has now been taken away. Further, if shares are issued to a venture capital fund or company or to entities notified by Central Government, then the provisions of this section would not apply to premium charged on such issue. This is a recipient specific exemption available u/s. 56(2)(viib).

Notification No. 29/2023 dated 24th May, 2023

Recently, the CBDT has notified the following entities as exempt entities under the first proviso to S. 56(2)(viib):

i. Government and Government related investors such as central banks, sovereign wealth funds, international or multilateral organizations or agencies including entities controlled by the Government or where direct or indirect ownership of the Government is seventy-five percent or more;

ii. Banks or Entities involved in Insurance Business where such entity is subject to applicable regulations in the country where it is established or incorporated or is a resident;

iii. Any of the following entities, which is a resident of any country or specified territory listed in Annexure (refer table of countries below), and such entity is subject to applicable regulations in the country where it is established or incorporated or is a resident:

a) entities registered with SEBI as Category-I Foreign Portfolio Investors;

b) endowment funds associated with a university, hospitals, or charities;

c) pension funds created or established under the law of the foreign country or specified territory;

d) Broad Based Pooled Investment Vehicle or fund where the number of investors in such vehicle or fund is more than fifty and such fund is not a hedge fund or a fund which employs diverse or complex trading strategies.

The name of countries that are notified are:

Our Comments

Investment from other preferred investment jurisdiction such as Mauritius, Singapore, Netherlands, UAE, etc. are not listed in the exemption category. It may be noted that majority of the investments flow into India through these preferred jurisdictions. Inclusion of these jurisdictions could have diluted the effect of withdrawal of exemption to investments made by non-residents.

Some, important amendments have also been made in the rules prescribed under this section. Rule 11UA(2) of the IT Rules prescribed under this section has been amended to include within the pricing guidelines, the price at which shares are subsequent issuance of shares that is done within 90 days of such qualified issue, could be pegged to the price of such issue. This exemption, however, comes with a caveat that the amount of funds raised from the subsequent issue should not be higher than the qualified issue to exempt entities. This could be seen to address the mischief that could be created if the subsequent issue was far higher than the initial issue to exempt entities, thereby using the earlier issue only to set a higher benchmark. It may be noted that the issue of shares to non-residents could be benchmarked under additional approaches to valuation, viz. comparable companies’ multiples (“CCM”) approach, probability weighted expected return approach, milestone analysis method, option pricing method,  and replacement cost approach. This could be seen as a bridge between the provisions of the FEMA and the IT Act. The former has, since many years, required issue of shares to be at a price not lower than the value determined as per internationally accepted valuation methods, which inter alia includes methods such as CCM, Discounted Cash Flow (“DCF”), replacement cost etc. Prior to the amendment in the IT Rules, if the value of shares issued to non-resident as determined under DCF approach was lower than the CCM approach and if the issue was commercially agreed to be at CCM based value, which is aligned with FEMA Regulations, the issuer was required to pay tax on the excessive premium charged. This would happen as the DCF value would have justified a lower premium than the premium justified under the CCM approach. It is a welcome move to align provisions under FEMA and the IT Act, especially since now S. 56(2)(viib) covers even cases of issue of shares to non-resident investors.

It may be noted that there may be many instances when DCF approach may not be found appropriate for a particular business, in which case, even if shares are issued to a resident, it may be preferable to value them using other approaches. However, the other approaches that are available to non-resident shareholders are not available to resident shareholders. It needs to be understood as to why should the methods of valuation be different for a resident and non-resident.

Another important amendment is brought about by offering safe harbour for issue which is at 10% premium to the fair value determined. This implies that if the issue took place at a price higher than fair value by 10%, the excess would not be brought to tax under the provisions of this section.

One more ancillary amendment is to consider the date of valuation as the date of the report of the merchant banker if the same is not older than 90 days from the date of the issue.

Besides the above, the originally prescribed method of determination of value using the book value of assets and liabilities remains unchanged. The assessee could also determine the value basis the underlying values of tangible and intangible assets.