From Union Budget FY17, there are a lot of expectations on seeking clarity on multiple tax issues and introduction of various tax incentives/reforms for start-ups in line with the Make-in-India initiative. There are several inconsistencies/interpretation issues under the Income-tax Act, 1961, which require a closer consideration and an appropriate resolution for the taxpayer. One such is Section 56 of the Act, which includes transactions for an inadequate consideration/deemed gift.
Section 56(2)(vii) taxes any property received without consideration/for inadequate consideration by an individual or a Hindu Undivided Family (HUF). Section 56(2)(vii-a) extends the coverage of these provisions to closely-held companies. However, it is limited only to receipt of shares of a closely-held company. Section 56(2)(vii-b) provides that where a closely-held company receives from a resident any consideration for issue of shares that exceeds the face value of such shares, the difference between the consideration and the Fair Market Value (FMV) of such shares shall be taxable in the hands of the issuing company.
There are many inconsistences or interpretation issues in the Section.
Receipt of shares versus transfer of shares: Section 56(2)(vii-a) was introduced to prevent transfer of unlisted shares below their FMV. However, it uses the words ‘receipt of shares’ instead of ‘transfer of shares’, which has a much wider connotation, and on a strict interpretation may include even the fresh issue of shares (preferential issue, rights issue, etc.)
Considering the intent as provided in the memorandum and the words used in Section 56(2)(vii-a), it can be said that only the receipt of shares which is pursuant to transfer of shares should be taxable. Allotment of shares indicates creation of a capital asset only and such creation does not amount to transfer, thus fresh issue of shares should not be taxable under Section 56(2)(vii-a). There is ambiguity whether this provision can be applicable on share buy-back or capital reduction. When the shares which have been subject matter of tax under Section 56(2)(vii-a) are transferred, then for the purpose of computation of capital gains on future sale of such shares, their FMV is considered to be their cost of acquisition. It can be inferred that the shares taxed under Section 56(2)(vii-a) have to be kept alive and not cancelled/extinguished. Hence, Section 56(2)(vii-a) should not apply to buy-back of shares/capital reduction, when such shares are extinguished/cancelled.
Deterrent for restructuring involving mergers, demergers: The intention behind introducing Section 56(2)(vii-b) was to restrict black money circulation through fund infusion in companies at a substantially high premium. But the Section may be triggered in case of mergers/demergers as well. Even though mergers/demergers have been excluded from the applicability of Section 56(2)(vii-a), a similar exclusion/exemption is not available under Section 56(2)(vii-b).
So, while structuring any business reorganisation or merger/demerger, it is important to consider the implications under these provisions, to provide consistency in terms of tax neutrality throughout the Act.
Gift given by an HUF to its members: Gift received by an HUF from its members is not taxable. However, there is no specific exemption for gift given by an HUF to its members, even though such members qualify under the ‘relative’ definition provided under the Act.
As per judicial precedents, an HUF is a ‘group of relatives’ as it consists of persons lineally descended from a common ancestor, who are covered within the definition of a ‘relative’. Thus, a gift received by a member from its HUF is a gift from a relative and should not be considered as taxation in case of a non-cash consideration.
The term ‘any consideration’ used in Section 56(2)(vii-b) would include both cash and non-cash considerations. But the method for valuation of such non-cash consideration is not specified. Only once the clarification is provided in this direction, can the Section have meaningful application.
We hope that the upcoming Budget provides clarifications/explanations with respect to various provisions of Section 56(2).
(With inputs from Namita Gupta, associate director, Tax)
The author is partner, Tax, KPMG in India. Views are personal