The Union Budget 2016 is the second full budget of the existing government and there seems to be 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 (the Act) that require a closer consideration and an appropriate resolution for the taxpayer. One such example is that of Section 56 of the Act, which includes transactions for an inadequate consideration/deemed gift.
Section 56(2) (vii) of the Act taxes any property received without consideration/for inadequate consideration by an individual or a Hindu Undivided Family (HUF). Section 56(2) (viia) of the Act extends the coverage of these provisions to closely-held companies. However, it is limited only to receipt of shares of a closely-held company.
Further, Section 56(2) (viib) of the Act 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.
Some of the inconsistences/interpretation issues in the Section are as follows:
Receipt of shares vs transfer of shares
Section 56(2) (viia) of the Act was introduced to prevent transfer of unlisted shares below their FMV. However, the Section 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 (e.g. preferential issue, rights issue, , etc.)
Considering the intent as provided in the memorandum and the words used in the Section 56(2)(viia) of the Act, it can be said that only the receipt of shares which is pursuant to a transfer of shares should be taxable. Allotment of shares indicates creation of a capital asset only and such creation does not amount to transfer, therefore, fresh issue of shares should not be taxable u/s 56(2)(viia) of the Act.
Further, 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 u/s 56(2)(viia) of the Act are transferred, then for the purpose of computation of capital gains on future sale of such shares, the FMV of such shares is considered to be their cost of acquisition. Considering this, it can be inferred that the shares taxed u/s 56(2) (viia) of the Act have to be kept alive and not cancelled/extinguished. Hence, Section 56(2)(viia) of the Act should not apply to buy-back of shares/capital reduction, in particular when such shares are extinguished/cancelled.
Deterrent for restructurings involving mergers, demergers, etc.
The intention behind introduction of Section 56(2) (viib) of the Act was to restrict black money circulation through fund infusion in companies at a substantially high premium. However, the Section may possibly be triggered in case of mergers/demergers as well. Even though mergers/demergers have been excluded from the applicability of Section 56(2) (viia) of the Act, a similar exclusion/exemption is not available under Section 56(2) (viib) of the Act.
Therefore, while structuring any business reorganization/merger/demerger, it is important to consider the implications under these provisions in order to provide consistency in terms of tax neutrality through-out the Act.
Gift given by a HUF to its members
Gift received by a HUF from its members is not taxable. However, there is no specific exemption for gift given by a HUF to its members, even though all such members qualify under the ‘relative’ definition provided under the Act.
As per various judicial precedents, a 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 received 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) (viib) of the Act would include both cash and non-cash considerations. However, 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 addresses these issues and provides clarifications/explanations with respect to various provisions of Section 56(2) of the Act.
By Prashant Kapoor
(The author is Partner, Tax, KPMG in India; with inputs from Namita Gupta, Associate Director, Tax; The views and opinions expressed herein are those of the authors and do not necessarily represent the views and opinions of KPMG in India)