The issue of shares by a company and its subscription by a shareholder is ordinarily on capital account, from the perspective of the company as well as the shareholder. No income can arise on issuance of shares by a company.
This principle was relied upon by a few denigrates to launder ill-gotten monies into formal commerce. To avoid this, the Legislature sought to treat monies received by a company on issuance of its shares, as resulting in income in the hands of the company.
Separately, tax on gift received was abolished in 1998. The tax was partly reintroduced by the Finance Act, 2004 in clause (v) of Section 56(2) of the Income Tax Act, 1961. This section sought to tax receipt of money by an individual or Hindu undivided family, without consideration. The object of the new section was stated to curb bogus capital-building and money laundering. By Finance Act, 2009, the ambit of taxation was expanded from just receipt of money to receipt of any property (including shares). The provision was modified from time to time and Legislated as Section 56(2)(x) by the Finance Act, 2017 with effect from 1 April 2017. The said section applies when any person receives, in any previous year, any property, either without consideration or for inadequate consideration, provided that (i) if without consideration, the Fair Market Value (‘FMV’) of such property is more than INR 50,000; and (ii) if with inadequate consideration, the difference between the FMV and actual consideration is more than INR 50,000. In such a scenario, the entire amount of FMV, if without consideration, and the entire differential amount (FMV Minus consideration paid) would be added to the income of the recipient of the property under Section 56(2)(x). The phrase ‘fair market value’ has been defined to mean the value as determined in accordance with Rule 11U and Rule 11UA of the Income-tax Rules, 1962 (‘IT Rules’).
‘Person’ includes all the types as provided under the Act, be it individual, company, firm, etc. ‘Property’ amongst other things, includes ‘shares and securities’, which form part of the Capital Asset of the recipient.
In this article, we will examine as to whether, in case of fresh issuance or allotment of shares, be it Equity Shares or Preference Shares, Section 56(2)(x) would apply in the hands of the person to whom such shares are issued/allotted if the shares are issued for consideration less than the FMV.
As stated above, the wordings of 56(2)(x) of the IT Act are very broad and they create a deeming fiction whereby if any person receives any property from any other person, for a consideration less than fair market value of the property, shall be deemed to have taxable income from the transaction. The deeming fiction created is a departure from the common understanding of the meaning of the word ‘income’. Hence, for any reason, if the transaction does not fall within the strict wordings of the deeming fiction, the fiction would not be attracted.
Rule 11U, read with Rule 11UA of the IT Rules provides for determination of fair market value for various situations and purposes.
In our view, Section 56(2)(x) would not be attracted in the hands of the person to whom such shares are issued/allotted if the shares are issued for consideration less than the FMV due to following reasons.
Firstly, Section 56(2)(x) of the IT Act brings to tax, receipt of property by any person ‘from any other person’. Therefore, to fall within the ambit of taxation under this section, the property should be ‘received from any person’. A property can be received from any person, only if the other person from whom the property is received, holds the property before conveying it further. It is a well-settled principle that, in case of issue of shares, the shares come into existence for the first time only when they are allotted to the shareholders. An issue of shares is the creation of the property for the first time. When the shares are allotted to the shareholders, such allotment would not amount to receipt of property ‘from another person’.
Secondly, the Section is an anti-abuse provision, inserted after abolition of Gift Tax Act, was introduced to prevent laundering of unaccounted monies. The anti-abuse provision therefore will not apply to genuine issue of shares to shareholders. Thus, if due to justifiable commercial reason, the issue of shares is done at a price less than fair market value of those shares, there is no abuse of the provisions of law, and hence the section 56(2)(x) would clearly not apply.
Thirdly, no tax can be levied on the shareholders for exercising their option under the contract. When laws are made by representatives of people, it can be presumed that the law maker had in mind what the society considers honest, fair and reasonable. The Legislature could not have intended to tax a person for performing his obligations under a contract. By no degree of fairness and justice, where there is clearly no understatement of consideration in respect of the transfer and the transaction is perfectly honest and bona fide and, in fulfilment of a contractual obligation, the shareholders should be liable to pay tax on gains which have not accrued or arisen to them.
The issue discussed hereinabove, though having significant commercial implication, has not been subject to much judicial interpretation. While the Karnataka High Court has held that fresh issue of shares would not be regarded as ‘receipt’ of property as contemplated in the Section, the Income-tax Tribunal has taken a contrary view. The order of the Tribunal is under challenge before the Bombay High Court. In any case, for the detailed reasons discussed in the earlier paragraphs, fresh issue of shares by a company, either under a right issue or preferential allotment, should not be subject to tax in the hands of the shareholder under Section 56(2)(x) of the Income Tax Act.
[The authors are Partner and Principal Associate, respectively, in Direct Tax Team at Lakshmikumaran and Sridharan Attorneys, Mumbai]
