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NASSCOM’s Policy Brief on CBDT Circular No 03/2019

NASSCOM Policy Brief

28.01.2019

CBDT Circular No. 03/2019 dated January 21, 2019

Taxation of income where a private company or a firm receives shares of a private company from a person for no or inadequate consideration

Section 56(2)(viia) of Income Tax Act 1961

Central Board of Direct Taxes (‘CBDT’), vide issue of Circular 03/2019 dated January 21, 2019, has reversed the clarification issued on December 31, 2018 which stated that  S. 56(2)(viia) of the Income-tax Act, 1961 (‘Act’) will not apply to cases pertaining to receipt of fresh issue of shares of a closely held company by a firm or a closely held company.[1]

S. 56(2)(viia) is an anti-abuse provision and seeks to levy tax on transactions involving transfer of shares which are concluded without consideration or at a consideration less than their fair market value (‘FMV’). A transfer below FMV is liable to be taxed in the hands of recipient(s) of the shares.

Chronology of events

  1. Finance Act 2010: Clause (viia) was inserted in S. 56 vide Finance Act 2010. The Memorandum explaining the provisions of Finance Bill 2010 provides the legislative intent: “….In order to prevent the practice of transferring unlisted shares at prices much below their Fair Market Value (FMV), it is proposed to amend section 56 to also include within its ambit transactions undertaken in shares of a company (not being a company in which public are substantially interested) either for inadequate consideration or without consideration where the recipient is a firm or a company ( not being a company in which public are substantially interested)……….” From a plain reading of the section and the memorandum, it has been interpreted that S. 56(2)(viia) is applicable only when shares are purchased from the market and is not applicable when a company allots the shares or issues fresh shares.
  2. CBDT Circular 08/2018 dated December 31, 2018: To clarify its position, CBDT released this circular stating that shares received by a private company from any person as a result of fresh issue of shares (including by way of bonus shares, rights issue and preference shares) shall be out of the purview of S. 56(2)(viia) and hence, will not be taxable. The section will only apply in case of transfer of shares for no or inadequate consideration. The views typically taken by the companies and investors align with the Circular dated 31 December 2018 and the Explanatory Memorandum to the Finance Act 2010 which had explained that the intention of the provisions were to prevent ‘transfer’ of shares at value below the FMV. This clarification would have brought relief to investors had it not been withdrawn by a subsequent circular.
  3. CBDT Circular No. 02/2019 dated January 04, 2019: CBDT withdrew the above circular through this circular on the ground that interpretation of the term “receives” used in S. 56(2)(viia) of the Act is sub-judice in certain higher judicial forums. Hence, CBDT decided that the matter required a fresh examination.
  4. CBDT Circular No. 03/ 2019 dated January 21, 2019: This circular states that a comprehensive review of interpretation of the term “receives” has been made. Based on this, CBDT has now clarified that the view taken earlier in Circular 10/ 2018 is not correct and hence shall not be considered by Income Tax Authority in any proceedings. This means that the section would apply to cases pertaining to fresh issue of shares for “no” or “inadequate” consideration.

Analysis

The circular has been issued under S. 56(2)(viia) of the Act which was applicable till 31st March 2017. For periods, on or after, April 1, 2017, the said matter is dealt under S. 56(2)(x) of the Act which was introduced vide Finance Act 2017 (applicable w.e.f 1 April 2017). Section 56(2)(x) is an all-encompassing provision which applies to all persons and not only to closely held companies and partnership firms.[2]

Transactions during April 1, 2010 – March 31, 2017: The effect of the circular dated January 21, 2019 is that fresh issue of shares including issue of preference shares on or after April 1, 2010 and before April 1, 2017 are covered under S. 56(2)(viia).  The position taken by CBDT appears to be contrary to the intent of this provision which was introduced to check tax avoidance in transfer of shares. Including fresh issues of shares within its ambit introduces tax liability for investors if they are not able to satisfy the tax department that the investment is for adequate consideration. Issue of bonus shares are expected to be out of the scope of S. 56(2)(viia) as it has been decided by Tribunal that issue of bonus shares does not come within the ambit of S. 56(2)(viia) of the Act.[3]

Transactions on or after  April 1, 2017: No such clarification has been made under S. 56(2)(x) of the Act which also uses the expression “receives” in a similar manner as S. 56(2)(viia). Therefore, it is open to interpretation whether fresh issue of shares on or after April 1, 2017 can be taxed in the hands of recipient on the ground that they have been issued for no or inadequate consideration.

The tax uncertainty continues for fresh issue of shares by closely held companies. Unless the tax department is satisfied, the transaction will be liable to be taxed in the hands of the:

  1. Investor(s) if the price is below the FMV [S. 56(2)(viia) or S. 56(2)(x)], and
  2. Company if the price is above the FMV [S. 56(2)(viib), commonly known as the Angel Tax][4]

We are studying the matter in detail. For further discussion kindly contact Ms. Tejasvi Gupta, Manager, Public Policy at Tejasvi@nasscom.in

Disclaimer: The policy brief is a preliminary understanding of NASSCOM’s policy team and may not reflect NASSCOM’s stand on an issue. The policy brief is not intended to be a legal advice or opinion. Readers are requested to consult a tax practitioner for the same.

[1] Closely held company as defined in S.2(18) of the Act

[2] Finance Act 2017 had replaced S. 56(2)(viia) with S.56(2)(x) and expanded the scope to cover all types of assesses and include certain transfers which not regarded as transfer under S.47 of the Act (Explanatory Memorandum, 2017).

[3] Tribunal in the case of Rajan Pai – TS-299-ITAT-2016 (Bang) held that issue of bonus shares is not taxable in the hands of the taxpayer, although the same was received without consideration.

[4] NASSCOM’s policy brief on latest developments on Angel Tax: https://community.nasscom.in/communities/policy-advocacy/government-eases-conditions-to-avail-safe-harbour-from-angel-tax.html

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