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Share subscription above fair market value would be subject to angel tax

The Bombay High Court has recently allowed a writ, challenging a reassessment notice served on the Assessee (by the income tax department) for FY11-12 on share premium issued by it. The assessing officer, however, failed to come up with any reasonable grounds that led him to believe that income had escaped assessment during the relevant FY. 

Section 56(2)(viib) was introduced into the (Indian) Income Tax Act, 1961 (“IT Act”) as an anti-abuse provision with effect from FY12-13, according to which, if a company issues shares at a value higher than its fair market value, then it will have to pay tax (angel tax) on such incremental value. Rule 11UA of the (Indian) Income Tax Rules, 1962 (“IT Rules”) provides mechanism for computing fair market value.

In the instant case, SLS Energy Private Limited[1] (“Assessee”) had raised INR 6.8 billion by issuing 6.8 million preference shares, with a face value of INR 1, at a premium of INR 999 per share during FY 2011-12. After reviewing the balance sheet, the tax authorities felt that the Assessee did not deserve a premium of INR 999 per share since it had not undertaken any business activity, except lending some money within its group companies. Accordingly, the tax authorities issued notice under Section 148 of the IT Act to reopen assessment proceedings for FY11-12.

The Assessee filed its objections after being provided with a copy of the reasons recorded by the tax authorities. However, these objections were rejected. Then, the Assessee filed a writ petition before the Hon’ble Bombay High Court (“HC”), challenging the show-cause notice issued by the tax authorities. The Assessee’s plea was that it was incorporated for the purpose of generation and distribution of electricity and accordingly it had entered into a memorandum of understanding with the Government of Madhya Pradesh for setting up a 1320 MW Thermal Power Project. It also claimed that it had raised funds by issuing preference shares at a premium for undertaking the said project with the Government of Madhya Pradesh.

After having heard the arguments, the HC decided the writ in favour of the Assessee, by holding that for reopening a tax assessment, tax authorities should have ‘reason to believe’ that income had escaped assessment and that the said reasons should have been formed on the basis of credible evidence available at their disposal. The Court also took into account the fact that the shares were issued in FY09-10 and Section 56(2)(viib) was introduced into the IT Act with effect from FY12-13. Therefore, since the transaction in question had taken place before the introduction of Section 56(2)(viib), the consideration allegedly received in excess of the fair market value cannot be taxed.

The HC also relied on its earlier decision in Vodafone Services India Pvt. Ltd.[2], wherein it had held that any money received as share application money is a capital transaction, which does not give rise to any income.

The tax authorities tried to raise an alternative ground that the instant income should be taxed as undisclosed income under Section 68 of the IT Act. However, the HC held that the relevant changes to Section 68 through the introduction of a new proviso became effective from April 1, 2012 and not during the relevant period i.e. FY 2010-11 and since the shares were allotted prior to the relevant amendment becoming effective, tax authorities cannot pursue their case.

It may be noted that Section 68 and Section 56(2) were inserted into the IT Act through Budget 2012. The Memorandum to the Finance Bill, 2012 placed both these amendments under the same heading i.e. ‘Measures to Prevent Generation and Circulation of Unaccounted Money’. Under Section 68, the entire amount received by the taxpayer could be taxed if the transaction is held to be ingenuine; whereas under Section 56(2)(viib), the consideration received for issuance of shares in excess of their fair market value could be subject to tax in the hands of the issuer.

This is an important decision which further reiterates that tax authorities should not unnecessarily disturb capital transactions, especially by raising such issues during the reassessment stage. The HC has also reconfirmed that tax authorities should carefully examine relevant provisions and their applicability during a particular time period before invoking them. It also stressed on the finality of the Vodafone decision regarding the capital nature of the share application money. These aspects are important even from the point of view of future applicability even though some of them may have been diluted through subsequent amendments.

Corporate entities must carefully examine the tax implications and take a holistic view on Section 68 and Section 56(2)(viib) of the IT Act while raising funds.

[1]SLS Energy Pvt Ltd v. ITO [TS-359-HC-2023(BOM)]

[2]Vodafone India Services P. Ltd. v. Union of India (2014) ITR 1 (Bom)