Section 56(2)(viib) not applicable where the company had only closely related shareholders

By virtue of section 56(2)(viib) of the Act, where a company (not being a company in which the public are substantially interested) receives from any resident person any consideration for issue of shares which exceeds the face value of such shares then the difference between the aggregate consideration received for such shares as exceeds the fair market value of the shares shall be deemed to be the income of the concerned company. Such difference will be chargeable to tax as “Income from Other Source”.

Chennai Bench of the Income Tax Appellate Tribunal (ITAT) in the case of Vaani Estates Pvt Ltd,ITA No. 1352/Chny/2018 dated 27 August, 2018 has made an interesting finding about taxation u/s 56(2)(viib).

The facts of the case were as under:

–          Assessee was engaged in the real estate business and had two shareholders – mother and daughter each holding 50% stake in the company.

–          Later on, mother acquired additional 10,100  shares of the Assessee company at a premium.  

–          The revised shareholding in the Assessee company becomes 75% and 25% by mother and daughter respectively.

–          Assessee used the fund for purchasing land.

–           On assessment, Assessing Officer made additions under the provisions of section 56(2)(viib) of the Act.

–          CIT (A) upheld the AO’s order.

–          Taxpayer’s pleased on following grounds:
a] Section 56(2)(viib) was introduced to deter the generation and use of unaccounted money through infusion of funds from unconnected persons or shareholders at a substantial premium which ultimately confers the benefit to existing shareholders by enhancing the value of their shareholding.  
b]The fair market value of the Assessee  after acquisition of land was equal to FMV computed in accordance with section 56(2)(viib) of the Act. 
c]  Even if the introduction of funds at a very high premium had benefitted mother, the transaction would not be subject to tax in view of the relative exemption granted under section 56(2)(x) of the Act.

Revenue’s submission was as under:

a]  Section 56(2)(viib) of the Act is very clear and absolute in its wording and does not provide for any exemptions other than the ones specifically provided. 
b] Section 56(2)(viib) provides a specific & clear cut mechanism to determine the FMV.  
c] In addition, the exclusion of “relatives” from the liability of taxation is provided only under sections 56(2)(v), 56(2)(vi) and 56(2)(vii) of the Act, and not under 56(2)(viib) of the Act.
d]  FMV arrived at by the taxpayer was subsequent to the receipt of share application money and acquisition of land and so it could not be considered for the purpose of section 56(2)(viib) of the Act. 
e] Considering the mechanism prescribed, the capital infusion by mother is subject to tax u/s 56(2)(viib) of the Act.

Chennai  Tribunal’s observation could be summarized as under:

A]  Section 56(2)(viib) is a deeming fiction introduced to curb the generation and use of unaccounted money. 
B] Source of investment of mother  was genuine and is undisputed.
C] Legal fictions should be carried to their logical conclusion within the framework of the purpose for which it is created. 
D] In case of the taxpayer, the corporate veil is required to be lifted and thereafter the transaction has to be viewed in light of relevant provisions.
E] On lifting of the corporate veil, it is well evident that a benefit of approximately 25% (revised shareholding) arose to the daughter due to infusion by her mother who is a prescribed relatives u/s 56(2)(vii).
F] Current infusion would not benefit the other shareholders inducted in future as the subsequent shares have to be allotted on the basis of its intrinsic value computed based on the mechanism provided under section 56(2)(viib) of the Act.

G] Harmonious reading of section 56(2)(vi), (vii) & (x) of the Act coupled with the logic, purpose & intention behind introduction of section 56(2)(viib) of the Act and lifting the corporate veil, it is very well clear that the provisions of section 56(2)(viib) of the Act is not attracted in the instant case.

H] Tribunal deleted the addition done under section 56(2)(viib) of the Act.

Author’s View:

To some extent, it may provide a legal ground for some companies who are in the process of restructuring group companies with family shareholders (i.e., relatives covered u/s 56(2)(x) of the Income Tax Act-1961).  However, any planning by relying on the above judgement may not be appropriate or proper. 

Recently Kerala High Court (HC) [WA No. 1297 of 2018 in WP (C) No. 3485/ 2018] has held that whether the amount received by the taxpayer in the form of share premium has been correctly offered to tax is an issue to be examined with reference to section 56(2)(viib) of the Income-tax Act, 1961. If it is found that the share premium has not been correctly offered to tax as provided therein, the taxpayer has to be assessed in accordance with the said provision.