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Tax on Share Premium- Its Impact on Angel Investment

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  1. Introduction:

All new companies at their initial stage require funds. Usually, start-up companies with promising future receive angel or venture capital investment at their initial stage. Typically, venture capital investment is preceded by angel investment, which is made by non-institutional high networth investors or professional angel investors, who rely on the future prospects of the company.  Given that start-up companies are thinly capitalised, such investment is typically made at a significant premium.

Starting from assessment year 1 April 2013, under Section 56(viib) of the Income Tax Act (“Act”) if a company issues shares at a price more than the face value of the shares, then the aggregate consideration received over and above the fair market value of shares will be subject to income tax. In other words such aggregate consideration which exceeds the fair market value of shares will be taxed.

  1. Section 56(viib):

As per Section 56(viib) of the Act (inserted by Finance Act, 2012) if:

  1. a company receives consideration for issue of shares from a resident, which exceeds the face value of shares,
  2. then the aggregate consideration which exceeds the fair market value of the shares will be subject to tax as income from other sources under the Act, at the rate of 30.90%. However if the income of the company is more than Rs. 1 Crore, then the income tax will be levied at 32.45%.

2.1       Exemption:

Tax under Section 56(viib) will not be levied if:

(a)         the consideration for issue of shares is received by the company from a non-resident; or

(b)         the consideration for issue of shares is received by a venture capital undertaking (an unlisted company engaged in the business of providing services, production or manufacture of articles or things. Provided that, the company is not engaged in the activity of non-banking financial activity, gold financing and such other activities which are not permitted under industrial policy of Government of India) from any of the following:

  • Securities and Exchange Board of India (“SEBI”) registered venture capital company; or
  • SEBI registered venture capital fund; or
  • Venture capital fund operating under a trust deed registered under Registration Act, 1908; or
  • Venture capital fund operating as a venture capital scheme made by Unit Trust of India.
  1. Fair market value of shares as per Section 56(viib):

Section 56(viib) levies tax on aggregate consideration which is in excess of fair market value of shares. As per Section 56(viib) the fair market value of the shares is higher of the value:

  1. as may be determined in accordance with such method as may be prescribed; (as of now the Government has not prescribed any method in this regard. However, Rule 11UA of the Income Tax Rules, 1962 (“Rules”) provides a method for calculating fair market value of shares and was enacted for the purposes of Section 56 of the Act. It is not certain if Rule 11UA will apply for the purposes of Section 56(viib). However, for the purposes of this note, we will rely on Rule 11UA, because at present this is the only government prescribed method,); or
  2. substantiated by the company to the satisfaction of the Assessing Officer, based on the value, on the date of issue of shares, of its assets, including intangible assets being goodwill, know-how, patents, copyrights, trademarks, licences, franchises or any other business or commercial rights of similar nature,

3.1       Point (a):

Under Rule 11 UA(C)(b) of the Rules, a formula is prescribed to determine fair market value of equity shares. This formula is based on the values of assets and liabilities that exist in the balance sheet and does not take into consideration the future prospects/earnings of the company. Therefore, if the company chooses to determine fair market value of equity shares as per Rule 11UA(C)(b), the company cannot rely on any variables, reports, projections and future earnings/prospects of the company. (This is under the assumption that no separate rules will be framed for Section 56(viib) and Rules 11U and UA will apply to 56(viib) as well.)

3.2       Point (b):

Even if the company chooses to substantiate the fair market value of the equity shares to the assessing officer as per point (b) above, the company will have to rely only on the value of assets that exist as on the date of issue of shares. Hence, the company cannot rely on its future earnings/prospects.

Both the aforementioned methods are historical and rely on net assets of the company in the case of (a) and total assets of the company in case of (b).  It is to be noted that in the initial stages no company has much assets and therefore the fair market value of equity shares as determined by point (a) or (b) will not reflect the real value which the company will have in its future.

  1. Fair market value of shares as per investors:

The investment is made by investors keeping in mind long terms prospects of the company. The investors determine value of the shares of a company depending on its future prospects/earnings. The investors evaluate future prospects/earnings of the company either on the basis of the business plan of the company or merely because of the faith in the management of the company. The valuation method under Section 56(viib) does not take into consideration the future earnings/prospects of the company.

To value its shares the companies rely on methodologies such as discounted cash flow, dividend discount method or maintainable profits method.  These methods give due credit to the future cash, dividend and earnings of the company. Since the investment is for a long term and even reliance on other historical bases such as previously concluded transactions for the same shares are not permitted.

  1. Tax on paid up share capital

It is to be noted that as per Section 56(viib) the “aggregate consideration” which exceeds the fair market value of the shares will be subject to tax. The section results in situation where tax will be levied if the fair market value is less than the face value of the shares.

Consider a company issues shares of face value of Rs. 100 at Rs. 110. The fair market value of the shares for the purposes of Section 56(viib) is determined at Rs. 90. Under Section 56(viib) the company will be liable to pay tax on Rs. 20, which consist of not only the premium but of share capital of the company as well.

This issue is more pertinent to the start-up companies which generally do not have substantial assets. For a start-up company Section 56(viib) may result in a situation where the company will be liable to pay tax not only on the premium received by it, but also on the amount contributed towards paid up capital of the company.

  1. Impact on domestic investments

 

The 2G scam had triggered need for section 56(viib). As per Central Bureau of Investigation (“CBI”) in 2G scam the bribe was paid to politicians through subscribing shares of their companies at heavy premiums. However, Section 56(viib) strikes hard at the genuine transactions, wherein the companies whose shares are worth being sold at premium are also subjected to tax.

The funds are to be utilised for the growth of business of the company. Levying a tax of 30% on the investment increases cost of the investment, both in terms of time and money. The time period in which investors can realise their investments increases. The rate of return which the company could provide investors decreases, thereby making domestic investments less attractive for the resident investors.

In order to protect genuine transactions and prevent abuse of payment of share premium, the government should prescribe such methods for calculating fair market value of shares which take into account future earnings and potential of the company.

Kushal Gupta [kushal.gupta@pxvlaw.com]

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