When a Company raises money from an external investor, usually they attribute a higher value to the company’s shares when allotting the deserving stake to the investors. Quite a few companies in our clientele have had inquiries from the Income Tax Department in the last three years when they have issued shares at premium to investors. There is nothing wrong in this practice though the IT is trying to go after such cases because there is a provision in the IT Act that allows them do so. However, there are some legally provided exceptions and this post intends to just state them with relevant background.

Section 56(2)(viib) of IT Act – where a company receives investment from any person being a resident, any consideration for issue of shares that exceeds the face value as well as fair market value (FMV) of such shares, the excess over and above such FMV shall be counted as the Income of the company and company shall be liable to pay tax on the same as applicable.

Suppose the Company raises Rs. 10 Cr at a valuation of Rs. 40 Cr., definitely the shares will be allotted to the investors at a price above their respective par value which could be Re.1 per share or Rs.10 or Rs. 100 per share or whatever the amount be. At this juncture the onus is on the Company to ensure that the ‘price per share’ at which they have allotted the shares to the incoming investor(s) are at a price that is lower or equivalent to the FMV. Suppose the FMV is Rs. 50,000 and shares have been allotted at Rs. 50,000 per share so that the valuation comes to Rs. 40 Cr at an aggregate enterprise level.

In such a case, there shall be ZERO income. However for some reason, the FMV was certified at only Rs. 10,000 as against Rs. 50,000. Then Rs. 40,000 per share would be the tax. This when multiplied by number of shares issued and allotted may come to an astronomical number of Rs. 4 Cr. In such a case, the Company will be obliged to pay tax @ 30% on 4 Cr – ie Rs. 1.2 Cr.

The following are the 3 specific circumstances where the above tax shall not be payable:

• Where investment has been received from a NON RESIDENT investor regardless of the quantum of the premium – it wont be subject to taxation under this provision
• Where the FMV of the shares of the company has been greater or equal to the price at which the investor has been allotted shares, there is no tax payable. However, Companies Act does not permit allotment at a price below the Fair value.
• The capital has been received from a SEBI registered Fund (Onshore or offshore). There are some Terms and conditions to be complied by the Fund here to ensure that the company in which they invest can get the benefit of this exemptions.
• Where the receiving entity is a registered Start up (Subject to certain conditions).

This means where companies that have taken capital from non resident investors (non resident as defined under Income Tax law) or raised it from a SEBI registered fund or the investment from their domestic investors is at a price lower than or equal to certified FMV are out of scope of this tax, If investment is coming into a Company from parties other than the above (i.e. from Indian residents including corporates, individuals or firms), a valuation report should ideally help justify the FMV of the Company.

What constitutes FMV or the method of arriving at FMV is not prescribed in great detail. Per se, the intent of the law is to ensure that unscrupulous money invested to siphon taxes. The spirit of the law should ideally be counted as well adhered to if a Company gets the valuation report from a Registered Valuer / Merchant Banker using appropriate method along with a note that details out the assumptions made to arrive at the value along with a rationale for the assumptions.

In case of a few companies,Tax department has been reaching out and attempting to tax or taxing companies for this premium. If companies are covered by the above exemption, the tax department shouldn’t go after and tax these share premiums. The advisors of the companies should be able to represent the case in the light of the above. There will hardly be a case where inspite the above exemptions are applicable, the assessing officer will win the case against the company.

Besides, there are also instances where the tax officers are challenging the valuation report. The rationale behind the same is – the certified valuation report is not realistic. It is interesting to note why they are doing that. Valuation reports are drawn up on the basis of projections of next 4-6 years. The assessments of Income Tax happen sometimes 2 years after the end of the year and if the Scrutiny is going on, 3-4 years post the end of the year. By then the company would have actual data of the projections for the period for which earlier projections were drawn. In most Companies (including some that are doing well), the revenue numbers are off and therefore even profits are far away. There are genuine reasons for the same but the officer is reluctant to accept or acknowledge these. He therefore ends up challenging the valuation report’s authenticity and sets aside the report.

There are a few cases where inspite of applicable exemptions and representations the same have been attempted to be taxed and orders have been passed refusing the exemption. On top of it, there have also been a freak case or two where penal proceedings have been carried out saying that the amount has been withheld by the company to circumvent tax. These type of cases may win at the appellate levels and even CIT (Commissioner of Income Tax) levels if company and its advisors are convinced that they have complied with all of their obligations under the law.

So, the Companies have to take this very seriously and the competent advise considering the provisions of Companies Act, Income Tax Act and of course valuation, at the time of planning investments itself is essential.