Treatment of Shares Premium received by closely held company on issue of shares

Introduction

Before understanding the tax treatment of premium received by closely held company on issue of shares under section 56(2)(viib) of Income Tax Act, 1967 lets discuss the problem before introduction of this section with the help of example.

Example: There is a Private company named ABC ltd in which Mr. Rahul hold 100% of its share capital. Balance sheet of company is as follows:

Mr. Rahul wants to convert his black money into white money and there is a person named Mr. Aakash who needs black money for some purpose like to purchase any property. Mr. Aakash subscribes 100000 shares of ABC ltd at a price of Rs 250/share (Face value= Rs10/share and FMV= 25/share) at a security premium of Rs240/share. Now Mr. Aakash gives a cheque of Rs 250 lakh to Mr. Rahul and Mr. Rahul in turn gives black money of Rs 250 lakh to Mr. Aakash.

Balance of ABC ltd after this issue of shares will be as follows:

Later on Mr. Aakash, sell 100000 shares to Mr. Rahul at the rate of Rs 40/share and book Capital loss of Rs 210 lakh (250-40*100000) and Mr. Rahul purchases these shares by using their white money of Rs 40 lakh (100000 shares*Rs 40/share) Therefore Mr. Rahul have effectively converted Rs 210 lakh (250 lakh - 40 lakh) black money into white money without losing any control over his company and it also gave benefit to Mr. Aakash as he got black money as he needed and also books capital loss of Rs 210 lakh in his books which he can further set off against Capital gain. However, Government incurred huge loss due to tax evasion and many private companies used to do such practice to convert its black money into white money. Therefore, government brought section 56(2)(viib) to restrict company to do such wrong practice which will be discussed further in this article.

Introduction of Section 56(2)(viib)

This Section says that where a closely held company i.e. private company receives any consideration for issue of shares that exceeds the face value of such shares then following income shall be taxable under Income from other sources (IFOS)

Aggregate Consideration - FMV of shares issued as per
On issue on shares           Rule 11UA (2) of Income Tax Act

In the above Illustration, since aggregate consideration (Rs 250/share) exceeds the face value of shares (Rs 10/share) issued, hence following income shall be taxable under Other Sources in hands of Company-:

Aggregate consideration in hands of ABC company by issuing shares = 250 lakh

FMV of Shares issued = 25 lakh (100000 shares* Rs25/Share)

Taxable under the head Other Sources = 250 lakh - 25 lakh = 225 lakh

Section 56 (2)(viib) is not applicable to widely held company i.e. public company for the reason that SEBI approves the price at which shares are issued by widely held company and don’t allow the widely held company to issue shares higher than the FMV of shares.

Rule 11UA (2) of Income Tax Act

The fair market value of unquoted equity shares shall be calculated simply by ascertaining “Book value of Assets & Others (Less) Book value of Liabilities.”

Fair Market Value of Unquoted Shares= (A+B+C+D-L) X (PV)/(PE)

Where,

A= book value of the assets in the balance sheet but not including as mentioned below.

L= book value of liabilities shown in the balance sheet, but not including as mentioned below.

B= the price which the jewellery and artistic work would fetch if sold in the open market on the basis of the valuation report obtained from a registered valuer.

C= fair market value of quoted shares and securities which shall be lowest price of such shares quoted on recognized stock exchange on the valuation date and if any case securities are not traded on valuation date then lowest price of the date immediately preceding the date of valuation.

D= the value adopted or assessed by any authority of the Government for the purpose of payment of stamp duty in respect of the immovable property

PE= total amount of paid up equity share capital as shown in the balance-sheet

PV= the paid-up value of such equity shares

For ascertaining the book value of assets (other than jewellery, artistic work, shares, securities and immovable property), following amounts shall be excluded:

• Any amount of income-tax paid, if any, less the amount of income-tax refund claimed, if any; and
• Any unamortized amount of deferred expenditure, which does not represent the value of any asset.

For ascertaining the book value of liabilities, following amounts shall be excluded:

• the paid-up capital in respect of equity shares;
• the amount set apart for payment of dividends on preference or equity shares
• reserves and surplus, by whatever name called, even if the resulting figure is negative, other than those set apart towards depreciation;
• any amount representing provision for taxation, other than amount of tax paid as reduced by the amount of tax claimed as refund
• any amount representing provisions made for meeting liabilities, other than ascertained liabilities;
• Any amount representing contingent liabilities other than arrears of dividends payable in respect of cumulative preference shares.

Conclusion

Before introduction of this section 56(2)(viib) many closely held company i.e. private company were engaged in such practice where they used to convert black money into white money and by issuing shares more than FMV of shares. and government has to incur huge loss of taxes But now if closely held company issue shares more than FMV of shares then difference of aggregate consideration and FMV of shares as per Rule 11 UA(2) shall be taxable under the head Other Sources in hands of company. Therefore this section restricts the company to convert black money into white money and also saved the Government from incurring huge loss of taxes.