NOTE ON LEGAL EFFECT OF AMENDMENT TO SECTION 56(2) OF INCOME TAX ACT, 1961 ON ANGEL INVESTMENTS
The Union Budget 2012 has introduced a new clause in the Income Tax Act, 1961, according to which, with effect from April 1, 2013, that portion of consideration received for the issue of shares of a public unlisted company or private company to an Indian resident that is in excess of the fair market value of those shares, will be subject to tax in the hands of the companies under the head “income from other sources”. The aim of this note is to examine the legal effect of amendment made by the Finance Act 2012 to Section 56(2) of the Income Tax Act, 1961 by introduction of clause (viib). It highlights the impact on angel investors in light of the SEBI (Alternative Investment Fund Regulations)2012. The AIF Regulations have further made it difficult for these investors to invest in start ups as stricter requirements have been laid down by SEBI. The paper examines the clause (viib) and discusses its ambit in light of its applicability to closely held companies, residents, receipt of consideration for shares and method of determination of the fair market value. Simultaneous application of Section 68 and Section 56(2)(viib) has also been discussed.
The paper reflects that the amendment introduced by the government with the noble objective of controlling the flow of unaccounted money would not have the desired result on the economy in as much as the start ups and genuine small businesses would be affected. While any legislation aimed at eradicating money laundering and tax evasion is extremely desirable, it is required of the Finance Ministry to ensure that at the same time such legislation does not dissuade entrepreneurial initiatives thereby impeding overall economic growth. Since the notification is yet to be issued by the government granting exemption to a certain class of investors and the SEBI AIF Regulations also mention that certain concessions may be granted to the VC Funds depending on their need, there is still a ray of hope for the angel investors.
Key Words: Finance Act 2012; Income Tax Act 1961; SEBI (Alternative Investment Fund Regulations) 2012; angel investors;
1. Provision under the Income Tax Act,1961
Section 56(2) lists incomes chargeable to income tax under the head ‘Income from Other Sources.’ Finance Act, 2012 inserts clause (viib), with effect from 1-4-2013(assessment year 2013-14) to include ‘share premium’ received by a company in excess of its fair market value , as its income chargeable under the head ‘ Income from other sources.’ The clause is as follows:
“where a company, not being a company in which the public are substantially interested, receives, in any previous year, from any person being a resident, any consideration for issue of shares, in such a case if the consideration received for issue of shares exceeds the face value of such shares, the aggregate consideration received for such shares as exceeds the fair market value of the shares shall be chargeable to income tax under the head “Income from other sources”.
Finance Act, 2012 simultaneously amends the definition of income in section 2(24) by inserting clause (xvi) to include the above consideration exceeding fair market value as income.
The clause does not apply to:
(i) A venture capital undertaking receiving the consideration for issue of shares from a venture capital company or a venture capital fund ; and
(ii) A company receiving the consideration from a class or class of persons (‘Notified persons’) as may be notified by Central Government.
The exception given to venture capital companies and venture capital funds appears to stem from the fact that these entities are regulated under the SEBI (Alternative Investment Fund) Regulations 2012 and hence there is some measure of scrutiny already in place over investments made by them. The explanation to Category I AIF under SEBI (AIF) Regulations provides that “Venture Capital Company” or “Venture Capital Fund” will be eligible for tax “pass through” benefits as per Section 10 (23FB) of the Income Tax Act, 1961.
Clause (viib) introduced by the amendment will affect the participation of private equity funds or high net worth individuals or risk capital. The clause will impact genuine start-ups and other Small and Medium Enterprises (SMEs) looking to grow rapidly particularly in the services sector, as they depend upon angel investors or private equity funds for their funding as they are thinly capitalized. Such funding is normally at a substantial premium as the underlying assets of the start up do not support a higher fair market value. Thus, such funding normally depends on future prospects of the company rather than the current value of the assets of the company. This provision could destroy the developing culture of angel investors and private equity funds funding promising entrepreneurs, who have the skills but very few assets. The provisions might encourage companies to form Limited Liability Partnerships, to raise foreign exchange from angel investors residing outside India, subject to applicable FDI requirements or to raise funds from individual Indian resident investors by issuing convertible debentures of the company.
With a view to address concerns raised by the angel investors, exclusion has been granted from levy of such tax to certain notified class of persons by way of an enabling provision. Since the notification has not been issued by the Central Government in this regard, it is difficult to comment on the group of permitted class (es) of investors that would be excluded.
2. SEBI AIF Regulations
The SEBI AIF Regulations 2012 even make it difficult for angel investors to register as VC Funds with it. The Regulations mention that VCF’s have positive spill over effects on the economy, and that it may, along with the government and other regulators, consider granting incentives or concessions based on the need of the funds.
The AIF Regulations have drastically increased the minimum fund size from INR 5 Crores to INR 20 Crores and the minimum amount that can be accepted from an investor from INR 5 lakh to INR 1 crore. The increase is significant. Angel investors in India cannot individually invest more than about INR 20-25 lakhs. They may not be able to constitute such a large fund and to pool these amounts. Further, there are additional restrictions on the tenure of the fund (which shall be at least 3 years) and heavy disclosure and record keeping requirements that will significantly add to the costs of operating as registered entities.
SEBI’s AIF Regulations makes it impractical for the angel investors to register with it. However, SEBI has mentioned that it will consider giving exemptions for VC Funds depending on their need. Although, the existing funds which are not registered under the VCF Regulations and which seek registration but are not able to comply with all provisions of AIF Regulations, may seek exemption from SEBI from strict compliance with the AIF Regulations.
3. Objective of the Amendment to Section 56(2) of the Income Tax Act, 1961
The amendment has been classified under the heading “Measures to Prevent Generation and Circulation of Unaccounted Money”. Companies were issuing shares at a substantial premium to convert the unaccounted money without providing any valuation justifying the premium. The amendment covers such unjustified premium and the excess is being taxed as income of the company.
II. INTERPRETATION OF THE CLAUSE
1. Applies only to a closely held company
The clause is applicable to companies in which the public are not substantially interested. It is not applicable to a widely held company. Thus, the clause includes:
(i) those companies which, not being private companies, are not listed on a recognized stock exchange, and
(ii) those companies that are excluded from the scope of the definition of “companies in which public are substantially interested” provided under section 2(18) of the Income Tax Act, 1961. By the exclusion of a “company in which the public are substantially interested” in the proposed clause, it can be inferred that this proposed clause is applicable generally to a private company and a public unlisted company. However, it would be advisable to seek specific legal advice as to whether or not a company, in any particular instance of issuance of shares, is affected by the proposed new clause.
2. Consideration has to be received from a ‘person’ who is a ‘resident’.
‘Person’ is defined under Section 2(31) and ‘Resident’ under Section 2(42) of the Act. ‘Resident’ is defined by Section 2(42) of the Act as follows:
“Resident means a person who is resident in India within the meaning of Section 6”.
Section 6 provides for the test for determining the residential status of a person. Any person who satisfies the test of residence would be covered under this section. Thus, any person who is a non resident within the meaning of the definition would not be covered and any consideration paid by such non-resident to a closely held company for the shares in it, although, the amount of premium exceeds the fair market value of the shares, company may not be liable to tax.
An important point to mention here is that in case of allotment of shares to non-residents, FEMA regulations relating to FDI come into play which prescribe a Discounted Free Cash Flow method (DCF) for valuation of equity shares. The price at which the shares will be allotted to non-residents must not be less than price as per DCF method as per the extant FEMA regulations for unlisted companies. It is generally observed that price as per DCF method is much higher than the face value of the equity shares and the non-residents are required to pay a high premium.
If the shares are issued at the same price (at a premium similar to non-residents) to the resident investors, the Company will have to shell out tax on the difference between the consideration received and fair market value in respect of shares allotted to the residents. If the shares are say issued at fair market value to the residents and at a price as per DCF method to the non-residents, it might result in a paradoxical situation. If that happens, the amendment might not be successful in preventing generation and circulation of unaccounted money.
3. Any consideration.
Consideration can be in cash or in kind. If the consideration is in kind, the value of thing obtained in exchange could be considered as the value. The clause contemplates the receipt of consideration for issue of shares. Hence, if there is no consideration, for the issue of shares, the clause cannot apply .
For the above reason, the clause cannot apply to bonus shares as such shares are issued without charge or without any consideration. No new funds are raised with the issue of bonus shares.
4. For issue of shares
‘Share’ is defined under Section 2(46) of the Companies Act, 1956 . As per the amendment to the Income Tax Act, 1967, clause (viib) of Section 56(2) of the Act excludes-
(a) Shares issued by a widely held company
(b) Bonus Shares
(c) Securities, as defined under the Securities Contracts (Regulation) Act and/or various other provisions of the Act, other than shares in a closely held company. Thus, debentures or convertible debentures are excluded.
(d) Shares by a venture capital undertaking from a venture capital company or venture capital fund.
5. Fair market value
Fair market value is defined as an explanation to the clause to mean:
1. Value as may be determined in accordance with the prescribed method.
2. Value as may be substantiated by the company, to the Assessing Officer’s satisfaction, based on the value, on the date of issue of shares, of its assets.
A lot would hinge upon the yet to be prescribed methodology for arriving at the ‘fair market value’. It could be on the same lines as Rule 11UA . However, since the method is based on the book value of the assets it may not in all cases correspond to the aggregate consideration and hence, the company may have to substantiate the value, which is an option given to the company. If exercised, such opinion would have to meet the satisfaction of the Assessing Officer. Such satisfaction must be capable of being tested in an objective manner. And, if the material or evidence, produced objectively substantiates the value, based on assets, such value cannot be rejected by the Assessing Officer.
The emphasis on “satisfaction of the Assessing Officer” (in this provision and many other provisions in this year’s Budget), where the prescribed method for computing the fair market value of the shares is not followed, could result in a state of uncertainty regarding the valuation of shares done by the Company. This is because the Company will not be able to determine till the assessment stage whether it’s computation of Fair Market Value of the shares, on which the taxability of the excess consideration depends, is correct and acceptable to the Assessing Officer.
III. Simultaneous application of Section 68 and Section 56(2)(viib)
In case of a closely held company, subscription to shares at a premium could attract:
(i) Section 68 of the Act and oblige the company to explain source of source and if the Assessing Officer is not satisfied, the amount received(towards share capital and share premium) could be assessed as “cash credits” and included in the total income of the company; and
(ii) Section 56(2) (viib) providing for the inclusion of excess consideration in the total income of the company.
Prima facie, both the provisions can be applied as both of them are specific and provide for a specific treatment. However, on the principle that the same income cannot be taxed twice, an addition cannot be made, in respect of the same amount twice, by applying both the provisions. Either the entire amount may be treated as cash credit and accordingly assessed under Section 68 or the excess consideration may be treated as income under Section 56(2) (viib) and the balance amount (aggregate of share capital and share premium minus excess consideration, that is, to put it differently, aggregate of the face value of the shares and the share premium to the extent not considered as excess consideration) may be treated as cash credit under Section 68.
If the amount is assessed as cash credits in the hands of the company, its assessment in the hands of the shareholders, as unexplained investment (under Section 69), may not be ruled out .
The amendment to section 56(2) of the Income Tax Act, as discussed above, will have an impact on the “resident angel investors” and not on investors who do not satisfy the test of ‘residence’ as per Section 6 of the Income Tax Act. Also, angel investors have the option to invest in convertible debt securities which are excluded from the purview of this amendment which covers only ‘shares’. Although the above discussed amendment to the Income Tax Act has a worthy objective of controlling the flow of unaccounted money in the economy but this has an unintentional effect on the investments made by angel investors which help in funding the start-ups as discussed above. The government has not issued the notification yet but the AIF Regulations have made it almost impossible for angel investors to fund start-ups in light of the restrictions and limitations imposed on the investments.