Taxation of Special Income Under Section – 56(2)(vii) & (viia) including Valuation Rules

1. Taxation of Special Income Under Section – 56(2)(vii) & (viia) including Valuation Rules Presented by: CA Prashant Kapoor Mergers and Acquisitions - Tax July 10, 2010

2. Contents 1 Background 2 Section 56(2)(vii) - Analysis 3 Section 56(2)(vii) - Issues 4 Section 56(2)(viia) - Analysis 5 Section 56(2)(viia) - Issues 6 Valuation Rules 2 2

3. Background 3 3

4. Background – Income from Other Sources Section 56(1) reads as under: “Income of every kind which is not to be excluded from the total income under this Act shall be chargeable to income-tax under the head “Income from other sources”, if it is not chargeable to income-tax under any of the heads specified in section 14, items A to E” • The above charging section is same as section 12 of the Income-tax Act, 1922. • Two conditions are required to be satisfied for any income to be chargeable under the head income from other sources: - - Income not included under any other head; and - Income included in the total income of an assessee. Any income chargeable under a specific head can be charged only under that head and no part of that income can be charged again under section 56 4

5. Section 56(2)(vii) 5 5

6. Section 56(2)(vii) Section 56(2)(vii) reads as under: “where an individual or a HUF receives, in any previous year, from any person or persons on or after the 1st day of October, 2009,— (a) any sum of money, without consideration, the aggregate value of which exceeds fifty thousand rupees, the whole of the aggregate value of such sum; (b) any immovable property, without consideration, the stamp duty value of which exceeds fifty thousand rupees, the stamp duty value of such property; (c) any property, other than immovable property,— (i) without consideration, the aggregate FMV of which exceeds fifty thousand rupees, the whole of the aggregate FMV of such property; (ii) for a consideration which is less than the aggregate FMV of the property by an amount exceeding fifty thousand rupees, the aggregate FMV of such property as exceeds such consideration : Provided that where the stamp duty value of immovable property as referred to in sub-clause (b) is disputed by the assessee on grounds mentioned in sub-section (2) of section 50C, the Assessing Officer may refer the valuation of such property to a Valuation Officer, and the provisions of section 50C and sub-section (15) of section 155 shall, as far as may be, apply in relation to the stamp duty value of such property for the purpose of sub-clause (b) as they apply for valuation of capital asset under those sections. 6

7. Section 56(2)(vii) Provided further that this clause shall not apply to any sum of money or any property received— (a) from any relative; or (b) on the occasion of the marriage of the individual; or (c) under a will or by way of inheritance; or (d) in contemplation of death of the payer or donor, as the case may be; or (e) from any local authority as defined in the Explanation to clause (20) of section 10; or (f) from any fund or foundation or university or other educational institution or hospital or other medical institution or any trust or institution referred to in clause (23C) of section 10; or (g) from any trust or institution registered under section 12AA. Explanation.—For the purposes of this clause,— • “assessable” shall have the meaning assigned to it in the Explanation 2 to sub-section (2) of section 50C; (b) “FMV” of a property, other than an immovable property, means the value determined in accordance with the method as may be prescribed; (c) “jewellery” shall have the meaning assigned to it in the Explanation to sub-clause (ii) of clause (14) of section 2; (d) “property” means the following capital asset of the assessee, namely:— (i) immovable property being land or building or both; (ii) shares and securities; (iii) jewellery; (iv) archaeological collections; (v) drawings; (vi) paintings; (vii) sculptures; (viii) any work of art; or (ix) bullion; (e) “relative” shall have the meaning assigned to it in the Explanation to clause (vi) of sub-section (2) of this section; (f) “stamp duty value” means the value adopted or assessed or assessable by any authority of the Central Government or a State Government for the purpose of payment of stamp duty in respect of an immovable property;” 7

8. Section 56(2)(vii): Memorandum explaining provisions The Memorandum to Finance Bill, 2010 explains the rationale behind Section 56(2)(vii) as under: “The provisions of section 56(2)(vii) were introduced as a counter evasion mechanism to prevent laundering of unaccounted income under the garb of gifts, particularly after abolition of the Gift Tax Act. The provisions were intended to extend the tax net to such transactions in kind. The intent is not to tax the transactions entered into in the normal course of business or trade, the profits of which are taxable under specific head of income. It is, therefore, proposed to amend the definition of property so as to provide that section 56(2)(vii) will have application to the ‘property’ which is in the nature of a capital asset of the recipient and therefore would not apply to stock-in-trade, raw material and consumable stores of any business of such recipient. C. In several cases of immovable property transactions, there is a time gap between the booking of a property and the receipt of such property on registration, which results in a taxable differential. It is, therefore, proposed to amend clause (vii) of section 56(2) so as to provide that it would apply only if the immovable property is received without any consideration and to remove the stipulation regarding transactions involving cases of inadequate consideration in respect of immovable property. These amendments are proposed to take effect retrospectively from 1st October, 2009 and will, accordingly, apply in relation to the assessment year 2010-11 and subsequent years.” 8

9. Section 56(2)(vii): In Summary - Applicability & Exclusions • Applicable to: • Money or moveable property or immovable property received by Individual / HUF; and • Value of above exceeds Rs.50,000. • Exclusions - Any gift received: • From any relative • On the occasion of the marriage of the individual • Under a will or by way of inheritance; • In contemplation of death of the payer; • From any local authority as defined under section 10 (20) • From any fund or foundation or university or other educational institution or hospital or other medical institution or any trust or institution referred to in section 10 (23C); or • From any trust or institution registered under section 12AA. 9

10. Section 56(2)(vii): Computation Mechanism Taxability under Section 56(2)(vii) Situation 1: Any sum of money exceeding Rs.50,000 without consideration– Taxable Income: Entire sum Situation 2: Where immovable property with a stamp duty value exceeding Rs.50,000 is received without consideration- Taxable income: Stamp duty value. Situation 3: Where there is inadequate consideration for a moveable property i.e. the consideration (say INR ‘x’)is less than the aggregate FMV of such property by an amount exceeding Rs.50,000 - Taxable income: Aggregate FMV of such property exceeding the consideration (i.e. FMV minus ‘x’). 10

11. Section 56(2)(vii) – Issues 11 11

12. Section 56(2)(vii): Issues In case of immovable properties, the same amount would become taxable in the hands of the transferor and the recipient (i.e. stamp duty value as provided in section 50C would be chargeable to tax in the hands of transferor as Capital Gains and as Income from Other Sources in the hands of the recipient under section 56) What would be the position when individual transfers the money or property to HUF or vice versa? Whether the term ‘relative’ is to be interpreted by the relation of Karta or all members of HUF including all female members? Whether transfer of money or property from a private trust to the individual beneficiaries would be taxable in the hands of beneficiaries? Whether any amount given free of interest without any consideration will come within the purview of the section 56(2)(vii)? 12

13. Section 56(2)(viia) 13 13

14. Section 56(2)(viia) Section 56(2)(viia)1 reads as under: “Where a firm or a company not being a company in which the public are substantially interested, receives, in any previous year, from any person or persons, on or after the 1st day of June, 2010, any property, being shares of a company not being a company in which the public are substantially interested,— (i) without consideration, the aggregate fair market value of which exceeds fifty thousand rupees, the whole of the aggregate fair market value of such property; (ii) for a consideration which is less than the aggregate fair market value of the property by an amount exceeding fifty thousand rupees, the aggregate fair market value of such property as exceeds such consideration: Provided that this clause shall not apply to any such property received by way of a transaction not regarded as transfer under clause (via) or clause (vic) or clause (vicb) or clause (vid) or clause (vii) of section 47. Explanation — For the purposes of this clause, “fair market value” of a property, being shares of a company not being a company in which the public are substantially interested, shall have the meaning assigned to it in the Explanation to clause (vii);” 1As inserted by Finance Act 2010 14

15. Section 56(2)(viia): Memorandum explaining provisions The Memorandum to FB 2010 explains the rationale behind Section 56(2)(viia) as under: “Under the existing provisions of section 56(2)(vii), any sum of money or any property in kind which is received without consideration or for inadequate consideration (in excess of the prescribed limit of Rs. 50,000/-) by an individual or an HUF is chargeable to income tax in the hands of recipient under the head ‘income from other sources’. However, receipts from relatives or on the occasion of marriage or under a will are outside the scope of this provision…… These are anti-abuse provisions which are currently applicable only if an individual or an HUF is the recipient. Therefore, transfer of shares of a company to a firm or a company, instead of an individual or an HUF, without consideration or at a price lower than the fair market value does not attract the anti-abuse provision. In order to prevent the practice of transferring unlisted shares at prices much below their fair market value, it is proposed to amend section 56 to also include within its ambit transactions undertaken in shares of a company (not being a company in which public are substantially interested) either for inadequate consideration or without consideration where the recipient is a firm or a company (not being a company in which public are substantially interested). Section 2(18) provides the definition of a company in which the public are substantially interested. It is also proposed to exclude the transactions undertaken for business reorganization, amalgamation and demerger which are not regarded as transfer under clauses (via), (vic), (vicb), (vid) and (vii) of section 47 of the Act.” 15

16. Section 56(2)(viia): Rationale The amendment proposes to cover the transfer of shares without / for inadequate consideration. We understand the amendment has come in view of the two advance rulings in the case of Amiantit International Holding Limited (AAR No. 817 of 2009) and Dana Corporation (AAR No. 788 of 2008), wherein it was decided that transfer of shares without any consideration would result in failure of computation provisions in section 48 and consequently, the charging provision under section 45 cannot be invoked to charge the capital gains tax. 16

17. Section 56(2)(viia): Dana Corporation 17

18. Section 56(2)(viia): Amiantit International Holding Limited 18

19. Section 56(2)(viia): Corresponding amendments Section 2(24)(xv) – Definition of “Income” expanded “Income includes any sum of money or value of property referred to in ………. clause (viia) of sub-section (2) of section 56” Section 49(4) – Cost of acquisition in certain cases “Where the capital gain arises from the transfer of a property, the value of which has been subject to income-tax under clause (vii) and clause (viia) of sub-section (2) of section 56, the cost of acquisition of such property shall be deemed to be the value which has been taken into account for the purposes of clause (vii) and clause (viia)” Thus, the FMV of the shares as per Section 56(2) to be considered as cost of acquisition in the hands of recipient of shares 19

20. Section 56(2)(viia): Applicability Shares in a closely held Indian / Foreign co. Receipt of shares (physical or demat / equity or preference) Transferee / Recipient Transferor / Donor Recipient – (a) Needs to be a Firm or a Co. other than a Co. in which public are substantially interested; (b) Can be a R/NR Transferor – (a) Can be any “Person”; (b) Can be a R/NR Receipt of shares – (a) Could be in demat or physical form; (b) Could be equity / preference shares; (c ) Shares could be of an Indian / Foreign Co. Receipt of shares – Should be on or after 1 June 2010; Receipt of shares – Shares should not be in a Co. in which public are substantially interested. On or after 1 June 2010 • Firm / Closely held Co. (R / NR) • Any person (R / NR) 20

21. Section 56(2)(viia): Exclusions Transactions excluded from the applicability of Section 56(2)(viia) These exclusions are not applicable if shares received by an Individual and HUF 21

22. Section 56(2)(viia): Computation Mechanism Taxability under Section 56(2)(viia) Situation 1: Where FMV of shares exceeds INR 50,000 and there is NIL consideration – Taxable Income: Aggregate FMV of the shares Situation 2: Where there is inadequate consideration i.e. the consideration (say INR ‘x’)is less than the aggregate FMV of the shares by an amount exceeding INR 50,000 - Taxable income: Aggregate FMV of the shares exceeding the consideration (i.e. FMV minus ‘x’). • As per recent CBDT notification, FMV of unquoted shares to be determined as under - • Equity shares –’Book value’ computed in the specified manner • Other shares – Price which such shares will fetch in the open market as supported by a valuation report of a Merchant Banker or Chartered Accountant 22

23. Section 56(2)(viia)- Issues 23 23

24. Section 56(2)(viia): IssuesReceipt of “newly allotted” shares/ warrants/ debentures Whether issue of fresh shares (bonus shares / rights shares / shares allotted in a preferential issue) at a price lower than the FMV would attract Section 56(2)(viia)? Whether issue of warrants (which entitles the investor to subscribe for equity shares) will attract Section 56(2)(viia)? Whether issue of debentures (whether non-convertible or partly convertible or fully convertible) will attract Section 56(2)(viia)? Whether receipt of equity shares on conversion of preference shares / debentures attract Section 56(2)(viia)? Whether forfeiture of shares or a subsequent re-issue of forfeited shares by a Co. will attract Section 56(2)(viia)? 24

25. Section 56(2)(viia): IssuesBusiness restructuring / re-organisation Whether buy-back of shares / reduction of capitalat a price below the FMV of such shares would attract Section 56(2)(viia)? In case of an amalgamation / de-merger / slump sale,whether Section 56(2)(viia) would apply in the hands of amalgamated / resulting / transferee company in case of receipt of shares by them which were held as investment by the amalgamating / de-merged / transferor company? Whether Section 56(2)(viia) can apply to shares received on liquidation? Whether receipt of shares by companies under a family settlement / family succession would attract Section 56(2)(viia)? Whether contribution of shares by a Partneras its capital in the firm would attract Section 56(2)(viia)? Does it make a difference if a firm is an LLP formed under Limited Liability Partnership Act, 2008? Does it make any difference if the firm is an Indian registered firm or is a foreign partnership? 25

26. Section 56(2)(viia): IssuesTrusts Will Section 56(2)(viia) apply if shares are settled on a trust, if the beneficiary of the trust is a firm or a company? Will Section 56(2)(viia) apply if shares are distributed by a trust to its beneficiaries who are firms or companies? 26

27. Section 56(2)(viia): IssuesThreshold limit of INR 50,000 - Computation For meeting the threshold limit of INR 50,000 whether receipt of shares of each individual Co. should be considered or should one aggregate shares of all companies received during the year? For determining the taxable amount, should one aggregate transactions of inadequate / Nil consideration or, aggregate all transactions including transactions with adequate consideration? 27

28. Valuation Rules 28 28

29. Section 56(2)(vii) & (viia): Valuation Rules –Notification no. 23/2010 dated 7 April 2010 Quoted Shares and Securities Valuation date shall be the date on which the respective property is received by the assessee 29

30. Section 56(2)(vii) & (viia): Valuation Rules –Notification no. 23/2010 dated 7 April 2010 Unquoted Shares and Securities 30

31. Section 56(2)(vii) & (viia): Valuation Rules –Notification no. 23/2010 dated 7 April 2010 Unquoted Shares and Securities Jewellery and Archaeological collection, Drawings, Paintings, Sculptures or any work of art 31

32. Glossary of Terms B/S: Balance Sheet CBDT : Central Board of Direct Taxes COA : Cost of Acquisition Co. : Company DTAA: Double Taxation Avoidance Agreement FB : Finance Bill FMV : Fair Market Value HUF : Hindu Undivided Family INR : Indian National Rupees LLP : Limited Liability Partnership NR : Non-Resident R : Resident TP: Transfer Pricing 32

33. Thank You for Your Interest and Attention!!! For any questions, please feel free to contact: Prashant Kapoor, M&A - Tax Director Direct: +91 124 334 5318 prashantkapoor@kpmg.com 33