The issue of taxation on share premium has been of major tax controversy over the past few years and has rightly taxed money launderers and unearthed sham transactions. At the same time it has created hardships for start-ups and corporates in their fund raising and restructuring transactions.

1. TAXATION OF SECURITIES PREMIUM OR
SHARE CAPITAL ISSUED
BY CLOSELY HELD COMPANIES

2. INTRODUCTION
Taxation of share premium or securities premium in India is litigation prone; especially where securi-
ties premium raised is quite high in absolute and more so in relative terms. Stakes are huge, since
what is sought to be taxed in share subscription money or share premium.
Initially, the income tax authorities resorted to tax securities premium or share capital u/s 68 of
Income tax Act, 1961 (“ITA”). However, in CIT Vs. Stellar Investment Limited [192 ITR 287 (Del)], it was
held that such increased share capital cannot be taxed in the hands of the company since it does
not amount to undisclosed income. This position was affirmed by Hon’ble SC in 251 ITR 263. Later, a
specific amendment was brought w.e.f. 1st April 2012 by introduction of S. 56(2)(viib) and first proviso
to S. 68 of ITA providing the circumstances and manner of taxation of securities premium / share
capital, although it is considered a capital receipt. These sections intended to curb the malpractice
of conversion of black money by charging premium higher than fair value of closely held compa-
nies (“CHC”).
Considering that S. 56(2)(viib) was too harsh for startup companies, certain “eligible startups” were
exempted from S. 56(2)(viib) vide notification no 45/2016 dated 14th June 2016. But, the procuring
the certificate of “eligible startup” from DIPP comes with several riders. As per newspaper reports,
this provision has created intense tax controversies between Income-Tax Department and Startup
companies who charge substantial premium in view their bright prospects, while Income-Tax
Department feels that premium charged is in excess of fair value, and requires startup companies to
pay tax u/s 56(2)(viib). On account of these tax controversies this section is now popularly known as
“angel tax”.
This article provides an insight into the key issues and judicial precedents in connection with taxa-
tion of securities premium / share capital issued by a CHC.

3. 1. RELEVANT SECTIONS IN BRIEF
1 .1 . A closely held company (“CHC”) or company in which public is not substantially interested are
not defined under ITA. A reference to the definitions of “Company” u/s 2(17) of ITA and “company in
which public is substantially interested” u/s 2(18) of ITA help us understand the meaning of “closely
held company”. For the sake of simplicity, certain private companies and unlisted public companies
would qualify as CHC, subject to the conditions laid out in S. 2(18) of ITA.
1 . 2 . S. 56(2)(viib) and 68 which govern the taxability of share premium / share capital for a CHC are
summarized below.
No. Description
Period of applicability On / after AY 2013-14 On / after AY 2013-14
First proviso to S. 68S. 56(2)(viib)
1
Payer Any resident person Any resident person3
Quantum of taxation Consideration in excess of
FMV
Entire share capital or share
premium received
5
Taxable person CHC, except VCUs and
eligible startups
CHC, except VCUs2
Nature of transaction CHC receives consideration
for issue of shares for an
amount exceeding FMV of its
shares
CHC receives consideration
for issue of shares, and CHC
fails to justify genuineness of
transaction and source of
funds in the hands of investor
/ payer to the satisfaction of
AO
4
Tax impact of income
considered taxable
Income taxed under the head
income from other sources at
normal rates with allowable
deductions, allowances and
set-off.
Income taxed @ 60% (30%
upto 01.04.2017) without any
deductions, allowances or
set-off of losses
6
Each of the aforesaid point is discussed in detail below.

4. 2. PERIOD OF APPLICABILITY
2. 1. First proviso to S. 68 – whether restrospective?
It was a settled law that the assessee is not required to prove the “source of source”, i.e., source of
funds in the hands of shareholder / investor CIT v M/s. Dwarkadhish Investment (P) Ltd. & Ors. [330
ITR 298 (Del)].
The first proviso to S. 68, introduced w.e.f AY 2013-14, has reversed this settled law regarding
“source of source”. It provides that if the assessee is a CHC, receiving share application money,
share capital or share premium from a resident other than a VCF or VCC, the CHC shall also have to
prove the source of funds in the hands of the resident investor.
The Courts have held that the first proviso to S. 68 is clarificatory in nature and hence is retrospec-
tive in application - Pragati Financial Management (P.) Ltd. v. ITO [394 ITR 27 (Cal)], Rajmandir Estates
(P.) Ltd. v. Pr. CIT [386 ITR 162 (Cal)] &[245 Taxman 127 (SC)], Subhlakshmi Vanijya (P.) Ltd. v. CIT [60
taxmann.com 60 (Kol)].
2. 2. Year of applicability of S. 56(2)(viib) in case of time gap between receipt of share application
money and allotment of shares:
Often, there is a time gap between receipt of share subscription money and allotment of shares.
Assuming that share application money is received in year 1 and shares are allotted in year 2, a
question may arise as to the year in which S. 56(2)(viib) should be applied. The word “receives” used
in S. 56(2)(viib) leads to an impression that taxability arises in year 1. However, it is pertinent to note
that under the Companies Act, 2013, share subscription money is required to be refunded to the
applicants on failure of the company to allot shares within a specified time. Thus, share subscription
money becomes the property of the company only upon allotment. Until then, it remains a liability of
the company. The intent of S. 56(2)(viib) is to tax the amount which has crystallized into share capital
or share premium upon allotment. Hence, it can be argued that S. 56(2)(viib) would apply in year 2.
Continuing the above example, if a company was a CHC at the time of receipt of application money
but ceased to remain a CHC at the time of allotment of shares, S. 56(2)(viib) may not apply. Similarly,
if the payer / investor is a resident at the time of receipt of application money but becomes a
non-resident at the time of allotment of shares, S. 56(2)(viib) would not apply.

5. 3. TAXABLE PERSON
3. 1. A CHC (as explained in para 1.1) receiving securities premium or share capital from a resident
shall be the Taxable Person for the purpose of S. 56(2)(viib) and first proviso to S. 68.
3. 2. Investments by Venture Capital Funds (VCFs) and Venture Capital Companies (VCCs) in Ven-
ture Capital Undertakings (VCUs) are governed by SEBI Regulations. Hence, Venture Capital Under-
takings (VCUs) receiving funds from VCFs / VCCs are exempted from S. 56(2)(viib) & first proviso to
S. 68. The terms VCF, VCC and VCU are defined u/s 10(23F) of ITA.
3. 3. While S. 56(2)(viib) specifically exempts “eligible startups” (see para 3.4) from its ambit, first
proviso to S. 68 does not provide any such exemption to “eligible startups”. Thus, if an “eligible
startup” being a CHC, procures share capital from a resident angel investor, it has to satisfy the AO
about the genuineness of the transaction and source of funds in the hands of investor.
3. 4. Meaning of “Eligible Startups” – S. 56(2)(viib) adversely impacted start-ups raising capital from
angel investors. Accordingly, “startups” satisfying the conditions of DIPP Notification dated
17.02.2016 were exempted from S. 56(2)(viib) (but NOT first proviso to S. 68) vide Income tax notifica-
tion no. 45/2016 dated. 14.06.2016. Thus, an entity shall be considered as a ‘startup’-
a. Up to five years from the date of its incorporation/registration,
b. If its turnover for any of the financial years has not exceeded Rs. 25 crore, and
c. It is working towards innovation, development, deployment or commercialization of new products,
processes or services driven by technology or intellectual property.
d. If it is not formed by splitting up or reconstruction of a business already in existence
e. It has submitted an application for being recognized as a startup and obtained a certificate of an
eligible business from the relevant Government authority.
We see that registration as a “eligible startup” for non-applicability of S. 56(2)(viib) comes with many
riders.
3. 5. The notification exempting “eligible statups” was issued on 14.06.2016. As per newspaper
reports, startups which received funding in the period from 01.04.2012 till 14.06.2016 have received
notices from the IT Department u/s 56(2)(viib). The key reason for issue of notices is manner and
method of valuation of start-ups. While investors value the start-ups based on their idea / market
potential, it may not be accepted by the IT Department.

6. 4. PAYER / INVESTOR
4. 1. Applicability of S. 56(2)(viib) to non-residents viz-a-viz transfer pricing:
It is well established that S. 56(2)(viib) is not applicable to subscription of share capital by a non-resi-
dent and consequently transfer pricing provisions shall not apply to such a transaction. In Vodafone
India Services (P.) Ltd. v. Union of India [50 taxmann.com 300 (Bom)], it was held that:
“Theamountsreceivedonissueofsharecapitalincludingthepremiumisundoubtedlyoncapitalaccount.Sharepremium
havebeenmadetaxablebyalegalfictionundersection56(2)(viib)andthesameisenumeratedasincomeinsection2(24)(x-
vi).However,whatisbroughtintotheambitofincomeisthepremiumreceivedfromaresidentinexcessofthefairmarket
valueoftheshares.Inthiscasewhatisbeingsoughttobetaxediscapitalnotreceivedfromanon-residenti.e.premium
allegedlynotreceivedonapplicationofALP.Therefore,absentexpresslegislation,noamountreceived,accruedorarisingon
capitalaccounttransactioncanbesubjectedtotaxasincome.”
Vodafone’s decision is followed by in many decisions, viz. SKR BPO Services (P.) Ltd. v. ITO [55
taxmann.com 84 (Bom)], ATC Telecom Tower Corporation (P.) Ltd. v. DCIT [57 taxmann.com 249
(Mum)], Equinox Business Parks (P.) Ltd. v. Union of India [55 taxmann.com 222 (Bom)], S.G. Asia
Holdings (India) (P.) Ltd. v. DCIT [54 taxmann.com 376 (Bom)].
Further, the Government of India accepted the aforesaid decision of Vodafone vide Instruction
2/2015 dated 29th January, 2015 and directed all officers to adhere to the ratio decided in Voda-
fone’s case.
4. 2. Where a CHC raises share capital from a non-resident, the transaction is not covered under S.
56(2)(viib). In case the AO seeks to cover the transaction u/s 56(2)(x) where a non-resident receives
shares of a company for nil or adequate consideration [S. 56(2)(vii) and (viia) before AY 2017-18], it
may be suitably argued in favour of the non-resident, that non-residents are governed by special
provisions under ITA as well as RBI regulations. The legislature intended to cover only residents by
way of S. S. 56(2)(viib). In the absence of a specific requirement, the transaction of issue of shares
by CHC to a non-resident shall not be taxed in the hands of CHC.
However, S. 56(2)(x) [S. 56(2)(vii) and (viia) before AY 2017-18] would continue to apply for the
non-resident if shares are subscribed by the non-resident for nil or inadequate consideration. In that
case, taxability would arise in the hands of the non-resident on the difference between FMV and
consideration paid, if any.
4. 3. Similarly, where shares are issued to non-residents, the first proviso to S. 68 does not apply and
the CHC is not required to prove source of funds in the hands of the non-resident. Investment by
non-residents in already governed by sectoral and pricing guidelines under RBI regulations.

7. 5. NATURE OF TRANSACTION
5. 1. The ITA intends to tax incomes which are revenue in nature. Accordingly, capital receipts like
share capital and share premium, are out of the purview of taxation, unless specifically provided.
This is supported by Vodafone India Services Private Limited v UOI& others [368 ITR 01 (Bom)], Shell
India Markets Private Limited v UOI and Others [369 ITR 516 (Bom)]. The decision of Green Infra Ltd.
V. ITO [38 taxmann.com 253 (Mum)] has held that “itisaprerogativeoftheBoardofDirectorsofacompanyto
decidethepremiumamountanditisthewisdomoftheshareholderswhethertheywanttosubscribetosuchaheavypremi-
um.TheRevenueauthoritiescannotquestionthechargingofsuchofhugepremiumwithoutanybarfromanylegislatedlaw
oftheland.”
This stand of the judiciary was reversed with the introduction of S.56(2)(viib) w.e.f. AY 2013-14 and
share subscription money received exceeding FMV was sought to be taxed as Income from Other
Sources (“IFOS”). Nevertheless, the aforesaid judicial precedents would still hold true in case of
assessments pertaining to any AY prior to AY 2013-14.
5. 2. Sections 56(2)(viib) and first proviso to S. 68 essentially provide for taxation on allotment of
shares. Accordingly, fresh issue of capital and as well as rights issue would be covered. Further,
transactions like issue of Compulsory Convertible Debentures or Compulsory Convertible Prefer-
ence Shares may also be covered. In a recent decision of Microfirm Capital (P.) Ltd. v. DCIT [89
taxmann.com 23], the Kolkata Tribunal held that S. 56(2)(viib) is wide enough to cover all classes of
shares including Redeemable Non-Cumulative Preference Shares.
5. 3. Transactions like issue of shares on merger, demerger or any other restructuring may be cov-
ered under these sections in the absence of any specific exclusion. (Also, refer para 6.3 on consid-
eration in kind). It remains to be seen as to what course will the law take and whether a genuine
case of restructuring with no intent of tax evasion may be exempted from these sections.
5. 4. Allotment of shares pursuant to a bonus issue (refer Sudhir Menon HUF v ACIT [148 ITD 260
(Mum)] and DCIT v. Dr. Rajan Pai [82 taxmann.com 347 (Bang)]) or share split would not be covered
u/s 56(2)(viib) and 68. Similarly, transactions of buy-back of shares, reduction of share capital or
redemption of preference shares are not within the ambit of S. 56(2)(viib) and S. 68.
5. 5. In the context of rights issue of shares, it has been held in Sudhir Menon HUF v ACIT [148 ITD
260 (Mum)], that

8. 6. QUANTUM OF INCOME SOUGHT TO BE TAXED
6. 1. The quantum of income sought to be taxed is divided in 2 categories:
6. 1. 1. Under S. 56(2)(viib) - If a CHC issues shares at a price exceeding FMV, the difference
between the consideration received and FMV shall be considered as IFOS and would be taxed at
rates applicable to the assessee with allowable deductions and exemptions.
Let’s consider taxability in the hands of CHC in different scenarios:
Particulars Eg A
Face value 10
3
10
30 30
10
25
Yes Yes
35
15
NIL 5
25
15
Yes
5
12
FMV
Issue price
Whether shares issued at a price exceeding face value?
Quantum of securities premium
Eg CEg B
Income taxable u/s 56(2)(viib) - Consideration less FMV
a. Rights issue would be considered as “transfer” for the purpose of S. 56(2)(vii)(c)
b. Where rights issue of shares is exercised by shareholders on a proportionate basis, based on
their existing shareholding, S. 56(2)(vii)(c) though applicable per se, does not have any adverse
impact. Hence, S. 56(2)(vii)(c) does not apply.
c. In case of disproportionate allotment of rights shares, i.e., S. 56(2)(vii)(c) would apply.
With due respect to the Hon’ble Tribunal, we believe this decision requires a re-consideration on the
following aspects:
a. Allotment of shares and transfer of shares are two separate transactions as held in Khoday Distill-
eries Ltd v CIT (2008) 307 ITR 312 (SC). Hence, rights issue of shares should not be considered as
transfer.
b. Subscription to a rights issue, even though made on a pro rata basis, may violate the intent of S.
56(2)(viib).
6. 1. 2. S. 68 – If a CHC receiving share capital / securities premium fails to justify the nature and
source of funds to the AO, entire amount received shall be taxed at 60% (30% upto 01.04.2017)
without any deductions, allowances or set-off of losses.

9. 6. 2. The word “consideration” used in the aforesaid sections is wide enough to cover consider-
ation received in cash or kind. Accordingly, issue of shares in case of amalgamation or demerger
would amount to receipt of consideration in kind. While such specified cases, which are not regard-
ed as transfer u/s 47 of ITA, are specifically exempted under S. 56(2)(vii), (viia) and (x), there is no
similar provision u/s 56(2)(viib) or 68. Thus, where a CHC issues shares to a resident under a
scheme of amalgamation or demerger, S. 56(2)(viib) and 68 may be attracted. However, genuine
cases of restructuring may be saved from the rigours of S. 56(2)(viib) and 68.
6. 3. Both, S. 56(2)(viib) and 68, provide for taxability in the hands of a CHC on non-satisfaction of
prescribed conditions. A question may arise whether CHC can be taxed under both the sections. If
yes, then it would lead to absurd circumstances, i.e., the amount being taxed at 30% u/s 56(2)(viib)
and at 30% or 60% u/s 68. This would lead to taxation upto 90% of the share capital subscribed.
Thus, the chances of dual taxation seem to be miniscule as both provisions may not apply simulta-
neously on the same amount of share capital.
6. 4. Where a CHC issues shares to a resident, a question may arise whether the same can be
taxed once in the hands of CHC u/s 56(2)(viib) and again in the hands of the resident investor u/s
56(2)(vii), (viia) or (x). On a plain reading of the ITA, the answer would be in the affirmative. Though
the legislature does not intend to tax the same amount in the hands of two different persons, it
would be advisable to seek an expert’s opinion in case of issue of shares by a CHC.
7. DETERMINATION OF FAIR MARKET VALUE
7. 1. The concept of FMV is not relevant for S. 68 which provides for taxation of entire consideration
received.
7. 2. FMV for S. 56(2)(viib) –FMV of unquoted equity shares shall be higher of the following:
7. 2. 1. As per Rule 11UA– Either Net Asset Value method or Discounted Free Cash Flow Valua-
tion, at the option of assessee - pls refer to circular dated 29/11/2012 on DCF , OR
7. 2. 2. as may be substantiated by CHC to the satisfaction of AO, 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.
No valuation method is prescribed u/s 56(2)(viib) for unquoted securities other than equity shares.

10. 8. CONCLUSION
Issue of shares by a CHC, whether a fresh issue or under restructuring, could be a taxing affair. It can
become all the more taxing for startups to comply with a bunch of regulations and compliances at a
time when they are struggling to find feet in their respective business arena. No wonder, there is a
hue and cry from angel investors and startups.
Nevertheless, based on tax evasion or sham transactions discovered in the past in case of CHCs,
the IT Department continues to raise questions in connection with share capital raised at hefty
premium. The General Anti-Avoidance Rules (“GAAR”) introduced w.e.f. 01.04.2017, further empow-
er the AO to disregard arrangements executed solely with the intent of tax avoidance without any
commercial justification.
What is required is a balanced approach whereby genuine CHCs are not harassed under the guise
of tax evasion and tax evaders are rightfully caught. This is easy said than done. Unless Budget 2018
issues clarifications on unresolved issues, prudent tax planning and judicial precedents continue to
guide the way for capital infusion or restructuring in case of CHC.
7. 3. Recent judicial precedents suggest that for the purpose of determining FMV, AO is entitled to
look into the valuation report submitted, even though it may be from an independent valuer.
7. 3. 1. In Microfirm Capital (P.) Ltd. v. DCIT [89 taxmann.com 23 (Kol)], the manner of valuation
of preference shares was considered appropriate and the discount rate was accepted. Further, fair
value was also considered to be at arm’s length since an independent investor had also made an
investment at the same value.
7. 3. 2. In case of M/s Madhurima International Pvt. Ltd. vs. Pr CIT [I.T.A. No.42 1/Mum/2017], the
assessee adopted DCF method of valuation based on the report of a CA. The Tribunal held that the
valuation report did not consider certain basic aspects of valuation as per DCF method. Hence, the
Revenue is entitled to re-open the assessment to determine FMV as prescribed under R. 11UA and
then decide the case accordingly.