Amendment in section 56(2)(viib) in Budget 2023



Our Finance Minister – Ms. Nirmala Sitharaman announced the budget on 1-Feb-2023. One of the key amendments announced in the budget is pertaining to the amendment brought about in section 56(2)(viib). This section deals with taxability arising in hands of Indian company on primary issue of shares in certain cases. Hitherto, this section covered taxability arising in a situation when Indian Company issued shares and received consideration from investors who were residents in India. In other words, this section covered in its ambit only situations where consideration was received from residents in India. With this amendment, it is proposed to widen the ambit to cover Non-resident Investors as well.

About section 56(2)(viib) (old):

Before we dwell deep into the amendment and its implications, in a brief way let us understand the section 56(2)(viib). The key features of the old section 56(2)(viib) are as under:

  1. Assessee – Indian company in which public are not substantially interested
  2. Taxable Event – Issue of shares to persons who are resident in India at a premium.
  3. Taxable Income – Difference between the Issue Price and the Fair Market Value of the shares.
  4. Manner of taxability – The taxable income is to be offered to tax by the Assessee Company under the head Income From Other Sources.
  5. Exclusions and special conditions – This section does not apply to assessee companies that are registered as Start-ups. Further, there is a specific exclusion for investment being received from certain class of eligible investors like Venture Capital Funds etc.   

The objective of this section was to keep a check on infusion of capital in the company over and above its fair price. In a few cases, this route was also used to channel the illegal / unaccounted domestic money into the legitimate system. The tax department was also serious and vigilant as far as the enforcement of this section is concerned. This is evident from the number of cases under litigation on this section.

Proposed Amendment:

The amendment in effect aims to broaden the ambit of the taxable event covered above. As per the amendment, now issue of shares to non-resident investors at a premium would also be covered in the ambit of taxable event.

If we look at this amendment from a positive angle, then one can say that with this amendment, the Government has tried to create a level playing field between resident and non-resident investors. Keeping all parameters constant – during the old regime, an Indian Company would have always preferred to accept investment from a non-resident investor over a resident investor as that would have saved the Investee Company the pain of facing the potential litigation under this section. Thus, in a way by expanding the ambit of this section, the Government has brought in parity over its stand towards both resident as well as non-resident investors.

On the contrary, a few people are holding a view that this might negatively hamper the Foreign Direct Investment inflows in the country. At this stage, our country needs to be implementing measures that would attract more foreign investment and such amendments which might discourage such investment is the last thing that we need. Thus, these people are looking at this amendment in a negative way. Only time will unfold the true effect!

The amendment is effective from AY2024-25 onwards. Thus, it would be applicable for investments that happen on or after 1-Apr-2023.

Potential challenge relating to Valuation:

One of the potential issues that would arise on account of this amendment is going to be around the Valuation methodology that is adopted for valuing the Fair Market Price of the shares.

As per section 56(2)(viib), there is a pre-defined methodology to be followed for valuing the shares. This methodology is laid down in rule 11UA. Though there is an exception allowed to follow any other method, but that has a narrow scope and an arbitrary acceptance power on the AO. Thus, for all practical reasons, assessee companies prefer to follow the methodology laid down in rule 11UA itself.

At a macro level, there are two methods prescribed under rule 11UA – Book Value method and Discounted Cash Flow method. Also, rule 11UA does not expressly permit deriving valuation by a combination of methods.

On the flip side, when a non-resident investor invests in an Indian closely held company under the Foreign Direct Investment (FDI) route, then there is a Valuation methodology even prescribed under the regulations of Foreign Exchange Management Act (FEMA). As per the Non-debt Instrument Rules of FEMA, the Indian Company has the flexibility to carry out valuation as per any internationally accepted pricing methodology. Further, a price derived by using a combination of methods is allowed. It is mandatory that the non-resident investor should invest at a price that is either equal to or higher than the fair valuation price.

To summarize – as per Income-tax, the Indian company would have to value the company as per rule 11UA and investment should happen either at the fair price derived as per the valuation or a price lower than that.

As per FEMA, the Indian company would have to value the company as per any internationally accepted pricing methodology and investment should happen either at the fair price derived as per the valuation or a price higher than that.

If we reconcile the above two positions of the statutes then it steals away the flexibility of Indian company. Indian Company would have to mandatorily get valuation done by rule 11UA methodology. Also, the investment should happen exactly at the price derived by the valuation – Neither a Rupee Up nor a Rupee down. If the transaction happens at a lower price, then it would be violation under FEMA. If valuation happens at a higher price then it would lead to adverse taxability.

Further, with the advent of technology, we are seeing many different business models emerging day in and day out. For many businesses, it is actually not feasible to derive its fair value by either using the book value method or the DCF method. To get the right value – they need to use any other methodology like Earnings Capitalisation Method, Comparable Transaction Method, Market Price Method, etc. Or a combination of two or more methods. Such businesses might not be able to achieve their desired value by following such strict process. It would be detrimental to them. The only way out available to such companies would be to follow the valuation methodology that suits them best and be prepared to face the Litigation risk of convincing the AO about its appropriateness.

It would be a welcome move, if the Government aligns the valuation guidelines under both the Income tax and FEMA regulations.

Closing Remarks:

Preliminarily, it looks like the above issue of Valuation is an incidental problem that might not have come to the notice of the Government. If a suitable relief of clarification is given by the Government, then the acceptance of this amendment would be more positive.

About Author:

CA Dhruv Shah is Partner at Ambavat Jain and Associates LLP. He heads the practice of International Taxation and FEMA.