Buying or selling equity shares in India is covered by multiple laws – the Companies Act 2013, SEBI regulations, FEMA regulations, anti-competitive law (on occasion). Income tax, however, is usually applicable irrespective of the circumstances of the transaction. In equity share transactions, most buyers assume that tax valuations are required for capital gains, but miss the fact that tax under the head "other income" may be triggered. Tax valuations are actually required frequently, in order to support the buyer and seller's position to the tax authorities.
Tax valuations and Capital Gains tax
The understanding of tax valuations and capital gains tax is fairly straightforward. Section 45 covers all capital assets that may be sold (thereby including shares in a company, whether listed or unlisted). Section 48 provides the mode of computation of capital gains, stating that:
Capital gains = Selling price (-) Cost of acquisition (-) Any related selling costs
Tax would be charged on such capital gain at the rate of 10% without indexation benefits or 20% with indexation benefits. There are exceptions and provisos (e.g. for non-residents selling shares in an Indian company) however capital gains are well-understood by most.
Section 50CA tax valuations
When an entity sells equity shares held in a private company, if the consideration received is less than fair market value (FMV), the FMV will be substituted for the consideration. Capital gains tax must then be computed on the difference between FMV and cost.
E.g. If Company X sells its shares in Company Y where cost of shares is 100, sale price is 150 and FMV is 200: X will be taxed on (200-100) instead of (150-100). The tax paid will therefore also be 2x.
Section 56 tax valuations
The intent behind Section 56 (which covers miscellaneous income sources) was originally to tax income such as interest, gifts received, dividends, etc. However it has been broadened to include income and notional income from sale of shares. This is done by including the following:
Subsection (viib): When a private company raises capital from a resident at a premium to face value of shares, the amount that exceeds the fair value of the shares is considered "other income". This clause excludes funds received from a VC firm.
E.g. If Company A raises ₹ 100 of capital against a face value of shares of ₹ 30 and the fair value is calculated to be ₹ 50, the company will be taxed on ₹ 50 (100-50).
Subsection (x)(c): When any entity receives shares for a consideration that is nil or less than FMV by over ₹ 50,000, the difference between the FMV and consideration will be treated as an income. This in effect is a "bargain purchase" provision that attempts to tax a recipient of any asset for buying it cheap.
E.g. If an individual buys shares in Company B from Company C at a price of ₹1 million and the FMV of the shares is calculated to be ₹3 million, the individual will be taxed on a notional gain of ₹2 million.
Implications of Section 56 tax valuations
What is unique about the provisions of Section 56 is that they tax entities that do not seem to have any obvious 'gain' which is to be taxed. After all, if debt funding by a company is not taxable in its hands, why should equity funding be? Similarly, until a buyer of shares sells the same shares, can we say a 'gain' has occurred? Finance and tax professionals alike find the provisions somewhat counter-intuitive however it seems they are here to stay.
It's also important to note that Section 56, being a section for "miscellaneous income" has the highest marginal tax rate of 30%++. In case of foreign companies, the applicable tax rate is 40%++. Capital gains can be charged at 10%++ or 20%++ which is comparatively much more advantageous.
FMV and tax valuations
There is a recurring reference to fair market value or FMV as can be seen above. What is FMV? FMV is defined under Income Tax Rule 11UA and Rule 11UAA. These rules specify that tax valuations be carried out with the following interpretations of FMV:
FMV for sections except 56(2)(viib): FMV is to be calculated for unlisted equity shares using a modified asset valuation method. This method requires the substitution of book value of certain assets with their fair value – usually immovable property, shares held, art and jewellery, etc. Certain accounting assets and liabilities are also to be ignored. Finally the net asset value (pro-rated to paid-up capital) is the FMV.
FMV for section 56 (2)(viib): FMV for the section relating to fund-raising by a private company is defined as net asset value or discounted cash flow (DCF) value of the shares of the company. This is the only instance in which an income approach is permissible in tax valuations.
Other points to note
Tax valuations are usually triggered in fund-raising and when shares are bought/sold below the FMV. In the majority of transactions for going concerns and profitable businesses, this does not apply as consideration is usually well above FMV. However in many businesses it may either be below FMV or close enough to FMV to trigger taxation. FMV also changes depending on the balance sheet date and may therefore cause a shock post-transaction if significant movements have occurred.
All in all, it is best to conduct tax valuations while contemplating the transaction or immediately post-transaction, to understand what the tax implications are. Importantly, CFOs and tax heads must remember that it is not only the obvious 'gains' that are covered by the Income Tax Act – it is also the notional and potential gains that are in the tax net.
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The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.