Tax Insights
from India Tax & Regulatory Services
www.pwc.in
Mumbai bench of Tribunal holds that section 56(2)(viia) not
applicable to receipt of shares of a foreign company before
amendment to Rule 11U with effect from 1 April 2019
November 22, 2019
In brief
The Mumbai bench of the Income-tax Appellate Tribunal1 (Tribunal) in the case of the taxpayer held that provisions of section 56(2)(viia) of the Income-tax Act, 1961 (Act) do not apply to purchase of shares of a foreign company by an Indian company. In addition, the Tribunal also held the provisions of this section do not apply because Rules 11U and 11UA of the Income-tax Rules, 1962 (Rules), prior to the amendment made in Rule 11U of the Rules with effect from 1 April 2019, did not provide for the computation mechanism of the fair market value (FMV) of the shares of the foreign company.
In detail
Facts
• The taxpayer, a company incorporated in India, was engaged in the business of manufacturing and distribution of certain oils and chemical.
• The directors of the taxpayer purchased shares of a Singapore-based company (S Co.).
Subsequently, the directors of the taxpayer sold the aforesaid shares to the taxpayer at their cost price, considering the same as the FMV basis the valuation reported
prepared by chartered
1 ITA No. 1703/Mum/2019
accountant using discounted cash flow method (DCF Method).
• The taxpayer filed its return of income before due date declaring a loss.
However, it revised its return as it did not disclose the above investment in S Co. in the Foreign Asset schedule.
• S Co. had invested in shares of a company listed on the National Stock Exchange (hereinafter referred to as ‘listed company’).
• The promoters raised the capital in the listed company in the form of
private equity. As per the shareholder agreement between the investor and promoters, shares of promoters (including S Co.) in listed company were placed in an escrow account as security to investor.
• Accordingly, in the share valuation report of S Co, the investment in shares of listed company was valued at “zero” because the shares were placed in an escrow account and could not be sold due to the overriding charge created.
• The tax officer (TO) computed the FMV of
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shares of S Co. revising the same based on the financials of S Co. as on 31 December 2014, as per the method prescribed under Rule 11UA(2)(a) of the Rules, and made an addition under section 56(2)(viia) of the Act.
This addition was confirmed by the Commissioner of Income-tax (Appeals) [CIT(A)].
Issue before the Tribunal Whether the shares of a foreign company acquired by the taxpayer is liable to tax under section 56(2)(viia) of the Act?
Revenue’s contentions
• The projections used in the valuation report were at huge variance with the actuals and same is not to be accepted.
Valuation report was
unrealistic and was based on data provided by the
management/ directors to arrive at the required value and was a backward exercise.
• The dispute between shareholders of listed company, has no connection with the valuation of shares of S Co., as they held no shares in S Co.The value of the shares of the listed company could not be treated as “zero”, therefore, the provision for impairment should not have been made in accounts of the S Co.
• Valuation should be carried out in accordance with provisions of Rule 11UA(2)(a) of the Rules read with section 56(2)(viia) of the Act.
Taxpayer’s contentions
• The shares of the listed company were in escrow, which may be invoked and therefore, the value of such shares in hands of S Co. (an
2 RBI Notification No. FEMA 263/RB-2013 dated 5 March 2013
investment company) is virtually “zero” and were fully impaired.
• The transaction of acquisition of shares was to comply with the revised Reserve Bank of India (RBI)/ FEMA
regulation2 prohibiting direct investment in foreign shares by a resident individual.
• The provisions of Rule 11UA of the Rules does not apply to a transaction of acquisition of shares of a foreign company.
• The TO erred in making the addition under section 56(2)(viia) of the Act by computing the FMV as per book value of shares under Rule 11UA(2) of the Rules, which is applicable only in case of transactions covered under section 56(2)(viib) of the Act.
• The value as computed by the TO was not in accordance with the law, as it was computed on a different date and not on the date of valuation.
Tribunal’s ruling The provisions of section 56(2)(viia) of the Act are not applicable on the acquisition of shares of a foreign company by an Indian company on the following grounds:
• The provisions of section 56(2)(viia) of the Act are applicable on the acquisition of shares of the company in which the public is not substantially interested. The Tribunal held that the provisions of this section do not cover the foreign company.
• The term “Balance sheet”
referred to in Rule 11U of the Rules does not cover a foreign company balance sheet. The
3 CIT v. B. C. Srinivasa Shetty [1981] 128 ITR 294 (SC)
amendment made in Rule 11U of the Rules to cover foreign company was
introduced with effect from 1 April 2019 to curb this mischief of foreign companies not being covered. The said amendment was to be applicable prospectively and hence, did not apply to the year under appeal.
• In response to the
department’s contention that pre-amended Rule 11U of the Rules was applicable to any company which included foreign company, it was held that such interpretation is not acceptable as the same will make the amendment redundant.
• The TO had valued the shares based on the Balance sheet of S Co. which was not audited by an auditor appointed under provisions of the Companies Act 1956. Rule 11UA read with Rule 11U of the Rules requires the
balance sheet to be audited by an auditor appointed under section 224 of the Companies Act, 1956. Therefore, as the computation mechanism provided in Rule 11UA of the Rules is not applicable to the present facts, the provisions of section 56(2)(viia) of the Act cannot be invoked. The Tribunal also reiterated the principal laid down by the Supreme Court in the case of B.C. Srinivasa Shetty3 that the charging provision and the computation provision should be read together, i.e., the charging provision of section 56(2)(viia) of the Act is not workable, as the computation mechanism fails in the instant case.
In addition to the above, following was upheld:
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• The purpose of incorporation of the taxpayer and transfer of shares of S Co. was to fulfil the requirements of the revised RBI regulations2 and not to make any gain.
• In view of the anticipated net liability towards investors, the value of shares of listed company in hands of the S Co. was virtually “zero”.
Considering this and other facts, the FMV of S Co.
computed as per the DCF method needed to be accepted.
• The TO cannot compute FMV
as per Rule 11UA(2) of the Rules, as its applicable only to transactions covered under section 56(2)(viib) of the Act.
• Therefore, the TO was directed to delete the addition.
The takeaways
• The Tribunal has held that the provisions of section 56(2)(viia) of the Act are not applicable on acquisition of shares of foreign companies prior to 1 April 2019 as otherwise, it will make the amendment to Rule 11U of
the Rules redundant.
• The Tribunal has held that the computation mechanism, as provided in Rule 11U read with Rule 11UA of the Rules fails in case of foreign company shares and
therefore the same cannot be liable to tax under section 56(2)(viia) of the Act.
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