India: Reducing the rigours of change in tax law arising on additional investment in share capital of subsidiary

​published on 20 April 2023 | reading time approx. 3 minutes

Indian tax law contains a deeming provision [section 56(2)(viib)] to tax excess of share premium over the Fair Market Value (‘FMV’) of shares. Earlier, the provision was applicable only in respect of shares issued to resident shareholders. The recent amendment by the Finance Act, 2023 has amplified the scope of this provision to cover shares issued to non-resident shareholders as well with effect from 1 April 2023. Thus, the amendment impacts shares issued by Indian subsidiary to foreign parent entity at premium, if the shares are issued at a value higher than FMV.



In terms of Indian foreign exchange control regulations (‘FEMA’), shares cannot be issued to non-resident shareholders below FMV. There could be certain tax challenges as well in such situation. Further, at times, there can be a difference in FMV as per income tax law vis-à-vis foreign exchange control regulations. Given these practical challenges that could be faced, on application of the amended provision, it becomes important to understand which safeguards can reduce the rigours of section 56(2)(viib). In this context, the recent decision of Chhattisgarh Metalinks and Alloys (P.) Ltd vs ITO[1] assumes importance. 
In the said case, the taxpayer company had allotted additional 5,000 equity shares for INR 100 each. The shares had face value of INR 10 each and as such, the share premium was INR 90 per share. The tax officer computed FMV of these shares at INR 85 per share. The tax officer invoked the provisions of Section 56(2)(viib) and taxed the excess portion of consideration amounting to INR 15 per share (INR 100 minus INR 85). Total addition of INR 75,000 was made in the hands of the taxpayer.
First appellate authority did not adjudicate the issue of applicability of section 56(2)(viib) and hence, the taxpayer challenged the issue before the Second appellate authority viz. Income Tax Appellate Tribunal (‘ITAT’).
The Company argued before ITAT that the shares were allotted on pro-rata basis to existing shareholders and there is no change in shareholding percentage pre and post allotment of shares amongst the shareholders. It was also argued that fresh issue of shares has not resulted into disproportionate allotment of shares and thus, addition under section 56(2)(viib) was not warranted. 
The ITAT, after tracing the history of introduction of provisions of section 56(2)(viib), observed that this provision is an anti-abuse measure to prevent laundering of money. It noted that the genuineness of transaction was not in dispute in taxpayer’s case. In case of proportionate right issue to existing shareholders, there is neither increase nor decrease in the wealth of the existing shareholders. The percentage of shareholding remains the same. It’s only effect is that the value of shares get split into multiple shares. In view of this, ITAT deleted the addition made under section 56(2)(viib).
This judgement is important especially after the amendment by the Finance Act, 2023 to Section 56(2)(viib), which has become effective from 1 April 2023. There have been judgements from ITAT on bonus issue earlier in the context of another provision wherein it was held that it would not apply to issue of bonus shares as there was neither any increase nor decrease in the wealth of the shareholders/ issuing company nor any change in the percentage shareholding. ITAT had also held that analogy of bonus shares can also be applied to issue of additional shares, to the extent it was proportional to the existing shareholding. Thus, ITAT has applied the ‘proportionality’ test and held that once that is fulfilled, rigors of FMV valuation to such genuine transactions are exempted. The above decision of Metalinks directly deals with impact of section 56(2)(viib) in the context of right issue and hence, is important. This is an important decision and till the time contrary view is expressed by Higher Courts this may give us defence to handle this situations. 
The ITAT has laid emphasis on genuineness of transaction and proportionality of share allotment to existing shareholders to delete the addition to income. These points can be used as a defence in case of any dispute raised by tax authorities. Further, as mentioned in the beginning, with amendment in section 56(2)(viib), appropriate share valuation methodology holds key to mitigate possibility of tax authorities raising dispute regarding taxation of share premium. 


[1] ITA No. 114/RPR/2021
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