CBDT Widens Tax Dragnet on Notional Income through Section 56(2), but Loopholes Remain
The abolition of Gift Tax Act in the year 1998 paved the way for one of the most dynamic sections of the Income Tax Act, 1961, namely, Section 56(2). Under this Section, all kinds of incomes and gains, which were from sources other than the sources mentioned in the Act at that time, were brought under the purview of income-tax (I-T). Now, incomes and gains arising out of such transactions, which were structured to pass on assets to some other party without any consideration or with inadequate consideration, are subject to be taxed under this Section.
While Section 56(2) gave the authorities a tool to keep a check on the transactions structured to merely launder unaccounted income, it also brought in many questions. The Central Board of Direct Taxes (CBDT) has, since, been releasing clarifications to address questions as well as making changes to the Section to cover all loose ends of laundering unaccounted incomes.
Recently, CBDT, in its circular dated 31 December 2018, came up with a clarification to address the question:
Does the terms 'receives' with regards to Section 56 (2)(vii a) include receiving shares of companies (where the public are not substantially interested) by way of issues of shares by way of fresh issue/ bonus issue/ issue of rights shares/ transaction of a similar nature?
Before we get to the clarification, let's first analyse the Sections - 56(2)(vii), 56(2)(vii a) , 56(2)(vii b) & 56(2)(x)
Analysis of Section 56(2)(vii) Section 56(2)(vii a) Section 56(2)(vii b) & Section 56(2)(x)
Section 56(2)(vii a) of the IT Act, 1961 was inserted by Finance Act, 2010. Referring to the memorandum of Finance Act, 2010
clause (vii a) was incorporated in Section 56 to prevent the practice of transferring unlisted shares at a price which was different from the fair market value (i.e., inadequate consideration or none) of the shares and also to include within its ambit transactions undertaken in shares of the company (not being a company in which the public are substantially interested) either for inadequate consideration or without consideration where recipient is a firm or a company (not being a company in which the public are substantially interested).
In layman’s terms, the act of receiving means to receive something which was already in existence and the act of creation of that particular thing.
Similarly, receipt of shares, by way of fresh issue/ bonus issue/ issue of rights shares/ transaction of similar nature, is an act of creation of securities and not transfer of the same. The CBDT, in its circular dated 31 December 2018, has clarified the same. Section 56(2)(vii a) is applicable to transactions involving subsequent transfer of shares form the initial receiver to some third party, and not the time of issuance of such shares.
It is palpable that the shares would be treated as goods only when they come into existence and issuance of shares is the act of bringing the shares into existence. The word 'receives' with respect to section 56(2)(vii a) would not include issuance of shares within its ambit.
The intent of insertion of clause (vii a) to Section 56 was to apply the anti-abuse provision, i.e., transfer of shares for no consideration or an inadequate one, it is hereby clarified by the CBDT circular that Section 56(2)(vii a) of the Act shall apply in cases where a company (not being a company in which the public are substantially interested) or a firm receives the shares of the company (not being a company in which the public are substantially interested) through transfer for no consideration or an in adequate one. Hence Section 56(2)(vii a) of the Act shall not be applicable on fresh issue of shares by the specified company.
Taxation of fresh issue of shares comes under the purview of Section 56(2)(vii b).
The Subhodh Menon Case in the Context of Section 56
Drawing from the above case law, right shares issued at a value below the fair market value to an individual/ HUF where allotment is disproportionate will not be taxable under Section 56(2)(vii)(c) of the IT Act, 1961. Shares issued higher than the proportion offered (based on shareholding) shall attract tax provisions.
The Union Budget 2017
introduced Section 56(2)(x) of the IT Act, 1961 widening the scope of income from other sources and also clubbing together Sections 56(2)(vii) & Section 56(2)(vii a). I-T shall not be chargeable at the normal rate for a fresh issue of shares for closely held companies.
Since the offence that Section 56(2)(vii a) was trying to curb is the same as Section 56(2)(x), the question still remains as to whether the term 'receives' clarified in the CBDT circular, shall have the same analogy for Section 56(2)(x)? Simply put, whether Section 56(2)(x) of the Act will also be limited to transfer of existing shares and not cover fresh issue of shares?
(Yutika Lohia works at Vinod Kothari Consultants Pvt Ltd)