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Expansion of Deemed Income Provisions - Impact and Controversies

March 20, 2017[2017] 79 taxmann.com 221 (Article)
376 Views

Introduction

1. The Finance Minister, while moving with other anti- abuse measures has proposed to widen the scope of deemed income provisions by inserting a new clause (x) in sub Section (2) of Section 56 to be applicable from AY 2018-191. This Section provides for taxability in the hands of any person who receives any property without consideration or for a consideration less than the Fair market value ('FMV') of such property determined in the prescribed manner. Further, similar to existing provisions, this provision would only trigger if the difference between the consideration paid and the FMV exceeds INR 50,000.

2. Existing provisions upto March 31, 2017

  Chapter IV of the Income-tax Act, 1961 ('the Act') contains provisions for computation of income from other sources. This is a residuary head of computation which seeks to tax incomes which otherwise do not fall under any other head of income. In the recent past, various categories of income have been added under this head to tax receipt of property by way of gift of money, gift of shares etc. Section 56(2)(vii) and 56(2)(viia) as presently in force have been explained below.
  Section 56(2)(vii) of the Act provides that if an individual/HUF receives any sum of money or property without consideration or for a consideration below the FMV, then the difference between the FMV and the consideration is taxable in the hands of the recipient, provided the difference is in excess of INR 50,000. Further, property is defined to include land and building, shares or securities, jewellery, sculptures etc
  Section 56(2)(viia) of the Act provides that if any firm or a company (not being a company in which public is substantially interested i.e. closely held companies) receives shares of another closely held company without consideration or for a consideration below the FMV, then the difference between the FMV and the consideration is taxable in the hands of the recipient, provided the difference is in excess of INR 50,000.
  The manner of determination of FMV for the above provisions was provided in the Income-tax Rules, 1962 ('the Rules')

3. Proposed amendment applicable from April 01, 2017

  Proposed Section 56(2)(x) provides that if any person receives any sum of money or property without consideration or for a consideration below the FMV of the property, the difference is taxable in the hands of the recipient, provided the difference is in excess of INR 50,000. Certain exceptions have been provided from the operation of this Section.
  The existing provisions of Section 56(2)(vii) and Section 56(2)(viia) shall accordingly not apply from April 01, 2017.

4. Impact of Proposed Amendment

A. Widened Scope

The proposed new Section 56(2)(x) will expand both, the category of assets and recipients to which the deemed income provisions would apply. The existing provisions2 are currently applicable only in case of individual or HUF and in limited case, to firm or closely held companies. With the introduction of this clause, the scope of this specific anti- abuse provisions has been widened to include all persons under the Act such as LLP, Association of persons, Body of individuals, listed companies etc

  In the ensuing table, we have analysed the widened scope of proposed amendment:
Particulars Old Provisions (applicable upto March 31, 2017) Proposed amendment (applicable w.e.f April 01, 2017)
Class of recipients Individual/HUF Firm/closely held company All persons including widely held company
Category of assets  
(a) Sum of money Taxable Not taxable Taxable
(b) Immovable property being land and building Taxable Not taxable Taxable
(c) Shares of Closely Held Company Taxable Taxable Taxable
(d) Shares of Widely Held Company Taxable Not taxable Taxable
(e) Jewellery, bullion Taxable Not taxable Taxable
(f) Archaeological collection, drawings, paintings, sculpture, paintings, any work of art Taxable Not taxable Taxable

B. Specific exemption on corporate re-organization

Under the existing provisions, exemptions were provided to certain categories of transfer provided under Section 47. Under the proposed amendment, the scope of exemption have been expanded to include certain other categories of transfer discussed below:

Transaction not regarded as 'transfer' Excluded under Section 56 (2)(vii) and (viia) Excluded under proposed Section 56(2)(x)
Section 47(i) Distribution of capital assets on partial or total partition of HUF No Yes
Section 47(vi) Transfer of capital asset by amalgamating company to amalgamated company No Yes
Section 47(via) Transfer of shares of Indian company by amalgamating foreign company to amalgamated foreign company Yes Yes
Section 47(viaa) Transfer of capital asset by amalgamating banking company to amalgamated banking entity No Yes
Section 47(vib) Transfer of capital asset by demerged company to resulting company No Yes
Section 47(vic) Transfer of shares of Indian company by demerged foreign company to resulting foreign company Yes Yes
Section 47(vica) Transfer of capital asset by predecessor co-operative bank to successor co-operative bank No Yes
Section 47(vicb) Transfer of shares by a shareholder of predecessor co-operative society for shares of successor co-operative society Yes Yes
Section 47(vid) Transfer or issue of shares by resulting company to the shareholders of the demerged company Yes Yes
Section 47(vii) Transfer of shares of by a shareholder amalgamating company to amalgamated company Yes Yes

C. Interplay with proposed new Section 50CA

  It has been proposed to insert a new Section 50CA in the Act. The said Section provides that where consideration for transfer of share of a company (other than quoted share) is less than the FMV of such shares determined (the manner of determination of FMV is yet to be prescribed), the FMV shall be deemed to be the full value of consideration for computing the capital gains.
  To ensure that the full value of consideration is not understated, the existing provisions of Section 50C provides that the stamp duty value should be considered as full value of consideration for transfer of said immovable property in certain cases. The proposed Section 50CA has been introduced to rationalise the extant provisions of the Act to cover in its ambit the transfer of unquoted shares on a value less than the FMV. No corresponding provision in Section 49 has been provided to consider a higher cost of acquisition for the buyer in cases where the provisions of Section 50CA are invoked. However, in cases where Section 56(2)(x) is invoked, the fair market value of the property considered to arrive at the deemed income in the hands of recipient buyer is deemed to be the cost of acquisition of the property as per Section 49.
  It should be noted that in respect of transfer of shares, application of proposed Section 50CA and Section 56(2)(x) would lead to double taxation.
  In the hands of the transferor, Section 50CA proposes to tax the difference between the FMV and consideration received for transfer of share as capital gain.
  Section 56(2)(x) seeks to tax the aforesaid difference in the hands of the transferee as well.
  To understand this better, lets consider an example wherein, Company A transfers its investment in an unlisted company of 100 shares (acquired at INR 20 each) to Company B at the rate of INR 150 each. The FMV of shares is INR 170 each for the purpose of both the proposed Sections.
Company A (Transferor) Company B (Transferee)
Particulars Old provisions New Provisions Particulars Old provisions New Provisions
Full value of consideration 15000 (100 shares* INR 150) 17000 (100 shares* INR 170) Fair market value 17000 (100 shares* INR 170) 17000 (100 shares* INR 170)
Less: Cost of acquisition 2000 (100 shares* INR 20) 2000 (100 shares* INR 20) Consideration paid to Company A 15000 (100 shares* 150 INR) 15000 (100 shares* INR 150)
Capital gains 13000 15000 Deemed income 2000 2000
Impact Due to proposed amendment, there would be an additional income of INR 2000 which would be chargeable to tax in the hands of transferor. Impact INR 2000 which has already suffered tax in the hands of transferor would be taxable again in the hands of Company B. Accordingly, both the proposed amendments together result in double taxation to the extent of INR 2000.

5. Controversies /Issues

Following are certain issues / controversies arising out of the proposed introduction of clause (x) in the Section 56(2).

1.   Applicability of proposed amendment in case of change in legal form
  To understand this, consider a case, where ABC Partnership firm proposes to convert into private limited company under Part I of chapter XXI of the Companies Act, 2013 (earlier Part IX of Companies Act, 1956).
  Balance sheet of ABC Partnership
  Liabilities INR Assets INR
  Partner's capital account 1000 Fixed Asset and current Assets (fair market value is INR 6000) 2000
  Partner's current account 1000    
  Total 2000 2000
  Balance sheet of ABC Private Limited (Post Conversion)
  Liabilities INR Assets INR
  Share capital 1000 Fixed Asset and current Assets (fair market value is INR 6000) 2000
  Reserve and surplus (share premium) 1000    
  Total 2000 Total 2000
  A question arises as to whether provisions of Section 56(2)(x) would apply in the above case in the hands of the company basis the argument that property received by the company (i.e. assets having fair market value of INR 6000) exceeds the consideration paid (i.e. issue price) of INR 2000. In this context, certain points should be considered in determining the applicability of Section 56(2)(x) to conversion of firm into company:
  Various judicial precedents3 have recognized that pursuant to conversion of partnership firm into company under Part XI of the Companies Act 1956 (i.e. Part I of chapter XXI of the Companies Act, 2013) there is only change in legal form and there is no transfer between two parties. Therefore, Part XI conversion is a mere statutory vesting and not a case of transfer of assets by the firm or receipt of property by the company.
  In the case of a conversion of firm into company, it is merely a change in legal status and the value of shares is equal to the net worth of firm prior to conversion.
  Section 56(2)(x) does not provide any exemption to the tax neutral conversions [like conversion of a partnership firm into Company, conversion of Company into LLP as provided in Section 47 (xiii) and Section 47 (xiiib)].
2.   Applicability of proposed amendment in case of Indirect transfer
  Consider a case where shares of Company B (resident of Country Y) is held by shareholder Company A (resident of Country X). Company B has no assets other than shares of Company C in India (i.e. assets located in India) - hence, shares of Company B are deemed to derive their full value from assets located in India.
  Company A decides to transfer the shares of Company B to Company D (resident of Country Y) without any consideration. The transfer of shares of Company B to Company D should result in indirect transfer of shares of Company C.
  However, a question arises as to whether receipt of shares of Company B (which derives its value from Company C shares situated in India) can trigger taxability in the hands of Company D (being recipient of Company B shares) under proposed Section 56(2)(x). In this context, certain points needs to be considered in determining the applicability of 56(2)(x) to indirect transfers:
  Explanation 5 to Section 9(1)(i) was introduced in light of the Vodafone decision to cover cases where shares of a foreign company which derived their value substantially from assets in India were transferred. Explanation 5 to Section 9(1)(i) seeks to cover the cases wherein taxable income arises as a consequence of the transfer (i.e. to the transferor company). So far as the transferee / recipient company is considered, it receives the asset and does not transfer any asset.
  Section 56(2)(x) is a deeming provision, i.e. it deems the difference in the consideration and the FMV as income in the hands of the transferee. Explanation 5 to Section 9(1)(i) is also a deeming provision and applying Section 56(2)(x) to indirect transfer would amount to impute a deeming fiction into another deeming provision.
  Section 56(2)(x) does not provide any exemption to the tax neutral merger of two foreign companies resulting in the indirect transfer of Indian Company as provided in Section 47 (viab).
3.   Applicability of proposed amendment in case of Slump sale
  Consider a case, where Company A is engaged in the business of manufacture of machines and sales & distribution of the same. Manufacturing and Sales & Distribution divisions qualifies as two separate business undertakings under 2(19AA) of the Act. Company B proposes to acquire Manufacturing division of Company A. As part of this arrangement, all assets (including building), liabilities, rights obligation, contract or approvals pertaining to manufacturing division of the Company A will be transferred to Company B for lump sum consideration as INR 100 crores.
  The FMV of the manufacturing undertaking comes to INR 150 crores. Now, the question arises as to whether provisions of Section 56(2)(x) would apply and accordingly the difference of INR 50 crores (i.e. consideration paid i.e. INR 100 crores less fair value of net assets i.e. INR 150) would be taxable in the hands of the Company B.
  Secondly, if the value allocated by the Company B to building is INR 10 crores but the fair market value of building as per Section 56(2)(x) is INR 12 crores, can 56(2)(x) apply on receipt of building?
  In this context, certain points should be considered in determining the applicability of 56(2)(x) to a Slump sale:
  The manufacturing business will be transferred as a whole, on a going concern basis. Further, since there will be no interruptions in the operations as a result of the transfer, the said transaction shall be treated as 'transfer of undertaking' as whole (not a case of transfer of individual assets) as envisaged in Section 50B of the Act. The term 'undertaking' is not included in the inclusive definition of 'Property' under Section 56(2)(x) of the Act.
  From the perspective of Company B, it has received the undertaking as a whole and not building independently.
4.   Inclusion of deemed income under Section 56(2)(x) under definition of income
  It should be noted that the provisions under Section 56(2)(vii) and Section 56(2)(viia) of the Actseek to cover the difference in consideration and FMV of property as deemed income. However, since these transactions may be per se capital in nature, the deemed income arising in this Sections has been included in the definition of income under Section 2(24) in order for such amounts to be considered as income under the Act.
  Section 56(2)(x) which operates on similar lines may also require an enabling provision under Section 2(24) in order for such deemed income to be taxable under the Act. However, currently no amendment has been proposed in the Finance Bill, 2017 to Section 2(24) to include the cases under Section 56(2)(x). This seems to be an omission and should most likely be considered when the Finance Act, 2017 is passed by the Parliament.

However, in case such an amendment is not proposed in the Finance Act, it would be interesting to see whether Section 56(2)(x) applies or whether the provision would fail in absence of inclusion of such transactions within the definition of income.

Concluding Remarks

6. Overall, the impact of the proposed amendment is going to be widespread and it would be important to analyse every transaction of purchase or receipt from a recipient's perspective to ascertain the potential impact. As discussed above, there are certain issues and controversies which are likely to arise on account of the amendment and it will help if certain clarifications are brought in the provisions to reduce litigation and provide certainty on the scope of these provisions.

■■


1. Consequently, clauses (vii) and (viia) of Section 56(2) of the Act would not be applicable post 01 April, 2017.

2. Section 56(2)(vii )and (viia)

3. CIT V Texspin Engg & Mfg. Works 263 ITR 345 (Bom) (2003)

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