In the dynamic landscape of Indian taxation, the Angel Tax provision has emerged as a formidable tool against black money. Enacted to curb the flow of unaccounted wealth, these provisions target closely held companies issuing shares at inflated prices. By taxing the excess over fair market value (FMV), the law aims to dismantle sophisticated money laundering schemes and enhance corporate transparency. As we delve into the intricacies of this section, it becomes evident that understanding its legislative purpose is crucial for both compliance and effective enforcement. Introduced by the Finance Act, 2012, Section 56(2)(viib) of the ITA (Angel Tax) targets unjustified excessive share premiums. This anti-abuse measure prevents the generation and circulation of unaccounted money disguised as share premiums. The FMV of equity shares and preference shares, including those issued to non-residents as per the Finance Act, 2023 amendment, is determined as per Rule 11UA of the Income-tax Rules, 1962. Taxpayers can choose their preferred valuation method, with Adjusted net asset value (NAV) and Discounted Cash Flow (DCF) being popular choices.
Since its introduction, the provisions of Section 56(2)(viib) of the ITA have been a subject of litigation. Key areas of contention include the choice of valuation methodology, the replacement of actual figures against estimates in the DCF method, the justification of the source of funds and investor credibility, retrospective application and applicability on the conversion of convertible instruments into equity. While these issues continue to exist, in this article, we will specifically discuss the recent judicial decisions on the applicability of Section 56(2)(viib) of the ITA to the following transactions:
- Conversion of loan into equity.
- Issue of shares to holding company.
- DECISION OF HON'BLE HIMACHAL PRADESH HC IN CASE OF IA HYDRO ENERGY (P) LIMITED1
In this matter, the partnership firm was converted to a company and loan provided by partners of the erstwhile partnership firm was converted into equity shares of the succeeding company at a premium. For the purpose of determination of value for issue of shares, the Assessee adopted DCF method. During the year of conversion, the Company declared a substantial loss. On scrutiny, the assessing officer made an addition under section 56(2) (viib) holding that the Assessee issued shares at a premium exceeding the FMV of the shares. According to the assessing officer, the taxpayer's valuation using the DCF method is bogus and has no correlation with the actual affairs of the company which has reported losses. CIT(A) and the Tribunal ruled in favor of the Assessee. Issues in Revenue's appeal filed before the High Court were two-fold:
- Whether provisions of section 56(2) (viib) of the ITA apply on conversion of a loan into Equity
- Whether the revenue is justified in rejecting the valuation method adopted by the taxpayer merely because of a huge difference in the projected figures and actual results?
Revenue contended that unsecured loans received in earlier years were a liability. On conversion to equity, the same should be treated as 'consideration received for issue of shares' under section 56(2) (viib) of the ITA. Further, the Revenue also highlighted the company's losses and significant deviations between projected and actual figures to justify substituting the DCF method with the NAV method as per Rule 11UA.
The High Court rejected the Revenue's appeal, stating that Section 56(2)(viib) of the ITA only applies if consideration is received for the issue of shares, which was not the case here. The assessee's books of accounts were duly scrutinized in the year in which the loan was accepted and the same was not disputed by the Revenue at that time. The High Court further observed that variations in projections and actual results do not invalidate the chosen valuation method and that the Revenue had no jurisdiction to replace the DCF method with the NAV method once the taxpayer has selected it as per Rule 11UA. The court emphasized that the Revenue could not prove that the loan-to-equity conversion was a scheme to defraud the authorities.
Inter-play with prevailing decisions on conversion of debt into shares
Previously, the Kolkata Tribunal2 interpreted the term 'consideration' in Section 56(2)(viib) to encompass all forms of consideration, not confined to monetary amounts alone. It observed that 'consideration' in this context includes various forms, whether tangible or intangible, pecuniary or non-pecuniary, and direct or indirect. Consequently, the conversion of Compulsorily Convertible Debentures (CCDs) into equity shares was deemed to constitute the receipt of consideration under this section.
In contrast, the Mumbai Tribunal3 in a case involving the conversion of Optionally Fully Convertible Debentures (OFCDs) into non-cumulative preference shares, adopted a different approach. It held that Section 56(2)(viib) of the Income Tax Act applies only when there is an actual receipt of consideration.
The Himachal Pradesh High Court, in its ruling for IA Hydro Energy (P) Limited, did not address the decisions of the Kolkata Tribunal or Mumbai Tribunal. The judgments from the Himachal Pradesh High Court and Mumbai Tribunal underscore the significance of the timing of the receipt of consideration, in contrast to the Kolkata Tribunal's focus on the broad scope of consideration irrespective of timing.
Although the Himachal Pradesh High Court's decision is not binding on other jurisdictions, its status as a High Court ruling lends it considerable persuasive authority in pending cases involving the conversion of debt into equity shares. The Kolkata Tribunal decision, which remains unchallenged in higher courts and unaddressed by the Himachal Pradesh High Court, would be of particular interest. With this conflict in interpretation, it would be interesting to see how other High Courts address the matter, especially in light of any Stare Decisis4 and Judicial Comity5 arguments that may potentially be advanced by the Revenue before the Higher Courts.
Given the contentious nature of the issue and the need for caution, many corporates converting debt into equity are obtaining valuation reports under Section 56(2)(viib) of the ITA.
- DECISION OF DELHI TRIBUNAL IN CASE OF SOLITAIRE BTN SOLAR (P.) LTD6
In this case, the assessee was a private limited company engaged in energy and infrastructure development. During the year consideration, the assessee allotted Optional Convertible Preference Shares (OCPS) to its holding company at a value of INR 1,000 per OCPS. During scrutiny, the Assessing Officer observed that OCPS were issued at premium of INR 990 per OCPS to its holding company. The Assessing officer rejected DCF method adopted by the company and adopted NAV, thereby levying tax under Section 56(2)(viib) of the ITA on the excess premium. CIT(A) ruled in favour of the Assessee.
The Delhi Bench of Tribunal rejected Revenue's appeal against the decision of CIT(A) and held that Section 56(2)(viib) of the ITA is not applicable in the present case as no benefit can be obtained by the assessee through the issuance of shares at an excess premium from its holding company. Relying on the Co-ordinate bench of Tribunal7, the Delhi Tribunal clarified that deeming provisions of Section 56(2) (viib) of the ITA does not apply to the issue of shares to existing shareholders/ holding company especially in the absence of any benefit occurring to any outsider.
In consonance with the view expressed by the Co-ordinate Bench, the Delhi Tribunal held that the addition under Section 56(2)(viib) of the ITA on the ground of FMV allegedly lesser than the premium charged on allotment of OCPS to parent co. i.e., holding co. is a damp squib. In summary, the Tribunal concluded that in this case, where convertible shares were allotted to a wholly owned 100% holding company, any potential benefit resulting from the alleged excess premium effectively accrues to the subscribers themselves, who already hold pre-existing rights in the company. Thus, on a common-sense approach, no purpose will be achieved by obtaining benefit by way of excess premium by the assessee from its own shareholder. The Tribunal emphasized that the purpose of Section 56(2)(viib) of the ITA, which is to tax the so-called excess premium as income, is not fulfilled when the shares are allotted to the same shareholders.
Impact on expanded applicability to transactions with non-resident shareholders
With the 2023 amendment, capital infusion into Indian private limited companies by overseas holding companies, as well as rights issues to existing overseas shareholders, has faced significant challenges. The primary issue stems from the conflicting pricing requirements under foreign exchange regulations, which mandate transactions to be "above" FMV, and Section 56(2)(viib) of the ITA, which requires transactions to be "below" FMV. In such cases, the Delhi Tribunal's judgment in the matter of Solitaire BTN Solar (P.) Ltd may serve as a useful reference.
Deeming fiction cannot be applied in a manner that contradicts the legislative intent of its introduction
Courts on multiple occasions have noted that one of the cardinal principles of interpretation of the fiscal statute is that they should be strictly construed. A deeming provision on the other hand is that it is intended to enlarge the meaning of a particular word for a definite purpose and thus, should not be extended beyond the mandate of the statute.8 This underscores the principles of non-arbitrariness and fairness. In the context of Section 56(2)(viib) of ITA, it's clear that this provision was enacted to address potential abuses related to the circulation of unaccounted money. Investment by existing shareholders, let alone a 100% holding company, where subscribers already possess rights in the company, is akin to transferring funds within one's own domain. This does not alter the shareholders' interests or control over the company, nor does it confer any unlawful advantage to the company. Applying Section 56(2)(viib) of the ITA on issue of shares to existing shareholders including the holding company would thus, be contradictory to legislative intent of such a provision.
In light of the above and considering the Government's aim to minimize litigation, issue of appropriate Governmental clarification/instruction to the assessing officers dealing in this context is need of the hour. A clarification which guides and requires the Assessing officers to thoroughly document their reasons for suspecting that the issuance of shares at a premium was intended to facilitate the circulation of black money.
Impact in specific scenarios
Capital infusion into equity shares and pricing of equity shares is a matter of negotiation between the parties. Prevalent practices of bridge funding, milestone-based funding, anti-dilution, Ratchets, etc. each employ distinct valuation mechanisms that are commonly used. Applicability of Section 56(2)(viib) of the ITA in such bona-fide scenarios, especially after the 2023 amendment involving non-resident investors is a matter of complex consideration. When cap
In the dynamic landscape of Indian taxation, the Angel Tax provision has emerged as a formidable tool against black money. Enacted to curb the flow of unaccounted wealth, these provisions target closely held companies issuing shares at inflated prices. By taxing the excess over fair market value (FMV), the law aims to dismantle sophisticated money laundering schemes and enhance corporate transparency. As we delve into the intricacies of this section, it becomes evident that understanding its legislative purpose is crucial for both compliance and effective enforcement. Introduced by the Finance Act, 2012, Section 56(2)(viib) of the ITA (Angel Tax) targets unjustified excessive share premiums. This anti-abuse measure prevents the generation and circulation of unaccounted money disguised as share premiums. The FMV of equity shares and preference shares, including those issued to non-residents as per the Finance Act, 2023 amendment, is determined as per Rule 11UA of the Income-tax Rules, 1962. Taxpayers can choose their preferred valuation method, with Adjusted net asset value (NAV) and Discounted Cash Flow (DCF) being popular choices.
Since its introduction, the provisions of Section 56(2)(viib) of the ITA have been a subject of litigation. Key areas of contention include the choice of valuation methodology, the replacement of actual figures against estimates in the DCF method, the justification of the source of funds and investor credibility, retrospective application and applicability on the conversion of convertible instruments into equity. While these issues continue to exist, in this article, we will specifically discuss the recent judicial decisions on the applicability of Section 56(2)(viib) of the ITA to the following transactions:
- Conversion of loan into equity.
- Issue of shares to holding company.
- DECISION OF HON'BLE HIMACHAL PRADESH HC IN CASE OF IA HYDRO ENERGY (P) LIMITED1
In this matter, the partnership firm was converted to a company and loan provided by partners of the erstwhile partnership firm was converted into equity shares of the succeeding company at a premium. For the purpose of determination of value for issue of shares, the Assessee adopted DCF method. During the year of conversion, the Company declared a substantial loss. On scrutiny, the assessing officer made an addition under section 56(2) (viib) holding that the Assessee issued shares at a premium exceeding the FMV of the shares. According to the assessing officer, the taxpayer's valuation using the DCF method is bogus and has no correlation with the actual affairs of the company which has reported losses. CIT(A) and the Tribunal ruled in favor of the Assessee. Issues in Revenue's appeal filed before the High Court were two-fold:
- Whether provisions of section 56(2) (viib) of the ITA apply on conversion of a loan into Equity
- Whether the revenue is justified in rejecting the valuation method adopted by the taxpayer merely because of a huge difference in the projected figures and actual results?
Revenue contended that unsecured loans received in earlier years were a liability. On conversion to equity, the same should be treated as 'consideration received for issue of shares' under section 56(2) (viib) of the ITA. Further, the Revenue also highlighted the company's losses and significant deviations between projected and actual figures to justify substituting the DCF method with the NAV method as per Rule 11UA.
The High Court rejected the Revenue's appeal, stating that Section 56(2)(viib) of the ITA only applies if consideration is received for the issue of shares, which was not the case here. The assessee's books of accounts were duly scrutinized in the year in which the loan was accepted and the same was not disputed by the Revenue at that time. The High Court further observed that variations in projections and actual results do not invalidate the chosen valuation method and that the Revenue had no jurisdiction to replace the DCF method with the NAV method once the taxpayer has selected it as per Rule 11UA. The court emphasized that the Revenue could not prove that the loan-to-equity conversion was a scheme to defraud the authorities.
Inter-play with prevailing decisions on conversion of debt into shares
Previously, the Kolkata Tribunal2 interpreted the term 'consideration' in Section 56(2)(viib) to encompass all forms of consideration, not confined to monetary amounts alone. It observed that 'consideration' in this context includes various forms, whether tangible or intangible, pecuniary or non-pecuniary, and direct or indirect. Consequently, the conversion of Compulsorily Convertible Debentures (CCDs) into equity shares was deemed to constitute the receipt of consideration under this section.
In contrast, the Mumbai Tribunal3 in a case involving the conversion of Optionally Fully Convertible Debentures (OFCDs) into non-cumulative preference shares, adopted a different approach. It held that Section 56(2)(viib) of the Income Tax Act applies only when there is an actual receipt of consideration.
The Himachal Pradesh High Court, in its ruling for IA Hydro Energy (P) Limited, did not address the decisions of the Kolkata Tribunal or Mumbai Tribunal. The judgments from the Himachal Pradesh High Court and Mumbai Tribunal underscore the significance of the timing of the receipt of consideration, in contrast to the Kolkata Tribunal's focus on the broad scope of consideration irrespective of timing.
Although the Himachal Pradesh High Court's decision is not binding on other jurisdictions, its status as a High Court ruling lends it considerable persuasive authority in pending cases involving the conversion of debt into equity shares. The Kolkata Tribunal decision, which remains unchallenged in higher courts and unaddressed by the Himachal Pradesh High Court, would be of particular interest. With this conflict in interpretation, it would be interesting to see how other High Courts address the matter, especially in light of any Stare Decisis4 and Judicial Comity5 arguments that may potentially be advanced by the Revenue before the Higher Courts.
Given the contentious nature of the issue and the need for caution, many corporates converting debt into equity are obtaining valuation reports under Section 56(2)(viib) of the ITA.
- DECISION OF DELHI TRIBUNAL IN CASE OF SOLITAIRE BTN SOLAR (P.) LTD6
In this case, the assessee was a private limited company engaged in energy and infrastructure development. During the year consideration, the assessee allotted Optional Convertible Preference Shares (OCPS) to its holding company at a value of INR 1,000 per OCPS. During scrutiny, the Assessing Officer observed that OCPS were issued at premium of INR 990 per OCPS to its holding company. The Assessing officer rejected DCF method adopted by the company and adopted NAV, thereby levying tax under Section 56(2)(viib) of the ITA on the excess premium. CIT(A) ruled in favour of the Assessee.
The Delhi Bench of Tribunal rejected Revenue's appeal against the decision of CIT(A) and held that Section 56(2)(viib) of the ITA is not applicable in the present case as no benefit can be obtained by the assessee through the issuance of shares at an excess premium from its holding company. Relying on the Co-ordinate bench of Tribunal7, the Delhi Tribunal clarified that deeming provisions of Section 56(2) (viib) of the ITA does not apply to the issue of shares to existing shareholders/ holding company especially in the absence of any benefit occurring to any outsider.
In consonance with the view expressed by the Co-ordinate Bench, the Delhi Tribunal held that the addition under Section 56(2)(viib) of the ITA on the ground of FMV allegedly lesser than the premium charged on allotment of OCPS to parent co. i.e., holding co. is a damp squib. In summary, the Tribunal concluded that in this case, where convertible shares were allotted to a wholly owned 100% holding company, any potential benefit resulting from the alleged excess premium effectively accrues to the subscribers themselves, who already hold pre-existing rights in the company. Thus, on a common-sense approach, no purpose will be achieved by obtaining benefit by way of excess premium by the assessee from its own shareholder. The Tribunal emphasized that the purpose of Section 56(2)(viib) of the ITA, which is to tax the so-called excess premium as income, is not fulfilled when the shares are allotted to the same shareholders.
Impact on expanded applicability to transactions with non-resident shareholders
With the 2023 amendment, capital infusion into Indian private limited companies by overseas holding companies, as well as rights issues to existing overseas shareholders, has faced significant challenges. The primary issue stems from the conflicting pricing requirements under foreign exchange regulations, which mandate transactions to be "above" FMV, and Section 56(2)(viib) of the ITA, which requires transactions to be "below" FMV. In such cases, the Delhi Tribunal's judgment in the matter of Solitaire BTN Solar (P.) Ltd may serve as a useful reference.
Deeming fiction cannot be applied in a manner that contradicts the legislative intent of its introduction
Courts on multiple occasions have noted that one of the cardinal principles of interpretation of the fiscal statute is that they should be strictly construed. A deeming provision on the other hand is that it is intended to enlarge the meaning of a particular word for a definite purpose and thus, should not be extended beyond the mandate of the statute.8 This underscores the principles of non-arbitrariness and fairness. In the context of Section 56(2)(viib) of ITA, it's clear that this provision was enacted to address potential abuses related to the circulation of unaccounted money. Investment by existing shareholders, let alone a 100% holding company, where subscribers already possess rights in the company, is akin to transferring funds within one's own domain. This does not alter the shareholders' interests or control over the company, nor does it confer any unlawful advantage to the company. Applying Section 56(2)(viib) of the ITA on issue of shares to existing shareholders including the holding company would thus, be contradictory to legislative intent of such a provision.
In light of the above and considering the Government's aim to minimize litigation, issue of appropriate Governmental clarification/instruction to the assessing officers dealing in this context is need of the hour. A clarification which guides and requires the Assessing officers to thoroughly document their reasons for suspecting that the issuance of shares at a premium was intended to facilitate the circulation of black money.
Impact in specific scenarios
Capital infusion into equity shares and pricing of equity shares is a matter of negotiation between the parties. Prevalent practices of bridge funding, milestone-based funding, anti-dilution, Ratchets, etc. each employ distinct valuation mechanisms that are commonly used. Applicability of Section 56(2)(viib) of the ITA in such bona-fide scenarios, especially after the 2023 amendment involving non-resident investors is a matter of complex consideration. When capital infusion transactions involve existing shareholders, one may evaluate it prudently to leverage the benefit of the Delhi Tribunal's decision on non-applicability of Section 56(2)(viib) of the ITA.
Impact for ineligible start-ups
The 2023 amendment has exacerbated the funding challenges faced by Indian companies that are not registered as startups with DPIIT. Existing foreign exchange regulations w.r.t. foreign direct investments are already stringent. Although the Delhi Tribunal's decision in the case of Solitaire BTN Solar (P.) Ltd may not be directly applicable to initial investments in ineligible startups, it could be relevant for subsequent investments where the investor is considered an existing shareholder. Nevertheless, caution is advised when structuring such investments.
- CONCLUSION
In the realm of tax legislation, judicial precedents are indispensable for protecting taxpayers from unpredictable enforcement and ensuring that tax laws are applied with their intended purpose. This principle is rooted in the 'Rule of Law,' a fundamental tenet of democratic societies that mandates all governmental actions, including taxation, conform to established laws to guarantee fairness, transparency, and predictability. Judicial oversight in the interpretation and application of tax laws serves as a crucial check against potential abuses of power by tax authorities, thereby preserving the integrity of the tax system. Recent judicial observations in cases such as IA Hydro Energy (P) Limited and Solitaire BTN Solar (P.) Ltd further illustrate this point.
Both rulings advance fair and predictable tax practices by reinforcing the judicially established principle that taxpayers may choose their preferred valuation method. 9/a> These rulings also reaffirm that the Assessing Officer lacks the authority to substitute the NAV method once the taxpayer has opted for the DCF method. This clarification ensures certainty for bona fide investors who base their investment decisions on estimates and prevents Assessing Officers from dismissing these estimates or valuations basis hindsight. This approach aligns with fundamental principle of certainty and predictability in tax laws established in the decision of Vodafone International Holdings BV vs. Union of India (2012).
The recent decisions of Delhi Tribunal10, including the case of Solitaire BTN Solar (P.) Ltd. indicate a trend where Section 56(2)(viib) is being considered inapplicable to transactions involving holding companies and existing shareholders. However, in the absence of clarification by the Revenue, companies seeking investments from existing shareholders should proceed with caution. The Revenue might still challenge these decisions before higher courts, and until a definitive ruling is issued by Higher Courts, there remains some uncertainty. It would be prudent for companies to closely monitor these legal developments and seek tailored advice based on their specific circumstances to mitigate risks.
Going forward, it would be interesting to see how the judicial landscape unfolds on these critical matters.
Footnotes
1 ITA No.4 of 2024
2Milk Mantra Dairy (P.) Ltd. v. DCIT - [2022] 140 taxmann.com 163 (Kolkata-Trib.)
3Rankin Infrastructure (P.) Ltd - [2022] 142 taxmann.com 37 (Mumbai - Trib.)
4 legal principle that directs courts to adhere to previous judgments (or judgments of higher tribunals) while resolving a case with allegedly comparable facts
5 principle whereby courts in one jurisdiction will show respect for the laws, judicial decisions, and judicial acts of another jurisdiction, without necessarily being bound to follow them.
6 [2024] 164 taxmann.com 170)
7 BLP Vayu (Projects-1) Pvt. Ltd. reported in (2023) 151 taxmann.com 47 (Del-Trib.) and DCIT v. Kissandhan Agri Financial Services (P) Ltd. [2023] 150 taxmann.com 390/201 ITD 159 (Del-Trib.)
8 Delhi Bench of Tribunal in the case of India Today Online Pvt. Ltd. v [2019] 104 taxmann.com 385/176 ITD 459 (Delhi - Trib.) and Supreme Court in case of Eicher Motors Ltd (1999)
9 Bombay High Court in Vodafone M-Pesa Ltd [2018] 92 taxmann.com 73 and Cinestaan Entertainment (P.) Ltd. [2019] 106 taxmann.com 300/177 ITD 809 (Delhi - Trib.)
10 BLP Vayu (Project-1) (P.) Ltd [2023] 151 taxmann.com 47/201 ITD 283(Delhi-Trib.), Kissandhan Agri Financial Servcies (P.) Ltd [2023] 150 taxmann.com390/201 ITD 159 (Delhi - Trib.) and Rugby Regency (P.) Ltd. [2024] 160 taxmann.com 1056(Delhi - Trib.)
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.