Anti - Abuse Tax Provisions on Primary Acquisitions
CA. Uttam Padival M.
The author is a member of the Institute. He can be reached at uttampadival@gmail.com and eboard@icai.in
“Section 56(2)(x) is an anti-abuse provision which penalizes by levying tax on acquisition for inadequate consideration of inter-alia, shares. Some argue that application of section 56(2)(x) to cases where shares are acquired through fresh allotments would lead to absurd conclusions. This article highlights that, it is not the provision, but the improper application of the provision which results in absurd conclusions. Read on…”
Basics
Shares can be acquired through two modes – Primary and Secondary.
Primary Acquisition is when shares are acquired on allotment by the company. Hence, Primary Acquisition is also termed as Acquisition Against Allotment (“AAA”). In the case of AAA, new shares are allotted by the company to the shareholders. The shareholder, as consideration, would pay the allotment price to the company. Consequently, the net assets of the company would increase to the extent of the total consideration received on account of the fresh allotment. Correspondingly, there would also be an increase in the total number of shares outstanding.
Secondary Acquisition is when a person acquires, from an existing shareholder, shares which have already been allotted by the company. Hence, Secondary Acquisition is also termed as Acquisition Through Transfer (“ATT”). Existing shares when exchanged between parties results in ATT. ATTs do not impact either the net assets of the company or the number of shares outstanding. The only impact of ATT on the company would be the change in the shareholder from transferor to the transferee.
Figure 1: Share Acquisition Types
Primary / AAA (Acquisition Against Allotment)
Issuing Company ➔ [New Shares] ➔ Shareholder / Acquirer
Shareholder ➔ [Allotment Consideration] ➔ Issuing Company
Impact: Net assets increase; shares outstanding increase.
Secondary / ATT (Acquisition Through Transfer)
Transferor (Existing Shareholder) ➔ [Existing Shares] ➔ Transferee (Acquirer)
Transferee ➔ [Transfer Consideration] ➔ Transferor
Impact: No impact on company balance sheet or shares outstanding.
Table 1 : Difference between Primary and Secondary Acquisitions
| Differentiator | Primary Acquisition / AAA | Secondary Acquisition / ATT |
|---|---|---|
| Existence of shares prior to the transaction | No | Yes |
| Recipient of consideration of the transaction | Issuing Company | Transferee |
| Impact on Issuing Company’s Asset Position | Increase | No impact |
| Impact on the shares outstanding | Increase | No impact |
Anti-Abuse Tax provisions on Share Acquisitions
If an asset is exchanged at a price lower than the minimum acceptable rational price, then there is a high probability that the transaction price is vitiated. In the case of Immovables, the price determined by the stamp duty authorities, can be considered as such minimum acceptable rational price. Similarly, in the case of shares, the minimum acceptable rational price is the Book Value per share. No rational person would, in normal circumstances, be willing to sell his shares at a price below its Book Value. Hence, if additional tax is levied on share transacted at less than the Book Value, it would work as an anti-abuse provision dissuading misreporting of the transaction price.
The Indian Income-tax Act, 1961 (“Act”; reference to any statutory provision, unless otherwise mentioned, refers to the statutory provisions of the Indian Income-tax Act, 1961) has promulgated certain anti-abuse provisions to check acquisition of shares at prices below the book value.
In 2009, section 56(2)(vii) was introduced to tax share acquisitions by individuals and HUFs for inadequate consideration. Subsequently, in the year 2010, section 56(2)(via), widened the scope to cover share acquisitions by partnership firms and closely held companies. In the year 2017, to give complete coverage, section 56(2)(x) was introduced, which provides for taxing share acquisitions for inadequate consideration by all forms of persons.
The aforementioned anti-abuse tax provisions provide that, if the transaction price is less than the Adjusted Book Value (“ABV”), difference between ABV and the transaction price will be taxable in the hands of the acquirer. Alternatively put, if the transaction price is higher than ABV, no tax u/s 56(2)(x) is attracted. Hence, these anti-abuse provisions, by prescribing the floor-price, monitor and tax such share acquisitions which are done below the ABV. The methodology for computing the ABV is contained in Rule 11UA of Income Tax Rules, 1962 which have been borrowed from the erstwhile provisions relating to Gift Tax and Wealth Tax.
While applicability of section 56(2)(x) on secondary acquisitions has been well-accepted, there has always been debate as to whether section 56(2)(x) is attracted on allotment of shares (primary acquisitions – AAA transactions). In order to clear the air, CBDT issued a circular1 clarifying that no anti-abuse tax is attracted on primary acquisitions. However, within just a week, owing to unintended political controversy, this circular was retracted2 citing the sub-judice status of the matter. There are two judgements3 by the Bombay bench of the Mumbai Income Tax Tribunal, which have held that section 56(2)(x) is equally applicable to primary acquisitions too.
Those who advocate applicability of section 56(2)(x) on primary transactions, put forward a simple but elegant argument - Sections 56(2)(x) is applicable on receipt of shares for inadequate consideration. In primary acquisitions too, since the allottee receives shares, if the consideration is inadequate, why should it not attract section 56(2)(x)?
Hypothetical Example: How Non-Applicability on Primary Acquisitions Leads to Tax Evasion
The promoter subscribed to the entire share capital being 1 Lakh shares of INR 10/- each of a newly incorporated company which was used to acquire an immovable property at fair market value of, say, INR 1 million.
Couple of years later, let us assume that the fair market value of the immovable has appreciated to INR 5 million. Thus, the ABV per share would be INR 50/- per share. For avoiding tax, if either the immovable property or the shares are sold for less than adequate consideration, the acquirer will be liable for tax on inadequate consideration by virtue of section 56(2)(x).
To evade this, the company allots 2 Lakh new shares at face value for INR 10/- to the acquirer. Now the ABV per share would drop from INR 50/- per share to INR 23.33/- per share. Subsequently, the promoter sells his shareholding of 1 lakh shares at INR 23.33/- per share to the acquirer.
Consequently, the right in the immovable property whose fair market value was INR 5 million, got indirectly transferred from the promoter to the acquirer at INR 2.33 million. Since, the transfer of the shares from the promoter to the acquirer is at ABV, the anti-abuse provision is not attracted. This evasion would be possible if section 56(2)(x) is not applied on share acquisitions through allotments. As explained later, these kinds of tax avoidance acrobatics will be dissuaded, if 56(2)(x) is applicable for secondary as well as primary acquisitions.
Arguments against applying Anti - Abuse tax provisions on Primary Acquisitions
The detractors of applying section 56(2)(x) to primary acquisitions have the following cogent arguments:
- Primary transactions are not transfers: Non-Transfer Argument;
- Since shares are chose4-in-action which come into existence on allotment, how can they be termed as property, which is the primary ingredient of section 56(2)(x)?: Non-Existence Argument;
- If primary transactions are subjugated to taxation, then it would lead to absurdity in case of primary acquisitions as part of bonus allotment or rights allotment: Illogical Ramification Argument.
While argument against application of section 56(2)(x) to primary acquisitions, on the face of it, appear to be realistic, on a deeper analysis, application of the anti-abuse tax provision on primary acquisitions, not only fulfils the anti-abuse objective but at the same time does not impinge genuine business transactions as explained further.
Arguments against Non-Transfer argument
Agreed that primary acquisitions are not a result of transfers. However, transfer is not one of the essential ingredients for section 56(2)(x). The taxing provision is applicable when a person receives the shares. How the shares were acquired, through primary acquisition or through secondary acquisition, is not the lookout of section 56(2)(x). It is a settled matter that when words of the statute are unambiguous, one is not supposed to go beyond the literal interpretation. Further, by applying contemporaneous exposition, we learn that with the intent to dissuade acquisition of shares for inadequate consideration, the legislature has introduced section 56(2)(x) as an anti-abuse provision. Since the mischief sought to be remedied is acquisition and not transfer, section 56(2)(x) is equally applicable to primary acquisitions as it is to secondary acquisitions.
Arguments against Non-Existence Argument
Non-existence arguers contend that Primary Acquisitions are a result of allotment. Since shares do not exist prior to allotment, how can one be presumed to have received something which did not exist? Hence, provisions of section 56(2)(x), should not be applicable for shares which have been acquired through allotments.
The Supreme Court5 has held that, in company law the word “allotment” means appropriation out of previously unappropriated capital of a company, of a certain number of shares, to a person and till such allotment, the shares do not exist as such. It is only on allotment that the shares come into existence and in every case the words “allotment of shares” have been used to indicate the creation of shares by appropriation out of the unappropriated share capital to a particular person.
From the above judgement, it can be inferred that shares do not exist prior to allotment. However, shares come into existence on allotment. The Non-Existence Argument would hold good against transfers, in which case, it can be argued well that the shares cannot be said to be transferred on their allotment, since they came to existence on allotment. However, section 56(2)(x) deals with receipts and not transfers and hence, there is no dispute about primary-acquisitions resulting in receipt of the shares.
Arguments against Illogical Ramification Argument
The following hypothetical example illustrates how applicability of section 56(2)(x) on primary acquisitions can purportedly lead to taxation and frustrate genuine business transactions.
A company has an ABV of INR 12 million. The Company has 2 promoters holding 1 share each. Because of the small number of shares, the shares have a high per share ABV – INR 6 million per share. The high per share value, make the shares illiquid. Hence, the company capitalizes the profits and issues Bonus shares. No monetary transaction has taken place on allotment of bonus shares. If we force section 56(2)(x) to the Primary Acquisition of Bonus shares, it would be akin to a bank charging a customer for exchanging one INR 2000/- denominated note for twenty INR 100/- denominated notes.
However, the above anomaly is a result of improper application of the anti-abuse provisions. To recollect the anti-abuse provision, Section 56(2)(x) provides for taxation of the difference between ABV and Consideration. A proper understanding of the above two terms is very important for proper application of the anti-abuse provisions.
Proper Application: Understanding ABV and Consideration
ABV (Adjusted Book Value)
The basic question is, at what point of time should the ABV, be computed: Pre-Acquisition or Post-Acquisition? In the case of Secondary Acquisitions, as inferred from Table 1, there would be no impact on the balance sheet of the company and hence the pre-acquisition and post-acquisition ABV would be the same. However, in case of Primary Acquisitions, both the total ABV of the company as well as the number of shares would increase post-allotment. Hence, for the purpose of section 56(2)(x) should the ABV be computed pre-allotment or post-allotment? The answer lies in Rule 11U(j) of the Income Tax Rules, 1962 which provides that ABV of the shares needs to be computed at the time of receipt of the shares i.e., post-allotment.
Consideration
Consideration for the purpose of section 56(2)(x) is that which is paid by the acquirer for acquiring the shares. Accordingly, the allotment price paid by the acquirer for acquiring shares would be the consideration for the purpose of 56(2)(x).
Additionally, there is one more element of consideration in primary acquisitions, which is not applicable in the case of secondary acquisitions. When new shares are allotted, depending upon the allotment price, the ABV-per share will increase or decrease as illustrated in the following table:
Table 2 : Impact of allotment on ABV-per share
| Notation | Particulars | Basis / Formula | Case 1 | Case 2 | Case 3 |
|---|---|---|---|---|---|
| A | Pre-Allotment Total ABV | Assumption | 2,000.00 | 2,000.00 | 2,000.00 |
| B | Total No. of Shares Pre-Allotment | Assumption | 100 | 100 | 100 |
| C | Pre-Allotment ABV per share | A ÷ B | 20.00 | 20.00 | 20.00 |
| D | No. of new shares allotted | Assumption | 50 | 50 | 50 |
| E | Allotment Price per share | Assumption | 15.00 | 20.00 | 25.00 |
| F | Total amount received by the Company on Allotment | D × E | 750.00 | 1,000.00 | 1,250.00 |
| G | Post-Allotment Total ABV | A + F | 2,750.00 | 3,000.00 | 3,250.00 |
| H | Total No. of Shares Post-Allotment | B + D | 150 | 150 | 150 |
| I | Post-Allotment ABV per share | G ÷ H | 18.33 | 20.00 | 21.67 |
| J | Increase / (Reduction) in ABV per share on account of allotment | I - C | (1.67) | - | 1.67 |
As can be observed from the above table, if the allotment price per share (Notation, “E”) is more than the pre-allotment ABV per-share (Notation, “C”), it results in an increase in the ABV per-share, post allotment (Notation, “I”) and vice-versa.
This increase or reduction in the ABV-per share as a result of a new allotment is nothing but the gain or loss experienced by the existing shareholders for their decision to allot shares at the allotment price.
If anything is paid by a person other than the acquirer, then such payment would not form part of the consideration for the purpose of section 56(2)(x). Hence, if the existing shareholder incurs loss in the ABV-per share as a result of the new allotment, but no shares are acquired by the existing shareholder, then such loss would not form part of the consideration for the purpose of section 56(2)(x). In other words, such amount of loss in ABV per-share borne by an existing shareholder to the extent of the new shares acquired, would form part of the 56(2)(x) consideration.
Two Components of Consideration in Primary Acquisition:
(A) Allotment price per share × No. of Shares Acquired
(B) Loss in ABV per share × No. of Shares Acquired
If the above peculiarities of ABV and Consideration in the case of primary acquisitions are properly understood and consistently applied, section 56(2)(x) would not result in taxation of genuine business transaction being bonus allotments and proportionate rights allotments. At the same time, Section 56(2)(x) would not leave untaxed such tax evasive manipulations through disproportionate rights allotments and allotments through preferential or private placements at disproportionately low allotment prices, as illustrated in the following table:
Table 3 : Impact of 56(2)(x) on various forms of Primary Acquisitions
| Notation | Particulars | Basis / Formula | Bonus Allotment | Rights offer accepted wholly | Rights offer accepted partially | Preferential / Private Placement |
|---|---|---|---|---|---|---|
| A | Pre-Allotment Total ABV | Assumption | 1,000.00 | 1,000.00 | 1,000.00 | 1,000.00 |
| B | No. of Shares held by X, pre-allotment | Assumption | 20 | 20 | 20 | 20 |
| C | No. of Shares held by Y, pre-allotment | Assumption | 30 | 30 | 30 | 30 |
| D | No. of Shares held by Z, pre-allotment | Assumption | - | - | - | - |
| E | Total No. of Shares Pre-Allotment | B + C + D | 50 | 50 | 50 | 50 |
| F | Pre-Allotment ABV per share | A ÷ E | 20.00 | 20.00 | 20.00 | 20.00 |
| G | No. of shares allotted to X | Assumption | 2 | 2 | - | - |
| H | No. of new shares allotted to Y | Assumption | 3 | 3 | 3 | - |
| I | No. of new shares allotted to Z | Assumption | - | - | - | 5 |
| J | Total No. of new shares allotted | G + H + I | 5 | 5 | 3 | 5 |
| K | Allotment Price per share | Assumption | - | 10.00 | 10.00 | 10.00 |
| L | Amount paid by X against new allotment | G × K | - | 20.00 | - | - |
| M | Amount paid by Y against new allotment | H × K | - | 30.00 | 30.00 | - |
| N | Amount paid by Z against new allotment | I × K | - | - | - | 50.00 |
| O | Total amount received against new allotment | L + M + N | - | 50.00 | 30.00 | 50.00 |
| P | Post-Allotment ABV | A + O | 1,000.00 | 1,050.00 | 1,030.00 | 1,050.00 |
| Q | No. of Shares held by X, post-allotment | B + G | 22 | 22 | 20 | 20 |
| R | No. of Shares held by Y, post-allotment | C + H | 33 | 33 | 33 | 30 |
| S | No. of Shares held by Z, post-allotment | D + I | - | - | - | 5 |
| T | Total No. of Shares Post-Allotment | Q + R + S | 55 | 55 | 53 | 55 |
| U | Post-Allotment ABV per share | P ÷ T | 18.18 | 19.09 | 19.43 | 19.09 |
| V | Fall in ABV per share due to allotment of new shares | F - U | 1.82 | 0.91 | 0.57 | 0.91 |
| W | ABV loss borne by X for acquiring new shares | B × V | 36.36 | 18.18 | 11.32 | 18.18 |
| X | ABV loss borne by Y for acquiring new shares | C × V | 54.55 | 27.27 | 16.98 | 27.27 |
| Y | ABV loss borne by Z for acquiring new shares | D × V | NA | NA | NA | NA |
| Z | Total Consideration from X for acquisition of new shares | L + W | 36.36 | 38.18 | - | - |
| AA | Total Consideration from Y for acquisition of new shares | M + X | 54.55 | 57.27 | 46.98 | - |
| AB | Total Consideration from Z for acquisition of new shares | N + Y | - | - | - | 50.00 |
| AC | Post-Allotment ABV of new shares acquired by X | G × U | 36.36 | - | - | - |
| AD | Post-Allotment ABV of new shares acquired by Y | H × U | 54.55 | 57.27 | 58.30 | - |
| AE | Post-Allotment ABV of new shares acquired by Z | I × U | - | - | - | 95.45 |
| AF | Amount taxable u/s 56(2)(x) for X | AC - Z | - | - | - | - |
| AG | Amount taxable u/s 56(2)(x) for Y | AD - AA | - | - | 11.32 | - |
| AH | Amount taxable u/s 56(2)(x) for Z | AE - AB | - | - | - | 45.45 |
Conclusion
Thus, we can conclude that section 56(2)(x) would equally be applicable to secondary as well as primary acquisitions. However, in the case of primary acquisition, it would have tax implication, if and only if, the allotment is disproportionate to the existing shareholding.