Budget 2023 – Applicability of section 56(2)(viib) to certain

business scenarios – does one shoe fit all ?

Jimit Devani Jason Sanctis

Partner, Deloitte Haskins & Manager, Deloitte Haskins and
Sells LLP Sells LLP

Summary

Budget 2023 proposes that non-resident investment in an unlisted company over and above
fair market value will be taxed. This is expected to lead to potential litigation over the
premium valuation.

Background

A common method to transfer funds between unconnected persons without any income-tax
implications was to infuse funds into a closely held company at a huge premium. This
resulted in the valuation of the company increasing and consequently of the shareholders
pre-infusion.

The Finance Bill, 2012 introduced section 56(2)(viib) of the Income-tax Act, 1961 (Act) as an
anti-abuse provision to prevent generation and circulation of unaccounted money through
share premium received from resident investors in a closely held company in excess of its
fair market value. It taxed the consideration or premium above fair market value (FMV) on
issue of shares in the hands of the closely held company. Rule 11UA of the Income-tax Rules,
1962 was prescribed for determination of FMV. In other words, the difference in the
consideration received and the FMV of the closed held company was subject to income-tax as
'income from other sources' in the hands of the closely held company (recipient).

However, this section was limited to Indian residents investing in closely held companies and
not applicable to non-resident investors1.

In 2019, Notification No. 13/20192 and Circular no. 16/20193 clarified that section 56(2)(viib)
does not apply to start-ups recognized by Department for Promotion of Industry and Internal
Trade ('DPIIT'), while, in cases where DPIIT approval is not there, inquiry should be carried
out only after approval of supervisory officer.

Amendment in brief

The Finance Bill, 2023 expanded the application of section 56(2)(viib) to non-residents. This
will make the provision applicable for receipt of consideration for issue of shares from any
person irrespective of his residency status. The amendment will be effective from financial
year 2023-24 onwards.

Impact on valuation
To ensure compliance with non-taxability under income-tax laws and foreign exchange
regulations (Foreign Exchange Management Act, 1999 – FEMA) valuation should be at FMV.

Under FEMA, the issue of shares has to at a minimum of FMV i.e., issue of shares below
FMV is not permissible.

Now, under the Act, the issue of shares require to be at or below FMV for not being subject
to tax under section 56(2)(viib).

Thus, the valuation of shares should be issued at FMV.

In practice, infusion of equity shares and pricing of equity shares in transactions are
governed by independent negotiations between the parties. Now, such price should match
with the FMV. To determine FMV, companies ought to obtain valuation reports from experts
such as a Merchant Banker. Further, the tax authorities can scrutinize and question these
reports during assessments.

Impact on certain scenarios

a. Investment in loss making companies

One of the reasons for investment in a loss-making company is because the company is
expected to grow from low revenues to a very high revenue in a short period of time. Another
reason is when the company can be turned around or revived. When the high revenue is
achieved the company may generate profit and may be viable for an Initial Public Offering
(IPO) thus, unlocking investor value. Further, in certain situations, the investment may be
more than the FMV because the business genuinely requires funds to survive in the business
environment or reach the next milestone or the next round of funding.

The amendment may affect decisions on investing in loss making companies which may be
revived by fund infusion.

b. Bridge funding

Bridge round is also known as "Discount to the next round" or "pre-funding round"
depending on the context.

In certain business situations, companies may need capital to create a rope or cash runway
to reach a certain milestone before a large round happens. At this point of time, the company
does not want to engage into a value discovery or valuation exercise. In addition to achieving
milestones, companies engage in bridge financing to increase rate of revenue growth, invest
in product improvement, avoid bankruptcy, etc. The investors infuse funds into the company
expecting the milestone to be achieved in a short period of time (such as coming months)
and the next round of funding to happen. However, money infused is at a discount valuation
to the next round of valuation. For example, due to Rs.1 million bridge round the company is
able to achieve desired milestones and subsequently raise a Rs.10 million at a Rs.40 million
post-money valuation. The bridge round investors would get to invest in the next round at a
valuation cap or discount rate:

♦   Valuation cap - The bridge round investors would invest in next round at a Rs.10
million post-money valuation (instead of Rs. 40 million).
♦   Discount rate (assuming 20%) -The bridge round investors would get to invest in the
next round at an Rs.32 million post-money valuation (80% x Rs.40 million).
The impact of section 56(2)(viib) will have to be analysed based on the Finance Bill approved
by Parliament.
c. Milestone arrangement

If a company meets a particular milestone or goal, the existing investors will invest
additional capital at higher valuation. The amount of infusion may be at a premium for
various reasons such as the business situation, to show confidence in the chief executive or
founder, investment in product development and improvement, to blitz scale the business
etc. The impact of section 56(2)(viib) will have to be analysed based on the Finance Bill
approved by Parliament.

d. Ratchets arrangement

In a ratchets arrangement, if a new investor gets a better deal or lower price on the share
allotment compared to an earlier investor then the earlier investor is eligible for a price
adjustment. For example, if the earlier investor was allotted shares at Rs. 1000 per share and
the new investor was allotted shares at Rs. 500 per share. Then, the older investor will get
an additional share for each share held so as to adjust the share price to the new investor
while the total value of holding remains the same.

The valuation at the different points of entry of the new investor and earlier investor are
different. The impact of section 56(2)(viib) will have to be analysed based on the Finance Bill
approved by Parliament.

e. Anti-dilution clause in agreement

An anti-dilution clause is to prevent investor value when the company valuation dips or loses
value. For example, a company is valued at Rs.1000 and the investor shares are valued at
100. Then, the company valuation falls to Rs. 500 and consequently, the investor share value
falls to Rs. 50. In such a case anti-dilution clause protects investor value. If the anti-dilution
clause is there the investor continues to be valued at Rs.100 as he will be issued new shares
equivalent to the dip in company value. This will lead to increase in share holding percentage
of the investor.

The valuation at the time of investing and at time of invoking the anti-dilution clause is
potentially different. The impact of section 56(2)(viib) will have to be analysed based on the
Finance Bill approved by Parliament.

Conclusion

Section 56(2)(viib) provision are already in force for resident investors and attracted
litigation around valuation, applicability to genuine business transactions and restructuring,
applicability to family settlements, etc. The inclusion of non-residents makes the section
applicable irrespective of residency. It could lead to increased tax out-flow for companies in
case of non-resident investments.

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1. Edulink Pvt. Ltd. v. ITO [2019] 108 taxmann.com 221/178 ITD 174 (Bang. - Trib.)
2. [Notification No. 13/2019/F. No. 370142/5/2018-TPL (Pt.)]
3. Circular No.16/2019 [F.No. 173/149/2019-ITA-I], dated 7-8-2019