Taxation of Share Transfers under the Income Tax Act, 1961

Section 56(2)(viia) – Introduced by Finance Act, 2010
The Finance Act, 2010 added Section 56(2)(viia) to the Income Tax Act, 1961 to control tax avoidance through the transfer of shares between private companies. This section applies when a closely held company or a firm receives shares of another private company:

Without any payment, or

For a value less than the Fair Market Value (FMV),

and the FMV or difference exceeds ₹50,000. In such cases, the difference is taxable as “income from other sources” in the hands of the recipient.

Exemption:
Share transfers as part of business reorganization such as amalgamation or demerger are not taxable under this section.

This provision restricts private companies from using share gifting for internal restructuring.

Section 56(2)(viib) – Introduced by Finance Act, 2012
The Finance Act, 2012 introduced Section 56(2)(viib) to curb unaccounted money being routed through inflated share valuations.

This section applies when a private limited company receives consideration from a resident individual or entity for issuing shares and the consideration exceeds the FMV.

The excess amount over FMV is taxed as “income from other sources” in the hands of the issuing company.

Exemption:
Shares issued to venture capital companies or venture capital funds are excluded from this provision.

Valuation of Shares – Rules 11U and 11UA
To calculate Fair Market Value, companies must follow Rule 11U and Rule 11UA of the Income Tax Rules, 1962:

Rule 11U defines key terms such as valuation date, balance sheet, etc.

Rule 11UA outlines the following methods for determining valuation of shares:

Methods of Valuation of Shares:
Net Asset Value (NAV) Method:
Based on the book value from the latest audited balance sheet, with specified adjustments.

Discounted Free Cash Flow (DCF) Method:
Requires a Valuation Report from either:

A Merchant Banker, or

A Fellow Chartered Accountant (FCA) who is also an IBBI Registered Valuer.

A valid Valuation Report is essential to justify the FMV during share issuance or transfer and to avoid tax liabilities under Section 56.

FEMA Regulations on Valuation of Shares
In July 2014, the Reserve Bank of India (RBI) gave investors more flexibility by withdrawing the compulsory use of the DCF method under FEMA. Now, investors can adopt any internationally accepted valuation methodology for determining FMV.

Applicability of FEMA Regulations:
Foreign Direct Investment (FDI) into Indian companies.

Transfer of shares between residents and non-residents.

Share swaps and issue of shares to foreign investors.

Conversion of debentures or preference shares.

Valuation Requirements under FEMA:
A Valuation Report certified by:

A Chartered Accountant, or

A Merchant Banker, or

An IBBI Registered Valuer.

For listed companies, valuation must follow SEBI guidelines.

For unlisted companies, valuation must be based on arm’s length pricing using internationally accepted standards.

FAQs on Valuation of Shares and Registered Valuer Requirements
– Who is authorized to issue a Valuation Report for share issuance?

As per Rule 11UA, a Merchant Banker or a Fellow Chartered Accountant registered as a Registered Valuer with IBBI is authorized.

– Is the Valuation Report mandatory for all share transfers?

Yes, especially under Section 56(2)(viib) and FEMA regulations. The report helps substantiate the FMV for taxation and compliance.

– What is the role of an IBBI Registered Valuer?

An IBBI Registered Valuer is certified by the Insolvency and Bankruptcy Board of India (IBBI) to perform valuations under various financial laws. Their reports are widely accepted for income tax and FEMA purposes.

– Can FMV be determined using only the Book Value Method?

Yes, Rule 11UA allows both the Book Value and the DCF Method. The choice depends on the transaction’s context and the company’s future projections.

– Is valuation required for transactions between group companies?

If the transaction falls under Section 56(2)(viia) or 56(2)(viib), or if FEMA regulations apply, a valuation is required even for group companies.

Conclusion
Sections 56(2)(viia) and 56(2)(viib) aim to prevent tax leakage through unfair share valuations. The rules prescribe how the valuation of shares must be conducted and documented through a valid Valuation Report issued by an authorized Registered Valuer or professional. Compliance with these provisions is key for both domestic and cross-border transactions, especially involving private limited companies.

For transactions involving residents and non-residents, the FEMA framework also emphasizes proper valuation through internationally accepted methods. In all such cases, engaging a certified professional like an IBBI Registered Valuer or Merchant Banker ensures proper reporting and reduces the risk of tax disputes.

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