Share Premium Received in Excess of The Fair Market Value (FMV) By Closely Held Company [section 56(2) (viib)]

Here’s a comprehensive analysis of Section 56(2)(viib) of the Income Tax Act, 1961, which taxes share premium received in excess of fair market value (FMV) by closely held companies:

1. Purpose and Scope of Section 56(2)(viib)

• Introduced in 2012to prevent money laundering through inflated share premiums in closely held companies.
• Applies to:
  • Closely held companies (not publicly listed) issuing shares (equity/preference) to resident or non-resident investors(post-2023 amendment).
  • Excess premium over FMV is taxed as “Income from Other Sources”.

2. Key Conditions for Taxability

• Trigger: Share issue price > FMV of shares.
• FMV Determination: Higher of:
  • Net Asset Value (NAV)or Discounted Cash Flow (DCF) method under Rule 11UA.
  • Value substantiated by the company (e.g., intangible assets like patents).
  • Exceptions:
  • Startups recognized by DPIIT (if share capital + premium ≤ ₹25 crore).
  • Investments by Venture Capital Funds (VCFs), SEBI-regulated AIFs, or notified entities (e.g., sovereign wealth funds).

3. Tax Calculation and Compliance

• Tax Rate: Normal corporate tax rates (e.g., 25–30%) on the excess premium.
• Example:
  • FMV per share: ₹50
  • Issue price: ₹100
  • Excess premium: ₹50/share → Taxable as income.
• Reporting: Disclose in ITR under “Income from Other Sources”.

4. Judicial and Practical Challenges

• Valuation Disputes:
  • Courts uphold DCF methodif projections are reasonable (e.g., CIT vs. VVA Hotels).
  • AO cannot arbitrarily reject valuations but can scrutinize assumptions.
• Recent Changes (2023):
  • Extended to non-resident investors.
  • New valuation methods (e.g., Milestone Analysis, Option Pricing) for non-residents.

5. Compliance Tips to Avoid Litigation

• Robust Documentation: Maintain valuation reports (prepared by merchant bankers <90 days old).
• Align with Other Laws: Ensure FMV complies with FEMA and Companies Act.
• Startup Exemption: File DPIIT registration and avoid prohibited investments (e.g., real estate)