Black Money Blocked by Section 56(2)(viib)

Black money became the most interested topic of discussion for all Indians when NDA government came to the power with the promise of bring back all black money hidden abroad.
The promise is yet to be fulfilled.
But do you know, the black money present in India is more than the money hidden abroad.
The Government should first try to curb all practices which are source for Black Money.
Bringing the section 56(2)(viib) of income tax act 1961, was one of the step which provides for taxability of premium received in excess of fair market value by a closely held company.
Before going into the section 56(2)(viib), first let us understand the loopholes for converting black money into white.
The easy way to get rid of Black money is to make it white and there are many illegal ways to convert it into white.

Example of Black Money Transaction

Mr. A has black money (unaccounted money on which no tax has been paid) of Rs. 20 crore and he wants to make it white. He runs a small company “A pvt. Ltd”.
The balance sheet of A pvt. Ltd. is as follows.

Liabilities Amount (Rs.) Assets Amount (Rs.)
Share Capital (1 crore
shares @ Rs. 10 each)
10 crore Net Assets 12 Crore
Reserves & Surplus 2 Crore
Total 12 Crore Total 12 Crore

To make the black money white, Mr. A will have to bring the black money in the books of accounts and at same time he will have to ensure that no tax is levied on such money.
In the above company all shares are held by Mr A and his relatives. So he has full controlling interest.
Mr. A makes an arrangement with Mr. B and accordingly Mr.
B will apply to purchase the 10 lac shares of M/s A pvt. Ltd. of face value of Rs.10 each at Rs. 200 per share at a premium of Rs.190 per share.
Therefore, Mr. B gives cheque of Rs.20 crores to the company and he is allotted 10 lac shares of A. Pvt. Ltd. Mr. A in turn gives cash i.e. black money of Rs.20 crores to Mr. B.
Now Balance Sheet of Company A Pvt. Ltd., is as under:-

Liabilities Amount (Rs.) Assets Amount (Rs.)
Share Capital (1 .10 crore
shares @ Rs. 10 each)
11 Crore Bank Balances 20 Crore
Share Premium 19 Crore Other Net Assets 12 Crore
Reserves & Surplus 2 Crore
Total 32 Crore Total 32 Crore

Mr. A and his family have successfully converted black money of Rs.20 crores into white money of Rs.20 crores in the hands of their company.
The share premium received is on capital account and being share capital receipt not taxable in the hands of company.
The shareholding pattern is:
Mr. A & his family                           1 crores shares of Rs.10 each.
Mr. B.                                                 10  lakh share of Rs.10 each.
Total                                                  110 lakh shares of Rs.10 each.
Mr. A and his family still have control over the company since shareholding pattern is as under:-
Mr. A & Family    90.91 %
Mr. B.                       9.09%
Let us understand the above example more practically.
So practically, what was happening was that instead of Mr. B, there would be let’s say 40 persons who have white money of Rs.50 lakhs, each then these 40 persons subscribes to 25,000 share each of Rs. 200 and A & Family gives black money of Rs.50 lakhs each to these 40 persons.
After this, the fair market value of shares of the company is derived as under:
Assets – Outsider Liabilities x Paid up value of unquoted equity share Paid up capital
32,00,00,000/11,00,000 x 10= Rs. 29.09 Thereafter, Mr. B./40 people will sell their shares to A & family  @ Rs.29.09 per share and there is no gift implications under section 56(2)(vii).
Mr.B /40 people book loss under the head Capital Gains of Rs.200 – Rs.29.09 = Rs.170.91 per share.
Mr. A and family purchases these 10,00,000 shares @ Rs.29,09 using their white money of Rs.2,90,90,000.
Therefore, Mr. A and his family have effectively converted Rs.17,09,10,000/- black money into white money and having 100% control over the company Mr. B/ 40 people are able to book loss of Rs.17,09,10,000 under the head capital Gains.
This kind of dubious planning has been nullified by introducing section 56(2)(viib) by Finance Act,2012. Section 56(2) (viib) provides as under:
Where a closely held company receives in any previous year from any person, being a resident any consideration for issue of shares that exceeds the face value of such shares then
-Aggregate consideration received Less Fair market value of the shares such shares shall be income from other sources in the hands of the company
In the example given above the fair market value of shares before issue of 10 lakh shares is:
12 crore/10 Crore    x 10 = Rs. 12 per share
Therefore,   Rs.20 crores    – Rs.12 x 10 lakhs shares
i.e Rs.20 crores – 1.20 crores    = Rs.18.80 crores is taxable as income from other sources in hands of the company.
– The above modus-operandi has been broken by introducing section 56(2)(viib)Therefore, now companies will stop issuing shares in the above said manner.
– The section applies only if a closely held company issues shares at a premium. The reason for not applying this section to a widely held company is that SEBI monitors and approves the price at which shares are issued by a widely held company.
– This section does not apply where a closely held company issues shares to a Non-Resident at a premium in excess of FMV.  The reason seems to be that non-resident will not like to convert his white money abroad in dollars into black money in India. Moreover, the money received from non-resident is regulated by FEMA and  also by rules of RBI.
-With a view to safeguard the genuine investment by bonafide companies it is provided that this clause will not apply to.
(i) A venture capital undertaking receiving the consideration for issue of shares from a venture capital company or a venture capital fund ; and
(ii) A company receiving the consideration from a class or class of persons (‘Notified persons’) as may be notified by Central Government.
There are various issues that arise as regards new clause (viib) which are dealt with as under:
(i) Share application money received on 30-3-2012, but allotment of shares made on 30-4-2012. Whether any amount taxable under new clause (viib)?
– It appears that taxability will arise in the year of receipt of consideration for issue of shares (and not year of allotment) since the words “receives” is used in new clause (viib ). Since, new clause comes into operation from A.Y. 2013-14, it appears that it will apply only if consideration is received on or after 1-4-2012. Hence, no question of taxability under new clause (viib).
(ii) Company is widely held company at the time of receipt of consideration but is converted to a closely held company at the time of allotment of shares
– It appears that status of company at the time of receipt of consideration is relevant and not its status at the time of allotment of shares. Therefore, since company was not closely held co. at the time of receipt of consideration, no question of taxability under new clause (viib) arises.
(iii) Company is closely held company at the time of receipt of consideration but is converted to a widely held company at the time of allotment of shares
– It appears that status of company at the time of receipt of consideration is relevant and not its status at the time of allotment of shares. Therefore, since company was closely held co. at the time of receipt of consideration, question of taxability under new clause (viib) arises.
(iv) Consideration was received from a non-resident who became a resident at the time of allotment
– Since clause (viib) applies to consideration received from a resident, the residential status at the time of receipt of consideration by company and not residential status at the time of allotment is relevant. Therefore, as person from consideration was received is non-resident at the time of receipt of consideration, no question of taxability under new clause (viib) arises.
(v) Whether consideration received in kind taxable under new clause(viib)?
–New clause (viib) refers to “any consideration for issue of shares”. The word “any” is very wide in scope and will take in its scope consideration received in kind also.
However, new clause (viib) only speaks of how FMV of shares will be determined. It does not say how consideration in kind will be valued for comparison with FMV of shares.
Since provision does not say how consideration in kind will be valued, a view is possible that it is not intended to apply where part or whole of consideration is received in kind.
The object seems to be to target cash transactions as black money is generated through cash transactions as can be seen from new proviso to section 68.
Thus it can be seen that the clear intention behind this Amendment is to control the unwarranted or bogus or unjustified subscription to share premium.
As explained in the example, it will certainly control and stop the menace of black money or unaccounted money being rotated and channelized through this mode of Companies.
But while doing this controlling exercise it may hit certain genuine transactions of bona fide share premium also.  There may be companies who cannot justify the share premium on the basis of existing valuation even if done on global valuation concept.
The Rules of Valuation are clearly prescribed in Rule 11U and 11UA (See Appendix 3 & 4). Therefore, any other global valuation done by best of the firm of Chartered Accountant or a Management Consultant may not be accepted by the Income Tax Authorities if not done strictly as per the Rules.
Particularly in cases of companies where software innovations are being conducted and are on pipeline or in cases where technology up gradation or a secret formula is planned to be sold through heavy share premium may be adversely affected by this Amendment.
The above provision was introduced by the Finance Act 2012. There are many more steps to be taken to curb the practice of black money.