56(2)(x) of the Income-tax Act, 1961 (“Act”) provides that where any person “receives” any specified “property” (which includes shares and securities without consideration or for a consideration which is less than its fair market value, as determined in accordance with the applicable rules (“Tax FMV”), then, the Tax FMV (where the property is received without consideration) or the excess of the Tax FMV over the consideration paid would be subject to tax in the hands of the recipient of “property” as “income from other sources”.
In this context, a question arises whether Section 56(2)(x) of the Act would apply to a cancellation of shares by an Indian issuer company, pursuant to a capital reduction sanctioned by the National Company Law Tribunal (“NCLT”).
Before we analyze the implications under Section 56(2)(x) of the Act, it is important to understand what a capital reduction under Section 66 of the Companies Act, 2013 entails. Section 66 of the Companies Act, 2013 provides that subject to sanction of the NCLT, a company may, inter alia, reduce its share capital by cancelling its share capital. In other words, in case of a capital reduction, unlike a share buyback, the shares are not first received by the company and then cancelled; instead the shares stand cancelled by operation of the order of the NCLT.
In this context, it is important to note that in order to trigger chargeability under Section 56(2)(x) of the Act, the following conditions must be cumulatively satisfied:
(a) the recipient must “receive” specified “property” from another person; and
(b) the receipt should be for a consideration which is less than the Tax FMV of such “property”.
For the purposes of Section 56(2)(x) of the Act, the definition of the expression “property” would be the same as defined under Explanation (d) to Section 56(2)(vii) of the Act. The relevant definition is extracted below:
“(d) “property” means the following capital asset of the assessee, namely, ………….
(ii) shares and securities; ………….”
Therefore, for the provisions of Section 56(2)(x) to apply, the recipient must receive specified property which should constitute a capital asset for the recipient. This interpretation is further clarified by the Memorandum explaining the provisions of Finance Bill, 2010 (through which the said definition of “property” was amended). The relevant extracts of the Memorandum read as under:
B. The provisions of section 56(2)(vii) were introduced as a counter evasion mechanism to prevent laundering of unaccounted income under the garb of gifts, particularly after abolition of the Gift Tax Act. The provisions were intended to extend the tax net to such transactions in kind. The intent is not to tax the transactions entered into in the normal course of business or trade, the profits of which are taxable under specific head of income. It is, therefore, proposed to amend the definition of property so as to provide that section 56(2)(vii) will have application to the ‘property’ which is in the nature of a capital asset of the recipient and therefore would not apply to stock-in-trade, raw material and consumable stores of any business of such recipient. …………..”
Further, the expression “receive” has not been defined in the Act. In the absence of a statutory definition, courts have held that recourse can be made to the common parlance definition of any term or expression. Black’s Law Dictionary defines “receive” to mean “to come into possession of or get from some outside source”. In other words, the term “receives” presupposes the existence of the thing or property in the hands of the recipient.
In light of the foregoing discussion, it could be argued that for there to be a charge under Section 56(2)(x) of the Act, the recipient must receive specified property which constitutes its “capital asset”. This view also draws support from other provisions of the Act. As an example, Section 49(4) of the Act provides as under:
“Cost with reference to certain modes of acquisition.
(4) Where the capital gain arises from the transfer of a property, the value of which has been subject to income-tax under clause (vii) or clause (viia) or clause (x) of sub-section (2) of section 56, the cost of acquisition of such property shall be deemed to be the value which has been taken into account for the purposes of the said clause (vii) or clause (viia) or clause (x).“
Section 49(4) essentially states that where the “receipt” of a capital asset has been subject to tax under Section 56(2)(x) of the Act in the hands of the recipient, the Tax FMV of such capital asset which has been considered for computing income under Section 56(2)(x) shall be deemed to be the cost of acquisition of such capital asset in the hands of the recipient. In other words, the Act pre-supposes that the “property” whose “receipt” is subject to tax under Section 56(2)(x), must be held by the recipient after its receipt.
In case of a cancellation of shares, pursuant to a NCLT approved capital reduction scheme, the issuer company cannot be said to be “receiving” its shares, and consequently, would not hold them as a “capital asset” at any point of time. Therefore, the proposed cancellation of shares by the issuer company fails to satisfy the “property” test as well as the “receives” test under Section 56(2)(x) of Act.
This proposition has been upheld by the Mumbai bench of the Income-tax Appellate Tribunal (“ITAT”), where while analyzing the implications of Section 56(2)(viia) of the Act in the context of a buyback of shares, the ITAT observed as under:
“31. A combined reading of the provisions of sec. 56(2)(viia) and the memorandum explaining the provisions would show that the provisions of sec. 56(2)(viia) would be attracted when “a firm or company (not being a company in which public are substantially interested)” receives a “property, being shares in a company (not being a company in which public are substantially interested)”. Therefore, it follows the shares should become “property” of recipient company and in that case, it should be shares of any other company and could not be its own shares. Because own shares cannot be become property of the recipient company.
32. Accordingly we are of the view that the provisions of sec. 56(2)(viia) should be applicable only in cases where the receipt of shares become property in the hands of recipient and the shares shall become property of the recipient only if it is “shares of any other company”. In the instant case, the assessee herein has purchased its own shares under buyback scheme and the same has been extinguished by reducing the capital and hence the tests of “becoming property” and also “shares of any other company” fail in this case. Accordingly we are of the view that the tax authorities are not justified in invoking the provisions of sec. 56(2)(viia) for buyback of own shares.”
The above decision confirms that since a company cannot hold its own shares under Indian law, it cannot be said that the company “receives” any “property” upon a share buyback for there to be a charge under Section 56(2)(viia) of the Act. Importantly, in case of a share buyback, the issuer company is required by law to extinguish and physically destroy the shares so bought within 7 days of the last date of completion of buy back. Therefore, while there is a “receipt” of its shares, such shares are not held by the issuer company and are cancelled in accordance with law. In contrast, in case of a capital reduction, the issuer company does not “receive” its shares in the first place. Accordingly, the above ruling which gives relief regarding applicability of Section 56(2)(viia) of the Act to a share buyback, should provide a stronger basis for arguing that Section 56(2)(x) of the Act does not apply to a capital reduction.
Having said that, given the aggressive interpretations adopted by the tax authorities in recent past, it would be advisable that the Government issues a clarification that transactions like capital reduction, share buyback etc. would not be covered by the provisions of Section 56(2)(x) of the Act.