(First published on Linkedin)
In a recent decision by the Cochin ITAT, the issue of whether deemed gift tax provisions under section 56(2)(x) of the Income-tax Act, 1961 (erstwhile section 56(2)(vii)) would apply to rights issue by a company to its existing shareholders was analysed in detail.
Key Issues Analyzed:
1. Whether deemed gift tax provisions apply to the fresh allotment of shares under a rights issue.
2. Whether disproportionate shareholding outcomes post-rights issue attract the provisions.
3. The distinction between rights renounced among relatives versus non-relatives.
4. The legislative intent and anti-abuse nature of Section 56(2)(x).
Key Takeaways:
1. Receipt vs. Allotment: Deemed gift tax provisions would apply even when the property (shares) is created through a fresh allotment, as in a rights issue.
The emphasis is on the act of “receipt” rather than the pre-existence of the property, bringing rights issues firmly under the ambit of Section 56(2)(x).
2. Disproportionate Rights Issue: Disproportionate shareholding outcomes post-rights issue increase the risk of triggering deemed gift tax provisions. Given the anti-abuse nature of deemed gift tax provisions which was designed to prevent the undervalued transfer of assets, renunciation of rights by non-relatives resulting in an indirect transfer of economic ownership at less than tax FMV can attract taxation. The principle of “what cannot be done directly cannot be done indirectly” would be invoked to underscore the taxability of such transfers.
3. Rights Renounced Between Relatives: Transfers between defined relatives remain exempt under the deemed gift tax provisions. Therefore, renunciation of rights between relatives is shielded from taxation, aligning with the statutory exemption for relative-to-relative transfers.
4. Proportionate Rights Issue – Limited Tax Risk: Where a rights issue is proportionate to existing shareholding, the tax risk is minimal, even if the final shareholding becomes disproportionate due to other shareholders not subscribing.
5. Valuation Issues – Distressed Acquisitions: When the issue price is lower than the adjusted net book value as per tax (e.g., INR 25), the difference may trigger Section 56(2)(x), treating the undervaluation as taxable in the hands of the investor. This is especially so in case of distressed acquisitions when the underlying value of land, or shares/ securities, or the net book value itself does not reflect the stress on the balance sheet.