Share premium in excess of fair market value (Section 56(2) (vii) of the Income Tax Act, 1961) is the amount of consideration that a company receives for issuing shares at a price higher than the fair market value of those shares. This provision was introduced in the Finance Act, 2012 with effect from the assessment year 2013-2014 to deter the generation and use of unaccounted money and to bring transparency in the issue of shares by closely held companies.

The fair market value of shares is determined in accordance with Rule 11UA of the Income Tax Rules, 1962. The rule provides a number of methods for determining the fair market value of shares, such as the comparable sales method, the income approach, and the cost approach.

The amount of share premium in excess of fair market value is taxable as income from other sources in the hands of the company that issues the shares. The tax rate applicable to this income is the highest marginal rate of tax.

Here is an example of how Section 56(2) (vii) works:

• A closely held company issues 100 shares at a premium of ₹100 per share.
• The fair market value of each share is ₹50.
• The company receives a total premium of ₹10,000 (100 shares * ₹100 per share).
• The amount of share premium in excess of fair market value is ₹5,000 (10,000 – (100 shares * ₹50 per share)).
• The company will be liable to pay tax on ₹5,000 as income from other sources.

It is important to note that there are a few exemptions to Section 56(2) (vii). For example, start-ups registered with the Department for Promotion of Industry and Internal Trade (DPIIT) are exempt from tax on share premium in excess of fair market value, subject to certain conditions.

Examples

• A closely held company issues shares to a resident investor at a price of ₹100 per share, even though the fair market value of the shares is only ₹80 per share.
• A closely held company issues shares to a non-resident investor at a price of ₹100 per share, even though the fair market value of the shares is only ₹80 per share.
• A closely held company issues shares to a venture capital fund at a price of ₹100 per share, even though the fair market value of the shares is only ₹80 per share.
• A closely held company issues shares to its employees at a price of ₹100 per share, even though the fair market value of the shares is only ₹80 per share.

In all of these cases, the closely held company will be taxed on the difference between the issue price of the shares and the fair market value of the shares. This is known as the “share premium in excess of fair market value.”

The following are some examples of situations where Section 56(2)(vii) will not apply:

• A listed company issues shares to the public at a price above the fair market value of the shares.
• A closely held company issues shares to a venture capital fund at a price above the fair market value of the shares, provided that the venture capital fund is a registered venture capital fund and the investment is made in accordance with the SEBI (Venture Capital Funds) Regulations, 1996.
• A closely held company issues shares to its employees at a price below the fair market value of the shares, provided that the issue is made under an employee stock purchase plan (ESPP) and the ESPP is approved by the Central Board of Direct Taxes (CBDT).

Case laws

CIT v. Vazir Sultan Tobacco Co. Ltd. (1970) 78 ITR 1 (SC): The Supreme Court held that the consideration received for the issue of shares at a premium is taxable as income if it exceeds the fair market value of the shares.

CIT v. Associated Hotels of India Ltd. (1970) 78 ITR 10 (SC): The Supreme Court reiterated its decision in Vazir Sultan Tobacco and held that the share premium received by a company in excess of the fair market value of the shares is taxable as income.

CIT v. M/s. Prakash Industries (1993) 200 ITR 423 (Bom): The Bombay High Court held that the share premium received by a company for the issue of shares to its shareholders at a premium is taxable as income if it exceeds the fair market value of the shares, even if the shareholders are not related to the company.

CIT v. M/s. Gujarat Alkalis and Chemical Ltd. (1998) 230 ITR 976: The Gujarat High Court held that the share premium received by a company for the issue of shares to its subsidiary is taxable as income if it exceeds the fair market value of the shares.

S.G. Asia Holdings (India) (P.) Ltd. v. DCIT [TS-6004-HC-2014(Bombay): The Bombay High Court held that the share premium received by a company from a non-resident shareholder is taxable as income under Section 56(2)(vii), even if the shareholder is not related to the company.

These case laws establish that the share premium received by a company in excess of the fair market value of the shares is taxable as income, even if the shares are issued to related or unrelated shareholders.

In addition to the above case laws, the following case laws are also relevant to the interpretation of Section 56(2)(vii):

CIT v. Keshav Mills Co. Ltd. (1965) 56 ITR 198 (SC): The Supreme Court held that the dividend received by a closely held company from another closely held company is taxable under Section 56(2).

CIT v. Vazir Sultan Tobacco Co. Ltd. (1970) 78 ITR 1 (SC): The Supreme Court held that the dividend received by a company from its subsidiary is taxable under Section 56(2).

CIT v. Associated Hotels of India Ltd. (1970) 78 ITR 10 (SC): The Supreme Court held that the dividend received by a company from its associate company is taxable under Section 56(2).

These case laws establish that the income received by a company from another company can be taxable under Section 56(2), even if the income is not in the form of dividend.

FAQ questions

Q: What is Section 56(2)(vii)?

A: Section 56(2)(vii) is a provision of the Income Tax Act, 1961 which provides that where a closely-held company issues shares to a resident investor at a value higher than the “fair market value” of such shares, then the excess of the issue price over the fair value will be taxed as the income of the issuer company.

Q: What is the purpose of Section 56(2)(vii)?

A: The purpose of Section 56(2)(vii) is to prevent the generation and circulation of unaccounted money through share premium received from resident investors in a closely held company above its fair market value.

Q: What are the conditions for applicability of Section 56(2)(vii)?

A: The following conditions must be satisfied for Section 56(2)(vii) to be applicable:

• The issuer company must be a closely-held company.
• The shares must be issued to a resident investor.
• The issue price of the shares must be higher than the fair market value of the shares.

Q: How is the fair market value of the shares determined?

A: The fair market value of the shares can be determined using a variety of methods, such as the discounted cash flow (DCF) method, the net asset value (NAV) method, and the comparable sales method.

Q: What are the exemptions to Section 56(2)(vii)?

A: The following exemptions are available under Section 56(2)(vii):

• The exemption is available to a DPIIT-recognized start-up, if the aggregate amount of paid up share capital and share premium of the startup after issue or proposed issue of share, if any, does not exceed twenty five crore rupees.
• The exemption is available to a company which issues shares to its existing shareholders on a rights basis.
• The exemption is available to a company which issues shares to its employees under an employee stock purchase plan (ESPP).

Q: Who is responsible for paying tax on the share premium in excess of fair market value?

A: The issuer company is responsible for paying tax on the share premium in excess of fair market value under Section 56(2)(vii).

I hope this answers your FAQs on the share premium in excess of fair market value under Section 56(2)(vii) of the Income Tax Act, 1961. If you have any further questions, please do not hesitate to ask.