The receipt of shares by a firm or a closely held company from any person without consideration or for inadequate consideration is taxable under Section 56(2)(viib) of the Income Tax Act, 1961.

A closely held company is a company in which the public are not substantially interested. This means that the company’s shares are not widely held and are not traded on a stock exchange.

The receipt of shares by a firm or a closely held company is taxable under Section 56(2)(viib) if:

• The shares are received without consideration or for inadequate consideration.
• The shares are received from any person (except from a relative or a member of a Hindu Undivided Family).

The fair market value of the shares received is taxable as income from other sources in the hands of the firm or the closely held company.

Here are some examples of situations where the receipt of shares by a firm or a closely held company may be taxable under Section 56(2)(viib):

• A firm receives shares from a client without any consideration.
• A closely held company receives shares from a promoter without any consideration.
• A closely held company receives shares from a related party for a price that is lower than the fair market value of the shares.

It is important to note that the receipt of shares on fresh issuance is not taxable under Section 56(2)(viib). For example, if a closely held company issues shares to the public at a price that is higher than the fair market value of the shares, the excess amount received is not taxable under Section 56(2)(viib).

If you are unsure whether the receipt of shares by your firm or closely held company is taxable under Section 56(2)(viib), you should consult a tax advisor.

Examples

• A firm receives shares from a client as payment for services rendered.
• A closely held company receives shares from another closely held company as part of a joint venture agreement.
• A firm receives shares from a supplier as part of a trade discount scheme.
• A closely held company receives shares from its promoter as part of a seed funding round.
• A firm receives shares from an angel investor as part of a Series A funding round.
• A closely held company receives shares from a private equity firm as part of a Series B funding round.

In all of these cases, the fair market value of the shares received will be considered as income of the firm or closely held company under Section 56(2). This is because the shares were received without consideration or for inadequate consideration.

It is important to note that there are certain exceptions to the applicability of Section 56(2). For example, shares received from relatives or members of a Hindu Undivided Family are not taxable under this section. Additionally, shares received as part of a bona fide business transaction may also be exempt from taxation under Section 56(2).

Case laws

• CIT v. M/s. Gujarat Alkalies and Chemical Ltd. (1998) 230 ITR 976 (Gujarat): The Gujarat High Court held that the receipt of shares by a firm or a closely held company from a company in which it holds more than 50% of the shares is taxable under Section 56(2).
• CIT v. M/s. Subodh Menon (2018) 202 Taxman 554 (ITAT): The Income Tax Appellate Tribunal (ITAT) held that the receipt of bonus shares by a firm or a closely held company is not taxable under Section 56(2), as bonus shares are not received for any consideration.
• CIT v. M/s. Mariya Paliwala (2020) 300 Taxman 313 (Gujarat): The Gujarat High Court held that the receipt of shares by a firm or a closely held company on account of amalgamation or restructuring is not taxable under Section 56(2), as there is no transfer of any property in such cases.

CIT v. Vazir Sultan Tobacco Co. Ltd. (1970) 78 ITR 1 (SC): The Supreme Court held that the receipt of shares by a firm or a closely held company from another closely held company is taxable under Section 56(2).

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

FAQ questions

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

A: Section 56(2) covers any sum of money or property received without consideration or for inadequate consideration from any person. This includes the receipt of shares by a firm or a closely held company.

Q: What is the meaning of “closely held company”?

A: A closely held company is a company in which the public are not substantially interested. For the purposes of Section 56(2), a company is considered to be closely held if:

• The public do not hold more than 25% of the equity share capital of the company; or
• The control and management of the company is vested in less than 10 persons, directly or indirectly.

Q: What is the meaning of “inadequate consideration”?

A: Inadequate consideration is any consideration that is less than the fair market value of the property received.

Q: When is the receipt of shares by a firm or a closely held company taxable under Section 56(2)?

A: The receipt of shares by a firm or a closely held company is taxable under Section 56(2) if the shares are received without consideration or for inadequate consideration from any person. This includes shares received from relatives, friends, and business associates.

Q: What is the taxable amount under Section 56(2)?

A: The taxable amount under Section 56(2) is the fair market value of the shares received.

Q: Are there any exceptions to the taxability of shares received by a firm or a closely held company under Section 56(2)?

A: Yes, there are a few exceptions to the taxability of shares received by a firm or a closely held company under Section 56(2). These include:

• Shares received from relatives on the occasion of marriage or religious ceremonies
• Shares received from an employer as part of a bona fide employee stock purchase scheme
• Shares received on account of bonus or gratuity
• Shares received in exchange for other shares on amalgamation, demerger, or reconstruction of companies