IN my previous piece on the budget 2023 and the taxation of non-residents, I had missed out a few issues that I hope to deal with now.

As we have already noted, in the absence of any gift tax in India, it was very easy for Indian resident taxpayers to claim receipt of substantial sums as gifts, sometimes from relatives and sometimes even from strangers out of 'natural love and affection.' If the alleged donor was abroad, resident of one of the Gulf countries, it was virtually impossible for the tax department to disprove such a claim. Even in situations involving pure domestic parties, the genuineness of the transactions could not be disproved, particularly if made through banking channels. It was primarily to plug this loophole that the Finance (No2 Act) 2004 introduced as an anti-abuse measure, a scheme whereunder receipt of gifts above a certain base limit from persons other than close relatives was made taxable in the hands of the recipients. Gifts are receipts in the capital field and cannot be taxed as income. Therefore, the definition of income was modified to include such gits as deemed income of the recipient. Under the Indian schedular system of taxation, any income has to fall under one of the five heads of income and thus this item of deemed income was placed under 'income from other sources.

To begin with, only gifts received by individuals and HUFs from unrelated parties in excess of INR 25,000 was brought within the ambit of taxation. Actually, the word 'gift' was not used but 'any sum of money' received without consideration. The provision was contained in section 56(2)(v) and provided exclusions for gifts from relatives, on occasion of marriage, under will or inheritance etc. Then, through the Taxation Laws Amendment Act, 2006, the scheme was modified to a certain extent and the limit was increased to INR 50,000. However, now, the provision applied to any sum of money received in the aggregate over INR 50,000. If the aggregate amount received exceeded 50,000, then the whole of the amount received became taxable. The relevant provision was now contained in section 56(2)(vi).

Then in 2009, through the Finance (No 2) Act, 2009, the scope of the provision was further expanded and the first major complication was introduced. So far, the provision applied only to sums of money. But anything which was received in kind having 'money's worth' i.e., property, was outside the purview of the existing provisions. Therefore, effective 1.10 2009, the relevant provisions were amended and the deemed income also applied specifically to any immovable property as also to any property, other than immovable property such as shares and securities, jewellery, archaeological collections, drawings, paintings, sculptures, or any work of art etc. In effect, gifts received in kind were now within the ambit of deemed income.

The moment any property, is brought into the equation, question of valuation inevitably arises. In case of immovable property, it was therefore provided that where an immovable property is received without consideration and the stamp duty value of such property exceeds fifty thousand rupees, the whole of the stamp duty value of such property shall be taxed as the income of the recipient. If an immovable property is received for a consideration which is less than the stamp duty value of the property and the difference between the two exceeds fifty thousand rupees (inadequate consideration), the difference between the stamp duty value of such property and such consideration was to be taxed as the income of the recipient. To deal with issues where the taxpayer questions the stamp value, the provisions relating to valuation as contained in section 50C was made applicable.

The question of valuation also arises in case of other movable assets, particularly financial assets such as shares. Therefore, the concept of fair market value was brought in and gifts in kind of such properties, the FMV of which exceeded INR 50,000 became taxable in the hands of the recipient. The provisions were now contained in section 56(2)(vii).

Till now, the provisions applied to individuals/HUF. Then in 2010, it dawned on the government that transfer of shares to a company or a firm without consideration or for inadequate consideration was not caught within its net. Apparently, the tax department noticed the widespread practice of transferring shares of unlisted companies at prices much below their fair market value. Therefore, a new sub-section (viia) was added to cover such situations. The shares transferred was to be of a private company and the transfer was also to be to a private company. Exceptions were made for company reorganizations, amalgamation, demerger etc. Stock-in-trade was also carved out of the application of the provision.

Long thereafter, in 2013, someone realised that while transfer of shares for inadequate consideration was caught within the vice of the provision, in the case of firms/companies, the provision applied only in cases where the immovable property was transferred without consideration . This was then rectified by the Finance Act, 2013. by substituting the existing 56(vii), clause (b) in two parts: (i) where the property was received without consideration and (ii) where the property was received for inadequate consideration.

In the meantime, during this period that a political event ultimately led to the introduction of what is now popularly known as the angel tax in India. In 2009, following the death of Y.S.R. Reddy, the then chief Minister of AP, his son who was an elected MP from Andhra wanted to step into his shoes, but did not succeed; whereupon towards the end of 2010, he decided to break away from the party.

News reports of that time suggest that the investigative agencies, IT, ED, and CBI got into action and it transpired that alleged influence peddling money was brought into the mainstream through a novel way by paying exorbitantly high premium for investing in shares of the companies floated by the group. Issuance of shares being in the capital field, this is a game that was being played by some Kolkata based operatives for long. There is speculation that it was because of these developments, that the Finance Minister in 2012 introduced a new sub-section in the already overstretched provision of section 56(2).

The budget speech made only a brief reference to this measure 'amongst a series of measures to deter the generation and use of unaccounted money' -

"Increasing the onus of proof on closely held companies for funds received from shareholders as well as taxing share premium in excess of fair market value ."

The newly inserted section 56(2)(viib) stated:

'(viib) where a company, not being a company in which the public are substantially interested, 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, the aggregate consideration received for such shares as exceeds the fair market value of the shares: (will be chargeable to tax as income from other sources)

Provided that this clause shall not apply where the consideration for issue of shares is received -

(i) by a venture capital undertaking from a venture capital company or a venture capital fund ( Note: or a specified fund added subsequently in 2019) ; or

(ii) by a company from a class or classes of persons as may be notified by the Central Government in this behalf.

Explanation. -For the purposes of this clause, -

(a) the fair market value of the shares shall be the value-

(i)as may be determined in accordance with such method as may be prescribed; or

(ii) as may be substantiated by the company to the satisfaction of the Assessing Officer, based on the value, on the date of issue of shares, of its assets, including intangible assets being goodwill, know-how, patents, copyrights, trademarks, licences, franchises or any other business or commercial rights of similar nature, whichever is higher;

(…)

As explained in the Memo, the new provision 56(2)(viib) stipulated that where an unlisted company, received, in any previous year, from any resident, any consideration for issue of shares and the consideration received exceeded the face value of such shares, the aggregate consideration received for such shares as exceeded the fair market value of the shares shall be chargeable to income tax under the head "Income from other sources."

The essential conditions therefore were that the company issuing the shares was to be a closely held company; the issue of shares was to be in excess of the face value of the shares and the consideration was to be received from a resident of India. Rule11UA was subsequently prescribed for determining the fair market value.

Following a regime change in 2014, the Government of India announced its Startup India programme in January 2016. According to the government website, the Startup India is a flagship initiative of the Government of India, intended to build a strong eco-system for nurturing innovation and Startups in the country that will drive sustainable economic growth and generate large scale employment opportunities. The main purpose was to reduce the regulatory burden on Startups thereby allowing them to focus on their core business and keep compliance cost low.

Finance Bill 2016 also proposed some significant tax benefits for eligible startups, most important of which was the introduction of section 80IAC that provided a deduction of one hundred percent of the profits and gains derived by an eligible start-up from a business involving innovation development, deployment or commercialization of new products, processes or services driven by technology or intellectual property, provided the start-up is set up before 1.4.2019. This date has since been extended several times. The rollover benefit of investing capital gains in section 54GB introduced in 2012 if the proceeds were invested in SMEs was also extended to start-ups.

Then, in 2017, the scope of the provision in section 56(2) relating to deemed gifts was further expanded and the section was rearranged and section 56(2)(x ) now dealt with cases of gifts of all kinds and it sought to prevent the practice of receiving the sum of money or the property without consideration or for inadequate consideration, by any person without consideration or for inadequate consideration in excess of Rs. 50,000. Some exceptions were provided in cases of receipt from trusts etc. There was no change in section 56(2)(viib).

As happens with any exemption regime, there is a constant tug of war between the tax administrators and the tax planners wanting to benefit from such regimes. In 2018, it came to the notice of the government that some tax officers were invoking the provision of section 56(2)(viib) in the case of some new ventures aka start-ups where typically, the initial seed capital is provided by relatives /friends with low share capital and low face value and where those seeking opportunity of future growth invest in view of the business model and future growth prospects .Determination of FMV of such shares do not always follow any straight formula. Such accounts would also tend to show large share premium. Accordingly, through a letter dated 6th of February, 2018, (F.No 173/14/2018-ITA-1), the CBDT directed that in case of start-up companies within the definition given by the DPIIT in G.S.R. 501(E), if any demand was raised by invoking section 56(2)(viib), the same should not be enforced.

Nevertheless, it seems that tax officers, always pressed to increase collections, found a fertile ground to question the valuations and the premiums and in many cases, notices were issued for reassessment, as well.

In 2019, the Department for Promotion of Industry and Internal Trade (DPIIT) under the Ministry of Commerce and Industry, issued a Gazette Notification on the 19th February, 2019 G.S.R. 127(E), whereunder, in paragraph 4, it was mentioned that a Startup shall be eligible for notification under clause (ii) of the proviso to clause (viib) of sub-section (2) of section 56 of the Act and consequent exemption from the provisions of that clause, if it fulfils the following conditions:

(i) it has been recognised by DPIIT under para 2(iii)(a) or as per any earlier notification on the subject

(ii) 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:

Provided that in computing the aggregate amount of paid-up share capital, the amount of paid up share capital and share premium of twenty five crore rupee s in respect of shares issued to any of the following persons shall not be included-

(a) a non-resident; or

(b) a venture capital company or a venture capital fund;

Provided further that considerations received by such startup for shares issued or proposed to be issued to a specified company shall also be exempt and shall not be included in computing the aggregate amount of paid-up share capital and share premium of twenty five crore rupees.

(iii) It has not invested in any of the following assets, -

(a) building or land appurtenant thereto, being a residential house, other than that used by the Startup for the purposes of renting or held by it as stock-in-trade, in the ordinary course of business;

(b) land or building, or both, not being a residential house, other than that occupied by the Startup for its business or used by it for purposes of renting or held by it as stock-in trade, in the ordinary course of business;

(c) loans and advances, other than loans or advances extended in the ordinary course of business by the Startup where the lending of money is substantial part of its business;

(d) capital contribution made to any other entity ;

(e) shares and securities ;

(f) a motor vehicle, aircraft, yacht or any other mode of transport, the actual cost of which exceeds ten lakh rupees, other than that held by the Startup for the purpose of plying, hiring, leasing or as stock-in-trade, in the ordinary course of business;

(g) jewellery other than that held by the Startup as stock-in-trade in the ordinary course of business;

(h) any other asset, whether in the nature of capital asset or otherwise, of the nature specified in sub-clauses (iv) to (ix) of clause (d) of Explanation to clause (vii) of sub-section (2) of section 56 of the Act.

Provided the Startup shall not invest in any of the assets specified in sub-clauses (a) to (h) for the period of seven years from the end of the latest financial year in which shares are issued at premium;

Explanation.- For the purposes of this paragraph,-

(i) "specified company" means a company whose shares are frequently traded within the meaning of Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 and whose net worth on the last date of financial year preceding the year in which shares are issued exceeds one hundred crore rupees or turnover for the financial year preceding the year in which shares are issued exceeds two hundred fifty crore rupees .

(ii) the expressions "venture capital company" and "venture capital fund" shall have the same meanings as respectively assigned to them in the explanation to clause (viib) of sub Section( 2) of Section 56 of the Act.

As we have seen earlier, proviso (ii) of section 56(2)(viib) states that the tax will not apply when the consideration for the issue of shares is received by a company from a class or classes of persons as may be notified by the Central Government in this behalf .

Therefore, the TPL wing of the CBDT issued a notification (S.O. 1131(E) dated 5th March, 2019 stating that the provisions of clause (viib) of sub-section (2) of section 56 of the said Act shall not apply to consideration received by a company for issue of shares that exceeds the face value of such shares, if the said consideration has been received from a person, being a resident, by a company which fulfils the conditions specified in para 4 of the notification number G.S.R. 127(E), dated the 19th February, 2019 issued by the Ministry of Commerce and Industry in the Department for Promotion of Industry and Internal Trade and files the declaration referred to in para 5 of the said notification.

Subsequently, the CBDT issued a circular 16/2019 [F.No. 173/149/2019-ITA-I], dated 7-8-2019] specifying the procedure of assessment in the case of start-ups as follows:

(i) Where the Startup Company has been recognised by the DPIIT but the case is selected under "limited scrutiny" on the single issue of applicability of section 56 (2)(viib), no verification on such issues will be done by the AOs during the proceedings u/s 143 (3)/147 of the I.T. Act, 1961 and the contention of such recognized Startup Companies on the issue will be summarily accepted.

(ii) Where the Startup Company has been recognized by the DPIIT but the case is selected under "limited scrutiny" with multiple issues or under "complete scrutiny" including the issue u/s 56(2)(viib), the issue of applicability of section 56(2)(viib) will not be pursued during the assessment proceedings and inquiry or verification with regard to other issues in such cases shall be carried out by the Assessing Officer, only after obtaining approval of his/her supervisory officer. Due procedure as per I.T. Act shall be followed with regard to other issues for which the case has been selected.

(iii) Where the Startup Company has not got DPIIT approval and the case is selected for scrutiny, inter alia on the grounds of applicability of section 56(2)(viib) or any other issue/s, then also inquiry or verification in such cases shall be carried out by the Assessing Officer, as per due procedure, only after obtaining approval of his/her supervisory officer.

Although the procedure laid down by the DPIIT is hemmed in with restrictions and may not be easy to apply, there was not much noise after the FM in her Budget speech of 2019 promised to remove the irritants. and the aforesaid procedure was laid down. On the contrary, the time limit for setting up the start-up was getting extended every year. From news reports, it is gathered that most of Indian start-ups were getting the funds form non-residents and the provision of the angel tax did not apply in such cases. The DPIIT approved startups was and continues to be outside the scope of the tax.

Now, however, the budget 2023 proposes to remove the exemption given to funds received from non-residents also. As explained in the Memo to the budget, it seems that the government feels that the generation and circulation of unaccounted money also take place through the share premium from non-residents as well. And, hence the move to amend the section. There is no change to other provisions of the section including the one specifically exempting from its provisions, considerations received from a venture capital company or a venture capital fund or a specified fund as also the consideration received from a class of persons as may be notified by the Government. As we have seen this second category of exemption governs the DPIIT approved cases.

Nevertheless, the move has set the cat amongst the pigeons. The start-up community is up in arms and now point out a litany of grievances including the shortcomings even in the extant DPIIT approved cases. Specifically, it has been pointed out that there is a dichotomy between the FEMA rules whereunder an Indian company cannot issue shares at less than FMV while under the ITA effectively shares cannot be issued at more than FMV. It has been emphasised that there is always a subjective element in the matter of valuation and that the start-up community will be very adversely affected by the proposed amendment.

It has been reported that the Chairman CBDT in his budget interactions was asked:

"The budget has amended the law to make the share premium received over fair value from non-residents taxable in the hands of the company. Start-ups have been complaining that the government has re-introduced angel tax in the Budget?"

And his answer was:

"Let them read the law properly. The amendment does not change anything for exempted start-ups. Some carve-outs have been made under the law which exempts start-ups from the said tax. But if they have any genuine concern, we will look at it." (Source: https://www.newindianexpress.com/thesundaystandard/2023/feb/05/govt-has-not-renewed-angel-tax-for-startups-central-board-of-direct-taxes-chairman-nitin-gupta-2544429.html

In that context, it may be worthwhile to have a relook at the DPIIT notification again.

4. A Startup shall be eligible for notification under clause (ii) of the proviso to clause (viib) of sub-section (2) of section 56 of the Act and consequent exemption from the provisions of that clause, if it fulfils the following conditions:

(i) it has been recognised by DPIIT under para 2(iii)(a) or as per any earlier notification on the subject (ii) 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:

Provided that in computing the aggregate amount of paid-up share capital, the amount of paid up share capital and share premium of twenty five crore rupees in respect of shares issued to any of the following persons shall not be included -

(a) a non-resident ; or

(b) a venture capital company or a venture capital fund;

The CBDT in its notification has also referred to the DPIIT notification with the result that as on date, in case of receipt of premium etc from non-residents there are no limits at all provided that the start-up is recognised by the DPIIT. Of course, it remains to be seen if there will be any change in the notifications in the future. The Notification also does not include the cases of receipts from specified funds -category I and II AIFs subsequently added by Finance No2 Act 2019 in the section itself.

The other amendment that I missed out in the first round relates to limitation on interest deductions to a related non-resident under section 94B introduced as a result of giving effect to the BEPS recommendation in Action 4. The limitation provision does not apply to a company engaged in the business of banking and insurance. This exclusion has now also been extended to Non-Banking Financial companies as may be notified by the government.

Of course, there may be other provisions including the ones relating to GIFT City that will affect the non-residents and that I hope to deal with later.