Companies continuously re-visit their group legal structures in tune with their global and national corporate strategies. As part of such reorganisation, shares of Indian subsidiaries are often transferred within the group, to different entities. While a domestic or cross-border sale of an Indian company’s shares to a third party is generally at fair market value, in group reorganisations the shares are sometimes transferred between two group companies without any consideration as a ‘gift’.
The RBI’s exchange control regulations specifically permit a ‘gift’ of shares between two non-residents, and do not prescribe any pricing guidelines for such a transaction. Valuation guidelines are prescribed only for the transfer of shares of an Indian company between a resident and a non-resident.
While the shares of a listed company should be valued in accordance with guidelines from the Securities and Exchange Board of India, the RBI provides for lower/ upper limits based on the discounted cash-flow valuation for transfer of an unlisted company’s shares.
As shares of an Indian company are transferred between two associated enterprises, an important question is whether the transfer price of the shares needs to be at arm’s length. It may be noted that transfer pricing regulations would be applicable only when there is income chargeable to tax in India as a result of the transfer. The Income-tax Act, 1961 specifically excludes a gift from a transfer liable to capital gains tax in India. In earlier rulings, the Authority for Advance Rulings held that shares of an Indian company transferred between two non-resident group companies without consideration would not be liable to capital gains, as the consideration cannot be determined.
To bring within the tax net the transfer of shares of an unlisted company for nil or inadequate consideration, Finance Act 2010 amended Section 56 of the IT Act. Accordingly, the difference between the prescribed value (similar to net book value) and consideration (if any) would be liable to tax in the hands of the transferee company as ‘Income from other sources’. This amendment encompasses gift transactions as well, levying tax on the transferee group company in India. For this section, a specific valuation methodology has been prescribed, adopting a net book value approach.
It is interesting to note that the above anti-abuse provisions do not apply to a listed company. So, a gift of shares of a listed company, off the stock exchange, could continue to be tax-exempt in India.
However, tax authorities could challenge the concept of a corporate ‘gift’ itself, on the basis that a company, being an ‘artificial juridical person’, is not capable of ‘natural love and affection’, which is a key characteristic of a gift.
Also, the newly introduced Section 50D could contest the reasoning that transfer of shares for no consideration is not taxable, due to failure of the computation mechanism.
The aforesaid section deems fair market value to be the full value of consideration where the consideration for transfer of a capital asset is not ascertainable. Here, the method to determine FMV has not been prescribed and raises another question on the appropriate valuation methodology — should it be discounted cash flow, as prescribed by the RBI; or net book value, as prescribed under Section 56; or some other method?
One would have to wait and see how the revenue authorities and courts view a corporate gift of shares, particularly in light of the proposed introduction of General Anti-Avoidance Rules (GAAR).
(Vinisha Lulla, Manager, contributed to the article.)
The question of whether a corporate ‘gift’ of shares should be taxed assumes importance, especially with when GAAR comes into force.