Treatment of tax expense on deemed income under section 56(2)(viia) of the Income-tax Act, 1961 arising on purchase of investments

Treatment of tax expense on deemed income under section 56(2)(viia) of the Income-tax Act, 1961 arising on purchase of investments.

A. Facts of the Case

1. A company (hereinafter referred to as ‘the company’) in which public is not
substantially interested is incorporated on May 5, 2010 under the Companies Act, 1956
with the object to generate, receive, purchase, develop, use, sell, supply, distribute,
transmit and accumulate electrical or any other form of power and energy in general by
conventional or non-conventional methods, from any source whether hydro, water, wind,
solar, thermal, gas, oil, diesel, nuclear or otherwise at power stations, plants,
establishments, works and other ancillary facilities of every kind and description and
transmit, distribute and supply such power through transmission lines, cables, wires and
other facilities on a commercial basis to cities, towns, streets, docks, factories, markets,
buildings and other places both public and private. The company is a wholly owned
subsidiary of a company, B Limited, which holds 15% of the equity shares of another
unlisted company, C Limited.

2. During the financial year 2010-11, it was decided by the Board of the company to
acquire, if possible, all the balance 85% equity shares of C Limited, which were held by
other not related shareholders. The company intends to hold this for long term purposes
being a strategic investment. Accordingly, the company has acquired additional equity
shares (representing balance 85%) from various unrelated parties in separate trenches for
an agreed consideration (excluding stamp duty and tax under section 56(2)(viia) of the
Income-tax Act, 1961). The acquisitions were at a price lower than the fair value of the
said shares calculated in accordance with manner prescribed under Rule 11 (UA) of the
Income Tax Rules, 1962.

3. Under the provisions of section 56(2)(viia) of the Income-tax Act, 1961, in the
instances, where shares of a company in which the public is not substantially interested
are acquired for a consideration which is less than the aggregate fair value of the shares
by an amount exceeding Rs. 50,000/-, the excess of the aggregate fair value over the
consideration is an income under the head ‘Income from Other Sources’.

4. The querist has stated that the company has paid tax on the the excess of the
aggregate fair value over the consideration paid in accordance with the requirements of
section 56(2)(viia). In addition to the above, the company has also incurred expenses on
account of stamp duty, franking and bank charges in connection with the said acquisition.
1 Opinion finalised by the Expert Advisory Committee on 12.08.2011.

5. According to the querist, the payment of income tax under section 56(2)(viia) has
arisen out of the transaction of acquisition of shares and the company would not have
incurred such an expense otherwise. The internal business case for acquisition of these
shares was justified to the Board by considering the basic cost of acquisition, the
transaction costs like stamp duties, the cost of transfer of shares and the tax payable under
section 56(2)(viia), i.e., deemed income arising from purchase of investments, which
would be directly associated with purchase of such shares.

6. The querist has further stated that the provision of tax under section 56(2)(viia) is
a recent addition to the Income-tax Act, 1961, and such a situation of taxes payable due
to acquisition is not covered directly in paragraph 9 of existing Accounting Standard
(AS) 13, ‘Accounting for Investments’, which deals with various costs that could be
considered as part of cost of acquisition of an investment. In view of this, the querist has
referred to relevant technical material from notified2 Indian Accounting Standards (Ind
ASs) for technical guidance on the subject matter.

7. The querist has stated that as per paragraph 11 of Indian Accounting Standard
(Ind AS) 32, ‘Financial Instruments: Presentation’, definition of financial assets includes
an equity instrument of another entity. Paragraph 38 of Indian Accounting Standard (Ind
AS) 27, ‘Consolidated and Separate Financial Statements’ provides, inter alia, as follows:
“38 For preparing separate financial statements the entity shall account
for investments in subsidiaries, jointly controlled entities and associates
either:
(a) at cost, or
(b) in accordance with Ind AS 39”
Paragraph 43 of Indian Accounting Standard (Ind AS) 39, ‘Financial Instruments:
Recognition and Measurement’, provides as follows:
“43 When a financial asset or financial liability is recognised initially, an
entity shall measure it at its fair value plus, in the case of a financial asset or
financial liability not at fair value through profit or loss, transaction costs
that are directly attributable to the acquisition or issue of the financial asset
or financial liability.”
As per paragraph 9 of Ind AS 39, “Transaction costs are incremental costs that are
directly attributable to the acquisition, issue or disposal of a financial asset or
financial liability (see Appendix A paragraph AG13). An incremental cost is one
2 The Committee wishes to point out that although Ind ASs have been placed on the website of Ministry of
Corporate Affairs, these Standards have not yet been notified by the Ministry.that would not have been incurred if the entity had not acquired, issued or disposed
of the financial instrument.”
Paragraph AG 13 of Appendix A, Application Guidance to Ind AS 39, states as follows:
“AG13 Transaction costs include fees and commissions paid to agents (including
employees acting as selling agents), advisers, brokers and dealers, levies by
regulatory agencies and securities exchanges, and transfer taxes and duties.
Transaction costs do not include debt premiums or discounts, financing costs or
internal administrative or holding costs.”

8. The querist has stated that in view of the above, especially paragraph 9 of Ind AS
39 and paragraph AG13 of Appendix A to Ind AS 39, the company is of the view that the
tax on this notional deemed income is a transaction cost, which otherwise would not have
been incurred by the company and should be treated as acquisition cost of the investment
and hence, has capitalised the said tax cost.
B. Query

9. The company has considered the basic consideration, stamp duty charges and tax
under section 56(2)(viia) as cost of investment in shares in its accounts. The querist
believes that the purchase has resulted in a cash outflow on account of tax under section
56(2)(viia) and that this cost is a direct result of the acquisition of these said shares as
also it was a part of the business case which justified the overall purchase at the all
inclusive price. Had the acquisition of these shares not been made, the company would
not have incurred such costs. On the basis of the above, the querist is seeking opinion of
the Expert Advisory Committee on the following issues:
(i) whether the payment of tax under section 56(2)(viia) would qualify to be treated
as part of the cost of investment in the balance sheet of the company in view of
the explanation provided in paragraphs 9 and 43 of Ind AS 39 read along with
paragraph AG13 of Appendix to Ind AS 39.
(ii) If answer to (i) is no, what is the correct accounting treatment of such tax
expenses on deemed income under section 56(2)(viia) of the Income-tax Act,
1961?
C. Points considered by the Committee

10. The Committee notes that the basic issue raised in the query relates to accounting
for tax paid under section 56(2)(viia) in the separate financial statements of the company.
The Committee has, therefore, considered only this issue and has not considered any
other issue that may arise from the Facts of the Case, such as, accounting for stamp duty,
franking and bank charges, cost of transfer of shares and other costs incurred, accountingin the consolidated financial statements and accounting in the books of holding company
or company C, applicability of Ind AS 39 or other Ind ASs in the instant case, etc.
Further, the opinion expressed hereinafter, is purely from accounting point of view and
not from interpreting any legal enactment, such as, Income-tax Act, 1961.

11. The Committee notes paragraph 56(2)(viia) of the Income-tax Act, 1961, which
provides, inter alia, as follows:
“Where a firm or a company not being a company in which the public are
substantially interested, receives, in any previous year, from any person or
persons, on or after the 1st day of June, 2010, any property, being shares of a
company not being a company in which the public are substantially interested, –
(i) without consideration, the aggregate fair market value of which
exceeds fifty thousand rupees, the whole of the aggregate fair
market value of such property;
(ii) for a consideration which is less than the aggregate fair market
value of the property by an amount exceeding fifty thousand
rupees, the aggregate fair market value of such property as exceeds
such consideration”

12. The Committee wishes to point out that although Ind ASs have been placed on the
website of the Ministry of Corporate Affairs, these Standards have not yet been notified
by the Ministry. Accordingly, till the Ind ASs are notified by the Ministry, the existing
notified Accounting Standards would be applicable. Therefore, in the instant case, the
Committee is of the view that the transaction of acquisition of investment in shares would
be governed by the existing notified AS 13.

13. With regard to accounting for the tax levied under section 56(2)(viia) of the
Income-tax Act, 1961, the Committee notes paragraph 9 of AS 13, which provides that
“the cost of an investment includes acquisition charges such as brokerage, fees and
duties”. Keeping in view the nature of the items of acquisition charges mentioned in AS
13, the Committee is of the view that the cost of acquisition should include only those
direct charges which are incurred ‘on’ acquisition of investment, i.e., the expenses,
without the incurrence of which, the transaction could not have taken place, such as,
share transfer fees, stamp duty, registration fees, etc. The Committee notes that tax paid
under section 56(2)(viia) is levied when consideration paid for acquisition of investment
is lower than its fair market value for an amount exceeding Rs. 50,000 and such lower
consideration paid is deemed as income of the assessee acquiring such investment. Thus,
this tax is not a tax ‘on’ acquisition of shares rather it is a tax on ‘deemed income’ under
Income-tax Act, 1961. Accordingly, the Committee is of the view that such tax expense
is not a cost incurred ‘on’ acquisition of investment rather it is incurred after the
transaction of the acquisition of investment. In other words, it is not a means of acquiring
such investments; rather it is a result of such acquisition. Accordingly, such tax cannot be
considered as acquisition-related cost and, therefore, cannot be capitalised as cost ofinvestment. The Committee is further of the view that such tax paid should be treated as
normal tax and charged off to profit and loss account in the year in which it is incurred.

14. Since the querist has sought to take support in this regard from Ind ASs, the
Committee has also examined this issue in the framework of Ind ASs independently
without relating it to AS 13 or any other existing notified Standard. Under the framework
of Ind ASs, the Committee notes that paragraph 38 of Ind AS 27 provides, inter alia, as
follows:
“38 For preparing separate financial statements the entity shall account
for investments in subsidiaries, jointly controlled entities and associates
either:
(a) at cost, or
(b) in accordance with Ind AS 39”

15. The Committee notes from the above that Ind AS 39 would be relevant only if the
entity exercises the option to account for investment in subsidiary under that Standard. It
may be noted that if that option is exercised, the Committee notes paragraph 43 of Indian
Accounting Standard (Ind AS) 39, ‘Financial Instruments: Recognition and
Measurement’, provides as follows:
“43 When a financial asset or financial liability is recognised initially, an
entity shall measure it at its fair value plus, in the case of a financial asset or
financial liability not at fair value through profit or loss, transaction costs
that are directly attributable to the acquisition or issue of the financial asset
or financial liability.”

16. Presuming that the investment is not a financial asset at fair value through profit
or loss, the Committee notes that paragraph 9 of Ind AS 39 provides, “Transaction costs
are incremental costs that are directly attributable to the acquisition, issue or
disposal of a financial asset or financial liability (see Appendix A paragraph AG13).
An incremental cost is one that would not have been incurred if the entity had not
acquired, issued or disposed of the financial instrument.”

17. The Committee further notes that paragraph AG 13 of Appendix A, Application
Guidance to Ind AS 39, states as follows:
“AG13 Transaction costs include fees and commissions paid to agents (including
employees acting as selling agents), advisers, brokers and dealers, levies by
regulatory agencies and securities exchanges, and transfer taxes and duties.
Transaction costs do not include debt premiums or discounts, financing costs or
internal administrative or holding costs.”

18. The Committee notes from the above provisions of Ind AS 39 that only those
transaction costs that are directly attributable to the acquisition of investment can be
capitalised with the investment. The Committee is of the view that although the tax levied
under section 56(2)(viia) may be considered as an incremental cost of acquisition of
investment, it cannot be considered as ‘a directly attributable cost’ due to the reasons
stated in paragraph 13 above. Accordingly, even on considering the relevant provisions
of Ind AS 39, such tax levied cannot be capitalised as cost of investment.
D. Opinion

19. On the basis of the above, the Committee is of the following opinion on the issues
raised by the querist in paragraph 9 above:
(a) The payment of tax under section 56(2)(viia) does not qualify for
capitalisation as a cost of investment in the balance sheet of the company
as mentioned in paragraphs 13 and 18 above.
(b) Tax paid under section 56(2)(viia) should be treated as normal tax and
charged off to profit and loss account of the year in which it is incurred as
discussed in paragraph 13 above.

Source : ICAI