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Tax Implications of Share Transfer Between Shareholders

Updated: Jul 5

The transfer of unquoted equity shares of an Indian company between two resident individuals is a common transaction, often arising in family settlements, business restructuring, startup cap-table management, rewarding advisors and private agreements. However, such transfers carry tax implications under the Income-tax Act, 1961, particularly under sections 50CA and 56(2)(x), which should be accounted for before executing such transactions.

In this article, we will consider a recently handled case as a scenario and explore the applicable provisions under the Income Tax Act and the valuation rules prescribed under the relevant Rules.

Case Study:

A founder of an early-stage startup (a Private Limited Company) approached us to carry out the transfer of equity shares between him and another founder, both being residents in India. They wanted to carry out this transfer before an external fundraise from a Venture Capital fund, so as to have a better distribution of capital between the two founders. The transfer was planned to be carried out at par value of ₹10 per share. The Company's NAV was less than ₹10 per share, primarily because of accumulated business losses in their latest Balance Sheet. Before executing the transaction, CKA carried out an analysis of tax implications on the transferor, transferee and the Company, and also determined the requirement of a valuation certificate.

In the case of transfer of shares of a Private Limited Company, a combined reading of Section 50CA, Section 56(2)(x), and Rule 11UA of the Income Tax Act and Rules is required. Here's a summary of our analysis:

1. Section 50CA (applicable on the transferor):

Where the consideration received on transfer of unquoted shares is less than the FMV, the FMV shall be deemed to be the full value of consideration for computing capital gains. ~Section 50CA of the Income Tax Act, 1961

This section applies on computation of full value of consideration when unquoted shares are transferred by a shareholder. The section refers to Rule 11UAA for the computation of FMV in such cases, which in turn refers to Rule 11UA(1)(c). The FMV so computed shall be the full value of consideration, if it is higher than the actual consideration, for the purpose of calculating capital gains in the hands of the transferor of shares.


2. Section 56(2)(x) (applicable on the transferee):

Where any person receives shares for a consideration less than the FMV, and the difference exceeds ₹50,000, the difference is taxable as income from other sources. ~Section 56(2)(x) of the Income Tax Act, 1961

If an individual receives shares for a consideration less than the FMV, and the difference exceeds ₹50,000, then the difference is treated as income from other sources in the hands of the transferee. Rule 11UA(1) covers all fair market value computation under Section 56 for shares, and hence the FMV for the purpose of determining tax incidence in the hands of the transferee shall be computed as per Rule 11UA(1)(c).

Together, the provisions of Section 50CA and 56(2)(x) prevent tax avoidance through the undervaluation of share transfers.

Which valuation method is prescribed for transfer of Equity Shares in the given scenario?

For the purpose of computing FMV of unquoted equity shares, Rule 11UA(1)(c)(b) is applicable. It prescribes a formula based on the book value of assets and liabilities. The formula is:

FMV = (A + B + C + D - L) * (PV / PE)

Where:

  • A to D include book value of assets adjusted for specific exclusions

  • L is book value of liabilities with defined exceptions

  • PV is paid-up value of equity shares being transferred

  • PE is total paid-up equity share capital


Notably, this is the only prescribed method for determining FMV in the case of share transfers between residents. Unlike in the case of share issuances under Section 56(2)(viib), there is no option to use DCF or any other method.

Is a valuation report mandatory for share transfers?

Technically, no, a valuation certificate is not mandatory in such transactions. Rule 11UA(1)(c)(b) simply prescribes a mechanism to compute the FMV. However, a valuation certificate becomes essential when:

  • The consideration deviates from FMV, triggering Sections 50CA or 56(2)(x).

  • You wish to establish a defensible value in front of tax authorities or during audits, if there is scrutiny from either of them.

  • Future investors or acquirers review past transactions during due diligence, and therefore as a good corporate governance practice a valuation certificate from a Chartered Accountant or a Merchant Banker shall be sought and documented.

Does the same rule apply in case of transfer of Preference Shares?

No. In the case of transfer of unquoted preference shares, Rule 11UA(1)(c)(c) becomes applicable. This rule is different from Rule 11UA(1)(c)(b) which is applicable on transfer of equity shares, as it does not prescribe a formula. Instead, it states that the valuation shall be "estimated to be price it would fetch if sold in the open market". Now this statement opens a whole pandora's box, because it is in stark difference to the NAV based valuation method prescribed for equity shares.


Let's add more clarity to it with the help of an example:

In our case study above, assume that the founder is transferring preference shares and the startup had recently raised a funding round from a Venture Capital Fund by issuing CCPS (compulsorily convertible preference shares), which is quite customary in the startup world. This external fundraise was at a valuation of ₹1000 per share. The company still has accumulated losses in its balance sheet and therefore the NAV of its shares are still less than ₹10 per share.


Now, in the given scenario,

  • Would it be possible for the founder to transfer his preference shares at ₹10 per share?

  • Can the founder simply seek a CA/MB's valuation certificate that values the shares using NAV basis (which is also an internally accepted valuation methodology)?

  • Will this attract the tax authority's attention, and if yes, will the NAV based valuation be justified?

Answers to these will depend on the nuances of each transaction and a finer reading of relevant judicial pronouncements.


Note: Just like in the case of transfer of unquoted equity shares, in case of transfer of unquoted preference shares, valuation certificate is not mandatory, however it may be sought from a Chartered Accountant or a Merchant Banker for documentation purpose.

Some more parallel questions that may be relevant to the above case:

  • Is the same rule applicable in case of transfer of shares from a Resident Indian to a Non-Resident?

  • Is the same rule applicable in case of transfer of shares from the founder to a VC Fund or a Family Office?

  • Do "advisory shares", which are often used by startups to reward certain shareholders, attract the above rules?

  • What if before the transfer of equity shares, the company had recently raised funds from external investors at a higher valuation? Can the Tax Authority challenge the FMV calculated under Rule 11UA if it significantly deviates from past transactions?

  • Can the Tax Authority consider a method of valuation other than the one prescribed under Rule 11UA, or the one adopted by the company?

You can direct your queries or comments to the authors here.


Disclaimer: The material herein is provided for informational purposes only. The information should not be viewed as professional, legal or other advice. Professional advice should be sought prior to actions on any of the information contained herein. CKA is not responsible for any matter concluded by any person based on the contents of this article.

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