Raising capital is one of the hardest parts of building a business. Some founders pitch for months; others get lucky with a single meeting. But once the money actually arrives, startups often discover the quieter, more technical layer beneath fundraising — taxation.
Section 56(2)(viib) is an anti-abuse provision (commonly known as the “Angel Tax” provision) that taxes the premium received by a closely held company on the issue of shares if the consideration exceeds the Fair Market Value (FMV) of those shares.
This excess amount is taxed as “Income from Other Sources” in the hands of the recipient company.
In simple words: it prevents companies from inflating share value to bring in unaccounted money under the guise of investments.
What Is Section 56(2)(viib)?
Section 56(2)(viib) applies when:
- A closely held company (usually a private limited company)
- Issues shares
- At a price higher than their fair market value
- To a resident investor
If the amount received is more than FMV, the extra premium is taxed.
This is why the provision is known for taxation of excess share premiums by private companies.
Why This Provision Exists
The government noticed that some companies were:
- Creating fake capital
- Issuing shares at inflated prices
- Laundering money under “share premium”
- Using shell companies as bogus investors
To stop this misuse, Section 56(2)(viib) was introduced as an anti-abuse provision which applies only to cases of bogus capital building & money laundering.
It’s not meant to punish genuine startups — though many founders have felt the pressure because valuation is subjective, and officers sometimes interpret rules aggressively.
Also Read: Tax on Gifts and Share Transactions
How Section 56(2)(viib) Works in Real Life
Imagine a startup issues shares at ₹100 per share. The FMV (based on Rule 11UA valuation methods) is ₹60 per share.
If a resident investor buys 10,000 shares, the company receives:
- ₹10,00,000 total
- FMV-based amount = ₹6,00,000
- Excess = ₹4,00,000
This ₹4,00,000 becomes taxable as Income from Other Sources in the hands of the company.
And yes — that tax can hit hard.
Who Is Covered Under Section 56(2)(viib)?
- Private limited companies
- Closely held companies
- Companies receiving investments from resident investors
Who is NOT covered?
- Investments from non-residents (though recent amendments impact this too)
- Listed companies"
- Certain government-notified startups
- Companies cleared by DPIIT & the Inter-Ministerial Board (IMB)
This exemption framework was built because the startup community protested that they were being taxed for genuine valuations.
Fair Market Value (FMV): The Heart of the Issue
The tension in Angel Tax cases often comes from FMV calculation.
FMV can be derived using:
- Net Asset Value (NAV)
- Discounted Cash Flow (DCF)
- Merchant banker certificates
- Rule 11UA valuation rules
The challenge?
Startups have low assets but high potential.
DCF captures future potential.
NAV captures today’s numbers.
This mismatch creates confusion — and sometimes tax notices.
Also Read: Tax on Gifts, Cash, and Property Received Without Consideration
Section 56(2)(viib) and Angel Tax Notices
A founder once told me,
“I spent more time explaining my vision to the tax officer than I did to my investor.”
Many startups faced notices asking why their shares were issued at a premium of ₹50, ₹100, or ₹200 when their books showed losses.
The officers asked:
“How can loss-making companies justify a premium?”
That’s when the government had to step in with relaxations & exemptions.
Key Exceptions to Angel Tax Under Section 56(2)(viib)
1. DPIIT-recognized startups
- If a startup has DPIIT recognition, the provision does not apply.
2. Approved valuations
- If valuation is supported by a valid report, tax cannot be levied arbitrarily.
3. Certain notified entities
- Funds & investors notified by government are exempt.
These relaxations protect genuine innovation.
Why This Provision Still Matters Today
Despite exemptions, Section 56(2)(viib) remains relevant because:
- Not all companies are DPIIT-recognized
- Some companies raise money at aggressive valuations
- Investors may be residents
- Valuation disputes still occur
- The rule helps prevent black money circulation
It’s a balance — protecting startups while stopping misuse.
Also Read: Tax on Gifts & Other Incomes Explained!
Key Takeaways About Section 56(2)(viib)
- It taxes a closely held company when it receives more than fair market value for shares.
- It is an anti-abuse provision targeting inflated share premiums.
- Excess premium is taxed as Income from Other Sources."
- It aims to curb bogus capital building & money laundering.
- DPIIT-recognized startups enjoy exemption from this provision.
- FMV determination (NAV/DCF) plays a crucial role.
Conclusion
Section 56(2)(viib) may feel intimidating, especially for early-stage founders who are simply trying to raise funds & grow. But once you understand the intent — preventing misuse while allowing genuine innovation — the rule begins to make sense. With proper valuation, DPIIT recognition, and transparent documentation, startups can raise capital confidently without fearing Angel Tax scrutiny.
And if you ever need help with valuation reports, DPIIT registration, or relief from angel tax notices, the expert team at CallMyCA.com is always ready to guide you with clarity and care.
