Background
Valuation is a very complex exercise demanding much more than number crunching and it becomes quite more complex when it comes to regulatory valuations where certain parameters are laid down. It may be difficult to weave these requirements to the peculiar facts of a case, thereby highlighting the important role of an expert valuer.
Valuation of equity shares i.e quotes as the well-unquoted shares is generally required for regulatory or financial reporting purposes for a business. In the valuation of shares, the underlying asset is the business and per-share value is calculated to arrive at the final valuation.
Earlier where shares were sold by the assessee for a consideration, which was not in conformity with the fair-market value of the shares, there was no mechanism under the Act to substitute the full value of consideration by value disclosed by the assessee for the purposes of computation of capital gains. Over the years, various Courts and Tribunals have held that amount declared by the assessee i.e. the transferred value cannot be substituted by any value for the purpose of the capital Gain. To plug this loophole, section 50CA was introduced w.e.f from 1-4-2018. Prior to that, section 56(2)(vii) was introduced which provided that if any property including shares and securities is received by any assessee (Individual or HUF) the value of which is less than Fair market value, the difference would be considered as income in the hands of the recipient of the shares or securities. Similar provisions were inserted for assessee being firm or company in which public are not substantially interested under section 56(2)(viia) w.e.f 01-06-2010. These sections 56(2)(vii) and 56(2)(viia) are now replaced by section 56(2)(x) from A.Y. 2018-19.
Broadly, the following consequences may arise on transactions involving the transfer of equity shares of an unlisted Indian company:
- In the hands of the transferor: Where the consideration received is lower than the fair market value, the fair market value will be the full value of consideration for the purpose of calculating capital gain as per section 50CA ; and
- In the hands of the transferee: Where the consideration paid is lower than the fair market value, the excess of fair market value over the consideration paid would be regarded as ‘income’ in the hands of transferee as per the provisions of section 56(2)(x).
Apart from that similar provisions were also inserted vide section 56(2)(viib) w.e.f 01-04-2013 in a situation where a company other than a company in which the public are substantially interested, issues equity shares, the following consequences may arise:
- In the hands of Issuer company: Where the issue price is higher than the face value, the excess of issue price over the fair market value is regarded as ‘income’ in the hands of the issuing company and subjected to tax; and
- In the hands of Subscriber of the equity shares: Where the issue price is lower than the fair market value, excess of fair market value over the issue price would be taxable u/s. 56(2)(x).
Having discussed the provisions of law, it is now clear that the determination of fair market value (FMV) is very relevant to decide the taxability of income that can be subjected to tax.
The FMV of unquoted equity shares for the purpose of section 50CA and section 56(2)(x) of the Act is governed by Rule 11UA(1)(c)(b) of the Rules.
Further, rule 11UA states that for the purposes of section 56 of the Act, the fair market value of a property, other than immovable property, (which includes unquoted equity shares) shall be determined in the manner prescribed in Rule 11UA of the Rules. The relevant extract of Rule 11UA is as under:
“11UA. [(1)] For the purposes of section 56 of the Act, the fair market value of a property, other than immovable property, shall be determined in the following manner, namely-…….,”
From a plain reading of the text/language of the Rules, it appears that the application of Rule 11UA is mandatory while computing the FMV of unquoted equity shares for the purpose of section 50CA and 56(2)(x) of the Act.
Thus in essence if equity shares are transferred /issued other than at fair market value, it may result in addition either in the hands of transferor or transferee or issuing company or subscriber of the shares.
The article herein deals with the three aspects i.e method of valuation of equity shares, issues in valuation and judicial precedent on the valuation of equity shares.
Broadly, the method of valuation of shares under the different statue are as under;
Method of valuation under Income Tax
- In this article we shall be deliberating the relevant method of valuation under the Income Tax Act read with rules thereof. The broad method for valuation of equity share are captured in chart below.
In case of quoted shares and securities[1]
Transacted through recognized stock exchange
If the quoted shares and securities are transacted through any recognized stock exchange, the fair market value of such shares and securities shall be the transaction value as recorded in such stock exchange;
Transacted other than recognized stock exchange
If such quoted shares and securities are transacted other than through any recognized stock exchange [i.e off-market transaction], the fair market value of such shares and securities shall be,—
- the lowest price of such shares and securities quoted on any recognized stock exchange on the valuation date, and
- the lowest price of such shares and securities on any recognized stock exchange on a date immediately preceding the valuation date when such shares and securities were traded on such stock exchange, in cases where on the valuation date there is no trading in such shares and securities on any recognized stock exchange;
In case of Unquoted equity shares
On transfer of Unquoted equity Shares
In case of transfer of unquoted equity shares the fair market value of unquoted equity shares shall be determined as per the formula given in Rule 11UA(1)(c)(b).
The fair market value on the valuation date shall be determined in the following manner namely
Fair Market Value of Unquoted Shares = (A+B+C+D-L) X (PV)
(PE)
Where
| A | = | book value of the assets in the balance-sheet[2] |
| B | = | the price which the jewellery and artistic work would fetch if sold in the open market on the basis of the valuation report obtained from a registered valuer; |
| C | = | fair market value of shares and securities as determined in the manner provided in this rule; |
| D | = | the value adopted or assessed or assessable by any authority of the Government for the purpose of payment of stamp duty in respect of the immovable property |
| L | = | book value of liabilities shown in the balance sheet[3] |
| PV | = | the paid-up value of such equity shares. |
| PE | = | total amount of paid up equity share capital as shown in the balance-sheet |
For the valuation process, there is no need to obtain any report from merchant bankers. However, the self-certified valuation would serve the purpose.
On Issue of Unquoted equity Shares
In case of the issue of unquoted equity shares by the company FMV can be calculated as per Rule 11UA(2), at the option of the assessee, out of the following two methods:
- NAV method
The fair market value of unquoted equity shares shall be calculated simply by ascertaining “Book value of Assets (Less) Book value of Liabilities” i.e Book Value Method or NAV method
Fair Market Value of Unquoted Shares= (A-L) X (PV)
(PE)
Where,
| A | = | book value of the assets in the balance-sheet[4] |
| L | = | book value of liabilities shown in the balance sheet[5] |
| PV | = | the paid-up value of such equity shares. |
| PE | = | total amount of paid up equity share capital as shown in the balance-sheet |
- DCF Method
The fair market value of the unquoted equity shares as determined by a Merchant Banker as per Discounted Free Cash Flow Method. Until May 23, 2018, a Chartered Accountant[6] was also permitted to determine the FMV of such equity shares. However, with effect from 24th May 2018, only Merchant Banker is authorised to determine the FMV of such equity shares.
Issues in valuation under Rule 11UA
As can be noted from above, the determination of the FMV of equity shares take into consideration two bases
- For items such as jewellery, artistic work, shares and securities, or immovable property, the fair value/ stamp value is to be considered and
- For remaining items of assets and liabilities, the relevant book value is to be considered.
Thus, it is important to determine what items of asset and liability appearing in the balance sheet shall be excluded/included for the purpose of valuation which is not specifically dealt with in the rules. Certain issues which may arise while determining valuation are as follows:
- Amount of income tax paid, if any, includes taxes paid on adjustments made in the assessment which are disputed in appeal depending on merits of case. A view can be taken that same may be included for the purpose computing book value of asset.
- Normally, total taxes paid would comprise of current tax and deferred tax. In a case where the current tax provision is made in the books of account on the final tax payable (which includes the effect of timing differences) and deferred tax asset is created separately for the timing differences, under this situation, deferred tax asset should not be considered as a tax paid but should represent the value of an asset.
- The Principle of exclusion of deferred expenditure would not apply to Prepaid expenditure. Deferred expenditure isan expenditure that would give enduring benefit. Further, Deferred tax asset is created when there is reasonable certainty that sufficient future taxable income will be available, against which the deferred tax asset can be realized. As mentioned above, deferred tax asset when created separately for the timing differences should represent the value of an asset. The exclusion, therefore, in such a case should not apply to deferred tax asset.
- It is to be noted that rent equalization reserve is created in the books of account to consider for the difference between the operating lease rent and equalized rent as required under the Accounting Standard. The same is not in the nature of a reserve and should, therefore, not be considered as forming part of reserves and surplus and should be included in book value of liabilities.
- It is pertinent to note that in case of transfer of unquoted equity share deriving majority value from intangibles assets such as goodwill, trademark or other intangible assets, approach of valuation provided will not reflect the true value of the shares of the company.
Judicial Precedents
Various Tribunal/courts have held that the Income-tax authorities cannot disregard the valuation of shares if the same has been computed as per the prescribed valuation rules (i.e. Rule 11UA) and they are bound to follow the same. Further, the department could scrutinise the valuation report submitted by the taxpayer either by himself or through an external valuer but they could not change the method of valuation as opted by the taxpayer.
- Hon’ble Delhi Tribunal[7] has rejected the valuation adopted by the tax authorities for the reason that specific rules for determination of FMV as prescribed should be followed.
- Hon’ble Mumbai Tribunal[8] has held that the tax authorities cannot substitute the FMV of shares as derived under Rule 11UA.
- Hon’ble Hyderabad Tribunal[9] has held that A.O. has to compute the fair market value in accordance with the prescribed method but cannot adopt the market value as fair market value under section 56(2)(viia) of the Act. The legislature in its wisdom has also given a formulae for computation of the fair market value which cannot be ignored by the tax authorities.
- Further, the Hon’ble Supreme Court[10] in the landmark decision held that when the rule making authority has prescribed a specific method for valuing the unquoted equity shares then the same needs to be followed by the tax authorities even though some other valuation method may also be available. Similar principle has been upheld in following judicial pronouncements [11]amongst others
- Hon’ble Bangalore Tribunal[12] has held that the AO can do own valuation or obtain a fresh valuation report from an independent valuer, but he cannot change the method of valuation opted by the taxpayer. For scrutinising the valuation report, the facts and data available on the date of valuation only has to be considered.
- Hon’ble Jaipur Tribunal[13] has held that where AO did not find any defect in valuation of shares arrived at by assessee on basis of discounted cash flow method, addition made by AO on basis of net asset value method was to be set aside.
Conclusion:
As discussed above, loopholes existing earlier are now ploughed by introducing the provisions in section 56(2)(vii)/(viia)(viib)/(x) and 50CA read with rule 11UA. Now if equity shares are transferred other than at fair market value, it may result in addition either in the hands of transferor or transferee or issuing company or subscriber of shares. For the purpose of determining FMV, the assessee is required to follow the relevant method prescribed under the Act. As held by various Tribunal / courts, the Income-tax authorities cannot disregard the method adopted by the assessees if the same is in conformity of valuation rules. However, it is open for the department to scrutinise the valuation report submitted by the taxpayer either by himself or through an external valuer.
In case of issue of unquoted equity share, the assessee has two options i.e NAV or DCF method for determining FMV. In case of transfer of unquoted equity shares, FMV is to be determined at book value [except a few items like jewellery, artistic work etc]. Hence in situations pertaining to the transfer of unquoted equity share deriving majority value from intangibles assets such as goodwill, trademark or other intangible assets, the approach of valuation provided will not reflect the true value of the shares of the company.
References
- Quoted shares or securities” in relation to share or securities means a share or security quoted on any recognized stock exchange with regularity from time to time, where the quotations of such shares or securities are based on current transaction made in the ordinary course of business; ↑
- For ascertaining the book value of assets, following amounts shall be excluded:
any amount of income-tax paid, if any, less the amount of income-tax refund claimed, if any; any unamortized amount of deferred expenditure which does not represent the value of any asset.↑
- For ascertaining the book value of liabilities, following amounts shall be excluded: the paid-up capital in respect of equity shares; the amount set apart for payment of dividends on preference shares and equity shares where such dividends have not been declared before the date of transfer at a general body meeting of the company; reserves and surplus, by whatever name called, even if the resulting figure is negative, other than those set apart towards depreciation; any amount representing provision for taxation, other than amount of income-tax paid, if any, less the amount of income-tax claimed as refund, if any, to the extent of the excess over the tax payable with reference to the book profits in accordance with the law applicable thereto; any amount representing provisions made for meeting liabilities, other than ascertained liabilities; any amount representing contingent liabilities other than arrears of dividends payable in respect of cumulative preference shares; ↑
- For ascertaining the book value of assets, following amounts shall be excluded
any amount of tax paid as deduction or collection at source or as advance tax payment as reduced by the amount of tax claimed as refund under the Income-tax Act any unamortized amount of deferred expenditure which does not represent the value of any asset. ↑
- For ascertaining the book value of liabilities, following amounts shall be excluded:
the paid-up capital in respect of equity shares; the amount set apart for payment of dividends on preference shares and equity shares where such dividends have not been declared before the date of transfer at a general body meeting of the company; reserves and surplus, by whatever name called, even if the resulting figure is negative, other than those set apart towards depreciation; any amount representing provision for taxation, other than amount of income-tax paid, if any, less the amount of income-tax claimed as refund, if any, to the extent of the excess over the tax payable with reference to the book profits in accordance with the law applicable thereto; any amount representing provisions made for meeting liabilities, other than ascertained liabilities; any amount representing contingent liabilities other than arrears of dividends payable in respect of cumulative preference shares; ↑
- Words “or an accountant” omitted by the Income-tax (Sixth Amendment) Rules, 2018, w.e.f. 24-5-2018 ↑
- Subodh Gupta (HUF) v. PCIT 89 taxmann.com 418 ↑
- Smiti Holding & Trading Co. (P.) Ltd .Vs. PCIT 99 taxmann.com 157 ↑
- Medplus Health Services (P.) Ltd Vs. ITO 68 taxmann.com 29 ↑
- Bharat Hari Singhania v. Commissioner of Wealth-tax Vs Commissioner of Wealth-tax 73 Taxman 3 ↑
- Rameshwaram Strong Glass (P) Ltd [2018] 96 taxmann.com 542 (Jaipur Tribunal), Sharukh Khan v. Dy. CIT [2018]90 taxmann.com 284 (Bombay), Karmic Labs Pvt. Ltd vs. ITO ITA No.3955/Mum/2018 (ITAT Mumbai), Flutura Business Solutions (P.) Ltd Vs. ITO 117 taxmann.com 567 (Bangalore – Trib.), Cinestaan Entertainment (P.) Ltd. Vs. ITO [2019] 106 taxmann.com 300 (Delhi – Trib.), Vodafone M-Pesa Ltd Vs. DCIT [2020] 114 taxmann.com 323 (Mumbai – Trib.) ↑
- VHBC Value Homes Pvt Ltd v. ITO ITA No.2541/Bang/2019 & ITA No. 37/Bang/2020 ↑
- Safe Decore (P.) Ltd [2018] 90 taxmann.com ↑
About Author:
Girish Sukhyani is a member of the Institute of Chartered Accountants of India having over 5 years of experience in international as well domestic tax including cross border transactions and investment besides handling compliance, litigation and regulatory matters. Apart from the same, Girish likes to play volleyball in his free time.
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