Valuation of Shares and tax treatment under Income Tax Act, 1961

 

Income Tax Rule 11UA deals with Valuation of unquoted equity shares. Under Income-tax Act, 1961, there are two options for valuation of FMV under rule 11UA:

The valuation rules are specified under Rule 11U, Rule 11UA, Rule 11UAA and Rule 11UB for various provisions under the Income-tax Act, 1961 which cover valuation options in case of various assets including equity shares and other securities.

There are two options for valuation of FMV u/r 11UA:

(a)    NAV method (Net asset value) : 

NAV is simply the price per share of the fund. As per Rule 11UA, there is no specific requirement that which person will do the valuation. Therefore, any registered valuer can do the valuation for issue of shares on fair Market Value.

(b) Discounted Free Cash (DFC) Flow Method: 

DCF model indicates the fair market value of a business based on the value of projected cash flows that the business is expected to generate in future. Rule 11UA(2)(b) deals with valuation as per DCF.

Under this method only Merchant Banker can do the Valuation of Securities. Earlier, a Chartered Accountant was also permitted to determine the FMV of such equity shares. However, with effect from 24th May 2018, this right of Chartered Accountant is taken away and therefore only Merchant Banker is authorized to determine the FMV of such equity shares under DCF method.

Who shall be the Valuer ?

Particulars	Under Income Tax Act	Under Companies Act,	Under FEMA
In case FMV is based on “Discounted cash flow (DCF)”  method	Only Merchant Banker can do valuation	Registered Valuer* can do valuation	CA or SEBI registered Merchant Banker can do valuation
In case FMV is based on other than “Discounted cash flow (DCF)”  method	Any Registered Valuer can do valuation	Registered Valuer can do valuation	CA or SEBI registered Merchant Banker can do valuation

 

From February 01, 2019, only a registered valuer is allowed to undertake valuation required under the Companies Act.

From 1 February 2019 no one, other than an IBBI (Insolvency and Bankruptcy Board of India) “Registered Valuer”, is authorised to conduct valuations under the applicable provisions of the Companies Act, 2013. The Insolvency and Bankruptcy Code, SEBI ICDR Regulations, 2018 and SEBI (REIT and InvIT) Regulations have also defined Valuer as a person who is registered under section 247 of the Companies Act, 2013.

 

Under Section 247(2) of the Companies Act, the registered valuer is required to:

(i)       Make an impartial, true and fair valuation of assets which may be required to be valued;

(ii)     Exercise due diligence while performing the functions of a valuer;

(iii)    Make the valuation in accordance with such rules as maybe prescribed; and

(iv)   Not undertake valuation of any assets in which he has a direct or indirect interest or becomes so interested at any time during or after the valuation of assets.

 

As per Income Tax Act until unless shares are issued on premium there is no need of valuation certificate.

In Brief

(a)	If Shares are issued on Face Value	·         no need to obtain of Valuation Report. Valuation report is required to obtain only in case of issue of shares on Premium.
(b)	if shares issued on premium	As per Income Tax Act until unless shares are issued on premium there is no need of valuation certificate. However, if shares issued on premium then valuation report issued by registered Valuer shall be accepted here.
(c)	In case of Valuation of Shares on “Discounted cash flow (DCF)” method	·         then only Merchant banker can do the Valuation. ·

 

In case of Rights Issue of shares - Valuation report is not required

As per Income Tax Act, in case of right issue of shares, shares are issued to existing shareholders only in proportion to their shareholding. Therefore, no need of Valuation of Shares. In other words, in case of right issue of shares whether on face value/ premium no need of Valuation Report as per Income Tax Act. Valuation is mandatory in case shares are issued at premium, else it might be considered as income of the company.

In case of Preferential Allotment of Shares

As per Income Tax Act, if shares issued on premium then valuation report issued by registered Valuer shall be mandatory. In other words, valuation is mandatory for allotment of shares on preferential basis and report taken from registered valuer shall fulfill the purpose of Income Tax Act.

Valuation of Shares (Fresh Issue and Transfer) as Per Rule 11UA of Income Tax Rules 1962

Particulars	Fresh Issuance	Transfer
Applicable Section and rule	Section 56(2)(viib) read with Rule 11UA(2)(a)	Section 56(2)(x) read with Rule 11UA(1)(c)(b)
Valuation Method	Discounted Cash Flow Method (DCF) or Book Value method	Book Value Method
Valuer	Merchant Banker	Not prescribed

 

Requirement of valuation certificate from both Merchant Banker and Registered Valuer

Any company which is not a start-up India registered [Companies registered with Department for Promotion of Industry and Internal Trade as Start-up] and issuing equity shares/preference shares to persons who are residents in India (excluding SEBI registered funds) and such issuance is under Private Placement basis. As this issuance entails compliance under section 42, 62(1) (c) of the Act and section 56(2) of the Income Tax Act 1961, the valuation report from both merchant banker and registered valuer is mandatory.

 

Requirement of valuation certificate only from Merchant Banker

Any company which is not a start-up India registered and issuing equity shares/preference shares as rights issue under section 62(1)(a) (Rights Issue) of the Act either to persons residents in India or persons residents outside India, then valuation report from merchant banker is sufficient.

 

Requirement of valuation certificate only from Registered Valuer

Under the following circumstances, the valuation report from Registered Valuer is sufficient:

(a) Any company which is not a start-up India registered and issuing debentures on private placement basis in terms of section 42, 62(1) (c) of the Act;

(b) Any company which is a start-up India registered and issuing equity shares /preference shares/ debentures. [Start-up companies are exempted from section 56(2)(viib) of Income Tax Act 1961 pursuant to notification from CBDT dated 11 April 2018]

KEY NOTE

The government has designated the Insolvency and Bankruptcy Board of India (IBBI) as the authority to implement the new regime of registered valuers.

 

CHECKLIST :

Type of Company	Scenarios	Valuation Report Requirement
		Merchant Banker & Registered Valuer	Only Merchant Banker	Only Registered Valuer who is a Chartered Accountant
Start-up India registered Company (see point below)	Issuance of Equity Shares/Preference Shares (Private Placement Basis)	X	X	Yes
	Issuance of Equity Shares/Preference Shares (Rights Issue)	X	X	Yes
	Issuance of Debentures	X	X	Yes
Other Companies	Issuance of Equity Shares/Preference Shares (Private Placement Basis)	Yes	X	X
	Issuance of Equity Shares/Preference Shares (Rights Issue)	X	Yes	X
	Issuance of Debentures	X	X	Yes

 

The fair market value of the shares =

(i)   as may be determined in accordance with such method as may be prescribed, or

(ii)  as may be substantiated by the company to the satisfaction of the Assessing Officer, based on the value, on the date of issue of shares

 

KEY NOTE

With effect from the 1st day of April, 2018 where a company, not being a company in which the public are substantially interested, receives, in any previous year, from any person being a resident, any consideration for issue of shares that exceeds the face value of such shares, the aggregate consideration received for such shares as exceeds the fair market value of the shares. FMV does not imply the actual market value of the shares at which shares may be transacted between parties. It is the value of shares as determined based on book value of the assets and liabilities of the company.

 

Valuation of shares as per Income tax rules

 Rule 11UA(1)(c)

(A)  Quoted shares and securities

(a)	If transaction carried out through recognized stock exchange	FMV is the Transaction Value as recorded in stock exchange
(b)	If transaction carried out other than through recognized stock exchange	Lowest price of such shares quoted on any recognized stock exchange : §  As on the valuation date: when trading in such shares and securities on any recognized stock exchange §  As on the day immediately preceding the valuation date: When no trading in such shares and securities on any recognized stock exchange

 

Transfer of Quoted shares (Based on actual price of the equity shares quoted on a recognised stock exchange)

The transfer of quoted shares (meaning - the shares quoted on any recognized stock exchange with regularity from time to time, where the quotation of such share is based on current transaction made in the ordinary course of business) is done through trading that takes place at the transaction value in the secondary market of the stock exchanges which is said to be its Fair Market Value. However, if such securities are transacted through a medium other the recognized stock exchange, then the basis for determination of FMV would be the lowest price quoted as on the said date.

 

(B)  Unquoted equity shares

As per Rule 11UA of the Income-tax Rules, 1962, the FMV of unquoted shares is to be determined as under:

The fair market value of unquoted equity shares =

(A+B+C+D – L)× (PV)/ PE

FMV= (A-L) * (PV) / (PE)

A= Book Value of assets after adjustments

B= Book Value of liabilities after adjustments

PE= Total amount of paid up equity share capital as shown in the balancesheet

PV= The paid up value of such equity shares

Type of security	Unquoted equity shares	Unquoted equity shares
Transaction	In case of fresh issuance of shares	Any person receiving the share or security
Applicable section and rule	Section 56 (2) (viib) read with Rule 11UA(2)	Section 56 (2) (x) read with Rule 11UA(1)(c)(b)
Method prescribed for computation of FMV	Discounted Cash Flow method (DCF) or book value method 1at the option of assesse	Book Value method *
Valuer	Merchant Banker for DCF. For book value not prescribed	Not prescribed

 

* Book Value Method prescribed under Rule 11UA(1)(c)(b) of Income Tax Rules, 1962 (Applicable to recipient of shares and securities)

FMV = (A+B+C+D-L) × (PV)/(PE)

 

Where

A  = Book value of Assets (other than jewellery, artistic work, shares, securities, immovable property)

B  = Fair value of jewellery and artistic work based on valuation report from registered valuer

C   = FMV of shares and securities as per Rule 11UA

D   = Stamp value of Immovable Property

L    = Book value of liabilities after certain adjustments as defined in rule

PV = Paid up value of such equity share

PE = Total amount of paid up equity share capital as shown in the balance-sheet

As per Rule 11UA of the Income-tax Rules, 1962, the FMV of unquoted shares is to be determined as under:

The fair market value of unquoted equity shares =

(A+B+C+D – L) X (PV)

PE

where,

 A= book value of all the assets (other than jewellery, artistic work, shares, securities and immovable property) in the balance-sheet as reduced by,—

(i)           any amount of income-tax paid, if any, less the amount of income-tax refund claimed, if any; and

(ii)         any amount shown as asset including the unamortised amount of deferred expenditure which does not represent the value of any asset;

(iii)       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;

(iv)       C = fair market value of shares and securities as determined in the manner provided in this rule;

(v)         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;

(vi)       L= book value of liabilities shown in the balance sheet, but not including the following amounts, namely:—

               (a)  the paid-up capital in respect of equity shares;

(b)      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;

(c)       reserves and surplus, by whatever name called, even if the resulting figure is negative, other than those set apart towards depreciation;

(d)      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;

(e)       any amount representing provisions made for meeting liabilities, other than ascertained liabilities;

(f)       any amount representing contingent liabilities other than arrears of dividends payable in respect of cumulative preference shares;

           

            PV  = the paid up value of such equity shares;

            PE  = total amount of paid up equity share capital as shown in the balance-sheet;

     KEY NOTE

(i) the fair market value of unquoted shares and securities other than equity shares in a company which are not listed in any recognized stock exchange shall be estimated to be price it would fetch if sold in the open market on the valuation date and the assessee may obtain a report from a merchant banker or an accountant in respect of which such valuation.

(ii) Irrespective of above valuation, the fair market value of unquoted equity shares for the purposes of sub-clause (i) of clause (a) of Explanation to clause (viib) of sub-section (2) of section 56 shall be the value, on the valuation date, of such unquoted equity shares as determined in the following manner:

          (a) THE FAIR MARKET VALUE OF UNQUOTED EQUITY SHARES =

               (A-L) X PV

                     PE

 

              where,

               A = book value of the assets in the balance-sheet as reduced by 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 and any amount shown in the balance-sheet as asset including the unamortised amount of deferred expenditure which does not represent the value of any asset;

              L =  book value of liabilities shown in the balance-sheet, but not including the following amounts,    namely:

(i)          the paid-up capital in respect of equity shares;

(ii)        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;

(iii)       reserves and surplus, by whatever name called, even if the resulting figure is negative, other than those set apart towards depreciation;

(iv)      any amount representing provision for taxation, other than 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, to the extent of the excess over the tax payable with reference to the book profits in accordance with the law applicable thereto;

(v)        any amount representing provisions made for meeting liabilities, other than ascertained liabilities;

(vi)      any amount representing contingent liabilities other than arrears of dividends payable in respect of cumulative preference shares;

 

                  PE  = total amount of paid up equity share capital as shown in the balance-sheet;

                  PV = the paid up value of such equity shares;

          (b) THE FAIR MARKET VALUE OF THE UNQUOTED EQUITY SHARES DETERMINED BY  A MERCHANT BANKER AS PER THE DISCOUNTED FREE CASH FLOW METHOD.

(C)   Unquoted shares and securities other than equity shares

        The value it would fetch if sold in open market on the valuation date

Type of security	Unquoted securities other than equity shares
Transaction	Applicable for all cases
Applicable section and rule	Section 56 (2) (viib) and (x) read with rule 11UA(1)(c)(c)
Method prescribed for computation of FMV	Not prescribed
Valuer	Merchant Banker or chartered accountant

 

Transfer of Unquoted shares of a public company or of a private company:

The transfer of unquoted shares is however subject to determination of a “Fair Market Value (FMV)” calculated in accordance with the method (formula) as prescribed in Rule 11U & 11UA of the Income-tax Rules, 1962. More or less, the value comes near to the Book Value. The said valuation has to be supported, reported and certified by a Category I – Merchant Banker OR a Chartered Accountant who should be a Fellow Member of the Institute of Chartered Accountants of India & not a Statutory Auditor of the Company.

 

In case of transfer of unquoted shares by a person at value lesser than fair market value as defined in above rule 11UA(1)(c)(b) and 11UA (1)(c)(c), the fair market value as defined in these rules shall be considered as sale consideration for such transaction. [Refer Section 50CA of Income tax act read with Rule 11UAA].

When an owner of Unquoted share in a Company transfers the shares to any person, he is required to pay Capital Gain tax on the difference between the sale consideration received by him and the cost of acquisition of such shares (or the inflation indexed cost, wherever applicable).

As per Rule 11U(b)(ii), for the purpose of determining FMV using book value method, For Indian company, Audited Balance Sheet as drawn up on the valuation date shall be required. For other companies, Audited Balance Sheet as drawn up on the valuation date which has been audited by the auditor of the company appointed under the laws in force of the country in which the company is registered or incorporated shall be required.

 

Section 56(2)(viib)/ Rule 11UA : Assessing Officer cannot change share valuation method adopted by assessee. The assessee has the choice to choose a prescribed method for ascertaining the market value of the shares transferred. If the assessee has chosen one method of valuation provided under Rule 11UA (i.e. DCF method), the Assessing Officer has no power or jurisdiction to change that method to another method

Section 56 allows the assessees to adopt one of the methods of their choice. But, the Assessing Officer held that the assessee should have adopted only one method for determining the value of the shares. In our opinion, it was beyond the jurisdiction of the Assessing Officer to insist upon a particular system, especially the Act allows to choose one of the two methods. Until and unless the legislature amends the provision of the Act and prescribes only one method for valuation of the shares, the assessee are free to adopt any one of the methods.

 

The assessee has issued shares at a premium. In order to ascertain the market value of the shares, the assessee adopted DCF method, as prescribed under Rule 11UA r.w.s 56(2) of the Act and accordingly, the shares were issued at a premium. According to the Ld. Assessing Officer, the valuation report furnished by the assessee is not realistic as the projections shown by the assessee in the valuation report were not realistic and were not achieved in actuality in the subsequent years. Whereas on the other hand the assessee has tried to justify the valuation with reference to orders book of Rs.18.01 crores. Therefore, only issue before us, whether the Ld. Assessing Officer has the power to change the method adopted by the assessee from one method to another method provided under Rule 11UA. We have perused the decisions relied upon by the assessee and are of the considered view that the issue is settled in the following cases, where it has been held that it is beyond the jurisdiction of the Assessing Officer to change the method of valuation.

Bombay High court, in the case of Vodafone M-Pesa Ltd. v. PCIT (2018) 92 taxmann.com 73 (Bombay)the Hon’ble court has held that the Ld. Assessing Officer cannot change the method adopted by the assessee for valuing the market value of the shares from discounted cash flow method to net asset value method, which was violation of Rule 11UA and accordingly, the impugned order was to be set aside. Similarly, the co-ordinate bench in the case of Vodafone M-Pesa Ltd v. PCIT (supra) has held that the Ld. Assessing Officer cannot change the method of valuation adopted by the assessee by merely relying on the actual results in the subsequent years and arbitrarily coming to the conclusion that projections were not achieved. We, therefore respectfully following the decisions as discussed above, set aside the order the Ld. CIT(A) and direct the Ld. Assessing Officer to delete the additions. (Related Assessment year : 2014-15) – [Karmic Labs (P) Ltd. v. ITO – Date of Judgement : 28.07.2020 (ITAT Mumbai)]

 

Fair market value (FMV) of shares issued at premium Discount cash flow method (DCF) – Net valuation method – Option to choose the method of valuation is with assesses-Determined Fair Market Value of shares issued at premium on basis of Discount Cash Flow method as per guidelines given by ICAI-Assessing Officer cannot change the method of valuation of shares at premium to Net Asset Value method.(NAV) [S. 56(2)(Viib), R.11UA(2) (b)]

It was held that,when law had given an option to assessee to choose any of method of valuation of his choice and assessee exercised an option by choosing a particular method (DCF), changing method or adopting a different method would be beyond powers of revenue authorities. Accordingly determined Fair Market Value of shares issued at premium on basis of Discount Cash Flow method as per guidelines given by ICAI, Assessing Officer cannot change the method of valuation of shares at premium to Net Asset Value method. (NAV) (Related Assessment year : 2013-14) – [Rameshwaram Strong Glass (P) Ltd. v. ITO (2018) 195 TTJ 465 : 172 ITD 571 : 170 DTR 415 (ITAT Jaipur)]

Fair market value of shares-Direct Cash Flow Method (DCF)-No evidence was produced for verifying the correctness of data supplied by the assessee.AO was justified in rejecting DCF method and adopting Net Asset value method.[R.11UA]

Assesee valued the equity value of shares of Rs 10 each at premium of Rs 40 per share, accordingly the fair value was determined by a Merchant banker only on basis of Direct Cash Flow Method (DCF), only depending on data supplied by assessee. AO rejected valuation report and independently determined FMV of shares at Rs. 9.60 each on basis of NAV method. FMV of shares over Rs. 9.60 i.e. RS. 40.40 was disallowed by AO. under Section 56(2)(vii) of the Act and added to assessee's income. On appeal by the assessee the Tribunal held that as no evidence was produced for verifying correctness of data supplied by assessee, AO was justified in rejecting DCF method and adopting Net Asset Value method. (AY.2014-15) Agro Portfolio (P.) Ltd (2018) 171 ITD 74 (Delhi) (Trib.)

Under valuation of shares - The “fair market value” of shares acquired has to be determined by the taking the book values of the underlying assets and not their market values

Allowing the appeal of the assesse the Tribunal held that; on the plain reading of above Rule, it is revealed that while valuing the shares the book value of the assets and liabilities declared by the TEPL should be taken into consideration. There is no whisper under the provision of 11UA of the Rules to refer the fair market value of the land as taken by the Assessing Officer as applicable to the year under consideration. Therefore, we are of the view that the share price calculated by the assessee of TEPL for Rs. 5 per shares has been determined in accordance with the provision of Rule 11UA. (Related Assessment year : 2014-15) Minda SM Tecnocast Pvt. Ltd. v. ACIT (2018) 170 ITD 12 (ITAT Delhi)]

 

Unquoted equity shares - Discounted cash flow method – Net asset value method – Option to adopt the method of valuation is with assessee - When no defect is found in valuation of shares arrived on basis of discounted cash flow method addition made by the Assessing Officer on basis of net asset value method was to be set aside

The assessee submitted valuation per equity share computed on the discounted cash flow method as per the certificate of Chartered Accountants wherein the value per shares was arrived at Rs. 54. 98 per share. The Assessing Officer did not accept said valuation and applied Net Asset Value method as per which value of share came to Rs. 26. 69 per share. Applying the said value, the Assessing Officer made addition under Section 56(2)(vii)(b) of the Act. Tribunal held that the provisions of Section 56(2)(vii)(b) gives an options to assessee to adopt any of methods which can be compared with Net Asset Value Method and Assessing Officer shall adopt value whichever is higher. Accordingly the since discounted cash flow method is one of prescribed method and, moreover, Assessing Officer had not found any serious defect in facts and details used in determining fair market value under said method, impugned addition made by him was deleted. (Related Assessment year : 2014-15) – [ACIT v. Safe Decore (P.) Ltd. (2018) 193 TTJ 898 : 169 ITD 328 : 165 DTR 339 (ITAT Jaipur)]

 

Section 56(2)(viib)/ Rule 11UA: The valuation of shares should be made on the basis of various factors and not merely on the basis of financials. The substantiation of the fair market value on the basis of the valuation done by the assessee simply cannot be rejected where the assessee has demonstrated with evidence that the fair market value of the asset is much more than the value shown in the balance sheet

As per the circle rate prescribed by the competent authority, the value of total assets i.e., the fair market value of the land which was converted from ‘agricultural’ into ‘institutional’ comes to Rs.113,00,72,749/-. If the other assets of Rs.9,17,608/- is added to such asset and the total liability of 46,55,69,537/- is deducted, then, the net asset comes to Rs.66,54,20,820/-. If the same is divided by the number of equity shares of 10,10,000/-, then, the value per share comes to Rs. 658.83 which is more than the premium of Rs. 5/- charged by the assessee on a share of Rs. 10/-. We, therefore, find merit in the argument of the ld. counsel for the assessee that the valuation of the shares should be made on the basis of various factors and not merely on the basis of financials and the substantiation of the fair market value on the basis of the valuation done by the assessee simply cannot be rejected where the assessee has demonstrated with evidence that the fair market value of the asset is much more than the value shown in the balance sheet. (Related Assessment year : 2014-15 – [India Convention and Culture Centre (P) Ltd. v. ITO – Date of Judgement : 27.09.2019 (ITAT Delhi)]

Section 56(2)(viib)/ Rule 11UA : Assessing Officer cannot discard assessee’s method of share valuation. The assessee has the option to determine the fair market value of shares either under the DCF method or the NAV method. The assessee's choice is binding on the Assessing Officer. While the Assessing Officer can scrutinize the working, he cannot discard the assessee's method and substitute another method (Vodafone M-Pesa Ltd. v. PCIT (2018) 92 taxmann.com 73 (Bom) referred)

 In the present case the valuation done by the assessee for valuing its shares is on the basis of DCF method and the Assessing Officer could not have substituted it by NAV method rather he should have arrived at another value, if any, by applying DCF method only. We also noted that the explanation and additional evidences produced before us shows that why projection has been made in that manner and have been substantiated by filing additional evidences/ papers on assessee’s paper book volume 2 at pages 1 to 78. We noted that this issue has been considering by the Hon’ble Bombay High Court and remanded back to the file of the Assessing Officer the issue regarding considering the value of shares in term of section 56(2)(viib) of the Act on the basis of DCF method. Here, in this present case also, we direct the Assessing Officer to consider these additional evidences and then can arrive at a correct value of share for charging of share premium in term of section 56(2)(VIIB) of the Act. But on the basis of DCF method only which is adopted by the assessee. Hence, the assessment order and the order of the CIT(A) is set aside and the matter restore back to the file of the Assessing Officer. In term of the above, we restore this issue to the file of the Assessing Officer.

 

While valuing the share premium and to determine the fair market value of shares in terms of section 56(2)(viib) of the Act, the assessee has option for adoption of valuation method and the basis of valuation has to be DCF method. The Hon’ble Bombay High court in Vodafone M-Pesa Ltd v. PCIT (2018) 92 taxmann.com 73 (Bombay) has held that in view of the Income Tax Rules, the method of valuation namely NAV method or DCF Method to determine the fair market value of share in terms of section 56(2)(viib) of the Act has to be done or adopted at the assessee’s option. Assessing Officer was undoubtedly entitled to scrutinize the valuation report and can tinker or determine a fresh valuation after confronting the assessee. However, the basis of valuation had to be DCF method and it is not open to the Assessing Officer to change the method of valuation which the assessee has duly opted. (Related Assessment year : 2013-14) – [Narang Access (P) Ltd v. DCIT - Date of Judgement : 22.08.2019 (ITAT Mumbai)]

 

Section 56(2)(viib): Valuation- start-up – Assessee has the option under Rule 11UA(2) to determine the FMV by either the ‘DCF Method’ or the ‘NAV Method’- The Assessing Officer has no jurisdiction to tinker with the valuation and to substitute his own value or to reject the valuation. The assessee has the option under Rule 11UA(2) to determine the FMV by either the ‘DCF Method’ or the 'NAV Method'. The Assessing Officer has no jurisdiction to tinker with the valuation and to substitute his own value or to reject the valuation. He also cannot question the commercial wisdom of the assessee and its investors. The ‘DCF Method’ is based on projections. The Assessing Officer cannot fault the valuation on the basis that the real figures donot support the projections. Also, the fact that independent investors have invested in the start-up proves that the FMV as determined by the assessee is proper

The assessee has the option under Rule 11UA(2) to determine the FMV by either the ‘DCF Method’ or the ‘NAV Method’. The Assessing Officer has no jurisdiction to tinker with the valuation and to substitute his own value or to reject the valuation. He also cannot question the commercial wisdom of the assessee and its investors. The ‘DCF Method’ is based on projections. The Assessing Officer cannot fault the valuation on the basis that the real figures don’t support the projections. Also, the fact that independent investors have invested in the start-up proves that the FMV as determined by the assessee is proper. 

 

There is another very important angle to view such cases, is that, here the shares have not been subscribed by any sister concern or closely related person, but by an outside investors like, Anand Mahindra, Rakesh Jhunjhunwala, and Radhakishan Damania, who are one of the top investors and businessman of the country and if they have seen certain potential and accepted this valuation, then how Assessing Officer or Ld. CIT(A) can question their wisdom. It is only when they have seen future potentials that they have invested around Rs. 91 crore in the current year and also huge sums in the subsequent years as informed by the ld. counsel. The investors like these persons will not make any investment merely to give dole or carry out any charity to a startup company, albeit their decision is guided by business and commercial prudence to evaluate a start-up company like assessee, what they can achieve in future. (Related Assessment year : 2015-16) – [Cinestaan Entertainment (P) Ltd v. ITO  - Date of Judgement : 27.05.2019 (ITAT Delhi)]

 

Section 56(2)(viib)/ Rule 11UA : Addition of premium amount cannot be made solely on the basis of valuation of loss making company -  Law on how to determine the "FMV" (Fair Market Value) of shares issued by a closely held company explained. The fact that the company is loss-making does not mean that shares cannot be allotted at premium. The DCF method is a recognised method though it is not an exact science & can never be done with arithmetic precision. The fact that future projections of various factors made by applying hindsight view cannot be matched with actual performance does not mean that the DCF method is not correct

Rule 11UA will apply only if option is exercised in sub-clause (i), but if the assessee has been able to substantiate the fair market value in terms of sub-clause (ii), then valuation done by the assessee cannot be rejected simply on the ground that it does not stand the test of method provided in 11U and 11UA. Here the assessee has been able to show that the aggregate consideration received and the shares which were issued does not exceed FMV and has demonstrated the value as contemplated in Explanation (a) and therefore, the working of the assessee as per Explanation (a) sub clause (ii) has to be accepted. Section 56(2)(viib) provides for fair market value to be opted whichever is higher either under sub-clause (i) or sub-clause (ii). Since the working of FMV so substantiated by assessee company as per sub-clause (ii) is higher than value prescribed under section 11UA, then same should be adopted for the purpose of valuation of the shares of the assessee company.

 

Addition of difference premium amount of Rs. 20/- per share in assessee-company on the ground that M company was a loss-making company was not justified as assessee had substantiated the shares issued at Rs. 30 per share was less than the FMV  and the underlying asset of assessee company, i.e., M was valued as per DCF method which was a recognised method where future projections of various factors by applying hindsight view and it could not be matched with actual performance, thus, to reject the valuation of M mainly on the basis of losses shown in the financial statement would not be correct, until and unless some discrepancy had been out either in the DCF method or in the Valuation Report furnished by an independent Valuer of M.

Held: Assessee-company was engaged in the business of development, design and maintenance of website and sale and purchase of shares. It had received share application money from M/s. M Ltd. The value of shares shown by assessee was Rs. 30 per share, i.e., face value of Rs. 10 and premium of Rs. 20/-. Assessing Officer required the assessee to justify the difference between premium charged and the book value of the shares and why the difference should not be added back in terms of section 56(2)(viib). Assessee had submitted that it had issued shares to M at a price of Rs. 30 per share based on the valuation report certified by independent Chartered Accountant. Assessing Officer rejected assessee’s contention. It was held  the fair market value of the shares can be determined, either in accordance with method prescribed which now has been given in Rule 11U and 11UA; or as may be substantiated by the company to the satisfaction of the Assessing Officer based on the value on the date of issuance of shares. Assessee had substantiated the fair market value which was based on Valuation Report which in turn was largely based on the valuation of share provided by the Valuer of the M as on 20.07.2012, wherein the valuer had applied DCF method in order to value the share of M. As per valuation report dated 27.12.2012, the value per share of assessee company on NAV method was worked out to Rs. 77.06, which was far more than on which assessee had issued shares, i.e., at Rs. 30. The underlying asset of assessee company, i.e., M was valued as per DCF method and value of shares of assessee-company was based on NAV method. When law envisages that the FMV can be determined in either of the two manners, whichever is higher, so as to demonstrate that the value of shares did not exceeds the FMV, then Assessing Officer could not insist upon to follow only one particular method.  It would be incorrect to hold that substantiation made by assessee had to be only in accordance with Rule 11U and 11UA. Also, noticing that auditor had reported that M was in losses and book value of the shares was negative and based on such statement to infer the value of the shares shown by the assessee was incorrect, would not be proper, especially, when the same auditor/valuer had valued the shares of M. Moreso, DCF method is a recognised method where future projections of various factors by applying hindsight view and it cannot be matched with actual performance. Valuation under DCF is not exact science and can never be done with arithmetic precision, hence the valuation by a Valuer has to be accepted unless, specific discrepancy in the figures and factors taken are found. Therefore, to reject the valuation of M mainly on the basis of losses shown in the financial statement would not be correct, until and unless some discrepancy had been out either in the DCF method or in the Valuation Report furnished by an independent Valuer of M. (Related Assessment years : 2013-14, 2014-15) – [India Today Online (P) Ltd. v. ITO – Date of Judgement : 15.03.2019 (ITAT Delhi)]

 

Provisions of Section 56(2)(vii)(c) of the Income-tax Act do not apply to the proportionate issue of right shares. Section 56(2)(vii) is a counter evasion mechanism to prevent money laundering of unaccounted income & does not apply to bona fide business transaction done out of business exigency. The difference between alleged fair market value of share and the subscribed value of shares cannot be assessed as income under section 56(2)(vii)(c)

 

Section 56(2)(vii) does not apply to bonafide business transaction. As explained hereinabove, shares were issued by the company to comply with a covenant in the loan agreement with State Bank of India which required the promoters to increase the total net worth of the company to Rs. 150 crores by 31 March, 2010. Therefore, the shares were issued by the company for a bonafide reason and as a matter of business exigency.

 

Relying on the CBDT Circular 1/2011 dated 6 April 2011 (which inter alia states that section 56(2)(vii) was inserted as a counter evasion mechanism to prevent money laundering of unaccounted income), the Tribunal held that as the issue of additional shares was bonafide, necessitated by a covenant of the Company’s USA Subsidiary’s loan agreement, carried out through banking channels and in the absence of any allegation regarding money laundering, no addition under section 56(2)(vii) could be made.

 

Circular No.1/2011 dated 6 April, 2011 issued by the CBDT explaining the provision of section 56(2)(vii) specifically states that the section was inserted as a counter evasion mechanism to prevent money laundering of unaccounted income. In paragraph 13.4 thereof where it is stated that “the intention was not to tax transactions carried out in the normal course of business or trade, the profit of which are taxable under the specific head of income”.

 

The Tribunal also held that section 56(2)(vii) was inapplicable in the current facts because it applied from 1 October 2009, whereas the contract between the company and the shareholder for issue by the company of shares was completed before such date. It was only the formal routine act of issuance of the share certificate by the company which took place after 1 October, 2009. -  (Related Assessment year : 2010-11) – [ACIT v. Subhodh Menon – Date of Judgement : 07.12.2018 (ITAT Mumbai)]

Section 56(2)(viia)/ Rule 11UA: The "fair market value" of shares acquired has to be determined by the taking the book values of the underlying assets and not their market values

On the plain reading of Rule 11UA, it is revealed that while valuing the shares the book value of the assets and liabilities declared by the TEPL should be taken into consideration. There is no whisper under the provision of 11UA of the Rules to refer the fair market value of the land as taken by the Assessing Officer as applicable to the year under consideration.

 

Where the assessee had acquired shares of one, TEPL which were valued the shares as per rule 11UA of the Income-tax Rules, 1962, i.e., on basis of book value of assets of TEPL and not as per market value of assets, the Tribunal held that the Assessing Officer was unjustified in making an addition under Section 56(2)(viia) by substituting the valuation adopted by the assessee with the market value and alleging that the difference was the income of the assessee. The Tribunal held that under the provision of rule 11UA there was no reference to the fair market value of the land as taken by the Assessing Officer and accordingly deleted the addition made. (Related Assessment year : 2014-15) - [Minda SM Technocast (P) Ltd v. ACIT (2018) 92 taxmann.com 29 (ITAT Delhi)]

 

Section 56(2)(viiib): – Fair market value of shares sold – Choice of method of valuation is with the assessee – Assessing Officer has no jurisdiction to insist that the assessee should only a particular method for determining the value of shares. Rule of constancy must be followed by the Assessing Officer

Rule 11UA allows the assessee the right to adopt the method of his choice for valuing shares (DCF, NAV etc.). The Assessing Officer has no jurisdiction to insist that the assessee should adopt only a particular method for determining the value of the shares. Assessing Officers should not deviate from earlier years’ decisions without assigning any concrete and justifiable reasons. Tax determination cannot be left to whims and fancies of a person. It is a serious task and has to be accomplished in a disciplined manner. If an assessee has been allowed a certain concession in earlier year/(s) it cannot be withdrawn in subsequent years without plausible reasons.

 

Section 56 allows the assessees to adopt one of the methods of their choice. But, the Assessing Officer held that the assessee should have adopted only one method for determining the value of the shares. In our opinion, it was beyond the jurisdiction of the Assessing Officer to insist upon a particular system, especially the Act allows to choose one of the two methods. Until and unless the legislature amends the provision of the Act and prescribes only one method for valuation of the shares,the assessees are free to adopt any one of the methods. (Related Assessment year : 2013-14)  – [DCIT v. Ozoneland Agro (P) Ltd. (2018) 64 ITR 6 : 53 CCH 427 (SN)(ITAT Mumbai)]