Tag Archives: Income Tax

Fund raising and valuation: Company can choose the methodology

The recent ruling by the income tax appellate tribunal (“Appellate Tribunal”) of Jaipur dated 12 July 2018 in the case of Rameshwaram Strong Glass Private Limited v ITO has come as a significant relief for tax payers. In this matter, the Appellate Tribunal has held that the income tax laws in India gives an option to the assessee under rule 11UA of the Income Tax Rules, 1962 (“Rules”) to adopt either the break-up value method or the Discounted Free Cash Flow (“DCF”) method for valuation purposes.

Brief facts of the case: Rameshwaram Strong Glass Private Limited (the “Company”) incorporated on 31 January 2011, is a closely held company manufacturing toughened glass. There was no business conducted by the Company from assessment years 2011-2012 to 2013-2014 except for purchase of land. During the assessment year 2013-2014, the Company issued shares at a premium as per the valuation report prepared by a chartered accountant as per the DCF valuation method. The assessing officer (“AO”) claimed that the break-up value method was to be adopted by the Company instead of the DCF method for the purposes of valuation. As per the AO, since the DCF method was adopted instead of the break-up value method, the Company received additional money through the issue of these shares. Also, the AO claimed that the valuation report was incorrect and not justified and the actual premium of the shares should have been lower than what was mentioned in the valuation report. The Company submitted a revised valuation report to the commissioner of income tax, appeals (“First Appellate Authority”) in which a bona-fide error in the earlier report was corrected. The Company also contended that the amount of share premium is a commercial decision which does not require justification under law and the shareholders has the discretion to subscribe to the same. However, the First Appellate Authority directed the Company to prepare the valuation report based on the actual figures and not on estimates. Based on this revised report, the First Appellate Authority held that the earlier valuation report prepared was incorrect, based on imaginary figures and without any basis.

The Company appealed against the order of the First Appellate Authority to the Appellate Tribunal. One of the contentions of the Company was that the Rules allow the Company to choose between the DCF method or the break-up value method. The valuation method adopted by the Company cannot be challenged by the AO as long as it is a recognized method of valuation. Also, the Company contended that the requirement of the tax authority to give valuation report based on the actual figures and then comparing the same with the valuation report prepared through DCF method is not correct since the valuation under DCF method is based on future estimates based on revenue, expenses, investment, etc. The value is derived from the future profitability or cash flows of the Company. Also, since this is a newly formed company, the DCF valuation method had to be used as the capital base of the Company would be very less.

The Appellate Tribunal agreed with the contention of the Company stating that the assessee has the right to choose the method of valuation.  The Rules clearly provide an option to the assesse to follow either the DCF valuation method or the break-up value method. The only condition cast upon an assessee is that the valuation report has to be given by a merchant banker or a chartered accountant using the DCF method who have expertise in valuation of shares and securities. When a particular method of valuation is provided under law and when the assessee has chosen a particular method, directing the assessee to follow a particular method is beyond the powers of the income tax authority. The AO can scrutinize the valuation report if there are arithmetical errors and make necessary adjustments or alterations. However, if the assumptions made in the report are erroneous or contradictory, the authority may call for independent valuer’s report or invite his comments as the AO is not an expert. Also, the First Appellate Authority’s direction to the Company to give the valuation based on actual figures and then comparing such valuation report with that of the earlier report is contrary to the provisions of law since the DCF valuation method is based on future estimates. Therefore, the Appellate Tribunal held that the valuation report prepared by the chartered accountant using the DCF method was proper and the action of the AO and the First Appellate Authority was invalid.

It remains to be seen whether the judgment of the Appellate Tribunal goes up to the Supreme Court. However, as of now, this comes as a relief, in light of the many nuances that we discussed in our earlier post on Early Stage Valuations: Legislative Context and Continuing Saga of Angel Tax.

Note: The Board of Direct Taxes (CBDT) issued a notification on 24 May 2018, whereby the word “or an accountant” from Rule 11UA was omitted. Therefore, if a company is issuing equity shares to resident individuals, merchant banker valuation would be mandatory.

Author: Paul Albert

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REMUNERATION TO INDEPENDENT DIRECTOR

The role of Independent Director features prominently in Corporate Governance Codes. In India, the Companies Act 2013 (the Act) and SEBI (Listing Obligations and Disclosure Requirements) Regulations 2015 have completely revamped the country’s corporate governance code.

Corporate governance generally places a fair amount of emphasis on the independence of a Board and the corporate governance models in India have drawn large references from the recommendations of the Cadbury Committee (1992) of the UK and the Sarbanes-Oxley Act of 2002 of the USA.

A director is independent only if the Board affirmatively determines that he or she has no material relationship with the company that adversely affects his or her ability to be independent from management in connection with the performance of duties as a Board member and committee member.  This assessment is fact specific and when assessing the materiality of such relationship, the Board should consider the source of the director’s compensation including any consulting, advisory or other compensatory fees.  This includes consideration of whether the director receives compensation from any person or entity that would impair his ability to make independent judgments about the company’s management decisions.

Please see our recent post on the independence of Independent Directors here.

It is pertinent to note that only listed companies and public companies having a paid-up share capital of ten crore rupees or more or having turnover of one hundred crore rupees or more, or having in aggregate, outstanding loans, debentures, and deposits, exceeding fifty crore rupees have to mandatorily appoint at least two Independent Directors (or such higher number as mentioned specifically under Rule 4 of the Companies (Appointment and Qualification of Directors) Rules 2014]. Private companies are exempted from appointing Independent Directors. However, private companies may appoint them if the Board is of the opinion that there is a requirement of an Independent Director or if any investment agreement mandates such appointment.

Independent Directors devote their valuable time to addressing the strategic issues in the course of the Board and Committee meetings and use their expertise while guiding the management of the Company from time to time. Independent directors, who are truly independent, can be an effective barricade against corporate frauds. However, active oversight and prudent judgment may suffer when remuneration comes into the picture, as it is an important factor which needs consideration. The extent of remunerating Independent Directors determines their retention and motivation to discharge their duties without cloudy judgments.

As per the Companies Act 2013, “remuneration” means any money or its equivalent is given or passed to any person for services rendered by him and includes perquisites as defined under the Income-Tax Act, 1961. Now, let us examine the various remuneration models of Independent Directors in India.

The remuneration of an Independent Director is restricted to the following emoluments:

  1. Sitting Fee: Sitting fee to an Independent Director may be paid for attending meetings of the Board or committees thereof, such sum as may be decided by the Board of directors of and shall not exceed INR 1,00,000 per meeting of the Board or committee thereof.The sitting fee to be paid to Independent Directors shall not be less than the sitting fee payable to other directors.
  2. Commission: The Act allows a company to pay remuneration to its Independent Directors either by way of a monthly payment or a specified percentage of the net profits of the company or a combination of both. Further, it states that where the company has either a managing director or whole-time director or manager, then a maximum of 1% of its net profits can be paid as remuneration to its Independent Directors. In case there is no managing director or whole-time director or manager, then a maximum of 3% of net profit can be paid. Thus, the basis of payment to the Independent Directors is the net profit of the Company. The Company is however not obligated to remunerate its Independent Directors. Hence the Company may pay profit related commission to the Independent Directors with prior approval of the members. Given this, the commission should be profit-linked only and not revenue based. The Act does not eliminate profit-related commission which could create a conflict of interest since the commission is linked to the company’s performance.
  3. Consulting Fee: The remuneration of Independent Directors has been restricted to sitting fees, reimbursement of expenses for participation in the board and other meetings, and profit-related commission. Therefore, it can be noted that Consulting Fee is not allowed to be paid to Independent Directors.
  4. ESOP: The Act and SEBI (Listing Obligations and Disclosure Requirements) Regulations 2015 prohibit the issuance of stock options to Independent Directors, in a bid to address the concern that it might be causing a conflict of interest and will affect their independence. An alternative option could have been to place restrictions either on the total amount of issue of stock options or put a time limit on exercising stock options, rather than having a complete prohibition.
  5. Sweat Equity: The Company may opt to remunerate its Independent Director by way of issuing sweat equity shares. However, such issuance shall be in accordance with the procedure prescribed under the Act. The total percentage of voting power of such independent director together with his relatives shall not exceed more than two percent.
  6. Refund of excess remuneration paid: If the Independent Director draws or receives, directly or indirectly, by way of fee/remuneration any such sums in excess of the limit as prescribed or without the prior sanction, where it is required, such remuneration shall be refunded to the Company within two years or such lesser period as may be allowed by the company and until such sum is refunded, hold it in a trust for the Company. The Company shall not waive the recovery of any sum refundable to it unless approved by the Company by special resolution within two years from the date the sum becomes refundable.

Thus, to sum up, apart from the restriction on stock options, the remuneration of independent directors has been limited to sitting fees, reimbursement of expenses for participation in the board and other committee meetings, profit-related commission, and issuance of sweat equity shares as may be approved by the shareholders.

Additionally, the SEBI (Listing Obligation Disclosure Requirement) Regulation 2015 requires every listed public company to publish its criteria for payment of remuneration to Independent Directors in its Annual Report. Alternatively, this may be published on the company’s website and reference may be drawn thereto in its annual report. Section 197 of the Companies Act, 2013 and Regulation 17(6)(a) of SEBI (Listing Obligation Disclosure Requirement) Regulation 2015 states that the prior approval of the shareholders of the company is required for making payment to its Independent Directors, as recommended by the Board of the Company.

Authors: Ms. Ifla.A (Associate at NovoJuris Legal)