Tag Archives: merchant banker valuation

Valuation for issuance of shares: Which method to choose?

Determining the fair market value (FMV) of unquoted shares may prove to be challenging for companies owing to choose the valuation method. There have been multiple rulings by the Income Tax Appellate Tribunal (the “ITAT”) wherein the methodology adopted by the company for the valuation has been rejected on the grounds of being non-substantial. However, few rulings have also been in favour of Companies where the ITAT has squashed the argument of the Assessing Officer (the “AO”) stating that the tax authorities can scrutinise the valuation report to the extent of finding any arithmetical mistakes and not compel a taxpayer to choose the method of valuation.

Despite Valuation practice being prevalent since the last six decades in India, there is no specific guidance on the same and the debate continues pertaining to the method to be followed.

Valuation Methods as per Rule 11UA of Income Tax Rules, 1962

As per Rule 11UA of Income Tax Rules, 1962, Companies have an option to adopt either the Net Asset Value (the “NAV”) method or the Discounted Free Cash Flow (the “DFCF”) method for valuation purpose. On 24 May 2018, the Central Board of Direct Taxes (CBDT) has amended the Income Tax Rules, 1962, by omitting the words “or an accountant” from rule 11UA(2)(b). As a consequence of such amendment, now only a merchant banker can independently determine the FMV of the unquoted equity shares by using the DFCF method and an accountant is no longer eligible to do this valuation.

Various Case Laws pertaining to the Valuation Methods opted by Companies

Case 1: In the case of M/s. TUV Rheinland NIFE Academy Pvt. Ltd., Vs. The Income Tax Officer, the Company had issued 5,00,000 shares having face value of INR 100 each, at a premium price of INR 479 per share, to its parent, TUV Rheinland (I) Pvt. Ltd. (“TUVR India”). The Fair Market Value (the “FMV”) of the shares was computed as Rs. 479 as per the DFCF Method which was based on the projections of the company’s future cash flows.

The Assessing Officer (the “AO”) rejected the valuation report on the grounds that the values were certified by the management of the taxpayer. Further, the AO computed the FMV based on the NAV and concluded that the FMV should be INR 84.20 per share. Hence, the AO passed an order wherein an addition of INR 19.74 crore was made to the taxpayer’s income. Such an addition was made under section 56(2)(viib) of the Income Tax Act, 1961.

The ITAT concluded that the AO had not rejected the choice of valuation method but the valuation entirely justifying that it was non-substantial and there is no proof given for the basis of estimates provided in the valuation. Further, the ITAT also mentioned that the actual figures did not have any relevance with the projections made. Thus, the arguments of the Company were rejected and reference was drawn from the ruling in Agro Portfolio Pvt. Ltd v. ITO wherein the AO can carry out its own independent valuation and adopt the NAV method for this purpose, after rejecting the original valuation by the Company.

Case 2: In the case of Innoviti Payment Solutions Pvt. Ltd. vs. ITO, the Company had issued 10,42,658 shares having face value of INR 10 per share at premium of INR 23.50 per share. The FMV was determined by a Chartered Accountant through the DFCF method.

The same was rejected by the AO mentioning that the accountant has taken haze cash flow as certified by the management and the projections were not verified by the valuer. Further, it also added that the company had failed to provide any basis for the projections and that the management had clearly ignored factors such as performance, growth prospects, earnings capacity, etc. The Bangalore Bench of the ITAT ruled that the projections made in the valuation report should be supported with reasonable certainty and in its absence the valuation report shall be deemed unworkable.

A similar contention was also drawn in the case of 2M Power Health Management Services Pvt. Ltd. vs. ITO.

Case 3: Contrary to the case 1 & case 2 above, the Bombay High Court in the case of Vodafone M Pesa Ltd. v PCIT, ruled that the AO do not have the authority to reject the method of valuation already adopted by the taxpayer. It justified that the AO has the power scrutinize the valuation report and point out any arithmetical error in the same, but not compel the taxpayer to choose an entirely different valuation method.

The Income Tax Rules, 1962 provides for an option to the taxpayer to choose either the DFCF or NAV method of valuation. Thus, the AO could not adopt a method of his choice, especially when Rule 11UA gives an option to the taxpayer to choose the method of valuation. Doing so, the it would render clause (b) of Rule 11UA(2) as purposeless.

The Jaipur Bench of the ITAT had drawn a similar ruling in the case of Rameshwaram Strong Glass Pvt. Ltd. vs. ITO and ACIT vs. Safe Decore Pvt. Ltd.

Concluding thoughts

Based on the various rulings, it can be concluded that the tax authorities do not have the power to order the taxpayer to adopt any particular method of valuation. The taxpayer has the right to choose the DFCF method or the NAV method for valuation as mentioned in the Income Tax Rules, 1962. However, it should be noted that the taxpayer should be able to provide reasonable information to substantiate the projections certified by the management. Since the valuation report shall be subject to scrutiny, the valuer should verify the parameters taken into consideration in preparation of the valuation report and should be in a position to justify the same.

Authors: Alivia Das and Shivani Handa

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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