Tag Archives: Valuation of Shares

Mumbai ITAT Provides Further Relief and Clarity on Valuation of Preference Shares

ACIT v Golden Line Studio Pvt. Ltd.

ITAT, Mumbai

I.T.A. No. 6146/Mum/2016 (Assessment Year 2011-12)

Judgment date: 31/8/2018

Factual Matrix of the Dispute

The case revolves around an instance of issuance of non-convertible redeemable preference shares (“RPS”) by a company called Golden Line Studio Pvt. Ltd. (the Assessee) to its holding company. The stance taken by the Assessing Officer (“AO”) in this case was that the RPS were issued at a premium of INR 490/- over the face value (INR 10/-) of the shares which seemed excessive and amenable to tax.

Brief Description AO’s Contentions

The AO in this case contended that there was no basis provided by the Assessee to justify the premium amount on the RPS, and thus had a Net Asset Valuation of the Assessee done, basis which the AO arrived at a fair market value of the RPS INR 38/- per share and contended that the share premium for the RPS also ought not have been more than INR 28/- per RPS.

The CIT(Appeals) in this case took a view that the AO was resorting to the provisions under Section 56(2)(viib) of the Income Tax Act, and since the provisions was only effective from Assesment Year 2013-14, it would not apply to the present instance.

However, the AO clarified before the CIT(A) and also before the ITAT, that the AO sought to assess the income from the share premium received by the Assessee under Section 68 of the Income Tax Act. According to the AO’s contention, under Section 68 of the Act, the Assessee is required to prove the “nature” and “source” of the receipts, otherwise income tax could be levied as unexplained cash credits. The AO implied that the excessive share premium was not accompanied with an appropriate justification as to the ‘nature’ of the receipt.

Tribunal’s Decision

The Tribunal disagreed with the contentions of the AO, and stated that the AO had misdirected himself in assessing the net asset value of the company for the RPS. The Tribunal pointed out that since Section 56(2)(viib) was not in play here, the AO did not have support of any provision of the Income Tax Act to assess the excess premium. The Bombay High Court’s decision in Vodafone India Services P Ltd v Union of India & Ors (2014) had settled that receipt by way of share capital is capital receipt, thus not assessable.

Moreover, the Tribunal observed and held that the ‘nature’ of the ‘share premium’ receipts was also not questionable because of the AO’s misdirected efforts confusing the different footings of equity and preference shares.

The ratio of this order is summarized as below:

Preference Shares and Equity Shares stand on different footing, the net asset value of a company really represents the value of Equity Shares and not the Preference Shares.”

It is so because preference shares are like quasi-debt instruments whereas equity shares are nothing but participating rights of the shareholders in the company. The valuation of equity shares is dependent on the intrinsic value of the company as they have rights in assets/funds of the company. On the other hand, valuation of quasi debt instruments like preference shares is entirely made on the basis of the returns received by the investor of such instruments.

In this case, the investor would receive a return of approx. 10% per annum, as the RPS were redeemable at a price of INR 750/- after 5 years of their issuance. Book value of the company related to the equity shares as such shares reflect the ownership over the assets of the company, but because of the different considerations involved in the quasi-debt nature of RPS, book value of assets cannot justify their pricing.

Important Takeaways

Share Premium as Capital Receipt

The ruling reinforces that share premium is a capital receipt and capital receipts should not be taxed unless a provision of the Act specifically deals with the aspect.

The Statutory Framework reflects the judicial opinion of various tribunals and courts

It is interesting to note that the holding of the Tribunal that net asset value of shares do not apply to preference shares is reflected in the valuation rules under the Income Tax Rules as well. Rule 11UA lays down the formula under the net asset value method for valuation of the fair market value of equity shares. However, for shares other than equity shares, Rule11UA(1)(c)(c) clearly states that open market valuation method will be adopted to determine the fair market value.

Relief for Early Stage Companies

The ruling definitely provides some relief to early stage companies where investments are often raised by issuance of preference shares at premium, on valuations based on DCF method rather than NAV method. However, the ruling is restricted to RPS specifically, where there is a fixed return involved. As such, the principles that could be extended for valuation of compulsorily convertible preference shares, remains to be seen yet.

Authors: Avaneesh Satyang and Sohini Mandal

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Deal structuring with the ‘startup tax’

The Finance Act 2012 brought in an amendment to tax the share premium which is above the fair value of investment by the resident angel investors and not proven satisfactorily to the tax assessing officer.  This amendment is effective 1 April 2013.

The fledgling Indian startup ecosystem has now started to thrive on the early stage investments by the angels, who invest based on startups creating value. Startup tax is anti entrepreneurship.

Many of you came back asking for possible structuring of investment deals for residents.  Before suggesting, here’s the relevant context (boring) but please read, and may be you can come up with some suggestions yourself.

The amendment to section 56 of the Income Tax Act, which is effective from 1 April 2013 provides for the following terms:

–       Consideration for issue of ‘shares’ in a ‘private limited company’ from a person being ‘resident’ in India.

–       Which exceeds face value, (the aggregate consideration received for such shares as exceeds the fair market value of the shares)

–       Fair market value means (i) “a value determined 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, of its assets, including intangible assets being goodwill, know-how, patents, copyrights, trademarks, licences, franchises or any other business or commercial rights of similar nature, whichever is high”

–       Amendment to section 68 of the Income Tax Act, requires explanation about the nature and source of money.

This now requires a substantiation of the valuation at which investors invest in the new and smart startups where the product, service, IP is to be proven with revenues. That is quite a task!

When we read the Direct Tax notification on “valuation of shares and securities

The fair market value of unquoted equity shares = (Assets-Liabilities) * (Paid up value of equity shares)/ (paid up equity capital)

Well, not that simple and each of the term has a norm to be followed for calculation.  But you get the idea…

However, the valuation rules for ‘securities other than equity’ is based on ‘price it would fetch if sold in open market’ supported by a valuation report from merchant banker or CA. (This was as per 2010 Direct Tax notification)

The updated Direct Tax notification refers to “the fair market value of the unquoted equity shares determined by a merchant banker or an accountant as per the Discounted Free Cash Flow method.” However, no clarity on valuation for securities other than equity shares is provided for.

Reading through the above requirements, then there are some possible structuring of investments that can be beneficial to the startup and the resident investors.

–       If the investment is from non-resident, NRE, FCNR account, then the startup tax is not applicable.

–       If the investment is from a VC, then the startup tax is not applicable.

–       We could ‘assume’ that if a resident angel investor, co-invests with a VC, then the valuation is somewhat proven. But sources of funds is still be explained to the Income tax authorities.

–       If the investment is in equity shares, then the valuation will be very low.  Then, proving to the satisfaction of the income tax officer will be hard.

–       Securities other than equity shares is valued at fair market value with valuation certificate by a merchant banker or a CA. Compulsorily convertible preference shares (CCPS) and compulsorily convertible debentures (CCD) are construed as ‘equity’ as per RBI norms, but the Direct Tax Circular refers to ‘equity shares’.  So, a possibility is to use CCPS and CCD as an instrument.  Other instruments that can be used are optionally convertible debentures, debentures, redeemable preference shares.

–       If the issuance is at a convertible debt, which converts to equity, then the conversion ratio and conversion price has to be carefully looked at.

–       One of the things to look at, in terms of control (voting), is to have a small number of equity shares (can be less than 10 numbers too) with differential voting rights.

We would love to hear your comments, leave them in the comments section.

DisclaimerThis is not a legal opinion and should not be considered as one.  Please check with your attorney before taking any actions.