Tag Archives: valuation

Valuation of shares: Choosing the Valuer

Valuation in early stage companies should be market driven, as in, there is an investor willing to invest and a company which is primed to grow. The discussion between them should be the guiding factor.

However, this point is highly regulated and the valuation has to be proven to the satisfaction of the tax officers. Such discretionary powers are causing heart-burn.

Due to the many changes, there is confusion of which valuation method to use, who to take the valuation certificate from, etc.

Prior to October 2017, any practising chartered accountant having an experience for more than 10 years or a merchant banker, was recognised to determine the valuation of the shares.

On 18 October 2017, the Ministry of Corporate Affairs (MCA) mandated that the valuation report has to be obtained from a Registered Valuer[1] in certain cases. This entailed that any company issuing securities under section 42 or section 62(1) (c) of the Companies Act 2013 (the Act), would require the valuation report from Registered Valuer, who is registered with the Insolvency and Bankruptcy Board of India as per Companies (Registered Valuers and Valuation) Rules, 2017 (“Registered Valuer Rules).

However, in terms of Rule 11 of the Registered Valuer Rules, there was a transitional arrangement until 31 January 2019, to get a valuation report from a practising CA with 10 years experience.

In addition to these requirements and conditions, the Central Board of Direct Taxes (CBDT) on 24 May 2018 amended the Rule 11 UA of Income Tax Rules, 1962, by omitting the words “or an accountant” from rule 11UA (2)(b). This change meant that the valuation report has to be obtained only from a merchant banker.

Now comes the difficulty with compliance. Compliance under section 42 of the Act and Rule 11 UA is difficult, since there are very few merchant bankers, who are Registered Valuers too.

As a result, many investors ask the companies to get valuation certificates from all the different valuers.

Scenario 1: Requirement of valuation certificate from both Merchant Banker and Registered Valuer

Any company which is not a start-up India registered[2] 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.

Scenario 2: 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.

Scenario 3: 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;[3]

To present this as a 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

 There are several open points.

Question on applicability of section 56(2)(x)

An open point on valuation report from merchant banker in case of issuance of shares by start-up India registered companies, still requires clarification. This is because, section 56(2)(x) of the Income Tax Act, 1961 mandates to a person who receives shares from a company to get the valuation report from a merchant banker. While the start-up company is exempted only under section 56(2)(viib), receipt of such shares by a person is not exempted. This point still requires clarification from CBDT.

Other open questions:

While it seems that the requirement of valuation report is clear under various enactments, there is still ambiguity in terms of say: (a) whom to approach in case of a person who received shares from Startup India registered company; (b) how to deal when there is difference in fair market value arrived by Registered Valuer and merchant banker. This might require approaching a valuer who is recognised under Companies Act and Income Tax Act, who is both a Registered Valuer and a merchant banker.

Happy to hear your thoughts.

___________

[1] Registered Valuer means a person registered with the Insolvency and Bankruptcy Board of India in accordance with Registered Valuer Rules.

[2]  Companies registered with Department for Promotion of Industry and Internal Trade as Start-up.

[3] Start-up companies are exempted from section 56(2)(viib) of Income Tax Act 1961 pursuant to notification from CBDT dated 11 April 2018.

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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

Anti-dilution protection in shareholders agreement – Implementation under Indian laws

Anti-dilution protection is one term which is present in almost every investment transaction. From the perspective of the founders, especially in case of a start-up or an early stage company, it is very important to understand the implications of having such a provision in the shareholders agreement (SHA). Founders generally tend to agree to so-called “standard” terms in the SHA, when in dire need of the investment. An anti-dilution provision has to be reviewed closely in order to ensure it is not too harsh on the founders and also since the transaction documents set precedents for the subsequent round of investments. This article discusses some of the main methods of anti-dilution protection usually seen in transactions in India and some of the difficulties associated with actual implementation of such anti-dilution provisions.

What is Anti-Dilution Protection?

Before moving to anti-dilution, we need to understand the concept of dilution. Dilution is the decrease in the shareholding percentage of a shareholder in a company due to increase in the number of outstanding shares. For example, when a company receives subsequent round of investment, the shareholding percentage of the existing investors gets diluted. It is good to have the value of a company increase in subsequent rounds of funding. However, there might be situations when a company may not perform or grow as expected due to which the value of the share decreases. In such a scenario, anti-dilution protection is triggered by the existing investors to maintain their shareholding percentage in the company to a certain extent (which is explained below).

Essentially, anti-dilution protection is such protection given to the existing investors of the company when new shares are issued in a subsequent round at a price per share which is lower than the price paid by the existing investors. It is pertinent to note that anti-dilution protection is applicable only when shares are issued at a price per share which is lower than the price paid by the existing investors and not for every subsequent issue of shares. The reason being that, if shares are being offered to subsequent investors at a price per share which is higher than the price per share paid by the existing investors, even though their percentage shareholding in the company reduces, the value of the shares held by them increases.

Anti-Dilution Protection and its Variants

In India, the two commonly used forms of anti-dilution protection are: (a) Full Ratchet and (b) Broad Based Weighted Average.

Full Ratchet: Under this method, if shares are issued at a subsequent round of investment at a price per share that is lower than the price per share paid by the existing investors of the company, then the price of the shares/ conversion price of the existing investors will be revised to the price at which the new shares being issued. In such scenario, either additional shares will be issued to the existing investors for the surplus consideration after such price adjustment without the existing investors making any further payments or conversion price would be revised to the price of such shares being issued. Thus, the full-ratchet method does not consider the number of shares held by the existing investors or the number of shares being issued in the subsequent investment round, but only considers the price at which the new shares are being issued and the new price will be applied to all the shares held by the existing shareholders. Thus, the full ratchet method of anti-dilution protection is very harsh on the Company and the Founders as compared to the broad based weighted average method. Also, the shareholding percentage of the founders may get diluted to a very large extent if a full ratchet provision is implemented.

Broad Based Weighted Average: As compared to full ratchet mechanism, broad based weighted average method uses a formula which considers the number of shares issued in a subsequent round of investment and the number of shares held by the existing investors. Therefore, the broad based weighted average method is fair to the founders as well as to the investors and is adopted more frequently in investment transactions. The weighted average formula used in the transaction documents describe how the weighted average price is determined by taking into the consideration the existing price or the conversion price of the shares, number of outstanding shares prior to the new issuance, the number of shares to be issued and the purchase consideration to be received by the company with respect to such issuance.

Implications of Anti-Dilution Provision 

Pricing Guidelines under Indian Laws:

Any further issuance of shares by a Company registered in India shall adhere to various provisions of the Companies Act, 2013 (the “Act”), Foreign Exchange Management Act, 1999 including rules and regulations notified thereunder, regulations prescribed by Securities Exchange Board of India (“SEBI”) (if applicable) and Income Tax Act, 1961 (the “IT Act”).

In India, implementation of anti-dilution protection is complex considering the existing laws. For instance, shares issued to foreign investors need to be in compliance with the pricing guidelines as provided in Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017 (“FDI Regulations”). As per the pricing guidelines, capital instruments which are issued or transferred to a foreign resident has to be priced as per any internationally accepted pricing methodology for valuation on an arm’s length basis duly certified by a chartered accountant or a SEBI registered merchant banker or a practicing cost accountant in case of an unlisted company.

Convertible Instruments: Additionally, in case of convertible instruments, the price/ conversion formula of the instrument should be determined upfront at the time of issue of the instrument and the price at the time of conversion should not in any case be lower than the fair value worked out, at the time of issuance of such instruments, in accordance with the FDI Regulations. Therefore, even adjusting the conversion ratio of a convertible instrument can pose complexities.

Considering aforementioned guidelines, enforcement of anti-dilution provisions and issue of shares pursuant to the same, especially to non-residents will be very difficult. Also, implementation of anti-dilution which results in issuance of new shares for no consideration, would not be allowed under the Act (which is applicable for both resident and non-resident investors).

Tax: Further, there is a complication which has to be examined under tax laws. As per section 56 (2) (x) (c) of the IT Act, when any person receives shares for a consideration which is less than the aggregate fair market value (FMV) by an amount exceeding fifty thousand rupees, the aggregate FMV of such property as exceeds such consideration is taxable as ‘income from other sources’ in the hands of the person receiving such shares.

Our thoughts:

Considering the nuances associated with the issuance of shares at a price below FMV or for no consideration, the actual implementation of anti-dilution provisions poses a lot of difficulties. Unless certain exceptions are brought in the existing laws, actual implementation could be a challenge in India, especially with respect to foreign investors.

Authors:  Mr. Paul Albert and Mr. Ashwin Bhat

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