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December 11, 2020

Can the AO change the method of share valuation which has been opted by the Assessee?

by CA Shivam Jaiswal in Income Tax

Can the AO change the method of share valuation which has been opted by the Assessee?

As per the provisions of Section 56(2)(viib) of the Income Tax Act, if a company in which public are not substantially interested, receives in any previous year, any consideration for issue of shares that exceeds the face value of such shares, the aggregate consideration received for such shares, if exceeds the fair Market Value of the shares shall be taxed as income from other sources.

The methods of valuation are prescribed in Rule 11UA(2) of the Rules.

According to Rule 11UA(2), the fair market value of unquoted equity shares shall be the value, on the valuation date, of such unquoted equity shares as determined in the following manner under clause (a) or clause (b), at the option of the assessee, namely:—

(a) the fair market value of unquoted equity shares = where, (A–L) × (PV), (PE)

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:

  • the paid-up capital in respect of equity shares;
  • 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;
  • reserves and surplus, by whatever name called, even if the resulting figure is negative, other than those set apart towards depreciation;
  • 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
  • any amount representing provisions made for meeting liabilities, other than ascertained liabilities
  • any amount representing contingent liabilities other than arrears of dividends payable in respect of cumulative preference shares;

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

P V = the paid up value of such equity shares; or

(b) 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.

Let us refer to the case of I-Exceed Technology Solutions Pvt. Ltd. Vs ITO (ITAT Bangalore), where the issue under consideration was whether the AO could change the method of valuation which has been opted by the Assessee.

Facts of the Case:

  • The assessee company was engaged in the business of developing software products and providing consultancy services to customers in banking and financial services industry.
  • The AO noticed that the assessee has issued 6,15,088 equity shares of Rs.10 each at a premium of Rs. 80 per share to six persons.
  • Accordingly, it collected share premium.
  • Out of the premium amount, the AO noticed that the share premium received from resident shareholders was Rs. 1,77,77,760.
  • Accordingly, he proceeded to examine the collection of share premium in terms of sec. 56(2)(viib).
  • The assessee furnished a valuation certificate obtained from a Chartered Accountant in support of the price at which the shares were issued.
  • The AO noticed that the CA had adopted discounted cash flow method (DCF Method) for valuation of shares.
  • In the valuation report, the accountant had arrived at the value per share at Rs. 87.56 per share.
  • However, the assessee has issued shares @ Rs. 90 per share including share premium of Rs. 80 per share. Accordingly, the assessee justified the share premium collected by it.
  • The AO noticed that, under DCF method, the valuation was arrived on the basis of projected figures.
  • Further, it was noticed that the details of projected results were furnished by the management only and the basis of projections were also not given.
  • Accordingly, the AO rejected DCF method of valuation.
  • AO took the view that the share valuation has to be arrived on the basis of book value, i.e., Net Asset value (NAV) method.
  • On the basis of assets and liabilities of the assessee, the AO worked out the value of per share @ Rs. 6.04.
  • Accordingly, the AO the view the share premium collected by the assessee is not justified.
  • Since share premium amount collected from resident persons could alone be assessed u/s 56(2)(viib), the AO assessed the share premium of Rs. 1,77,77,760 as the share premium collected from resident shareholders.

Order of Commissioner of Income Tax (Appeals) [CIT(A)]

  • The CIT(A), in principle, agreed with the view taken by the AO.
  • However, he noticed that the share premium received from resident shareholders was Rs.88,88,880 only and not Rs. 1,77,77,760 as assessed by the AO.
  • Accordingly, he confirmed the addition to the extent of Rs. 88,88,880.
  • Aggrieved, the assessee has filed an appeal before Income Tax Appellate Tribunal (ITAT)

Observations of ITAT on contention of AO

  • The law contemplated invoking provisions of section 56(2)(viib) of the Act only in situations where the shares are issued at a premium and at a value higher than the fair market value.
  • The fair market value contemplated in the provisions above shall be the value
    1. As may be determined in accordance with such method as may be prescribed; or
    2. Any other value to the satisfaction of the Assessing Officer
  • The law provides that, the fair market value may be determined with such method as may be prescribed or the fair market value can be determined to the satisfaction of the AO.
  • The provision provides an Assessee two choices of adopting either NAV method or DCF method.
  • If the Assessee determines the fair market value in a method as prescribed, the AO did not have a choice to dispute the justification.
  • The provisions of Rule 11UA(2)(b) of the Rules provides that, the Assessee can adopt the fair market value as per the above two methods and the choice of method is that of the Assessee.
  • ITAT took the view that the AO can scrutinize the valuation report and he can determine a fresh valuation either by himself or by calling a determination from an independent valuer to confront the Assessee but the basis has to be DCF method and he cannot change the method of valuation which was opted by the Assessee. 
  • ITAT was of the view that, the AO had erred in considering the actuals of revenue and profits declared in the future years as a basis to dispute the projections.
  • At the time of valuing the shares, the actual results of the later years would not be available.
  • What was required for arriving at the fair market value by following the DCF method were the expected and projected revenues.
  • Accordingly, the valuation was on the basis of estimates of future income contemplated at the point of time when the valuation was made.
  • It was clarified by the Assessee that the product which was being developed by the Assessee had substantial value and the Assessee was able to raise funds to the tune of Rs. 50.13 crores from international market

Reference by SC to an older case

SC was of view that the issue with regard to valuation had to be decided afresh by the AO on the lines indicated in the decision of ITAT, Bangalore in the case of VBHC Value Homes Pvt.Ltd., Vs ITO (supra) i.e.,

  • the AO can scrutinize the valuation report and he can determine a fresh valuation either by himself or by calling a determination from an independent valuer to confront the assessee but the basis has to be DCF method and he cannot change the method of valuation which has been opted by the assessee.
  • For scrutinizing the valuation report, the facts and data available on the date of valuation only has to be considered and actual result of future cannot be a basis to decide about reliability of the projections. The primary onus to prove the correctness of the valuation Report is on the assessee as he has special knowledge and he is privy to the facts of the company and only he has opted for this method. Hence, he has to satisfy about the correctness of the projections, Discounting factor and Terminal value etc. with the help of Empirical data or industry norm if any and/or Scientific Data, Scientific Method, Scientific study and applicable Guidelines regarding DCF Method of Valuation.

The order of CIT(A) was accordingly set aside for deciding the issue afresh after due opportunity of hearing to the Assessee.

In simple words, AO can scrutinize the valuation report and he can determine a fresh valuation either by himself or by calling a determination from an independent valuer to confront the Assessee but he cannot change the method of valuation which has been opted by the Assessee.

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