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July 26, 2023

The recognised approach for valuing shares is the discounted cash flow method

The recognised approach for valuing shares is the discounted cash flow method

Fact and issue of the case

These two appeals are filed by the assessee against different orders of the ld. Commissioner of Income Tax (Appeals)-3 [hereinafter referred to CIT (Appeals)] New Delhi for assessment years 2015-16 and 2016-17 in sustaining the addition made by the Assessing Officer under section 56(2)(viib) of the Income Tax Act, 1961 (the Act) in respect of share premium received by the assessee

First we take up the appeal of the assessee in ITA. No, 7345/Del/2019 for assessment year 2015-16. Brief facts are that the assessee, a Pvt. Ltd. company filed return of income on 1.01.2016 declaring loss of Rs.1,07,38,216/-. Assessment was completed under section 143(3) of the Act on 31.12.2017 determining the income of assessee at Rs.78,33,064/-. In the course of assessment proceedings the Assessing Officer noticed that assessee allotted 1,42,856 equity shares of Rs.10/- each at a premium of Rs.130/- per share. The assessee was asked to submit the valuation report and the report was submitted. The Assessing Officer noticed that the assessee followed Discounted Cash Flow (DCF) Method for valuation of share price. The Assessing Officer referring to the provisions of section 56(2)(viib) and the explanation he was of the view that assessee has to consider the valuation whichever is higher between

(i) the valuation according to Rule 11UA of Income Tax Rules or

(ii) the value of shares to the satisfaction of the Assessing Officer. The Assessing Officer was of the view that DCF method followed by the assessee for the valuation of shares is nothing but assumption for projected of cash flow and stated to be not only unjustified and un-related to the actual financial position of the assessee company but also without any rational basis. Thus, the Assessing Officer is not satisfied with the valuation of shares submitted by the assessee, he himself has determined the fair market value of the share at Rs.5.80 Paise and accordingly an amount of Rs.1,85,71,280/- was added as income from other sources under section 56(2)(viib) of the Act.

On appeal the ld. CIT (Appeals) sustained the action of the Assessing Officer observing that the Assessing Officer is competent within his powers to look into the fact whether the valuation report is fair and reasonable and the assessee has failed to justify the premium of Rs.130/- per share charged on allotment of un-quoted equity shares.

Before us the ld. Counsel for the assessee submitted that the appellant a private limited company during the year under appeal was engaged in the business of providing education in an effective manner by using integrated education and teacher training company, focused on making education engaging and effective in the 21st century and is focusing to build a stronger foundation to empower children with skills to compete in a rapidly changing world. Appellant filed its return of income under section 139(1) of Income Tax Act, 1961 in short “Act” on 01/01/2016 declaring loss of Rs.1,07,38,216. Return filed was selected under CASS for scrutiny and the case was taken up.

Ld. Assessing officer on 19/04/2016 issued notice under section 143(2) of the act along with notice under section 142(1). Subsequent notices were issues and appellant attended the hearings from time to time and submitted the replies

Ld. Assessing officer issued a final show cause notice purported to be dated 20/12/2017 sent by speed post and received by assessee on 25/12/2017 being fag end of the limitation period posted in relation to share capital and share premium received during the year. Having given such a short notice, the appellant with great difficulties, in response to the show cause notice, filed its reply vide letter dated 27/12/2017.

For share premium, the appellant during the subject Assessment Year has issued share capital and has received the Share premium. The amount of share capital allotted is 142856 equity share at face value of Rs.10/- and premium at Rs.130/-per share amounting to Rs.1,85,71,280/-. Appellant has adopted the discounted cash flow method (DCF) by which the share premium of the shares was determined at Rs 130/- per share in addition to face value of Rs.10/- by relying on the explanation (a) (i) in section 56(viib) of the Act where option is to determine the valuation by applying Rule 11 UA and carry valuation under DCF method as per clause (b) of said rule, in case assets of the company are not substantiated by factors such as Goodwill, Know- how, patents, copy right etc. (explanation applicable herein is (a) (ii) of section 56(viib). However, assessing officer, giving a complete go-bye to the provisions of the Act, considered income under section 56(2)(viib) amounting to Rs.97,62,947/- (i.e. share premium) by applying net asset liability method mentioned under rule 11UA. The fair market value of share as per Ld. Assessing Officer is Rs.5.85 per share.

Ld. Counsel referred to Rule 11UA (2) of Income Tax Rules which Rule is as under:-

“Notwithstanding anything contained in sub-clause (b) of clause (c) of sub-rule (1),

Observation of the court

In our considered view, for valuation or an intangible asset only the future projections along can be adopted and such valuation cannot be reviewed with actuals after 3 or 4 years down the line. Accordingly, the grounds raised by the asses see are allowed”.

The aforesaid ratios clearly endorsed our view as above. In any case, if law provides the assessee to get the valuation done from a prescribed expert as per the prescribed method, then the same cannot be rejected because neither the Assessing Officer nor the assessee ha ve been recognized as expert under the law.

There is another very important angle to view such cases, is that, here the shares have not been subscribed by any sister concern or closely related person, but by an outside investors like, Anand Mahindra, Rakesh Jhunjhunwala, and Radhakishan Damania, who are one of the top investors and businessman of the country and if they have seen certain potential and accepted this valuation, then how AO or Ld. CIT (Appeals) can question their wisdom It is only when they have seen future potentials that they have invested around Rs.91 crore in the current year and also huge sums in the subsequent years as informed by the Id. counsel. The investors like these persons will not make any investment merely to give dole or carry out any charity to a startup company like, albeit their decision is guided by business and commercial prudence to evaluate a startup company like assessee, what they can achieve in future. It has been informed that these investors are now the major shareholder of the assessee company and they cannot become such a huge equity stock holder if they do not foresee any future in the assessee company In a way Revenue is trying to question even the commercial prudence of such big investors like. According to the Assessing Officer either these investors should not have made investments because the fair market value of the share is Nil or assessee should have further invested in securities earning interest or dividend. Thus, under these facts and circumstances of the case, we do not approve the approach and the finding of the Id. Assessing Officer or Id. CIT(A) so to take the fair market value of the share at ‘Nil’ under the provision of Section 56(2)(viib) and thereby making the addition of Rs. 90.95 crores. The other points and various other arguments raised by the Id. counsel which kept open as same has been rendered. 36. Other grounds are either consequential or have become academic, hence same are treated as infructuous. In the result appeal of the appellant assessee is allowed.”

From the aforesaid extract of the impugned order, it becomes clear that the learned ITAT has followed the dicta of the Hon’ble Supreme Court in matters relating to the commercial prudence of an assessee relating to valuation of an asset. The law requires determination of fair market values as per prescribed methodology. The Appellant-Revenue had the option to conduct its own valuation and determine FMV on the basis of either the DCF or NAV Method. The Respondent-Assessee being a start-up company adopted DCF method to value its shares. This was carried out on the basis of information and material available on the date of valuation and projection of future revenue. There is no dispute that methodology adopted by the Respondent-Assessee has been done applying a recognized and accepted method. Since the performance did not match the projections, Revenue sought to challenge the valuation on that footing. This approach lacks material foundation and is irrational since the valuation is intrinsically based on projections which can be affected by various factors. We cannot lose sight of the fact that the valuer makes forecast or approximation based on potential value of business. However, the underline facts and assumptions can undergo change over a period of time. The Courts have repeatedly held that valuation is not an exact science, and therefore cannot be done with arithmetic precision. It is a technical and complex problem which can be appropriately left to the consideration and wisdom of experts in the field of accountancy, having regard to the imponderables which enter the process of valuation of shares. The Appellant-Revenue is unable to demonstrate that the methodology adopted by the Respondent-Assessee is not correct. The Assessing Officer has simply rejected the valuation of the Respondent-Assessee and failed to provide any alternate fair value of shares. Furthermore, as noted in the impugned order and as also pointed out by Mr. Vohra, the shares in the present scenario have not been subscribed to by any sister concern or closely related person, but by outside investors. Indeed, if they have seen certain potential and accepted this valuation, then Appellant-Revenue cannot question their wisdom. The valuation is a question of fact which would depend upon appreciation of material or evidence. The methodology adopted by the Respondent-Assessee, accepted by the learned ITAT, is a conclusion of fact drawn on the basis of material and facts available. The test laid down by the Courts for interfering with the findings of a valuer is not satisfied in the present case, as the Respondent-Assessee adopted a recognized method of valuation and Appellant-Revenue is unable to show that the assessee adopted a demonstrably wrong approach, or that the method of valuation was made on a wholly erroneous basis, or that it committed a mistake which goes to the root of the valuation process.

In view of the foregoing, we find that the question of law urged by the Appellant – Revenue is purely based on facts and does not call for our consideration as a question of law.”

The ratio of the decision of the Hon’ble Delhi High Court squarely applies to the facts of the assessee’s case. Thus, respectfully following the said decision, we hold that the Assessing Officer erred in discarding the DCF method of valuation of shares adopted by the assessee. Thus, we reverse the order of the ld. CIT (Appeals) and direct the Assessing Officer to delete the addition made under section 56(2)(viib) of the Act. The ground raised by the assessee on this issue is allowed.

Coming to appeal of the assessee for assessment year 2016-17 the ground taken by the assessee is identical to the ground of appeal for assessment year 2015-16. Facts being identical, the decision taken therein for assessment year 2015-16 applies mutatis mutandis to the appeal of the assessee for assessment year 2016-17. We order accordingly.

In the result, both the appeals of the assessee are allowed.

Order pronounced in the open court on : 04/07/2023


In the result, appeal of the assessee is allowed and ruled in favour of the assessee

Read the full order from here


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