Delhi HC provides relief to start-ups from angel tax as Proper Methodology was followed during Valuation

Income from other sources, which is the last among the five heads of income sketched out in the Income Tax Act, is essentially a head of income that includes all receipts that cannot otherwise be classified under any of the other heads of income. According to section 56 of the Income Tax Act, the following 3 conditions need to be satisfied for a receipt to be categorized as income from other sources.

• There is an income.
• Such income is not exempted under any other provisions of the Income Tax Act.
• Such income cannot be charged as salary, income from house property, profits and gains from business or profession, or capital gains.

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.

Let us refer to the case of the Pr Commissioner of Income Tax vs Cinestaan Entertainment Pvt Ltd (2021), where the issue under consideration was whether the shares issued based on the valuation received from the prescribed expert i.e., a Chartered Accountant using the DCF method which is one of the methods stipulated under Section 56(2)(viib) read with Rule 11UA(2)(b) was valid or not.

Facts of the Case:

• M/s Cinestaan Entertainment Pvt Ltd (Respondent-Assessee) was engaged in the business of entertainment.
• The Respondent-Assessee had received share premium from various subscribers/equity partners. These funds were required by the Respondent-Assessee for film production.
• The shares were issued based on the valuation received from the prescribed expert i.e., a Chartered Accountant who used the DCF method which is one of the methods stipulated under Section 56(2)(viib) read with Rule 11UA(2)(b).
• Based on the valuation report, the Respondent-Assessee issued shares to various equity partners at a premium.
• The Respondent-Assessee filed return of income for the relevant AY declaring nil income.
• The return was processed under Section 143(1) and the case was selected for “Limited Scrutiny”
• The reasons for scrutiny selection were:
• Large share premium received during the year
• Low income in comparison to very high investment; and
• Low income in comparison to very high loans/advances/investments in shares.
• Notice under Section 143(2) was issued and was followed by a detailed questionnaire along with the notice under Section 142(1).
• In response thereto, the Respondent-Assessee filed a valuation report.
• Thereafter, assessment order was framed under Section 143(3) of the Act and the total income of the Respondent-Assessee was assessed as Rs. 90,95,46,200.

Order of Appellate Authorities

• Aggrieved by the assessment order, the Respondent-Assessee preferred an appeal before the Commissioner of Appeals [CIT (A)], who upheld the additions made by the AO.
• The second appeal before the ITAT was allowed vide the impugned order and resultantly, the order of the CIT (A) was set aside.
• Aggrieved with the order of the ITAT, the Revenue appealed before the High Court (HC)

Observations of the HC on the issue of the present case:

• The AO disregarded the valuation report of the Respondent-Assessee primarily on the ground that the projections of revenue as considered for the purpose of valuation did not match the actual revenues of subsequent years.
• The AO made additions based on the assumption that the Respondent-Assessee made no efforts to achieve the projection as made out in the valuation report and therefore the share premium received by the Respondent-Assessee was without any basis and contrary to provisions of Section 56(2)(viib) read with Section 2(24)(xvi).
• Further, the AO held that the Respondent-Assessee failed to submit any basis of projection.
• He also held the view that in order to achieve the said projection, the Respondent-Assessee should have invested the share premium amount to earn certain income/return and whereas the Respondent-Assessee made investments in zero percent debentures of its associate company and therefore the basic substance of receiving a high premium is not justified.
• HC noted that the AO had issued notice under Section 133(6) to all the investors to seek confirmation, information and documents pertaining to the issuance of shares.
• Further, the venture agreement between the Respondent-Assessee and the investors was also filed before the AO.
• The ITAT thus, after due consideration of the record, concluded that neither the identity, nor the creditworthiness and genuineness of the investors and the pertinent transaction could be doubted.
• This fact stood fully established, before the AO and was not disputed or doubted. Therefore, the nature and source of the credit stood accepted.
• ITAT then proceeded to examine whether the AO after invoking the deeming provision under Section 56(2)(viib), could have determined the FMV of the premium on the shares issued at nil after rejecting the valuation report given by the Chartered Accountant based on one of the prescribed methods under the Rules adopted by the valuer.
• ITAT followed the dicta of the Supreme Court in matters relating to the commercial prudence of an assessee relating to valuation of an asset.

Observations of HC on whether the valuation of the assessee could be accepted or not

• The law required 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 was no dispute that methodology adopted by the Respondent-Assessee was 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 lacked material foundation and was irrational since the valuation was intrinsically based on projections which could be affected by various factors.
• One could not lose sight of the fact that the valuer made forecast or approximation, based on potential value of business.
• However, the underline facts and assumptions could undergo change over a period of time.
• The Courts had repeatedly held that valuation was not an exact science, and therefore could not be done with arithmetic precision.
• It was a technical and complex problem which could be appropriately left to the consideration and wisdom of experts in the field of accountancy, having regard to the imponderables which entered the process of valuation of shares.
• The Appellant-Revenue was unable to demonstrate that the methodology adopted by the Respondent-Assessee was not correct.
• The AO had simply rejected the valuation of the Respondent-Assessee and failed to provide any alternate fair value of shares.
• Furthermore, the shares in the present scenario were not subscribed to by any sister concern or closely related person, but by outside investors.
• If they had seen certain potential and accepted this valuation, then Appellant-Revenue could not question their wisdom.
• The valuation was a question of fact which would depend upon appreciation of material or evidence.
• The methodology adopted by the Respondent-Assessee, accepted by the ITAT, was 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 was not satisfied in the present case, as the Respondent-Assessee adopted a recognized method of valuation and Appellant-Revenue was 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 went to the root of the valuation process.
• HC found that the question of law urged by the Appellant-Revenue was purely based on facts and did not call for consideration as a question of law.
• Therefore, the appeal was dismissed

Thus, the Delhi High Court while giving relief to the start-ups from angel tax ruled that if a proper methodology is followed while valuing a company during valuation rounds, it should not be challenged later.