India: 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.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.