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Valuation of shares - Amended Rule 11UA indeed simplifies existing formula!

NOVEMBER 01, 2023

By J B Mohapatra

VALUATION of shares of a company, not being a company in which public are substantially interested, while being relevant and contentious for all practical purposes from situations of mergers or acquisitions, to restructuring, or obtaining loan against collateral of shares, in the Income Tax context has principally meant as a legislative tool against impunity succinctly summed up in paragraph 155 of FM's budget speech of 2012: "I propose a series of measures to deter the generation and use of unaccounted money. To this end, I propose………increasing the onus of proof on closely held companies for funds received from shareholders as well as taxing share premium in excess of fair market value." The underlying idea has always been to ensure fair valuation of shares of closely held companies in accordance with formal rules, prevent short charging of revenue and evasion of tax.

Rigours of this provision, subject to a rule based valuation, stand relaxed in terms of the proviso to section 56(2)(viib) in 2 classes of entities:

(i) consideration received by a venture capital undertaking from a venture capital company or a venture capital fund or a specified fund; specified fund meaning a category I or category II Alternate Investment Fund regulated under SEBI (Alternate Investment Fund) Regulations, 2012 or under IFSCA (Fund Management) Regulations, 2022

(ii) consideration received by a company from a class or classes of persons as may be notified by the central government in this behalf.

In exercise of the powers under clause (ii) above, investments in start-up subject to conditions have been exempted from application of section 56(2)(viib) since 2016 vide a series of notifications and modification to notifications : SO 1160 of CBDT/DOR dated 14-6-16, dated 5-3-19 and dated 24-5-23.

While Finance Act 2023 did bring foreign investors at par with resident investors and got them within the mischief of section 56(2)(viib) with effect from 1-4-24, a 2-pronged strategy for retaining a conducive investment environment via the subordinate legislation route has been attempted. One is the Notification 29 dated 24-5-23 and the other is the amendment to rule 11UA.

While it is undeniable on facts that relaxation from rigours of section 56(2)(viib) remained confined to investment only in start-ups for close to 7 years, an honest appraisal in the interregnum would have indeed indicated need for more such relaxation considering the funds and technology requirement of small and medium businesses in the domestic sectors. So, now we have notification 29 dated 24-5-23 which permits investments from the following class of persons without the rigours of tax under section 56(2)(viib):

1. government and government related investors such as central banks, sovereign wealth funds, international or multilateral organizations or agencies including entities controlled by the government or where direct or indirect ownership of the government is seventy-five percent or more;

2. banks or entities involved in insurance business where such entity is subject to applicable regulations in the country where it is established or incorporated or is a resident;

3. any of the following entities, which is a resident of any country or specified territories listed in annexure, and such entity is subject to applicable regulations in the country where it is established or incorporated or is a resident :-

entities registered with Securities and Exchange Board of India as Category-I Foreign Portfolio Investors;

endowment funds associated with a university, hospitals or charities;

pension funds created or established under the law of the foreign country or specified territory;

broad based pooled investment vehicle or fund where the number of investors in such vehicle or fund is more than fifty and such fund is not a hedge fund or a fund which employs diverse or complex trading strategies.

Investments from the class of entities mentioned in (3) above are permissible in terms of the notification, if the entities have been established or incorporated or are tax residents of a select group of 21 countries - from Australia to USA. It is evident that the specific entities in the notification have been finalised only upon evaluation of regulatory and compliance architecture of sectors and specific jurisdictions wherefrom the funds would be originating from.

Amendment to rule 11UA is also in line with the drive and direction for inviting investments on reasonable and equitable terms and eliminate vexatious and unintended consequences of the erstwhile rule. Thus apart from the two methods for valuation of shares - DCF and NAV method-available to residents under rule 11UA, five additional methods have been made available for non-resident investors. A system of price matching among the price of shares established in cases of government notified entities or by VC funds or specified funds with the subsequent transactions for resident and non-resident shareholders has been put in place. Plus, a safe harbour of 10% variation in value has been allowed.

While it is undeniable that the amendment to rule 11UA has been timely and will assist in some measure to surmount prevailing interpretational hurdle, some issues below need a clearer understanding to have a grasp of the legislative intent and the road map.

(a) First, price matching between the rate at which shares had been issued to a venture capital fund (VC Fund) or a venture capital company (VC company) or a specified fund under sub rule 2(A) (c) or a notified entity under sub rule 2A(e) of rule 11UA with any subsequent issue of shares to any investor , whether resident or non-resident, is allowed under the new rule thereby implicitly and statutorily sanctifying the rate as negotiated either by a venture capital undertaking with a VC fund or a VC company or a specified fund, or by any company with a government notified entity. When price matching for a resident or non-resident shareholder is allowed through the modality of an earlier price discovery by a VC fund or VC company or notified entity, there are good basis for similar price matching between resident and non-resident shareholders made directly by either of them through the mechanism of sub rules (a) or (b) or (d) of rule 11UA (2)(A), since the valuation mechanism for each of them is clearly defined and driven by an unambiguous rule. Conversely, the present arrangement of price matching only through a price discovery by a VC fund etc lays undue credence to the valuation methodology and practice prevalent among the alternate investment funds/ VC funds and somewhat places the methodology put in place for resident and non-resident shareholders through Income Tax's own rule on a lower pedestal. As it is, while SEBI is mandated to regulate pooled vehicles like PE, VC funds etc, securities of private or closely held companies are not regulated by SEBI, and therefore valuation aspects of unlisted equity by a VC fund may not be as well -regulated as assumed under the present Income Tax rule.

(b) Second, valuation of shares for a resident investor remains as before: either the net asset value under sub-rule (2)(A)(a) or as determined by a merchant banker as per discounted free cash flow method under sub-rule (2)(A)(b). Valuation of shares for a non-resident shareholder, apart from NAV and DCF now includes under sub-rule (2)(A)(d) a choice among 5 additional methods: comparable company multiple, probability weighted expected return, options pricing, milestone analysis, and replacement costs. The choices to the non-resident shareholder in the latter sub-rule are not available to the resident shareholder whereas choices to the resident shareholder are available to the non-resident shareholder.

In accordance with rule 16 of Companies (Registered Valuers and Valuation) Rules, 2017 relevant to section 247 of the Companies Act, a valuation wherever it is required to be performed, shall be in terms of Central Government notified valuation standards. Until any standard is notified, the Registered Valuer shall perform the valuation according to: valuation standards of any valuation professional organization or an internationally accepted valuation methodology or valuation standards specified by SEBI, RBI, or any other regulatory body. Ordinarily depending on the context for which valuation is required to be made, a registered valuer is free to choose for a valuation method irrespective of the residential status of the investor from among the NAV method, the market price method, DCF, comparable company multiples method, yield method, price of recent investment method, liquidation value method, weighted average method or any other method that the valuer may choose to adopt depending on the context and circumstance of the subject under valuation. Among the choices before a valuer, the most relevant of the methods which ensures the most objective, impartial and true and fair valuation may not always be found within the NAV and the DCF methods. That said, if a selection of those relevant and additional methods are available to a select class of investors, it will be equitable to have those methods equally available across all classes of investors. More so, when price matching among the resident and non-resident shareholders has been permitted under few circumstances.

(c) Third, in spite of the methodology under rule 11UA for valuation of shares of a company in which public are not substantially interested, the choice for adopting the FMV between the rate as per rule 11UA and any other rate depends on the satisfaction of the assessing officer as per Explanation (a)(ii) of section 56(2)(viib). The provision reads as follows:

"Explanation.- For the purposes of this clause,-

(a) the fair market value of the shares shall be the value-

(i) as may be determined in accordance with such method as may be prescribed; or (ii) as may be substantiated by the company to the satisfaction of the Assessing Officer, based on the value, on the date of issue of shares, of its assets, including intangible assets being goodwill, know-how, patents, copyrights, trademarks, licences, franchises or any other business or commercial rights of similar nature,

whichever is higher;"

Thus only in cases where the value as determined by the assessing officer is higher than the one determined under rule 11UA that the value as determined by the assessing officer would get substituted as the FMV of the shares. Conversely, if the value as determined by the assessing officer is lower than the value as per rule 11UA, which often is the case, this provision should have no plausible application. Considering the fact that the intent of section 56(2)(viib) is to capture and tax the difference between the issue price (which reportedly often is trumped-up and inflated) and the FMV as per a transparent rule, how does the mechanism of selecting the higher of the two values : one under rule 11UA and the other as determined by the assessing officer, to quantify the difference and tax it as income from other sources, subserve the larger legislative intent is not known.

(d) Though the consequences owing to the dichotomy between the methods of valuation of unlisted shares under the erstwhile provisions of Income Tax Act and the provisions under Foreign Exchange Management (Non-Debt Instruments) Rules 2019 have been alleviated to a large extent by permitting a further set of alternative valuation methods to the non-residents under the amended rule 11UA, and providing for a 10% safe harbour leverage in issue price qua the FMV as derived under the rules via sub-rule 4 of rule 11UA, the most basic of the issues: whether to adopt a value in excess of floor price as per leverage given under the FEMA regulations, which in some cases exceed the FMV as determined under rule 11UA of Income Tax Rules, and thereby face a tax consequence in liable cases, or to adopt a ceiling value as per Income Tax rule and avoid tax consequence does persist. Rule 21(2) of Foreign Exchange Management (Non-Debt Instruments) Rule, 2019 reads as follows:

"Pricing guidelines

21. (1) The pricing guidelines specified in these rules shall not be applicable for any transfer by way of sale done in accordance with Securities and Exchange Board of India regulations where the pricing is specified by Securities and Exchange Board of India.

(2) Unless otherwise prescribed in these rules, the price of equity instruments of an Indian company, -

(a) issued by such company to a person resident outside India shall not be less than :

(i) the price worked out in accordance with the Securities and Exchange Board of India guidelines in case of a listed Indian company or in case of a company going through a delisting process as per the Securities and Exchange Board of India (Delisting of Equity Shares) Regulations 2009;

(ii) the valuation of equity instruments done as per any internationally accepted pricing methodology for valuation on an arm's length basis duly certified by a Chartered Accountant or a Merchant Banker registered with the Securities and Exchange Board of India or a practising Cost Accountant, in case of an unlisted Indian Company.

[Explanation: In case of convertible equity instruments, the price or conversion formula of the instrument should be determined upfront at the time of issue of the instrument. 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 these rules.]

Thus even though the amended Income Tax rule has expanded the valuation methodologies for a non-resident investor, and permitted certain safe harbour additional percentage to the FMV as derived under the rules, the issuer company nonetheless has to remain simultaneously compliant to the provisions of pricing guidelines under the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 and abide by a precise valuation under the Income Tax rule to avoid any adverse tax consequence.

Establishing a true and fair valuation of shares of a closely held company even from a tax perspective cannot be precise enough to accommodate all concerns and apprehensions. It is much easier to say that the value corresponds to certain predicted return at a specific moment but much harder to build a formula around that proposition. Amendment to rule 11UA should be read as a further attempt to simplify an existing formula and make that work in the field.