THE POLICY LAB (TPL) - 49
AUG 06, 2024

By J B Mohapatra

A: VALUATION of financial instruments under the Income Tax Act (ITA) particularly those concerning valuation of shares of companies, not being companies in which public are substantially interested or put simply shares of closely held and unlisted companies, important as it is for all the stakeholders to see that no one including the revenue is short-charged owing to dependency of the parties to the transaction on wrong data, inaccurate projections, and wrong valuation methodology, has the end goal of rendering a true and fair representation of financial affairs of the concerned entity for all stakeholders including those in regulatory positions.

B: Clause 23 of the Finance Bill, 2024 quoted below in that context is significant:

"23. In section 56 of the Income-tax Act, in sub-section (2), in clause (viib), after the second proviso, the following proviso shall be inserted with effect from the 1st day of April, 2025, namely:--

"Provided also that the provisions of this clause shall not apply on or after the 1st day of April, 2025."

Brought into the statute books via Finance Act 2012, and now proposed to be withdrawn via Finance Bill , 2024, the object and purpose of section 56(2)(viib) of Income Tax Act (ITA) introduced in 2012 are provided in FM's speech of 2012 :

"155. I propose a series of measures to deter the generation and use of unaccounted money. To this end, I propose

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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

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C: Operative parts of Explanatory Memorandum to Finance Act, 2012 are as below:

"Share premium in excess of the fair market value to be treated as income

Section 56(2) provides for the specific category of incomes that shall be chargeable to income-tax under the head "Income from other sources".

It is proposed to insert a new clause in section 56(2). The new clause will apply where a company, not being a company in which the public are substantially interested, receives, in any previous year, from any person being a resident, any consideration for issue of shares. In such a case if the consideration received for issue of shares exceeds the face value of such shares, the aggregate consideration received for such shares as exceeds the fair market value of the shares shall be chargeable to income- tax under the head "Income from other sources. However, this provision shall not apply where the consideration for issue of shares is received by a venture capital undertaking from a venture capital company or a venture capital fund.

Further, it is also proposed to provide the company an opportunity to substantiate its claim regarding the fair market value. Accordingly, it is proposed that the fair market value of the shares shall be the higher of the value-

(i) as may be determined in accordance with the 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 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.

This amendment will take effect from 1st April, 2013 and will, accordingly, apply in relation to the assessment year 2013-14 and subsequent assessment years."

D: In essence, section 56(2)(viib) applies to receipt against issue of shares by a company, not being a company in which the public are substantially interested. If the consideration for issue of shares exceeds the face value of such shares, the aggregate consideration received for such shares as exceeds the fair market value of the shares is deemed as income of the company from other sources. An exemption from rigours of the section is in-built in the section itself: (i) in respect of consideration received by a venture capital undertaking from a venture capital company or a venture capital fund or a specified fund and (ii) consideration received by a company from a class or classes of persons as may be notified by the central government in this behalf. Exemption from impact of section 56(2)(viib) for investment in start-ups is on account of one such government notification. Another notification dated 24-5-23 also exempts investment from a select class of persons such as government owned or related entities, sovereign wealth funds etc situate in 21 select countries from being considered under this provision.

E: The section is driven by Rule 11UA (the Rule having been revised in May 2023), and is fully formulaic. 4 valuation methods for determining the fair market value of shares if the consideration for shares is received from a resident: (a) NAV method (b) DCF method (c) the price per share paid by a venture capital fund or a venture capital company or a specified fund while issuing shares to a venture capital undertaking (d) the price per share paid by an entity notified in terms of clause (ii) below 1st proviso to section 56(2)(viib). For a non-resident investor in a company, being a company in which the public are not substantially interested, an additional set of valuation methodology is available- (a) comparable company multiple method (b) probability weighted expected return method (c) option pricing method (d) milestone analysis method and (e) replacement cost method.

F: While no reasons are available in the Explanatory Memorandum to Finance Bill 2024 that adduce a rationale for withdrawal of the provision, it would be inaccurate to buy in to the argument that withdrawal of section 56(2)(viib) was actuated solely as a consequence to its adverse impact on start- ups. Two reasons for that: one, start-ups are specifically exempt under the stated provision, and two, the provision intended to cover all classes of companies, not being companies in which public are substantially interested, and not just the start-ups.

One suspects that withdrawal was more to do with (i) complication in managing the tax provision in accordance with the rules, (ii) severe compliance challenges for the taxpayers, (iii) asymmetric valuation methodologies qua other legislations, and (iv) reportedly, an element of subjectivity while administering the rules, which at times have been called out by the courts.

G: Examining the withdrawal of section 56(2)(viib) in tandem with other attendant and extant provisions in ITA, and whether the withdrawal has the potential of raising issues of inter se consistency and equity, 2 aspects are worth noting:

First, the case of indirect transfer of shares. The provisions under section 9(1)(i) define, explain and determine all manner of income deemed to accrue or arise in India, including income from transfer of shares in a company incorporated outside India, but value of the share derived substantially from assets located in India. As per clause (b) of Explanation 6 in section 9, "the value of an asset shall be the fair market value as on the specified date, of such asset without reduction of liabilities, if any, in respect of the asset, determined in such manner as may be prescribed". The prescribed Rule is Rule 11UB.

Sub-clause (3) of Rule 11UB reads as follows:

"(3) Where the asset is a share of an Indian company not listed on a recognised stock exchange on the specified date, the fair market value of the share shall be its fair market value on such date as determined by a merchant banker or an accountant in accordance with any internationally accepted valuation methodology for valuation of shares on arm's length basis as increased by the liability, if any, considered in such determination."

So though section 56(2)(viib) stands withdrawn, if it is a case of indirect transfer of shares within the meaning of section 9, there is a prescribed methodology for valuing shares of an unlisted Indian company being the subject of indirect transfer. That prescription for valuation of shares as per Rule 11UB is still subsisting and in accordance with a prescribed Rule despite the amendment leading to withdrawal of section 56(2)(viib).

Second, there are 2 specific provisions in ITA which intend to tackle cases of under-valuation of shares of a company, not being a company in which the public are substantially interested or cases of unlisted companies.

(i): Under section 50CA, if the consideration received on transfer of unlisted shares is less than the fair market value determined as per a prescribed rule, the fair market value will be deemed as the full value of consideration in the hands of the transferor. Prescribed Rule is Rule 11UAA, which mandates the valuation to be made as per Rule 11UA.

(ii) Under section 56(2)(x)(c), receipt of a 'property' for a consideration which is less than the aggregate fair market value of the 'property' shall be considered as income from other sources in the hands of the transferee or the recipient. 'Property' here includes shares and securities in terms of clause (d) of Explanation to clause (vii) of section 56(2)(b) and the appliable rule for determining fair value is Rule 11U/11UA.

In other words, taxability in cases of under-valuation of shares of a company, not being a company in which public are substantially interested, continue to be statutorily addressed, both in the hands of the transferor under section 50CA or in the hands of the transferee in terms of section 56(2)(x).

H: One may argue that the provision for valuation of shares of unlisted companies for the purposes of Foreign Exchange Management (Non Debt Instruments) Rules 2019 also follows a similar dual policy in allowing overvaluation in case where equity instruments of a closely held company are issued to a person resident outside India but prohibits over valuation when equity instruments are transferred from a person resident outside India to a person resident in India. The specific provision contained in Rule 21 of Foreign Exchange Management (No Debt Instruments) Rules, 2019 reads as follows:

"21. Pricing guidelines

(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 :

(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.

(b) transferred from a person resident in India to a person resident outside India shall not be less than,-

(iii) 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.

(c) transferred by a person resident outside India to a person resident in India shall not exceed :

(iii) 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."

To my mind, the underlying logic of formulating the specific methodology for valuation of shares under the Foreign Exchange Management (Non Debt Instruments) Rules, 2019 is definitely for regulating inflow and outflow of foreign exchange to and from India, and that logic may be wholly irrelevant for the purposes of ITA which now will allow over-valuation of shares at the time of issue but will proceed to tax the under- valuation of shares at the time of issue or at the time of transfer under the proposed dispensation of law consequent to the Finance bill 2024.

I: Clause 32 of Finance Act 2023 which proceeded to include non-resident investors within the ambit of section 56(2)(viib) with effect from 1st April 2024 is equally relevant. Before this amendment, only resident investors were considered to fall within the scope of that provision. The rationale for including non-residents within the scope of the provision according to the Explanatory Memorandum to Finance Bill of 2023 was for "bringing the non-resident investors within the ambit of section 56(2)(viib) to eliminate the possibility of tax avoidance". Operative portions of the Explanatory Memorandum 2023 on this amendment are as follows:

"2. Clause (viib) of sub section (2) of section 56 of the Act was inserted vide Finance Act, 2012 to prevent generation and circulation of unaccounted money through share premium received from resident investors in a closely held company in excess of its fair market value. However, the said section is not applicable for consideration (share application money/ share premium) received from non-resident investors.

3. Accordingly, it is proposed to include the consideration received from a non- resident also under the ambit of clause (viib) by removing the phrase 'being a resident' from the said clause. This will make the provision applicable for receipt of consideration for issue of shares from any person irrespective of his residency status.

4. These amendments will be effective from the 1st day of April, 2024 and shall accordingly, apply in relation to the assessment year 2024-25 and subsequent assessment years."

The rationale for withdrawing the very provision under section 56(2)((viib) one year after expanding its scope and rigour is not discernible either from the Bill or the Explanatory Memorandum of 2024.

J: Internal inconsistency apart, there appears no fall-back mechanism within the existing substantive provisions in ITA or its rules to address issues of inflated valuation qua fair market value determined in terms of existing Rule 11UA, now that section 56(2)(viib) is proposed to be withdrawn. Any reliance on the provisions under section 68 and specifically the second proviso thereto (which makes a reference to unexplained share capital, share application money or share premium in case of a company, not being a company in which public are substantially interested, for deeming the unexplained amount as income of the company) to address issues of over-valuation of shares, to my mind, would be statutorily impermissible, since section 68 is invoked for ascertaining identity and creditworthiness of the creditor/ shareholder and genuineness of the transaction, and in no manner can be invoked to question taxpayer's own version and logic for determining a particular value for the shares it has issued.

K: Valuation methodologies for determining fair market value of shares of closely held companies being diverse and open to contrary interpretation by stakeholders, there always has been a fair degree of uncertainty in regulatory decisions on any matter emerging thereon. The rules formulated for determining fair market value under ITA did not definitely infuse the required precision or had been reasonable while being administered in few or many cases.

The reaction to a set of unworking rules by way of withdrawing the very substantive provision though raises few basic issues: One, whether no regulation for determining an upper cap for pricing at the time of issue brings us back to the same space which necessitated the introduction of the very provision in 2012. Two, whether allowing free pricing without norms or rules and having no statutory filter to prevent inflated valuation runs contrary to tax department's strict position on under-pricing. Three, will unregulated pricing and no tax consequence for over pricing result in an uneven playing field for the corporates to conduct their business.

A deeper analysis of the probable consequences of withdrawal of the provision should be in order.