Intricacies in issue of Shares
Intricacies in issue of Shares

    INTRICACIES IN THE ISSUE OF SHARES OF A PRIVATE COMPANY

    Introduction to Sec 56:
    Any income profits or gains includible in the total income of the assessee, which cannot be included under any of the preceding heads of income, is chargeable under the head ‘Income from Other Sources’ U/S 56. Thus, this head is a residuary head of income and brings within its scope all the taxable income, profits, or gains of an assessee which fall outside the scope of any other heads of Income under the Income Tax Act.

    What is Sec 56(2)(viib)
    The Finance Act, 2012 inserted clause (viib) in section 56(2) of the Income-tax Act, 1961 (“Act”) with effect from April 1, 2012 to bring within the purview of taxation the premium received by a company (other than a “company in which public are substantially interested”[1]), on the issue of its shares in excess of the “Fair Market Value” (‘FMV’) of such shares. The FMV was to be the price (a) Arrived at as per the prescribed method OR (b) as may be substantiated to the assessing officer based on the value of the company at the time of issue of the shares. Also, as per the existing clause (viia) of section 56(2), if the consideration paid for the acquisition of shares (of a closely held company) is lower than the FMV of the shares, the delta is treated as income of the company or firm that acquires such shares. This section is applicable only to a Private Company i.e. a company in which public are not substantially interested.

    Rule 11U & 11UA:
    Rule 11U and Rule 11UA of the Income-tax Rules, 1962 (‘IT Rules’), amongst other things, prescribed the Net Asset Value Method (based on Balance Sheet values) for arriving at the FMV for the urposes of this clause (viia). No valuation rule was however prescribed for the purposes of clause (viib) of section 56(2). The CBDT has now issued a Notification[2] amending Rules 11U and 11UA of the IT Rules to provide for a valuation method for the purposes of clause (viib) of section 56(2) and also to make other incidental changes.

    Key amendments to the valuation rules:
    Following are the key amendments to the Valuation Method:

    i. Valuation method for clause (viib) of section 56(2) – Rule 11UA has been amended to allow the company issuing shares to determine the FMV either based on the (a) book value as per the Balance Sheet OR (b) based on the Discounted Free Cash Flow method.

    ii. Valuer – Rule 11UA has been amended to provide that the valuation for the purposes of clause (viib) has to be certified either by (a) a Fellow member of the Institute of Chartered Accountants of India (FCA) OR (b) by a merchant banker. Also, the FCA certifying the valuation should not be a tax auditor or statutory auditor of the company. So an ACA cannot certify the valuation report. Also, neither the tax auditor or the company nor the statutory auditor of the company is allowed to certify the valuation report.

    iii. Balance Sheet to be used for NAV valuation – The meaning of the phrase “Balance Sheet” has been amended to provide that for the purposes of clause (viia) of section 56(2) (transfer of shares at a price lower than the FMV), the Balance Sheet, as of the valuation date, has to be audited by the statutory auditor of the company. However, for the purposes of section 56(2)(viib), a company can use the Balance Sheet drawn on a date preceding the valuation date which has been approved and adopted in the annual general meeting, if the balance sheet on the valuation date is not drawn up. It may be noted that hitherto, the Rules did not require the Balance Sheet to be audited by the statutory auditor. So Audited Balance Sheet need not be drawn on the date of acquisition of shares, however audited balance sheet on the valuation date needs to be drawn for transfer of shares.

    iv. Valuation date - “Valuation date” as per Rule 11U has been amended to include the date on which consideration is received by the closely held company towards the shares issued [in the context of section 56(2)(viib)]. It may be noted that the valuation date is not the date of issue of shares, but the date of receipt of consideration.

    v. Changes to the NAV method – Rule 11UA has been amended to provide for the following changes in the components of the NAV method for valuation of equity shares –
    i. Assets – Hitherto, the Rules required reduction of advance tax paid and debit balance in the profit and loss account from the book value of assets. The amended Rules now require the following amount to be reduced in respect of taxes: tax deducted at source + advance tax paid (-) amount of taxes claimed as refund. Also, in addition to debit balance in profit and loss account, the unamortized amount of deferred expenditure and any other amount not representing the value of assets has to be reduced.
    ii. Liabilities – Hitherto, in arriving at the Liabilities to be reduced from the Assets, the Rules provided that the reserves and surplus, by whatever name called, shall not be included in the Liabilities. This has been now slightly modified to provide that even if the reserves and surplus have a negative balance, they shall not be included.

    Our Comments:

    i. The Provisions of Sec 56(2)(viib) are applicable from 1st April, 2012. The amendment to Rule 11UA is applicable from the date of the notification i.e. 29th November 2012. Therefore in the case of FMV transactions executed between 1st April 2012 and 29th November 2012, the benefit of DCF valuation methodology may not be available to the taxpayer company.

    ii. The provisions of section 56(2)(viib) are applicable in the context of shares issued by a closely held company to a resident shareholder (the said provisions do not apply to shares issued to non-residents). The amendment of the Rules to allow DCF valuation for valuing the equity shares is a welcome change. This will avoid taxation which could have otherwise arisen if only Balance Sheet based book values were allowed to be taken for valuation purposes. Further, in the case of investment by non-resident shareholders, while clause (viib) of section 56(2) would not have applied, any indirect downstream investment (say, through a holding company into other operating companies) could have created tax exposures for the downstream operating company, had the DCF method not been allowed. Also, this would have conflicted with the extant FDI policy, where even downstream investment by an Indian company having FDI (and owned/controlled by non-residents) is required to be made as per DCF valuation.

    iii. It is worthwhile to note that the amended rules does not disturb the broad valuation methodology (ie Balance Sheet book value based valuation) prescribed in case of secondary transfer of shares of closely held companies. Hence, in case of secondary transfer of shares of a closely held company, the taxpayer does not have an option to chose DCF valuation and has to adopt the NAV method based on Balance Sheet values. The relaxation in the definition of the term “Balance Sheet” to accept the latest audited balance sheet would lessen the burden of the tax-payer to prepare a balance sheet as on the valuation date.

    iv. However, the requirement of audit of the Balance Sheet as of the valuation date in the case of taxation under clause (viia) of section 56(2) is burdensome. This would require that for every transfer of shares attracting clause (viia) of section 56(2), the receiver of the equity shares has to require the company (the equity shares of which are transferred) to carry out an audit of the Balance Sheet by the statutory auditor, as of the valuation date. This burdensome requirement could have been avoided and should be done away with.

    All in all, these amendments are most welcome for the assessee company and are sincere steps in the right direction by the Government to add depth to the valuation techniques to be adopted while new shares are issued. No investor invests in a company at the Net Asset Value arrived by reducing liabilities from the assets. Investment decisions are based upon the future prospects of the company, modes of utilization of funds to be infused, debt equity ratio, debtors turnover ratio, cost of Capital, etc. Only Discounted Cash Flow Methodology can capture these facets.

    By Aniket Kulkarni
    Chartered Accountant