The Income Tax Appellate Tribunal (ITAT) in the case of M/s. Rameshwaram Strong Glass (P) Ltd. v The Income Tax Officer[1] has upheld the right of the company issuing shares to choose the valuation methodology under the provisions of the Income Tax Act, 1961 (IT Act) read with the rules framed thereunder (Tax Law) for the purposes of determining the ‘fair market value’ (FMV) of such shares at premium.It held that the tax authorities cannot require the taxpayer to change the valuation method adopted by it, when the Tax Law grants an option to select either the Net Asset Value (NAV) method or the Discounted Cash Flow (DCF) method. Under section 56(2)(viib) of the IT Act, when a closely held company issues shares at premium to residents, if the premium is more than what is justified by the value of shares, as per the valuation rules prescribed, then the difference is taxed as ‘income from other sources’ in the hands of such company.

Facts

The taxpayer in the instant case was a startup private limited company (Company), with no business activities in the relevant financial year except the purchase of an immovable property worth INR 3.27 lakhs. In the year under dispute, the Company had issued 140,000 equity shares with a face value of INR 10 each at a premium of INR 60 per share receiving a total premium of INR 84 lakhs over and above the share application money of INR 14 lakhs. The Assessing Officer (AO) sought justification for issuance of shares at premium in the face of the Company not having any worth except the underlying immovable property.

The AO was of the view that a prerequisite to issuing a share premium is substantial increase in the net worth mainly due to profitability, credibility, goodwill, etc. The Company in its response outlined that receipt of share premium was a ‘capital receipt’ and commercial decision not requiring justification under the law. Disagreeing with the submission of the Company, the AO taxed the difference between the aggregate share premium and the FMV of shares based on the NAV. Aggrieved by the order passed by the AO, the Company appealed before the Commissioner of Income Tax (Appeals), which decided the issue in favor of the AO, but directed the AO to revise computation to correct arithmetical errors. The Company moved the ITAT against the order of the first appellate authority.

The ITAT held that the tax authorities cannot compel a taxpayer to choose any one particular method prescribed under section 56(2)(viib) of the IT Act and Rule 11UA(2) of the Income Tax Rules, 1962 (IT Rules) – i.e. the NAV or DCF method – when the law has specifically vested the choice of option on the taxpayers and the taxpayer has exercised the option. Permitting the tax authorities to do so will render the clause (b) of Rule 11UA (2) irrelevant and purposeless. The ITAT relied on the case of ITO Vs M/s Universal Polysack (India) Pvt. Ltd.[2] wherein the Coordinate Bench of ITAT Jaipur held that the exercise of such an option by the taxpayer is not subject to fulfillment of any specified conditions and it is left to the sole discretion of the taxpayer.

The ITAT also observed that the tax authorities can scrutinise the valuation report to the extent of finding any arithmetical mistakes. The ITAT also observed that the tax authorities are entitled to scrutinise the valuation report and determine a fresh valuation either by themselves or by calling for a final determination from an independent valuer to confront taxpayers if the tax authorities find that the workings of the valuer or the assumptions made are erroneous or contradictory. In such cases, the tax authorities may suggest necessary modifications and alterations to the valuation reports provided the same are based on sound reasoning and rationale. However, even in such cases, it is not open to the tax authorities to change the method of valuation, which has been opted by the taxpayer. Further, the tax authorities cannot ask taxpayers to submit valuation reports based on the actual numbers of subsequent years, which were the subject matter of DCF valuation.

CAM Comments

The above judgment will have a bearing on transactions involving fresh issuances of shares by closely held companies in India. It upholds the right of the taxpayer to opt for a method that the taxpayer considers appropriate and at the same time cautions that the valuation report must be justifiable as it is open to scrutiny for appropriateness and independent verification if tax authorities find the submitted report unacceptable.

It is important to note that the said Rule 11UA(2)(b) of the IT Rules has been amended recently, and the DCF valuation can only be undertaken by a merchant banker and not by a chartered accountant. In several cases, the tax authorities had compared actual performance of companies with the projections used by them for arriving at a value under the DCF method. In case of deviations in actual numbers and projections, tax authorities used to reject the DCF valuation used by the relevant company and treat excess premium as income of the company.

This decision should be helpful in reducing uncertainties for companies issuing shares at premium in justifiable situations and is thus welcome.

[1] ITA 884/JP/2016 dated July 12, 2018.

[2] I.T.A. 609/JP/2017 dated January 31, 2018.