The income tax department has recently decided to scrutinize many start-ups and unlisted subsidiaries of Indian companies as well as multinational companies. The bone of contention seems to be the unjustifiable and excessive evaluation of shares as against their fair market value. Notices are being sent to these companies and startups under Section 56 (2) (viib) of the Income Tax Act, 1961(hereinafter referred to as “the Act”).

Section 56 of the Act deals with the specific sources of income which are chargeable for income tax under the Act. According to sub-clause vii of the said section, it is clear that the income received by companies, with respect to shares is considered as a taxable source of income. Also, according to clause vii(b), if these shares are received, for a consideration which is in excess of the ‘fair market value’ of the shares then such aggregate income falls within the ambit of taxable income.

The explanation to this clause defines, fair market value to be such value:

  • as may be determined in accordance with such method as may be prescribed; or
  • 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;

Wherever the valuation of shares is done at a suspiciously higher rate, than the fair market value, the IT authorities are investigating for illegalities with a fine-toothed comb. The news article in Economic Times, dated September 13, 2017 states that “fair market value is assessed by the tax department based on past transactions and record of similar comparable companies… It is a commonly a commonly accepted practice among startups to calculate fair market value based in the discounted cash flow method, which is based on the present value of cash flow expected to be earned by the business in future.”

What is especially notable is that even though startups do not have the business structuring, practices and desired commercial results/ gains as of now, it is highly likely, that because of their strong and unique intangible assets in which investors and the statutory authorities foresee a promising future are being valued at a high market value. In the coming months it would be interesting to see that in the midst of the startup frenzy nation, will the IT Authorities target these nascent companies for higher valuation or find their valuation reasonable owing to their promising future!