Under the Income-tax Act, 1961 (IT Act), when a person receives, inter alia, shares of an unlisted company for a consideration which is less than fair market value (FMV) of such shares, then the difference between the FMV and the consideration paid/payable by the person is regarded as income from other sources of the person and taxed in the recipient’s hands at the tax rate applicable to the recipient on ordinary income. Rule 11UA of the Income-tax Rules, 1962 (IT Rules) had been notified a few years ago under which, the FMV for this purpose for unquoted equity shares was based on the book value of net assets of the company whose shares were transferred. Resultantly, any notional increase/decrease in the values of the assets appearing in the company’s balance sheet are not factored while computing FMV of such unquoted equity shares at present.
The Finance Act, 2017 also introduced the provision with respect to determining the FMV of shares in the hands of the seller for the purposes of determining capital gains for the seller. It provides that the seller will be deemed to have received FMV as a consideration, regardless of the price at which the transfer may have taken place (Section 50CA). The new provision mentioned that the rule for determining FMV would be prescribed in due course.
Pursuant to the above, the Central Board of Direct Taxes (CBDT) – the apex tax administering body for direct taxes in India has issued a draft notification on 5 May 2017 (Draft Notification) proposing the following:
(a) amend the valuation mechanism for ‘unquoted equity shares’ prescribed under Rule 11UA of the IT Rules from the currently followed book-value driven approach to a FMV driven approach; and
(b) insert a new Rule 11UAA to the IT Rules for prescribing the valuation mechanism for Section 50CA of the IT Act.
The Draft Notification is proposed to be effective from 1 April 2017. In line with the consultative approach being followed by the CBDT recently, the Draft Notification is open for public comments/suggestions until 19 May 2017.
Relevant from the perspective of acquirer of unquoted equity shares:
The Draft Notification marks a shift from the aforesaid book-value driven approach. It proposes that for valuation of ‘unquoted equity shares’, what is to be considered is the FMV of the net assets (as against the current mechanism of considering their book-values) and that such FMV would be determined as under:
1. Jewellery and artistic work owned by the company: Price which it would fetch if sold in the open market on the basis of the valuation report obtained from a registered valuer (i.e. a valuer who is registered in accordance with the Wealth-tax Act, 1957);
2. Immovable property owned by the company: Stamp duty value of the immovable property;
3. Shares and securities owned by the company:
(a) For quoted shares and securities: FMV computation is based on their exchange traded prices;
(b) For unquoted shares and securities (other than unquoted equity shares): Price which it would fetch if sold in the open market on the valuation date and the assessee may obtain a report from a merchant banker or an accountant in respect of such valuation;
(c) For unquoted equity shares: FMV is to be computed as per the amended Rule11UA proposed (i.e. for this purpose, the FMV of the assets owned by the investee company will have to be computed as per the amended Rule 11UA proposed);
4. For other assets (i.e. assets other than (1), (2), (3) above): Book-values.
The aggregate of the aforesaid asset-wise FMVs will be taken into consideration for computing the FMV of the unquoted equity shares. Similar to what is provided in the current valuation mechanism, the Draft Notification also permits deduction of book-value of liabilities in the FMV computation. Interestingly, preference-share capital continues to form part of liabilities even in the Draft Notification. Further, it is essential to note that while in the current valuation mechanism, there is a specific reference that the book-values of assets and liabilities have to be taken as per the balance-sheet of the company, the Draft Notification does not expressly mention that the aforesaid values of the assets and liabilities have to be taken as per the balance-sheet of the company.
Relevant from the perspective of transferor of unquoted equity shares:
The Draft Notification proposes to insert a new rule (Rule 11UAA) to the IT Rules which provides that the FMV for the purpose of Section 50CA is to be computed in accordance with the amended Rule 11UA proposed.
The proposal to shift from a book-value driven approach to a market value driven approach for valuation of unquoted equity shares marks a significant shift in India’s tax policy and is in line with its objective of a substance (rather than form) dominated income-tax levy, especially with the GAAR (General Anti Avoidance Rules) having come into force from 1 April 2017. This would mean that transfers of unquoted equity shares would have to take into account the fair values of all the assets owned by such company. It appears that investment which a company holds in a LLP or a partnership firm would still continue to be valued at book-values (given that such investments do not qualify as securities). This implies that the fair values of the assets of an LLP or partnership firm in which the company has invested would not be captured in the FMV of the unquoted equity shares of the company. Additionally, it is noteworthy that while the new Section 50CA applies to any type of unquoted shares (both equity and preference), given the specific language of this new valuation rule, it is not clear as to how preference shares would be valued for the purposes of Section 50CA.
While the move to put the Draft Notification for public comments/suggestions is in line with the international best practice of consultative approach, its proposed introduction with effect from 1 April 2017 may imply to be retrospective change in law – something which would run contrary to the present government’s approach of not bringing about any change retrospectively which creates a fresh liability. Resultantly, all corporate restructuring exercises would have to analyse the impact of this proposed amendment – both from the acquirer’s as well as transferor’s perspective (be it resident or non-resident).
Lastly, the method of computing the FMV in case of determination of excess premium at the time of issuance of shares remains unchanged.