Currently, Income Tax Act, 1961 (IT Act) provides for imputing income in the hands of the transferor/transferee if the transaction of transfer/receipt of unquoted shares is not at fair market value (FMV).
As far as the recipient is concerned, when a person receives, inter alia, unquoted shares of a company for a consideration which is less than FMV of such shares (by more than INR 50,000), Section 56(2) of the IT Act provides that the difference between the FMV and the consideration paid/payable, would be regarded as income from other sources in the hands of the recipient. Such income is taxed at the tax rate applicable to such recipient on its ordinary income.
In this regard, Rule 11UA of the Income-tax Rules, 1962 (IT Rules) (which was notified in the past) provided the mechanism to arrive at the FMV for unquoted equity shares, which was based on the book value of net assets of the company the shares of which were transferred. As far as FMV for the unquoted shares other than equity shares was concerned, Rule 11UA provided for valuation on a fair value basis. Consequently, any notional increase/decrease in the values of the assets appearing in the company’s balance sheet was not factored in computing the FMV of unquoted equity shares of the company.
In the context of capital gains arising to a transferor of unquoted shares, the Finance Act, 2017 introduced Section 50CA to the IT Act to the effect that the FMV of such shares will be regarded as “consideration” for computing capital gains, regardless of the price at which the transfer may have taken place if such unquoted shares are transferred at a value less than FMV.
The CBDT had issued draft rules prescribing the method for determination of FMV of unquoted equity shares under Section 56(2) and Section 50CA (Draft Rules) and had invited comments and suggestions of the stakeholders and general public. We had analysed the Draft Rules and provided our comments to the CBDT. Our update analysing the Draft Rules can be accessed here.
The CBDT has now released the Final Rules relating to method for determining FMV of the unquoted equity shares (Final Rules) for the purposes of Section 56(2) and Section 50CA of the IT Act.
The Final Rules would apply retrospectively, with effect from 1 April 2017. Under the Final Rules, the FMV of the unquoted equity shares would include the value of certain assets on a fair value basis as opposed to the book value driven approach, which was prescribed under the erstwhile Rule 11UA. Now, the FMV of the unquoted equity shares would include the FMV of the following underlying assets as against the book value of such assets:
- immovable property, the FMV for which would now be stamp duty value;
- equity shares held by the company, the FMV for which would be determined in accordance with the Final Rules;
- shares and securities (other than equity shares) held by the company, the FMV for which would be the value that such securities would fetch in open market; and
- artistic work and jewellery owned by the company, the FMV for which would be the value that such securities would fetch in open market on the basis of a valuation report obtained from registered valuer.
The Final Rules are nearly in line with the Draft Rules, with the following exceptions:
Exclusion of dividends from book value of liabilities
The Draft Rules excluded the amount set apart for dividends on equity shares and preference shares. However, the Final Rules exclude such dividends, where it has not been declared at a general body meeting before the date of transfer. Thus, dividends declared before the date of transfer would be included in the book value of liabilities, while determining the FMV of unquoted equity shares.
Clarity on the valuation date
For the purpose of Section 50CA, the Draft Rules were silent regarding the date on which valuation had to be undertaken. The Final Rules state that the valuation date would mean the date on which the unquoted shares are transferred.
Further, the Final Rules also provide the FMV of unquoted shares other than equity shares (such as preference shares) for the purposes of Section 50CA, would be on fair value basis, as provided in Section 56(2), which was not specifically dealt the Draft Rules.
While the Final Rules have amended the valuation norms for determining the FMV for secondary acquisitions/transfers of unquoted equity shares, the FMV determination in case of primary allotment of unquoted equity shares continues to be based on the book value driven method. As far as valuation for unquoted preference shares is concerned, the FMV method remains the same (i.e. fair value basis), both for primary as well as secondary acquisitions/transfers.
Stakeholders (including Khaitan & Co) had sought clarity from the CBDT on the valuation of unquoted shares for cross holding structures and where the company the shares of which are being transferred holds shares of a foreign company. Unfortunately, these concerns remain unaddressed in the Final Rules.
The fair value basis valuation would be of vital significance and would pave way for notional increase or decrease in the value of the underlying assets of the company, to be included in the FMV of the unquoted equity share. While one would have hoped for the Final Rules to apply prospectively, the Final Rules apply with effect from 1 April 2017. Given that the provisions of Section 56(2) (subject to certain exceptions) and Section 50CA apply to both residents as well as non-residents, it needs to be seen whether the sale consideration for unquoted equity shares met the FMV test under the Final Rules for unquoted shares transferred between 1 April 2017 and 13 July 2017 (the date on which the Final Rules were notified) and transfer of unquoted shares going forward.