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Issue Of Shares By Unlisted Cos: Valuation Tangles

Published on Fri, Jul 04,2014 | 22:15, Updated at Fri, Jul 04 at 22:15Source : 

By: Girish Vanvari,  Co-Head, Tax - KPMG

(with inputs from Rohit Jain, Chartered Accountant)

As is widely anticipated, a stable Central Government and positive policy initiatives may revive investor outlook towards India.  One can expect that many Indian companies would be gearing up for expansion, and look to tap funds through equity infusion.  However, pricing the shares for raising funds has become a tricky affair under the current Indian tax and regulatory environment.  Some of the relevant valuation requirements for an unlisted Indian company have been discussed hereafter.

Requirement Under Foreign Direct Investment Policy
Under the Foreign Direct Investment Policy, issue price of shares by an unlisted Indian company to a non-resident should not be less than the value of shares determined by using the Discounted Cash Flow Method (DCF Method).  The DCF Method takes into account the future cash flows of the company for arriving at the value of the shares being issued.  

Further, the policy also provides that in case there is a transfer of shares from a non-resident to a resident, the price should not be more than the fair value determined as per the same DCF method.    

Requirement Under The Companies Act, 2013[Companies Act]

Under the Companies Act, a company may, inter alia, raise share capital through preferential allotment.  In such a situation, the issue price of shares shall not be less than the price determined by a valuer.  However, for this purpose, no specific valuation methodology has been prescribed yet.

Requirements Under The Transfer Pricing Provisions Of The Income-Tax Act, 1961[‘The IT Act’]

Broadly speaking, section 92 of the IT Act provides that ‘income’ from transactions with associated enterprises shall be computed having regard to the arm’s length price. For this purpose, ‘arm’s length price’ is defined to mean the price which is applied or proposed to be applied in a transaction between persons other than associated enterprises in uncontrolled conditions. The Finance Act, 2012, has retrospectively amended the scope of transfer pricing provisions to, inter alia, include capital financing transactions.

The essence of application of transfer pricing provisions is to ensure that income is computed having regard to arm’s length price. In a transaction involving issues of shares, which is a capital transaction, the application of transfer pricing provisions, in absence of any income element, is itself a debatable issue.

In the context of the subject, two recent high-profile cases involving issue of shares to non-residents immediately resonate:

  • The Vodafone case: In this case, Vodafone India entity had issued shares at a premium based on valuation done in accordance with the guidelines issued under the erstwhile Capital Issues (Control) Act, 1947.  This valuation was in line with the requirement under the then prevailing exchange control regulations.  The Indian tax authorities did not agree with the valuation and determined a higher value of the shares based on the Net Asset Value methodology (NAV Method).  Consequently, the tax authorities sought to levy additional tax in hands of the Vodafone India entity.
  • The Shell case: In this case, again, the tax authorities did not agree to the valuation of shares done for further issue of shares by the Shell India entity to its overseas parent company.  The tax authorities determined a higher value by changing certain underlying assumptions in the DCF valuation made by the Company.

Both, the Vodafone and Shell cases, are currently pending at different appellate forums for adjudication.      

Requirements Under Section 56 Of The IT Act

Section 56(2)(viib) of IT Act provides that any amount received by a privately/ closely held company  from an Indian tax resident for issue of shares in excess of  fair market value of the shares is chargeable to tax in the hands of the issuing company.

The fair market value (‘FMV’) for this purpose is to be determined as per the prescribed NAV Method or DCF Method at the option of the taxpayer, or at such value as may be substantiated by the company to the satisfaction of the Tax Officer.  

Incidentally, section 56(2)(vii)/(viia) of the IT Act contains specific provisions for levy of income tax in the hands of the recipient of shares in a privately held/closely held company, if such shares have been received for a consideration less than the FMV of such shares.  The Income-tax Rules provides a specific methodology for computing FMV for section 56(2)(vii)/(viia), which is an NAV based approach.

The intent of introduction of provisions of section 56(2)(vii)/(viia) was to act as an anti-abuse provision to prevent transfer of existing assets below FMV, and it appears that this provision may not be applicable for issue of fresh shares.  However, this does not take away the fact that even a transfer of shares requires a separate valuation for Indian income-tax purposes.  

Conclusion - The Need To Simplify Requirements

As can be seen from the above, the valuation requirements and approach varies under different situations and lack uniformity.  Compliance under one law may not be sufficient as different parameters have been prescribed under different legislation.  The multiplicity of requirements and lack of certainty would in particular impact issue of shares by start-up entrepreneurs, privately held companies or where shares are issued to residents and non-residents, either simultaneously around the same time.

In times where taxpayers and investors are looking for certainty and clarity, it would be important to balance the different requirements to the extent possible, bearing in mind that each of the requirements have a purpose.  While on this point, it may be relevant to note that the Reserve Bank of India in its Bi-Monthly Monetary Policy statement issued in April 2014 relating to FY 2014-15 had indicated doing away with the valuation requirement for issue of shares to non-residents and allowing issue of shares on the basis of acceptable market practices. However, no operating guidelines have been issued thus far.

One hopes that the Government takes note of the practical issues associated with the different set of compliances, and takes appropriate simplification measures for a matter as basic as infusing share capital into an Indian business.


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