In two interesting cases, one from the Delhi High Court and the other from the Chennai Income Tax Appellate Tribunal (the “Chennai ITAT”), the importance of a share valuation report in settling tax disputes has, once again, come to the fore.
The Delhi High Court case
In the Delhi High Court matter, an Indian company issued shares for a premium of US$12,459,537 to various subscribers. The premium was calculated based on a tax valuation report issued by a chartered accountant using the prescribed calculation methods (in this case the discounted cash flow method) under the Indian tax rules.
The Indian tax authorities disregarded the tax valuation report on the grounds that:
(i) the revenue projections in the tax valuation report did not match the actual revenue earnings of subsequent years;
(ii) no efforts were made by the Indian company to substantiate the projected revenue numbers in the valuation report; and
(iii) the Indian company should have invested the share premium amount to earn income instead of investing it in debentures of associate companies.
Therefore, the tax authorities taxed the share premium amount received by the Indian company as income from other sources.
The Delhi High Court held that the share valuation report cannot be disputed by the tax authorities simply because the subsequent performance of the company does not match the projections. Valuation of shares is a technical and complex matter best left to experts in the field of accountancy and should not be interfered with. The Delhi High Court did not allow the share premium amount to be taxed.
The Chennai ITAT case
In the Chennai ITAT case, an Indian company raised a capital of US$2,397,260 to repay an existing loan by issuing preference shares to another Indian company. The Indian tax authorities contended that the Indian company had a negative net worth and had not provided a tax valuation report to substantiate the calculation. Therefore, the excess consideration received on the issuance of preference shares over and above the fair market value was unexplained income subject to tax as income from other sources.
The Chennai ITAT held that, in the absence of a tax valuation report, the preference share issuance transaction looked doubtful and unacceptable, and hence, was subject to tax.
The importance of a tax valuation report
Indian tax law contains anti-abuse provisions (the “Tax Provisions”) that aim to prevent laundering of unaccounted income through closely held companies by putting the onus on such companies to justify any funds received from shareholders in the form of share premium or otherwise in excess of the fair market value.
The Tax Provisions emphasize the requirement of a fair market valuation report to be obtained from a registered valuer (generally a chartered accountant or a merchant banker registered with the Securities Exchange Board of India) based either on the net asset value formula or the discounted cash flow methodology. While the net asset value method is based on the actual numbers as per the latest audited financials, the discounted cash flow method is premised on estimated future projections.
The importance of tax valuation reports has also been highlighted by India’s Supreme Court (the “SC”) in the cases briefly discussed below.
(i) In the Miheer Mafatlal case, the SC held that valuation of shares is a technical and complex problem which can be appropriately left to the consideration of experts in the field of accountancy and should not be interfered with.
(ii) In the GL Sultania case, the SC held that if the valuer adopts the prescribed method of valuation, or in the absence of any prescribed method, adopts any recognized method of valuation, that valuation cannot be assailed unless it is shown that: (a) the valuation was made on a fundamentally erroneous basis; (b) a patent mistake had been committed; or (c) the valuer adopted a demonstrably wrong approach or a fundamental error going to the root of the matter.
(iii) In the Renuka Datla case, the SC held that if the valuer applied the standard methods of valuation, considered the matter from all appropriate angles without taking into account any irrelevant material or eschewing from consideration any relevant material, that valuation cannot be challenged on the ground of its being vitiated by fundamental error.
(iv) In the Duncans Industries case, the SC held that the question of valuation is basically a question of fact and courts should not interfere with the finding on such a question of fact if the valuation is based on relevant material on record.
(v) In the SA Builders case and in the Panipat Woollen case, the SC held that the tax authorities cannot sit in the armchair of a businessman to decide what is profitable and how the business should be carried out. Commercial expediency cannot be questioned by the tax authorities.
Perhaps, the Chennai ITAT decision may have been different had the Indian company substantiated its preference share issuance through a tax valuation report. In recent times, tax officers have been taking aggressive positions and have either challenged the valuation methodology adopted by a valuer or the underlying assumptions made in determining the valuation. The focus has been to augment the tax base and impose taxes on any case of undervalued share issuance by treating it as income from other sources.
We recommend that all investors (foreign and domestic) should: (a) adhere to the relevant Tax Provisions at the time of issuance, transfer or receipt of shares and/or other types of securities from Indian entities; and (b) ensure that valuations are based on cogent assumptions and appropriate methodologies. An aggressive approach, especially in start-up and unicorn valuations, can be cause for trouble in the future. Currently, only DPIIT-registered start-ups are not taxed on share premium received over and above the fair market value.
Valuers should also ensure that they retain all the necessary documentation to address tax challenges.
About the Author
Ravi S. Raghavan has more than 25 years of experience in corporate tax advisory work, business re-organizations, international taxation (investment and fund structuring, repatriation strategies, treaty analysis, advance rulings, exchange control regulations, FPI taxation), tax litigation services, and other tax issues (including withholding taxes, capital gains tax, permanent establishment concerns, employee taxation, and tax holiday schemes).
Ravi has spoken at different forums on various tax matters, including at the Annual India Tax Forum in New Delhi, and at the Annual Symposium on India’s Taxation Regime at the National Law School of India University, Bangalore