SKP Tax Alert
CBDT finalises Rules for valuation of unquoted equity shares – provides clarity but implementation challenges remain
 
Transfer of unquoted equity shares for a value less than the fair market value attracts tax implications for the seller and the receiver, under the Income tax Act, 1961 (ITA). 

From a seller’s perspective, section 50CA of the ITA provides that the fair market value will be assumed to the sale price and the capital gains chargeable to tax will be calculated accordingly. From a receiver’s perspective, the newly inserted section 56(2)(x) provides that the difference between the fair market value and the consideration paid will be treated as Income from Other Sources. 

These provisions are applicable with effect from 1 April 2017 (for earlier periods, the buyer was liable to tax on similar lines under different provisions).

The calculations for section 50CA and section 56(2)(x) are based on the fair market value.  The CBDT had earlier issued draft Valuation Rules on 5 May 2017. The CBDT has now finalised these Rules (Final Valuation Rules) with certain changes by amending the Income-tax Rules, 1962 (Rules)[1].  These Rules will be applicable from 1 April 2017. 

The valuation formula of these Rules, which is largely a Net Asset Value (NAV) based valuation, has been summarised as follows:
 
Particulars Provisions
Scope FMV of unquoted equity shares
Formulae (A + B + C + D - L) * (PV)/(PE)
A Book Value of all assets in the Balance Sheet except those referred in B, C and D. It would be reduced by:
  • Any amount of income-tax paid less the amount of refund claimed if any; and
  • Any amount shown as asset including the unamortised deferred expenditure which does not represent the value of any asset
B
  • The price at which jewellery, artistic work would fetch if sold in the open market
  • On the basis of valuation report obtained from a registered valuer.
C FMV of shares and securities determined as per Rule 11UA
D Stamp duty value assessed or assessable by any Government Authority in respect of immovable property
L Book value of liabilities in the Balance Sheet, but not including the following
  • The paid-up capital in respect of equity shares;
  • The amount set apart for payment of dividends on preference shares and equity shares where such dividends have not been declared before the date of transfer of such shares at a general body meeting of the company;
  • Reserves and surplus, by whatever name called, even if the resulting figure is negative, other than depreciation reserve;
  • Any amount representing provision for taxation, other than amount of income-tax paid, less the amount claimed as refund to the extent of the excess over the tax payable with reference to the book profits in accordance with the law applicable thereto;
  • Any amount representing provisions made for meeting unascertained liabilities;
  • Any amount representing contingent liabilities other than arrears of dividends payable in respect of cumulative preference shares
PV The paid-up value of such equity shares
PE Total amount of paid-up equity share capital as shown in the balance-sheet
Valuation Date Date of transfer/receipt of equity shares
Audit requirement The Balance Sheet as on valuation date needs to be audited by the Statutory Auditors of the company
 
In respect of securities other than equity shares, the existing provisions of determination of FMV shall continue. The FMV in such cases shall be the market value as determined by a Merchant Banker or a Chartered Accountant.
 
SKP's comments

The finalisation of the Valuation Rules will provide certainty to taxpayers in the determination of FMV for transactions of transfer or receipt of unquoted equity shares. 
 
The earlier valuation rules were based on the book value of the company.  The Final Valuation Rules now recognise the underlying value of certain assets such as shares and securities, immovable property and jewellery and therefore the valuation shall be more realistic than the existing rules.
Implementation of the Final Valuation Rules, however, may create certain challenges discussed below, which need to be suitably addressed by CBDT through amendments in the relevant Rules.
  1. The valuation rules are applicable from 1 April 2017.  As such, they would cover in their purview the transactions that are concluded between 1 April 2017 and 12 July 2017.  This becomes a case of retrospective application of the computation provisions and could give rise to inadvertent implications.  Any corporate restructuring activities undertaken during this period may have to be revisited to assess the tax impact as per the Final Valuation Rules. 
  2. Where a company holds shares and securities as investments, the value of such shares and securities will now be determined as per the Final Valuation Rules. This could create challenges or even an impossibility in cases of Cross holdings (i.e. where both companies hold shares in one another). 
  3. The FMV has to be determined based on the Balance Sheet as on the Valuation date, which is the date of transfer/receipt of the equity shares. Furthermore, the Balance Sheet is required to be audited by the Statutory Auditors of the company. The earlier valuation rules permitted the use of the Balance Sheet adopted in the last concluded Annual General Meeting, before the date of transfer. However, the Final Valuation Rules do not contain such provisions.  This requirement will create additional compliance burden on the taxpayer in preparing the Balance Sheet on the date of transfer/receipt and getting the same audited. 
     
  4. There could also be significant challenges for transfer of shares by small shareholders.  A small shareholder, most likely, will not be in a position to require the company to prepare its Balance Sheet on the valuation date and get the same audited by its Statutory Auditors.  Furthermore, even the company cannot be expected to draw up its Balance Sheet and get the same audited due to the transfer of shares by any shareholder from time to time.
  5. The valuation of equity shares will have to be necessarily based on the NAV-based formula provided under the amended Rule 11UA.  The uniform application of the NAV-based formula will not appreciate case-specific differences.  Furthermore, the valuation mechanism under the Final Valuation Rules cannot be challenged by the taxpayer.  Hence, the Final Valuation Rules, which are in the nature of anti-abuse provisions, may have unintended consequences.
Taxpayers should take into account the requirements and the implications of the Final Valuation Rules in carrying out transactions of corporate restructuring and sale and purchase of shares.
 
[1] Amendment to Rule 11UA and insertion of Rule 11UAA, vide Notification No. 61/2017 dated 12 July 2017
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