Volume 5, Issue 26

22nd December, 2012

Tax Alert
CBDT modifies Rules for valuation of unquoted Equity shares

Under the Income Tax Act (ITA), any gift in the form of a movable property, inter alia including, unquoted equity shares received from non relatives by an individual/ Hindu Undivided Family (HUF) or by a firm/closely held company (in specified circumstances), the Fair market value (FMV) of which exceeds Rs.50,000/‐ shall be considered as a “income from other sources”. This is explained in the table below :

Status of Recipient Nature of Gift - Unquoted Equity shares Sum taxable
Individual/ HUF
i) Received without consideration
Entire FMV
ii) Received for a consideration which is less than the FMV by an amount exceeding Rs. 50,000
FMV minus consideration paid for the shares
Firm/closely held company
i) Received from a closely held company without consideration
Entire FMV
ii) Received for a consideration which is less than the FMV by an amount exceeding Rs. 50,000
FMV minus consideration paid for the shares

The Government has prescribed Rules 11U and 11UA for the purpose of determining the fair value of  unquoted equity shares for the situations covered in the table above. Rule 11U lays down certain definitions of the terms used in Rule 11UA while Rule 11UA lays down the methodology for determining the fair value of various assets, inter alia, including for unquoted equity  shares and securities. The Central Board of Direct Taxes (CBDT) has recently issued Notification No. 52/2012 dated 29th November, 2012 making changes in Rules 11U and 11UA.  This tax alert discusses the said changes in the Rules.

  • As per the existing method of valuation already prescribed under the Rule 11UA, the FMV of unquoted equity share is based on the book values of asset minus the book values of liabilities. In considering the book values of assets and liabilities certain assets and liabilities are to be excluded which do not represent actual assets or actual liabilities. Accordingly, while arriving at the aggregate book values of the assets, amounts paid as advance tax and debit balance of the profit & loss account are to be excluded.
    Now, as per amended Rules, the book value of the assets will have to be reduced by any amount of tax paid as deduction or collection at source, advance tax as reduced by the amount of tax claimed as refund and any amount shown in the balance sheet as asset including the unamortised amount of deferred expenditure which does not represent the value of any asset. Thus, as per the amendment the value of equity shares will decrease to the extent of TDS and TCS receivable and deferred expenditure but increase to the extent of income-tax refund claimed by the company as compared to the existing rules.
  • As per the revised Schedule VI under the Companies Act, the debit balance in profit & loss account is no longer to be shown on the assets side of the Balance Sheet. Hence, as per revised Rule now the debit balance of profit & loss account is not required to be reduced from the book values of the asset.
  • Earlier there was no requirement for getting the balance sheet audited for NAV valuation. However, now it is compulsory to get the balance sheet audited.

Changes applicable for fair valuation of fresh issue of shares

The Finance Act, 2012 inserted a new clause in section 56 of the ITA which provides for taxability of money received by a closely held company for issue of its shares. The section provides that if a private limited company issues shares to any resident at a price which is more than the face value of the shares and which exceeds ‘FMV’ of the shares, then the excess amount so received by the company (i.e. amount received over and above the FMV), will be taxable in the hands of the company as “income from other sources”. The method for determining the FMV for issuance of shares was not prescribed hitherto. However, it was provided in the existing section that the tax payer, at its option, can adopt higher of the FMV as per the method to be prescribed and the value of the share based on the values of the assets which the assessee has to substantiate to the satisfaction of the assessing officer. Now, the method for valuation of shares has been prescribed. The amendments in the Rules in this regard are as under .

  1. In Rule 11UA, the Government has introduced a new sub rule which prescribes the method for calculating the fair market value of share for the purpose of determining whether the price at which the shares are issued results into any income in the hands of the issuer company. The new sub rule 11(2) prescribes two methods for determining the fair market value of the shares:
    1. The Net Asset Value method which is similar to the existing method of determining the income in the hands of the individual, and HUF if they are receiving any unquoted equity shares free of cost or at concessional price or in case of firm and company, when they are receiving shares of the private limited companies free of cost or at concessional rate.
    2. Discounted Free Cash Flow Method (DCF). This valuation can be done by a Chartered Accountant or by a merchant banker.

    The assessee has an option to choose any of the methods prescribed.

    The option of adopting the higher value between the FMV value of shares based on  any of the above two methods or value of shares based on the values of the assets in the balance sheet still remains.  

  2. In relation to this amendment, Rule 11U has also been modified to change certain definitions. The definition of “accountant” has been amended. As per the existing definition, the term “accountant” means any Chartered Accountant. The amended definition provides that the valuation on issuance of shares should be done by a Chartered Accountant who is not a Statutory Auditor or Tax Auditor of the company. Further, as per the amendment, it appears that only a Fellow Chartered Accountant (as defined under the Chartered Accountants Act, 1949) can do the valuation for issuance of shares.

  3. The definition of the term ”balance sheet” has been amended. As per the existing definition “balance sheet” in relation to any company means a balance-sheet of such company as drawn up on the valuation date. As per the amended definition, the meaning of the balance sheet remains the same except that the same is required to be audited. The amended rule also provides that for the purpose of arriving at the fair value of shares based on the NAV for issuance of shares by the company, if a balance sheet is not drawn up as on the valuation date, the balance sheet drawn up as on a date immediately preceding the valuation date and which has been approved and adopted in the annual general meeting of the shareholders of the company has to be considered.

SKP’s comments

This amendments recognise certain primary principles of valuation of shares for the purpose of issuance of shares. The IT Rules provide an option to a tax payer to choose either the NAV or the DCF method for issuance of shares. This will provide relief to all the companies which are planning to issue shares at premium as the NAV based value is not likely to reflect the true value of shares and the company has the option to value shares at DCF. A company can also adopt the valuation of shares based on the asset values appearing in the balance sheet.

Further, the amendment imposes significant conditions to improve the authenticity of the Balance Sheet by requiring that the Balance Sheet should be audited by the Statutory Auditors for the purpose of arriving at the fair value.  This is likely to increase the cost of compliance for the tax payer.

Another important point for consideration is that the amended Rules come into force from 29th November 2012. Section 56(viib)  dealing with issuance of shares came into force from 1st April 2012. Thus in the intervening period there was no method of valuation prescribed. In such a case whether one can take a view that since no method was prescribed for the intervening period, the tax payer was free to issue shares at any price without any restriction and without any need to satisfy the assessing officer or since there already existed the requirement of satisfying the assessing officer, if the tax payer has adopted the fair values of assets, then the tax payer cannot be considered at liberty to adopt any value? This remains an open issue and one would have to wait for the courts to adopt some view on this.