Volume 5, Issue 30

29th January, 2013

Tax Alert
Tribunal prefers DCF method over erstwhile CCI guidelines for determining arm’s length price for transfer of shares


Recently the Chennai Bench of the Income Tax Appellate Tribunal (the “Tribunal”) ruled its acceptance of the Discounted Cash Flow (“DCF”) methodology over the Controller of Capital Issues (“CCI”) Guidelines for determining the arm’s length price (“ALP”) for sale of shares. The Tribunal held that the valuation of shares based on erstwhile CCI Guidelines were for a different purpose and could not be used for determining the ALP of shares for transfer pricing purposes.

Facts of the case:

Ascendas India Pvt. Ltd. (“Ascendas India/ taxpayer”) is engaged in the business of building and leasing out techno-parks and software parks. During the year under consideration, Ascendas India sold investments in two of its group companies, L&T Infocity Ascendas Ltd. (“LTIAL”) and Ascendas (India) IT Park Ltd. (“AITPL”). LTIAL was a 50:50 joint venture between the taxpayer and L&T Infocity Limited (“LTIL”), whereas in AITPL the taxpayer and its group companies held more than 85% shares. These investments were sold to an overseas associated enterprise Ascendas Property Fund India (“APFI”).

With regards to the sale of LTIAL shares, the taxpayer used the Comparable Uncontrolled Price (“CUP”) method to benchmark the transaction. The taxpayer contended that LTIL, an independent party, sold its shares to APFI at the same price as the taxpayer (Rs. 11,848/share). Regarding the sale of AITPL shares, the pricing was supported by the taxpayer with a valuation certificate (at Rs. 3.07/share) prepared by a Chartered Accountant in accordance with the erstwhile CCI Guidelines.

TPO & DRP Observations

According to the Transfer Pricing Officer (TPO), the transfer of LTIAL shares by LTIL to APFI could not be considered an uncontrolled comparable transaction. The TPO held that the relationship of the taxpayer with LTIL, through common participation in LTIAL, automatically resulted in LTIL and taxpayer being associated enterprises. Thus sales of shares by LTIL and taxpayer to APFI were intimately connected transactions.

Regarding the sale of AITPL shares, the TPO remarked that the valuation based on CCI Guidelines was not relevant for the purpose of ascertaining the arm’s length price under the transfer pricing rules. Further the TPO observed that the FEMA Guidelines had been amended to replace CCI Guidelines with DCF methodology for valuation of unlisted shares, effective April 2010. Thus for both share transactions, the TPO proposed the DCF methodology. Accordingly, the TPO determined the arm’s length price for LTIAL shares at Rs. 26,655/share and that of AITPL shares at Rs. 70.52/share (as against Rs. 11,848/share and Rs. 3.07/share respectively, determined by the taxpayer). Consequently, an adjustment of Rs. 2.4 billion (USD 48 million approx.) was proposed by the TPO.

The Dispute Resolution Panel affirmed the above view of the TPO, and rejected the plea of the taxpayer that the DCF method applied by the TPO suffered from errors.

Tribunal’s Ruling

The Tribunal observed that the sellers of LTIAL shares (the taxpayer and LTIL) entered into a single agreement with APFI. Even the price mentioned on the agreement was consolidated for the sale of shares by both the sellers. Thus considering one transaction on the agreement as an uncontrolled transaction, and comparing with the second transaction was not acceptable. CUP method used by the taxpayer was therefore rejected by the Tribunal.

The Tribunal was of the opinion that fixing enterprise value based on discounted value of cash flow was a method used worldwide. In the taxpayer’s case, where the market value of the investment was not readily ascertainable, DCF was the most appropriate method. The Tribunal remarked that looking at the prescribed methods under Section 92C of the Act, a water tight attitude of interpretation shall defeat the purpose of transfer pricing rules and regulations. The endeavour was to arrive at a comparable uncontrolled price for the shares sold and this might require subtle adjustments in the prescribed methods.

The Tribunal acknowledged the arithmetic inaccuracies highlighted by the taxpayer in the weighted average cost of capital (“WACC”) computation on account of the application of the DCF method. Accordingly, the case was restored to the AO for rectification of errors. At the same time, the Tribunal rejected the taxpayer’s plea that discount be given for illiquidity of shares, stating that WACC would take into account all the associated risks.

SKP’s Comments

This well reasoned ruling has put to rest some of the queries in connection with valuation of shares in the case of cross-border transactions between associated enterprises. DCF can be clearly inferred to be the more appropriate method for determining arm’s length valuation of unlisted shares.

The above ruling assumes significance in the light of the expanded definition of ‘international transaction’ by the Finance Act of 2012. The expanded definition now covers all types of capital transactions especially subscription to capital, reorganization, restructuring and share transfer, even in cases where income from such transactions is not taxable in India. Thus taxpayers are now required to plan such restructuring, reorganization and share transfers more effectively and after taking into consideration the valuation aspects.