RBI Guideline on issue of shares by an Indian company to a non-resident and transfer of shares of an Indian company from a resident to a non-resident, or vice versa
New guidelines on private firm’s share do not provide guidance on the use of DCF method, be it in terms of discount rates or to compute cash flows into perpetuity. A series of regulatory and tax changes has completely changed the rules for transacting in shares of a private company in the country.
Recently, the Reserve Bank of India (RBI), through two separate announcements, amended the pricing guidelines applicable for issue of shares by an Indian company to a non-resident and also for the transfer of shares of an Indian company from a resident to a non-resident, or vice versa.
In all such cases, the new guidelines stipulate that the value of shares is to be determined using discounted free cash flow (DCF) method.
This is a significant departure from the past where in cases of a fresh issue of shares and for a transfer from a resident to a non-resident, a historical valuation bases was used (the erstwhile Controller of Capital Issues, or CCI, guidelines).
The new guidelines do not lay down further guidance on how the DCF method is to be used, be it in terms of discount rates or calculation of cash flows into perpetuity.
While the DCF method is a generally-accepted method for valuing the shares of a company, the rigidity in the new guidelines has resulted in several odd situations.
The new guidelines state that the value of the shares as arrived at by adopting the DCF method shall be the minimum price to be paid for the subscription of new shares by a non-resident or in case of a transfer of shares by a resident to a non-resident.
The same value or price then becomes the maximum price in the case of a transfer of shares by a non-resident to a resident. These guidelines would also apply in case of a newly-incorporated company.
In a situation where the company is set up using nominee Indian shareholders, applying the DCF method for transfer of shares to the non-resident, there could be an appreciation in value overnight.
The new guidelines should have also provided leeway in determining whether DCF is indeed applicable to a company given its facts and circumstances.
For example, in the case of a company with a large asset base but negative cash flows, using the DCF method may not be appropriate. Similarly, in the case of start-ups with IPs estimating future cash flows would be difficult.
What makes these guidelines more relevant is the recent change in the income-tax law. Effective June 1, 2010, subject to some limited exceptions, all transactions in shares of a private limited company must take place at a fair value.
If the shares are transacted at less than fair value, the difference between the fair value and the actual consideration paid is deemed as income from other sources for the transferee.
The Central Board of Direct Taxes (CBDT) has prescribed guidelines for determining the fair value of the shares, and these guidelines essentially adopt the net asset value (NAV) method. Again, there is no leeway prescribed and the NAV method is to be applied in all cases.
These new provisions are also unclear on whether they apply only to a transfer of shares or whether they apply in the case of an issue of fresh shares by a company, including, for example, issue of bonus shares by a company or even a rights issue.
This once again opens up the debate that when bonus shares are issued, there is a drop in the value of the original shares and, hence, it cannot be said that there is no consideration.
Bear in mind that under the income-tax law, transactions between related parties must also satisfy the arm’s-length pricing test under the transfer pricing regulations, and these regulations do not prescribe methodology for determining the arm’slength price of shares of a private company.
The net impact of all these changes is that the same transaction will now be subject to three different set of, sometimes competing, rules, and trying to comply with all the rules could have unintended consequences.
Let’s consider this: there is a transfer of shares of an Indian private company by a resident to a non-resident, and both parties are related.
From an exchange control perspective, the transfer will have to be made at least at a price equal to the price arrived at under the DCF method.
However, if this price is less than the fair value determined using the NAV method, it would result in income for the resident transferee.
To avoid this, if the transfer is made at the NAV-based value, there could still be a deemed income to the transferor under the transfer pricing regulations if the arm’s-length price is held to be higher than the NAV basis.
While there is a separate case to be made out as to whether the surrogate gift tax that has been reintroduced is valid, the larger issue is that a single transaction should not be subject to multiple and conflicting pricing guidelines.
There is no doubt that the erstwhile CCI guidelines were outdated and there is a need for a more robust valuation methodology.
Yet, some consistency in approach and providing flexibility for company-specific situations would have been welcome. I believe that we would expect further guidance on these aspects from the regulators, as additional practical situations get thrown up.
Whether DCF method of valuation of share is applicable for newly incorporated companies engaged in the business with longer gestation period and hence there will not be immediate cash flows