MobiCom Technologies Pvt. Ltd. Vs ITO (ITAT Bangalore)
Introduction: The case of MobiCom Technologies Pvt. Ltd. vs. ITO (ITAT Bangalore) revolves around the contentious issue of share premium. This article delves into the details of the case to shed light on the legal proceedings and the rationale behind the tax authorities’ decision.
Detailed Analysis: The appeal, filed by MobiCom Technologies, challenges an order passed by the National Faceless Appeal Centre (NFAC), Delhi, arising from an earlier decision by the Income Tax Officer (ITO), Ward No. 4(1)(4), Bangalore. The ITO’s decision, made under section 143(3) of the Income Tax Act, 1961, pertains to the assessment year 2016-17. The crux of the matter is the addition of Rs. 1,04,50,000 under section 56(2)(viib) of the Act. This addition is based on the ITO’s determination that the share premium received by MobiCom Technologies exceeded the fair market value of the shares issued.
MobiCom Technologies, a company engaged in providing software development services, filed its return of income, declaring a loss of Rs. 9,40,028 for the assessment year in question. The company did not claim startup status as defined by the Department of Industrial Policy and Promotion (DIPP) and did not provide any certificate to substantiate such a claim.
During the scrutiny assessment, the ITO issued notices under section 143(2) and 142(1) to MobiCom Technologies. It was discovered that the company credited a sum of Rs. 1,14,95,000 under the security premium reserve account. Additionally, MobiCom Technologies allotted 1045 shares with a total value of Rs. 10,45,000 (at Rs. 1,000 per share) and treated the remaining Rs. 1,04,50,000 as share premium. The shares, each valued at Rs. 1,000, were issued at a premium of Rs. 10,000 to Shri Rathan Kumar. The company also provided a valuation report by an accountant. However, the valuation method used, based on the Discounted Cash Flow (DCF) approach for future growth estimation, did not align with Rule 11UA of the IT Rules, as per the Assessing Officer’s assessment.
Further investigation led to the summoning of the valuer, Shri K.R. Narasimha Murthy, on 16.11.2018 to verify the basis and strategy for arriving at the share premium of Rs. 10,000 per share. The ITO rejected the DCF method and justified this decision by citing section 56(2)(viib) of the IT Act, which pertains to consideration for shares exceeding their fair market value. The fair market value of the shares is determined based on the company’s assets, including intangible assets, such as goodwill, patents, copyrights, trademarks, licenses, and franchises, or as per Rule 11UA(2), whichever is higher. Since MobiCom Technologies failed to substantiate the market value of shares, Rule 11UA(2) came into play.
The Hon’ble Supreme Court’s decision in the case of M/s. G L Sultania & Others vs. SEBI emphasized that the valuation of shares involves technical and complex issues, best left to experts. The valuer’s methods should only be challenged if a fundamental mistake or erroneous basis is evident. In this case, the Assessing Officer found that MobiCom Technologies’ valuation was significantly inflated compared to its actual revenue over the past three years, rendering it unreliable.
In a similar vein, the Hon’ble High Court of Karnataka, in the case of M/s.Fidelity Business Services India (P) Ltd. vs. ACIT, agreed to hold an inquiry into the fair market value of the shares, highlighting that the valuer’s conclusions should not be sacrosanct and can be examined by the Assessing Officer.
In line with these precedents, the ITO decided to reject the DCF method and opted for the Net Asset Value (NAV) method to determine the fair market value of the shares. The DCF method had been based on projections for several years, and the significant variance between the projections and actual results for prior assessment years cast doubt on the accuracy of the valuation.
Conclusion: The MobiCom Technologies vs. ITO case showcases the importance of a fair and accurate valuation of shares, especially in the context of share premium. While the DCF method was used, its reliability was called into question due to discrepancies between projected and actual financial performance. This case underscores the need for valuation methods to align with legal and regulatory requirements and highlights the authority’s power to reject valuation methods it deems inappropriate. Ultimately, the tax authorities’ decision to add the excess share premium to MobiCom Technologies’ total income was upheld, emphasizing the importance of a sound valuation approach to avoid taxation disputes.
FULL TEXT OF THE ORDER OF ITAT BANGALORE
The instant appeal filed by the assessee is directed against the order dated 11.05.2023 passed by the National Faceless Appeal Centre (NFAC), Delhi arising out of the order dated 29.12.2018 passed by the ITO, Ward No. 4(1)(4), Bangalore u/s. 143(3) of the Income Tax Act, 1961 (hereinafter referred to as “the Act”) for A.Y. 2016-17 whereby and whereunder the addition of Rs. 1,04,50,000/- u/s. 56(2)(viib) of the Act made by the Ld.AO holding the share premium received by the appellant company is in excess of fair market value of the share has been confirmed.
2. The brief fact leading to the case is this that the appellant company engaged in providing software development services for computer of all kinds, peripherals, consumables and software, registered on 09.04.20 15 filed its return of income on 23.09.20 16 declaring loss of Rs.9,40,028/-. It is relevant to mention that the assessee company did not claim itself as a start-up as defined by DIPP, neither filed any certificate to prove that the company is registered as a start-up. During the course of scrutiny assessment, a notice u/s. 143(2) followed by notice u/s. 142(1) was issued to the assessee. It was revealed that the assessee credited a sum of Rs.1,14,95,000/- under security premium reserve account. It had allotted 1045 shares totaling value of Rs. 10,45,000/- (Rs. 1,000/- per share) and treated the balance of Rs.1,04,50,000/- as share premium. The equity shares of Rs.1,000/- each were issued at premium of Rs. 10,000/- each to one Shri Rathan Kumar. The valuation report of the accountant was also filed. It was found that the valuation of the shares were done on the books following DCF method forecasting the future growth which is a hypothetical estimation and not in accordance with Rule 11 UA of the IT Rules as of the opinion of the Assessing Officer.
3. During the course of scrutiny assessment, the valuer of the shares namely Shri K.R. Narasimha Murthy was summoned on 16.11.2018 in order to verify the basis and documents relied upon and strategy adopted to arrive the share premium at Rs. 10,000/-. The Ld.AO did not accept the DCF method of valuation of the share for the following reasons as it appeared from the order passed by the Ld.AO:
“2.5. In this regard, it is pertinent to note the pro visions of clause (viib) of Sub-section (2) of section 56 of the IT Act 1961, which stipulates that “where a company, not being a company in which the public are substantially interested, received in any previous year, from any person being a resident, any consideration for issue of shares that exceeds the face value of such shares, the aggregate consideration received for such shares as exceeds the fair market value of the shares’, shall be chargeable to income-tax under the head “Income from Other Sources”.
2.6. With respect to the Fair Market Value of the shares, the market value of shares is to be calculated either as may be substantiated by the company to the satisfaction of the Assessing Officer, based on the value, on the date of issue of shares, of its assets, including intangible assets being goodwill, know-how, patents, copyrights, trademarks, licenses, franchises or any other business or commercial rights of similar nature or as per the provisions of Rule 11 UA(2), which so ever is higher. Since the assessee has failed to substantiate the market value of shares, the provisions of Rule I 1 UA(2) are attracted which reads as under:-
“Notwithstanding anything contained in sub-clause (b) of clause (c) of sub-rule (1), the fair market value of unquoted equity shares for the purposes of sub-clause(i) of clause (a) of Explanation to clause (viib) of sub-section (2) of section 56 shall be the value, on the valuation date, of such unquoted equity shares as determined in the following manner under clause (a) or clause (b), at the option of the assessee, namely: –
the fair market value of unquoted equity
1. Shares = (A-L) x (PV)
(PE)
where,
A = book value of the assets in the balance-sheet as reduced by any amount of tax paid as deduction or collection at source or as advance tax payment as reduced by the amount of tax claimed as refund under the Income-tax Act and any amount shown in the balance-sheet as asset including the unamortized amount of deferred expenditure which does not represent the value of any asset:
L = book value of liabilities shown in the balance-sheet, but not including the following amounts, namely:-
1. the paid-up capital in respect of equity shares;
2. 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 at a general body meeting of the company;
1. reserves and surplus, by whatever name called, even if the resulting figure is negative, other than those set apart towards depreciation;
1. any amount representing provision for taxation, other than amount of tax paid as deduction or collection at source or as advance tax payment as reduced by the amount of tax claimed as refund under the Income-tax Act, to the extent of the excess over the tax payable with reference to the book profits in accordance with the law applicable thereto;
1. any amount representing provisions made for meeting liabilities, other than ascertained liabilities;
1. any amount representing contingent liabilities other than arrears of dividends payable in respect of cumulative preference shares;
P E = total amount of paid up equity share capital as shown in the balance sheet;
P V = the paid up value of such equity shares; or
(b) The fair market value of the unquoted equity shares determined by the Merchant banker or an accountant as per the Discounted Free Cash Flow method.
2.7. It may be noted that the Hon’ble Supreme Court in its decision in the M/s. G L Sultania & Others . Vs. SEBI (Civil A No.1704 of 2006) dated 16/05/2007 has given the following finding in Para 32 of the order:
“These decisions clearly lay down the principle that valuation of shares is not only a question of fact but also raised technical & complex issues, which may be appropriately left to the wisdom of experts, having regard to the many imponderables which enter the process of valuation of shares. If the valuer adopts the methods of valuation prescribed, Or in the absence of any prescribed method, adopts any method of valuation. His valuation can not be assailed unless it is shown that the valuation was made on a fundamentally erroneous basis, or that a patent mistake had been committed. Or the valuer adopted a demonstrably wrong approach or a fundamental error going to the root of the matter.”
In this case, the fundamentals of the Company adopted by the valuer is found to be highly inflated in comparison to the actual revenue in last 3 years. Hence, the value of the share adopted is highly inflated and it does not reflect the true state of affair of the company.
2.8. In a recent judgment dated 23/07/2018 in the case of M/s.Fidelity Business Services India (P) Ltd. . Vs. ACIT reported in 95 Taxmann.Com.253, the Hon’ble High Court of Karnataka has held that “the Tribunal was perfectly justified in directing an enquiry into the FMV of shares of the assessee Company which could have an implication of taxability U/s.2(22)€ of the IT Act.”
Hence, the Hon’ble High Court of Karnataka has agreed to held enquiry into the FMV of the Share and conclusion drawn by the valuer can not be a sacrosanct figure, which can not be examined by the AO.
2.9. Further, the Hon’ble ITAT, New Delhi in the case of M/s. Agro Portfolio Pvt. Ltd has held that in the absence of correctness of the result of DCF method, left no option to the AO but to reject the DCF method and to go by NAV method to determine the FMV of the shares.
2.10. In the present case, the valuation of shares is based on the Discounted cash flow method and on the projected financials, 2014-1 5, 2015-1 6, 2016-17, 2017-1 8, 2018-19 & 2019-20. The sales and PAT projections based on which the share value has been arrived at is reproduced as under:-
“ANNEXURE-I
Convertible after 2019-2020
Existing equity shares : 300
No. of Preference shares : 1045
Preference shares to be converted to Equity Shares : for 1 Preference shares
12 Equity Shares
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