Assessing Officer’s Power to challenge Valuations [wrt Section 56(2)(viiib)]

Introduction

Businesses, and their consultants, have a natural desire to make use of the most favourable set of legitimate accounting tools available to them, but the Income Tax Act frustrates this desire (in the context of issuance of shares by an unlisted company to resident investors) by restricting their options to two – the Net Asset Value (“NAV”) and Discounted Cash Flow (“DCF”) methods.

Further, there is an inherent tension between these two methods. The NAV is a conveniently objective methodology for Revenue, that requires few assumptions and fewer projects. For the assessee however, it may be an irrationally constraining and crude method that fails to fully capture the potential value of the business based on which the investor has likely valued them. The DCF method allows for this projected revenue to be capture, but it can have a significant amount of subjectivity involved, particularly for start-ups or other business with innovative models for which precedent and industry norms are hard to find. Nevertheless, the requirement of administrative convenience is a well understood principle of taxation by both sides, and the limitation of two valuation methodologies is palatable to most taxpaying companies – provided they have the freedom to utilise and defend DCF-based valuations in a reasonable manner. Here, the AO’s discretion to challenge the valuation becomes important, and 3 issues arise in respect of the same.

• Issue 1: Whether the AO can change the method of valuation of unquoted shares under Rule 11UA of Income Tax Rules, 1962?

• Issue 2: Whether the AO can reject the Fair Market Value (“FMV”) determined under the DCF method due to non-furnishing of supporting documents called for by him?
• Issue 3: Whether the AO can reject the FMV determined under the DCF method by comparing actual performance figures with the projections used?

Issue 1: Jurisdiction of the AO to change the valuation methodology suo moto 

A major issue of contention in appeals related to Section 56 is the unilateral change of the valuation methodology by the AO – usually when the AO is not satisfied by the justification of the DCF valuation and makes a suo moto change to the NAV method.  After more than half a decade of lack of clarity, the Bombay High Court has provided well-reasoned judgment on the issue in 2018 in response to a writ petition by Vodafone M-Pesa Ltd.[1] The same has been duly noted as decided jurisprudence by ITAT benches since.

The relevant potion of the judgment stated:

“the Assessing Officer is undoubtedly entitled to scrutinise the valuation report and determine a fresh valuation either by himself or by calling for a final determination from an independent valuer to confront the petitioner. However, the basis has to be the DCF Method and it is not open to him to change the method of valuation which has been opted for by the Assessee.”[2]

Though the High Court does not mention it, there is another argument to support AO not being allowed to change. The Supreme Court in Apollo Tyres v CIT, Kochi[3] had laid down that the audited profit and loss account cannot be re-appreciated by the AO. Arvind Datar, while editing Kanga & Palhivala,[4] has observed that a similar standard would apply even in this case, and the DCF workings made by the merchant banker must be accepted by the AO unless he alleges fraud or collusion between the assessee and the merchant banker.

After the Bombay High Court judgment, this position has been cited by several ITAT judgments as a guidance that must be followed. The Bangalore Bench of ITAT observed, in Innoviti Payment Solutions Pvt. Ltd. Vs ITO[5]:

“in our considered opinion, in the present case, when the guidance of Hon’ble Bombay high Court is available, we should follow this judgment of Hon’ble Bombay High Court in preference to various tribunal orders cited by both sides and therefore, we are not required to examine and consider these tribunal orders.”[6]

It is worth noting that there is a conflicting judgment of the Kerala High in Sunrise Academy of Medical Specialities (India) (P.) Ltd. vs. ITO,[7] however it is non-applicable based on the observation by ITAT Bangalore in Town Essential Pvt Ltd:

“In the present case also, we prefer to follow the judgment of Hon’ble Bombay High Court rendered in the case of Vodafone M-Pesa Ltd., Vs. Pr. CIT (supra) in preference to the judgment of the Hon’ble Kerala High Court cited by DR of the Revenue rendered in the case of Sunrise Academy of Medical Specialities (India) (P.) Ltd. Vs. ITO (supra) because this is settled position of law by now that if two views are possible then the view favourable to the assessee should be adopted.”[8]

 This position has been maintained in subsequent judgments. In a more recent case before the Delhi Bench of the ITAT, the ITAT approvingly noted of the CIT(Appeals) order against additions by the AO, observing that:

“I am of the view that the AO cannot change the method of valuation of shares adopted by the assessees and the projected figures cannot be compared blindly with the actuals to state that the valuation report is not correct. However, the AO is competent and within his powers to look into the fact whether the valuation report is fair and reasonable.”[9]

The settled position now may be considered to be that Section 56(2)(viib) read with Rule 11UA provides the assessee with two options for the determination of FMV. The choice of the method is that of the assessee. The AO can scrutinize the valuation report and confront the assessee with a fresh valuation either by himself or by calling for a determination by an independent valuer – but the basis of that valuation has to be the DCF method where that was the choice exercised by the assessee. It is not up to the AO to change the methodology, only to dispute its application.

Issue 2: Rejection due to non furnishing of documents 

In a few cases,[10] the exercise of validity of projections has been reduced to the question of furnishing supporting documents to justify such projections. It has already been held in various judgments of the ITAT, including Intelligrape Solutions,[11] that the valuer is not expected to independently verify the data provided by the company but work off of such data – except unless acting as a merchant verified banker.

While there isn’t extensive jurisprudence on the matter, the order of the CIT (Appeals), noted in the Delhi ITAT judgment in Gamma Pizzakraft,[12] is interesting for attempting to deal with this. In that case, the AO had rejected the report of the valuer for being “just of 4 pages.” He summoned the valuer to appear with supporting documents. The CIT(A)’s finding with respect to this issue is more to do with fact of the submission of the documents, than with the law. However, the ITAT does approve of his observation that-

“However, in the absence of any prescribed format or size, one cannot reject the valuation merely on that ground [i.e. non submission of supporting documents]. Further, the AO has not pointed out any specific deficiency in the Valuation Report itself hence, it would be incorrect to reject the DCF method solely on that ground.”[13] 

This reaffirms the general jurisprudence that the rejection of valuation report cannot be on procedural or technical grounds merely, but requires a substantial demonstration of problems that cannot be reduced to a single factor. 

Issue 3: Rejection of FMV on basis of deviation between projected figures and actuals 

In the same Gamma Pizzakraft(Overseas) case,[14] the facts of the case involved a scenario where the AO compared the projections of Profit After Tax (“PAT”) made in the valuation report of the assessee with the actuals achieved in the intervening period, and observed a difference between the two. The CIT(Appeals), in his decision, addressed the issue via the following observations.

“In the instant case, the AO has compared the actual performance of the company post valuation date with the projections. The AO thus has the benefit of hindsight. But the valuers do not have it. The AO has not pointed out any relevant facts which should have been considered by the Valuer at the time of valuation which he had missed out. Basing his decision on the basis of hindsight is not only unfair but also goes against the very principles of valuation of shares today on the basis of projecting their future performance…”[15]

The final judgment of the ITAT in this case did not directly address this particular aspect, but noted that, given the clarity of answers and reasoning provided by the valuer in his statement, it no infraction of methodology has been brought out by the AO and the CIT(A)’s “well-reasoned order” (tacitly approving of the reasoning on the instant issue as well) is good in fact and law.

Reliance was also placed on the ITAT Delhi’s judgment in Intelligrape Software Limited,[16] where additions had been made on the grounds that year wise projected results had been far from the actual declared results in the final accounts. The ITAT bench in that case had observed-

“The rejection [of the assessee’s valuation] is unjustified as the valuation report is required under Rule 11UA of The Income Tax rules is based on the future aspects o f the company at the time of issuing the shares, it may vary from the actual figures depending on the market condition at the present point of the time.” 

At the same time however, it is also worth mentioning an ITAT Delhi judgmentin 2018 which, while deciding that the AO has jurisdiction to suo moto alter the valuation methodology, justified it by claiming –

“… This is so because unless and until the assessee produces the evidences to substantiate the basis of projections in cash flow and provides reasonable connectivity between those projections in cash flow with the reality evidenced by the material, it is not possible even for the Departmental Valuation Officer to conduct any exercise of verification of the acceptability of the value determine by the merchant banker”[17] 

This requirement of a “reasonable connectivity” between projected cash flow and “reality” implies that where there is other evidence to suggest a prima facie problem with the valuation, it is possible that future actuals can become one of the basis to reject such a valuation – however as the preceding judgments show, the position of law that emerges is that deviation from actual future revenues never ought to be the sole basis for such rejection. This understanding has been reaffirmed by the Delhi ITAT as recently as 2024 in ACIT v. Dhruv Milkose Pvt. Ltd.[18] The Tribunal in that case had agreed with the order of the CIT(Appeals) holding that “It is further held that the DCF Method is essentially based on the projections (estimations) and hence these projections cannot be compared with the actuals to expect the same figures as were projected”[19] while at the same time observing that unexplained or unreasonable deviations may cast doubt on the basis of the original valuation being bona fide and as per industry practice. 

[1]     Vodafone M-Pesa Ltd v. Principal Commissioner of Income Tax, (2018) SCC OnLine Bom 4323.

[2]     Id. at ¶ 8.

[3]     AIR 2002 SC 2131.

[4]     Kanga & Palkhivala, The Law and Practice of Income Tax (Arvind Datar eds., 11^th ed. 2020).

[5]     2019 SCC OnLine ITAT 721.

[6]     Id. at Para 12.

[7]     ITA No. 139/Bang/202.

[8]     Id. at ¶10.

[9]     ITA No. 8431/DEL/2019.

[10]   See Rameshwaram Strong Glass P. Ltd v. CIT, 2018 SCC OnLine ITAT 24811.

[11]   Intelligrape Software (P.) Ltd. v. CIT, 2020 SCC OnLine ITAT 9837

[12]   ITA No. 1309/Del/2020.

[13]   Id at ¶ 26

[14]   ITA No. 1309/Del/2020.

[15]   Id at ¶ 18.

[16]   ITA No. 3925/Del/2018.

[17]   (2018) 94 Taxmann.com 112 (Delhi-Trib) at ¶ 15.

[18]   ITA No. 8431/DEL/2019.

[19]   Id. at ¶ 4.

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Authors:

i. Sidhart Kumar, Final year B.A.,LL.B. (International Trade Law Hons.) student at National Law University, Jodhpur.

ii. Varsha Agarwal, Final Year B.A.,LL.B (Business Law Hons.) student at National Law University, Jodhpur.