As seen in recent years, Indian Revenue Department (IRD) has been deep diving into various transaction for evaluating their economic substance and authenticity, especially where the transactions relate to valuation of assets. This article has tried to provide a holistic view of how valuation is looked into by The Organization for Economic Co-operation and Development (OECD), the United Nations and IRD with respect to Transfer Pricing (TP).
We see that whenever there is any TP litigation in relation to valuation of assets or shares, following are the issues that are raised by the IRD while evaluating the valuation report:
1. Method of valuation; and
2. Authenticity of the projections used in the valuation.
1. Method of valuation
Various method are used to determine the valuation of any particular item, e.g. Discounted Cash Flow (DCF), Net Assets Method, Capitalization Method, Super Profit Method, Average Profit Method etc. Irrespective of the valuation method used, it is important to explain the reason and circumstance under which such valuation method is adopted and convince the IRD that the method adopted is the best method.
OECD TP Guidelines
Para 3.73 of the OECD TP Guidelines provides relevant guidance for paras to be referred for the valuation, relevant extract of the para is produced below:
“The reasoning that is found at paragraphs 6.181-6.185, which
provide guidance on the arm’s length pricing of transactions involving intangibles for which valuation is highly uncertain at the time of the transactions, applies by analogy to other types of transactions with valuation uncertainties………”
This paragraph explains that the guidance provided for valuation involving intangibles (valuation for which is highly uncertain), shall also apply to other transactions whose valuation possesses uncertainties.
Para 6.153 of the OECD TP Guidelines provides relevant guidance for para to be referred for the valuation techniques, which is produced below:
“…..In particular, the application of income based valuation techniques, especially valuation techniques premised on the calculation of the discounted value of projected future income streams or cash flows derived from the exploitation of the intangible being valued, may be particularly useful when properly applied. Depending on the facts and circumstances, valuation techniques may be used by taxpayers and tax administrations as a part of one of the five OECD transfer pricing methods described in Chapter II, or as a tool that can be usefully applied in identifying an arm’s length price.”
Accordingly, after reading the above and based on the facts and circumstances of each case, it can be inferred that the DCF method is a useful approach for the valuation and arriving at an arm’s length price for a transaction.
However, as per para 6.156 of the OECD TP guidelines the OCED does not endorse or reject that any specific valuation technique specifically suitable for the transfer pricing analysis.
United Nations Practical Manual on Transfer Pricing for Developing Countries 2017 (“UN TP Manual”)
Para B.5.6.8 of the UN TP Manual also provides that the DCF method is the most useful method. However, different valuation methods can be used based on the facts and the circumstances of the case, relevant extract of the para is produced below:
“Where reliable comparable uncontrolled transactions cannot be identified it may be possible, under certain circumstances, to use valuation techniques to help determine the arm’s length price for intangibles transferred between associated enterprises. In particular, the application of valuation techniques based on the calculation of the discounted value of projected future income streams or discounted cash flows (DCF) derived from the exploitation of the intangible being valued, may be useful. Depending on the facts and circumstances, valuation techniques may be used by taxpayers and tax administrations as a part of one of the methods described in Chapter B.3 or as a tool that can be usefully applied in identifying an arm’s length price.”
2. Authenticity of the projections used in the valuation
Projection of the future income of the company plays an important role in the valuation process. Usually the management of the company provides projected revenue to the Valuer. In almost all scenarios, the IRD would deep dive to evaluate the authenticity of these projections. IRD is often of the view that as the company’s management provides these projected numbers, they may present a tainted picture so as to achieve the required valuation.
OECD TP Guidelines
However, para 3.73 of the OECD TP Guidelines provides for situations in which it would be appropriate to reject the projections made by the management/company, extract of the para is produced below:
“….where there is no reason to consider that the valuation was sufficiently uncertain at the outset that the parties would have required a price adjustment clause or would have renegotiated the terms of the agreement, there is no reason for tax administrations to make such an adjustment as it would represent an inappropriate use of hindsight. The mere existence of uncertainty should not require an ex post adjustment without a consideration of what independent enterprises would have done or agreed between them.”
In case of Hard to Value Intangible (“HTVI”) the ex-post outcome can be taken as evidence to evaluate whether the ex-ante-pricing was appropriate or not. If the tax administration is satisfied with the reliability of the information on which ex-ante-pricing is based, no adjustment shall be made on the ex-ante pricing. An example can be, the actual outcome of a transaction can be taken as evidence to evaluate the reliability of the assumptions made while making the projections of the said transaction, following is the relevant extract of the guidance:
Para 6.192 of the OECD TP Guidelines “In these circumstances, the tax administration can consider ex post outcomes as presumptive evidence about the appropriateness of the ex ante pricing arrangements. However, the consideration of ex post evidence should be based on determination that such evidence is necessary to be taken into account to assess the reliability of the information on which ex ante pricing has been based. Where the tax administration is able to confirm the reliability of the information on which ex ante pricing has been based, notwithstanding the approach described in this section, then adjustments based on ex post profit levels should not be made. In evaluating the ex ante pricing arrangements, the tax administration is entitled to use the ex post evidence about financial outcomes to inform the determination of the arm’s length pricing arrangements, including any contingent pricing arrangements, that would have been made between independent enterprises at the time of the transaction, considering the guidance in paragraph 6.185. Depending on the facts and circumstances of the case and considering the guidance in Section B.5 of Chapter III, a multi-year analysis of the information for the application of this approach may be appropriate.”
As per para 6.193 of the OECD TP Guidelines, an adjustment shall not be made for the HTVI transactions which have
(i) no reliable comparable exist; and
(ii) at the time the transactions was entered into, the projections of future cash flows or income expected to be derived from the transferred intangible, or the assumptions used in valuing the intangible are highly uncertain, making it difficult to predict the level of ultimate success of the intangible at the time of transfer.
UN TP Manual
Furthermore, Para B.5.6.25 of the UN TP Manual also provides for situations in which it would be appropriate to reject the projections made by the management/company. An extract of the relevant para is produced below:
“……It is important to stress that it is generally inappropriate for a taxpayer or tax authority to undertake a DCF analysis based on ex post data in order to formulate an assessment of the ex ante value of an intangible. This is because it is difficult and often subjective to determine the ex ante view of risks after the risks have already materialized. Such an analysis may constitute an inappropriate use of hindsight……”
After a reading of the above, one can reasonably conclude that, the projected figures may be disregarded only when the projected figures were not estimated reasonably based on facts and circumstances available at the time of making the projections, or the projections deviate drastically from the actual results.
The said matter has also been litigated several times. Some judicial precedents have been presented below:
♦ Tally Solutions (P.) Ltd. Vs DCIT [IT Appeal no. 1235 (Bang.) of 2010]
In this case, the Hon’ble Bangalore Income Tax Appellate Tribunal (“ITAT”) was examining the application of the excess earning method which mainly revolves around DCF analysis (as mentioned in Para 10.2 of this judgement), wherein the Hon’ble ITAT rejected the Assessee’s contention to use actual sales instead of projected sales for the purpose of valuation of asset. The relevant extract of the ruling is produced below:
“10.2 … This valuation is upheld by the US courts while arriving at the sale value of a software product. Further, the valuation under the method mainly revolves around discounted cash flow (DCF) analysis which is known to economists for the times immemorial. Thus, the TPO used a reasonable well-accepted method of valuation…
…We agree with the TPO in adopting the above method and having concluded in the preceding paragraph that the excess earning method adopted by the TPO to arrive at the ALP is correct, we reject the assessee’s contention that the ALP should be computed based on actual sales and not projection adopted by TPO”
♦ DQ Entertainment (International) Ltd. Vs ACIT [ITA No. 151/Hyd/2015]
In case of DQ Entertainment (supra), wherein Hon’ble Hyderabad ITAT held that the valuations could not be reviewed with actuals after 3 or 4 years down the line. The relevant extract of the ruling is produced below:
“10. … We are in agreement with the above findings of the Bangalore Bench that the valuation method adopted for determining the future years cannot be replaced with actuals down the line, the valuation will go either way. When it goes to north, the revenue may adopt the same time, when it goes to south, the assessee may adopt, there won’t be any consistency. What is important is the value available at the time of making business decision. It should be left to the wisdom of the businessman, he knows what is good for the organization. No doubt, “IP” was sold to “AE”. The method adopted should be consistent and should be documented to review in the future. The review does not mean replacing the projection with actuals. It is the rational of adopting the values for making decision at the point of time of making decision. When the values are replaced subsequently, it is not valuation but evaluation i.e. moving the post of result determined out of projections. The revenue is doubting the valuation because the actual revenues were favourable. In rational decision making, the actual results are irrelevant.
… In our considered view, for valuation of an intangible asset, only the future projections alone can be adopted and such valuation cannot be reviewed with actuals after 3 or 4 years down the line. Accordingly, the grounds raised by assessee are allowed.
♦ Cinestaan Entertainment P. Ltd. Vs. ITO [ITA No. 8113/Del/2018]
In this case, Hon’ble Delhi ITAT rejected the IRD’s contention of replacing the projected figures with the actuals for the purpose of valuation. The Hon’ble ITAT held that the projections used for valuation are based on various factors existing at the time of undertaking valuation which cannot be evaluated purely based on arithmetical precision as compared to the actual results in future. The relevant extract of the ruling is produced below:
“33. … Whereas in a DCF method, the value is based on estimated future projection. These projections are based on various factors and projections made by the management and the Valuer, like growth of the company, economic/market conditions, business conditions, expected demand and supply, cost of capital and host of other factors. These factors are considered based on some reasonable approach and they cannot be evaluated purely based on arithmetical precision as value is always worked out based on approximation and catena of underline facts and assumptions. Nevertheless, at the time when valuation is made, it is based on reflections of the potential value of business at that particular time and also keeping in mind underline factors that may change over the period of time and thus, the value which is relevant today may not be relevant after certain period of time.”
Further, while pronouncing the above ruling, the Hon’ble ITAT also relied on the following cases [in addition to the case of DQ Entertainment (supra)], wherein it was held that challenging the valuation by applying a hindsight view is unknown to the law of valuations.
The extracts of both the cases relied by the Hon’ble Delhi ITAT are given below:
♦ Securities & Exchange Board of India & Ors [2015 ABR 291 – (Bombay HC)]
“48.6 Thirdly, it is a well settled position of law with regard to the valuation. that valuation is not an exact science and can never be done with arithmetic precision. The attempt on the part of SEBI to challenge the valuation which is but its very nature based on projections by applying what is essentially a hindsight view that the performance did not match the projection is unknown to the law of valuations. Valuation being an exercise required to be conducted at a particular point of time has of necessity to be carried out on the basis of whatever information is available on the date of the valuation and a projection of future revenue that valuer may fairly make on the basis of such information.”
♦ Rameshwaram Strong Glass Pvt. Ltd. v. ITO [2018-TIOL- 1358-ITAT- Jaipur]
“4.5.2. Before examining the fairness or reasonableness of valuation report submitted by the assessee we have to bear in mind the DCF Method and is essentially based on the projections (estimates) only and hence these projections cannot be compared with the actuals to expect the same figures as were projected. The valuer has to make forecast on the basis of some material but to estimate the exact figure is beyond its control. At the time of making a valuation for the purpose of determination of the fair market value, the past history may or may not be available in a given case and therefore, the other relevant factors may be considered. The projections are affected by various factors hence in the case of company where there is no commencement of production or of the business, does not mean that its share cannot command any premium. For such cases, the concept of start-up is a good example and as submitted the income-tax Act also recognized and encouraging the start-ups.”