In this write up, we are going to discuss the taxability, under Income Tax Law, where a private limited company issues share at a price which is more than its Face Value.
Section 56(2)(Viib) of Income Tax Act, 1961, stipulates as follows:-
where a company, not being a company in which the public are substantially interested, receives, 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:
Provided that this clause shall not apply where the consideration for issue of shares is received—
(i) by a venture capital undertaking from a venture capital company or a venture capital fund or
(ii) by a company from a class or classes of persons as may be notified by the Central Government in this behalf:
Provisions of Section 56(2)(viib) says that when a private limited company issues share at a price which is more than its Face Value then consideration receives in excess of Fair Market Value (FMV) is taxable under the head “Income From Other Source”.
Let us understand this in a simple word. ABC Pvt. Ltd. Issues its equity share, having face value of Rs. 10, at the price of Rs. 100/- per share. Suppose, in this case Fair Market Value of Equity share is Rs. 80/- Per Share. Now as per the provision of sec 56(2)(viib), consideration received in excess of FMV i.e. 80/- shall be taxable under head “Income From Other Source”, hence:-
|Consideration Received||Rs. 100/-|
|Taxable under head “Income From Other Source”||Rs. 20/- (Rs. 100-Rs.80/-)|
Explanation (a) to section 56(2)(viib) stipulates FMV as follows:-
Explanation.—For the purposes of this clause,—
(a) the fair market value of the shares shall be the value—
(i) as may be determined in accordance with such method as may be prescribed; or
(ii) 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, licences, franchises or any other business or commercial rights of similar nature,
whichever is higher.
Explanation (a) to section 56(2)(viib) says that FMV shall be higher of following:-
i. Value determined as per method prescribed (i.e. Rule 11UA), or
ii. Value as substantiated by company to the satisfaction of A.O.
Rule 11UA(2) of Income Tax Rules, prescribed the manner and method to determine the Fair Market Value. Rule 11UA(2) gives the two option to assessee to determine the FMV. Assessee can choose any option from the given two options. Rule 11UA(2) provides the below two options to the assessee:-
a. NAV Method [Rule 11UA(2)(a)]:
The fair market value of unquoted equity shares = (A–L)× (PV)/(PE)
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 unamortised 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:—
(i) the paid-up capital in respect of equity shares;
(ii) 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;
(iii) reserves and surplus, by whatever name called, even if the resulting figure is negative, other than those set apart towards depreciation;
(iv) 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;
(v) any amount representing provisions made for meeting liabilities, other than ascertained liabilities;
(vi) any amount representing contingent liabilities other than arrears of dividends payable in respect of cumulative preference shares;
PE= total amount of paid up equity share capital as shown in the balance-sheet;
PV= the paid up value of such equity shares; or
b. DCF Method [Rule 11UA(2)(b)]:
The fair market value of the unquoted equity shares determined by a merchant banker as per the Discounted Free Cash Flow method.
As per Rule 11U:-
a. “valuation date” means the date on which the property or consideration, as the case may be, is received by the assessee.
b. Balance Sheet for the purpose of Rule 11UA(2) means Audited Balance Sheet as on Valuation Date or last audited Balance Sheet.
c. Merchant Banker” means category I merchant banker registered with SEBI
Some Importation Judgements: –
1. Section 56 allows the assessees to adopt one of the methods of their choice. But, the AO held that the assessee should have adopted only one method for determining the value of the shares. In our opinion, it was beyond the jurisdiction of the AO to insist upon a particular system, especially the Act allows to choose one of the two methods. Until and unless the legislature amends the provision of the Act and prescribes only one method for valuation of the shares, the assessee are free to adopt any one of the methods. [Karmic Labs Pvt. Ltd vs. ITO (ITAT Mumbai)]
2. The valuation of shares should be made on the basis of various factors and not merely on the basis of financials. The substantiation of the fair market value on the basis of the valuation done by the assessee simply cannot be rejected where the assessee has demonstrated with evidence that the fair market value of the asset is much more than the value shown in the balance sheet. [India Convention and Culture Centre Pvt. Ltd vs. ITO (ITAT Delhi)]
3. The assessee has the option to determine the fair market value of shares either under the DCF method or the NAV method. The assessee’s choice is binding on the AO. While the AO can scrutinize the working, he cannot discard the assessee’s method and substitute another method. [Narang Access Pvt. Ltd vs. DCIT (ITAT Mumbai)]
4. The assessee has the option under Rule 11UA(2) to determine the FMV by either the ‘DCF Method’ or the ‘NAV Method’. The AO has no jurisdiction to tinker with the valuation and to substitute his own value or to reject the valuation. He also cannot question the commercial wisdom of the assessee and its investors. The ‘DCF Method’ is based on projections. The AO cannot fault the valuation on the basis that the real figures don’t support the projections. Also, the fact that independent investors have invested in the start-up proves that the FMV as determined by the assessee is proper. [Cinestaan Entertainment P. Ltd vs. ITO (ITAT Delhi)]
5. Law on how to determine the “FMV” (Fair Market Value) of shares issued by a closely held company explained. The fact that the company is loss-making does not mean that shares cannot be allotted at premium. The DCF method is a recognised method though it is not an exact science & can never be done with arithmetic precision. The fact that future projections of various factors made by applying hindsight view cannot be matched with actual performance does not mean that the DCF method is not correct. [India Today Online Pvt. Ltd vs. ITO (ITAT Delhi)]