Broadly, the valuation of financial instruments is required under the following laws & regulations:
A. The Income-tax Act, 1961
B. The Companies Act, 2013
C. FEMA Regulations
The requirements under the above laws and regulations have explained in detail in the ensuing paragraphs
The Income-tax Act, 1961 (‘the Act’) mandates valuations of financial instruments at a fair value under various provisions which have been stated hereunder:
This provision provides to tax direct or indirect transfer of capital assets, held by a company or an entity registered or incorporated outside India. Clause 3 of rule 11UB provides that the value of shares being transferred which will be taxed under the provisions of section 9(1)(i) should be valued in accordance with internationally accepted valuation mythology.
In accordance with this provision of the Act, where the transfer of shares of an unquoted company is less than the fair market value of such shares determined in the manner prescribed under Rule 11UAA of Income-tax Rules, 1962 (‘the Rules’), then the fair value so determined should be deemed to be the full value of consideration for the purpose of section 48 of the Act.
Section 50CA of the Act lays down the provisions which apply to the transferor whereas section 56 of the Act apply to a transferee person. Section 56(2)(viib) provides that where a Company, not being a company in which public are substantially interested, receives consideration for issue of shares from a resident person, which is more than the fair market value of such share determined under the Rule 11U and 11UA of the Rules, then the difference will be liable to tax in the ITR of the Company which issues such shares.
Further, as per section 56(2)(x), where a person receives from any other person, any shares or securities without consideration or a consideration less than fair market value, then the difference between such fair market value and actual consideration, if more than fifty thousand, shall be chargeable to tax in the hands of the transferee. The fair market value under this provision is computed in accordance with Rule 11U and 11UA of the Rules.
It is pertinent to note that in case of valuation of equity shares, the value has to be derived in accordance with the audited balance sheet. Further, under these valuation rules, values on the actual date of transfer should be considered for the purpose of arriving at the fair value of the share/ security.
Section 62 of the Companies Act, 2013 (‘the CA 2013’) with regard to the preferential allotment prescribes that the share value shall be determined in accordance with Companies (Share Capital and Debentures) Rules, 2014. This requirement does not apply to listed shares. These rules prescribe various methodology which can be followed for the purpose of arriving at the fair value of the shares of the Company.
The master directions on Foreign Investments in India issued under FEMA on 4 January 2018 define ‘capital instruments’ to include equity shares, debentures, preference shares and share warrants issued by an Indian company. The paragraph 4 of the said direction further explains that the Indian Company is permitted to receive foreign investment by issuing capital instruments to the investor and the capital instruments in the form of debentures would include fully, compulsorily and mandatorily convertible debentures. The transfer of such capital instruments are regulated under FEMA (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017. This regulation permits the person resident outside India, holding capital instruments of an Indian company or units in accordance with these Regulations to transfer the same to a person resident in India or vice versa by way of sale at value prescribed by the pricing guidelines. As per the pricing guidelines under FEMA, the transfer by way of sale shall be done at an arm’s length price which should be valued as per any internationally accepted pricing methodology.
Internationally accepted pricing methodology primarily implies using Discounted Cash Methodology. In case where any other methodology is more appropriate to apply considering various conditions, then the same may be applied after giving appropriate background of the case. Different approaches may also be applied by giving appropriate weights to each such method.