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The authors are Harshal Chhabra and Sashwat Kashyap, second and third year students, respectively, at Gujarat National Law University.
Introduction
The Bengaluru bench of the Income Tax Appellate Tribunal (“ITAT”) recently in a matter of M/s. MobiCom Technologies Pvt. Ltd. versus The Income Tax Officer, upheld the imposition of “Angel Tax” while rejecting the methodology employed by the taxpayer for determining the fair market value (FMV). Angel tax is levied on unlisted private companies when they receive funds from investors, such as share application money or premiums, exceeding the fair market value of their untraded shares. Section 56 (2) (vii b) of the Income Tax Act, 1961 (“IT Act”), empowers the government to impose angel tax. Under this provision, any surplus consideration received on the issuance of shares, exceeding the FMV, is considered taxable income. Angel Tax was introduced in 2012 to put a “check & control” mechanism on the detrimental practice of misrepresenting unaccountable funds through share premiums received from investors in a closely held company in excess of its fair market value. FMV can be determined based on the book value of shares or a valuation report by a merchant banker, whichever is higher, as chosen by the company. However, the valuation by a merchant banker often relies on the discounted future cashflows of start-ups, which can be highly volatile due to various factors. This poses challenges for start-ups in justifying their valuations to tax authorities, potentially affecting their future business prospects.
This article aims to dissect the critical flaws in the ITAT judgement, challenging its implications on fair market valuation. The Court’s rationale displays deficiencies in three key areas: it disregards the taxpayer’s authority to determine FMV in accordance with Rule 11UA, misinterprets the Discounted Cash Flow (“DCF”) method’s application, and misunderstands key provisions within the tax code. These shortcomings raise concerns about fairness, flexibility, and consistency in the tax assessment process, potentially leading to inconsistencies in determining fair market value.
The Valuation of fair market value
“Fair Market Value” means the value determined in accordance with the method as may be prescribed. There has been much discourse on the method to compute the fair market value. Rule 11 UA of the Indian Income Tax Rules, 1962 (“IT Rules”) suggests the manner in which this valuation has to be made. Central Board of Direct Taxes (“CBDT”) vide notification dated 25 September 2023, has amended Rule 11UA of the IT Rules for computation of fair market value of unquoted equity shares and compulsorily convertible preference shares for the purposes of Section 56(2)(viib) of the IT Act. CBDT through this notification has given multiple methods to commute FMV. One of the methods for unlisted equity shares is the “Discounted cash flow method”, where the provision permits the companies to determine the FMV of unlisted shares by adding up the current values of all the expected future cash earnings a company is projected to make. The adjustment for risk and time-related aspects through a discounted rate is a crucial step in this process, and it's important to note that only Merchant Bankers are authorized to carry out this valuation.
Unveiling the Court’s Holding
In this case, MobiCom Technological Pvt. Ltd. (“the Assessee”), which provides software development services, filed its income return in 2016, stating a loss of Rs. 9,40,028. The company was not registered as a start-up and did not provide any certificate to prove its start-up status. During the scrutiny assessment, the company credited Rs. 1,14,95,000 to its security premium reserve account, issuing shares worth Rs. 10,45,000 at a premium of Rs. 10,000 each. The valuation of these shares was done using the DCF method, which the Assessing Officer (“AO”) did not accept, as it did not comply with Rule 11 UA of the IT Rules. The valuer was summoned to explain the basis and strategy for arriving at the share premium, but the AO did not accept the DCF method. The income tax authorities raised several objections to the use of the DCF method. They contested its applicability, arguing that it was suitable only for equity shares and not for preference shares. Additionally, they advised the taxpayer to employ an alternative valuation approach that took into account the value of all assets, including intangible ones. Furthermore, they justified their rejection of the DCF method by highlighting substantial disparities between projected sales/revenue and actual results.
Based on these arguments, the tax authorities concluded that only the face value of the shares should be considered as a capital investment, while the entire share premium on these shares should be subject to taxation under the “angel tax” provisions. The ITAT upheld the tax authorities' decision, citing the precedent established in the case of M/s. Agro Portfolio Pvt. Ltd. vs. ITO. In this case, the tribunal ruled that if the accuracy of the DCF method’s results cannot be verified, tax authorities have the right to reject it and instead apply the Net Asset Value (NAV) method for valuation. Consequently, the tribunal rejected the taxpayer's DCF valuation report, supporting the tax officer's alternative share value calculation.
The judgement rests on the notion that without the ability to verify the data provided by the assessee to the merchant banker, the accuracy of the DCF method’s results remains uncertain. This compelled the AO to opt for the NAV method for determining the FMV of the shares, as referring the matter to the Department’s Valuation Officer would serve no purpose in the absence of such evidence.
Unearthing the Critical Flaws in the Judgement
The Court’s rationale exhibits deficiencies on three distinct fronts. First, it overlooks the taxpayer’s authority to determine FMV with professional certification by a merchant or an accountant, as stipulated in Rule 11UA (1) (c). The same provides a clear method for valuing shares and securities. The current provisions enable taxpayers to calculate FMV using recognized stock exchange data, even if transactions occur outside these exchanges. By failing to consider this provision, the judgement restricts the taxpayer’s right to employ an established methodology for FMV determination. This approach, in turn, raises questions about the fairness and flexibility of the tax assessment process. Even the recent changes that the CBDT has introduced give an ample method that can be adopted by the taxpayer to determine the FMV.
Second, in accordance with the Bengaluru ITAT’s interpretation of the DCF method, the ratio misinterprets the DCF method’s predictions in the instant case, applying a clause intended for a higher valuation, thus affecting fairness. Furthermore, the judgement fails to recognize the taxpayer’s right to choose between the NAV and DCF methods.
As per the ruling in Vodafone M-Pesa Ltd. v. Principal Commissioner of Income Tax, the tax authorities can only reject the valuation if it doesn’t conform to legal standards. As affirmed by Mumbai ITAT, assessing actuals against projections in DCF valuation is deemed ‘harsh’ and ‘improper.’ However, the judgement overlooks this, denying the taxpayer’s choice and the fundamental principle that valuation, if conducted in a legally correct manner, is beyond the walls of scrutiny. The judgement asserts the Assessing Officer’s right to scrutinize the valuation but improperly allows changes to the chosen method. This overlooks the core tenet that the chosen method should remain consistent unless incorrect.
Third, it is also true that the procedure specified in Clause (a)(ii) of the explanation to Section 56(2)(viib) of the Act differs from the ones outlined in Rule 11UA. However, the judgement fails to consider the clear distinction between the said provisions. Section 56(2)(viib) outlines a procedure that should only be employed if it results in a higher valuation than the prescribed method. However, the judgement incorrectly uses this clause to justify a lower assessment than the DCF value.
This approach is legally inconsistent and raises questions about the fair application of the tax code. The intention of Section 56(2)(viib) is to ensure that the valuation is not understated to evade taxes, making it crucial to adhere to the proper valuation methodology, especially in cases where the valuation method already prescribed is more conservative than the DCF value. The judgement’s misinterpretation creates ambiguity in tax assessments and may lead to potential inconsistencies in determining fair market value. It’s vital to uphold the integrity of valuation methods and their specific applications to maintain a fair and effective tax system.
Concluding Remarks
The valuation of the shares undertaken by the assessee is firmly rooted in the Discounted Cash Flow (DCF) method, and it is imperative to note that the Assessing Officer (AO) ought not to have replaced this approach with the Net Asset Value (NAV) method. Instead, the AO should have diligently sought an alternative valuation, if deemed necessary, by adhering exclusively to the principles of the DCF method. Furthermore, drawing insights from the precedent set in the case of DCIT vs. Holisol Logistics P. Ltd., wherein the Assessee employed the DCF method based on a report determining the fair market value conducted by an Accountant using the DCF method. The tribunal ruled that the valuation arrived at by the expert using the Discounted Cash Flow Method, which also provided a sound basis for projecting computations, must be acknowledged since it was corroborated by an independent valuer.
The recent decision of Bengaluru ITAT decision raises important questions about the methodology for determining fair market value. The rejection of the Discounted Cash Flow (DCF) method and the imposition of the Net Asset Value (NAV) method seems to overlook key provisions in the Indian Income Tax Rules and established legal precedents.
It is crucial that tax officials follow established legal requirements and refrain from arbitrarily rejecting appraisals. Ultimately, this case highlights the importance of a fair and consistent approach to valuing shares, especially when utilizing the DCF method, and calls for a more robust consideration of expert valuation reports.