Tax Insights
from India Tax & Regulatory Services
www.pwc.in
Tribunal holds that TO cannot tinker with prescribed valuation method adopted by taxpayer for computation under section
56(2)(viib) of the Act and question commercial prudence
July 4, 2019
In brief
The Delhi Bench of the Income-tax Appellate Tribunal (Tribunal) held that the tax officer (TO) cannot reject the valuation report obtained from a prescribed valuer under a method of valuation prescribed under section 56(2)(vii)(b) of the Income-tax Act, 1961 (Act). There are no express provisions under the Act or the Income-tax Rule, 1962 (Rule) where the TO can adopt his own valuation under the discounted cash flow (DCF) method or obtain a valuation from a different valuer.
The Tribunal further ruled that the TO cannot challenge the commercial prudence and wisdom of the taxpayer or the investors.
In detail
Facts
• The taxpayer1 was
incorporated in September 2013. In financial year (FY) 2014-15, the taxpayer was establishing a business of film production. The taxpayer issued certain shares at an aggregate premium of INR 909.5m.
• The issue price for shares were determined on the basis of valuation report from a chartered
accountant using the DCF method, as prescribed under section 56(2)(viib) of the Act read with Rule 11UA(2)(b) of the Rule.
1 I.T.A. No. 8113/ Del/ 2018
• The TO disregarded the valuation report on the basis that the projections of revenue considered for the valuation did not match the actual revenues of
subsequent years and that no basis of projections was provided.
• The TO made an addition of the entire share premium amount under section 56(2)(viib) of the Act .
• The Commissioner of income-tax (Appeals) (CIT(A)) upheld the order of the TO and held that the figures were fabricated and that the projections were mere paper plans.
• The taxpayer is in appeal
before the Tribunal on the ground that the CIT(A) has erred in upholding the TO’s order, treating the entire share premium as income without offering any cogent reasons.
Taxpayer’s contention
• Shares were issued based on a valuation report issued by an independent valuer, using the prescribed methodology.
• The law leaves no discretion, option or mandate with the revenue authorities, under section 56(2)(viib) of the Act, to interfere or vary the option exercised, and the valuation of an expert, following
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the prescribed valuation methodology. The fair value, determined in such manner, is binding upon the Revenue.
• It is a well-settled position that the TO cannot dictate the terms of how a taxpayer should conduct its business.
• Fiscal statutes must be construed strictly. As the taxpayer’s case is not covered under the explanation, the taxpayer is not required to satisfy the TO about the valuation.
• The TO did not point out any fundamental fallacy in the projections or methodology used. The projections made were very scientific and the taxpayer made its best efforts to achieve it. The taxpayer also provided detailed basis of projections to the TO. By no standards can the projections be termed unrealistic.
• The provisions of section 56(2)(viib) of the Act and section 68 of the Act are anti- abuse provisions aimed at checking the menace of unaccounted money and have no applicability to genuine business transactions.
• The law requires the determination of fair value, and the TO cannot escape the statutory requirement of determination of fair value by simply rejecting the valuation report.
• The TO cannot question the commercial wisdom of
investing funds in zero coupon bonds, as these are strategic investments to foray into certain businesses and not to earn dividend/ interest.
Revenue’s contention
• The taxpayer has not provided the basis and parameters of valuation while applying the DCF method.
• The valuation report was rejected, as projections considered for the valuation did not match the actual revenues of subsequent years.
• No efforts were made by the taxpayer to achieve the projections, and hence, share premium received is without basis and contrary to
provisions of section 56(2)(viib) of the Act.
• The valuer did not carry out any independent verification of the correctness of
projections.
• Under the DCF method, it is always possible for the company to decide the proposed value of shares and then travel back to tailor the figures through reverse engineering for its convenience.
Tribunal’s ruling
• The deeming fiction under the Act not only has to be applied strictly but also be seen in the context in which such deeming provisions are triggered.
• Rule 11UA(2) does not give any power to the TO to examine or substitute his own value in place of the value determined, or requires any satisfaction on the part of the TO to tinker with such valuation.
• When the statute provides that valuation can be done as per prescribed method and the same has been adopted by the taxpayer, TO has to accept the same.
• Valuation is done at a
particular point in time based on various factors and it cannot be evaluated purely based on arithmetical precision.
• When valuation is made, it is based on reflections of the
potential value of business at that time and considering underlying factors, that may change over time; thus, a value relevant today may not be relevant after a certain period of time.
• Shares have not been subscribed by related parties but by outside investors whose identity and creditworthiness is beyond doubt. Thus, the genuineness of transaction cannot be challenged. If investors have seen certain potential in the business and accepted this valuation, the Revenue cannot question their commercial prudence.
• An entrepreneur visualises the business based on future projections and undertakes all types of risks, which in turn, give higher returns. A Revenue official cannot guide a
businessman in the manner of undertaking risk, and hence, the taxpayer’s investment in zero coupon bonds cannot be challenged.
• Therefore, the Tribunal deleted the addition of share premium made by the TO.
The takeaways
The judgement provides relief for genuine business transactions, wherein investments are based on future projections and prospects of the company.
It has clearly noted that the TO cannot question the choice of method of valuation, as long as it can be justified by the taxpayer and a report to that effect has been obtained from a prescribed expert.
Let’s talk
For a deeper discussion of how this issue might affect your business, please contact your local PwC advisor
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