Acquisition of Shares – A perspective on tax considerations while determining fair market value
TAXABLE INCOME ON THE ACQUISITION OF SHARES: DEPENDENT ON FAIR MARKET VALUE
Under the provisions of the Income-tax Act, 1961,the sale of shares of an unlisted Indian company above the fair market value of the shares can result in “income” in the hands of the seller and consequently result in income-tax liability.Similarly, if the purchaser of shares of an unlisted Indian company pays a price lower than the fair market value of the shares purchased, the purchaser may become liable to pay income tax.
Recently, several unlisted Indian companies that have received investments and investors in such companies have received notices from the Income-tax department questioning the valuation at which deals have been concluded. The Income-tax department has claimed that analogous to a share sale transaction, subscription to shares of an Indian company will render the premium paid above fair market value, towards subscription to equity shares of the unlisted Indian company, liable to tax at the hands of the Indian company in case of issue of shares above fair market value (under Section 56(2)(viib) of the Income-tax Act, 1961, unless it falls within the prescribed exemptions). Similarly, the discount below fair market value will be liable to tax at the hands of the investor in case of issue of shares below the fair market value (under Section 56 (2)(x) of the Income-tax Act, 1961).
The exemptions from Section 56(2)(viib) of the Income-tax Act, 1961 include :
- An Indian unlisted company receiving share application money from non-resident applicants
- A “start-up” company registered with the Department of Industrial Policy and Promotion,that has obtained approval of the Inter-Ministerial Board of Certification,receiving investment in accordance with the stipulations provided in such approval
- The consideration for issue of shares is received by a venture capital undertaking from a venture capital company or a venture capital fund. The consideration for issue of shares is received by an Indian company from a class or classes of persons that are exempt pursuant to notification by the Central Government
It is important to note that the above should not apply to situations or affect transactions where there is neither any increase nor decrease in the wealth of a shareholder (or of the issuing company), such as on account of issuance of bonus shares, or for a pro-rata rights issue .
METHODOLOGY FOR VALUATION OF FAIR MARKET VALUE OF SHARES
Rule 11U read with Rule 11UA of the Income-tax Rules, 1962, provides the methodology to be adopted in order to determine the fair market value of the shares of an unlisted company under the Income-tax Act, 1961.
For an unlisted Indian company, the fair market value is the higher of (i) the fair market value determined under Rule 11UA(2) of the Income-tax Rules, 1962 (i.e. either by the net asset value method, or the discounted cash flow method), and (ii) the fair market value as determined by the assessee, which is substantiated by the assessee to the satisfaction of the Income-tax Assessing Officer.
According to judicial precedent , the valuation of shares carried out in compliance of Rule 11UA(2) of the Income-tax Rules, 1962, should not be subjected to scrutiny of the Income-tax Assessing Officer. Consequently, the onus to justify the genuineness of the valuation is on the assessee only if valuation is done other by the methodology prescribed under Rule 11UA(2). Further, since the assessee has the right to determine the methodology adopted to
determine the fair market value of the shares,the Assessing Officer cannot reject the method of valuation adopted unless the taxpayer fails to substantiate the valuation with data and evidence .