The Finance Act, 2017 wielded a double-edged sword by inserting provisions of Section 56(2)(x) and section 50CA in the Income-tax Act, 1961. The former provision amplifies its scope of taxability in the hands of the recipient, on receipt of sum of money or property without/ inadequate consideration by any person. The latter provision provides for taxability in the hands of the transferrer where consideration for transfer of unquoted equity share of a company is less than the fair market value determined in the prescribed manner.
These provisions lead to double taxation of a single transaction, ie, if unquoted equity shares are sold at a value less than the FMV the same shall be taxed twice—once in the hands of the transferrer, under section 50CA, and again in the hands of the recipient, under section 56(2)(x) of the I-T Act.
Considering the above provisions, the Central Board of Direct Taxes (CBDT) proposed to amend the rules, which provide a valuation methodology for unquoted equity shares by taking into account the fair market value of the specified capital assets and book value for the rest of the assets. The CBDT in a press release dated May 5, 2017, issued draft rules relating to valuation of unquoted equity shares.
The draft rules propose to replace the existing valuation rules, which are based on the book value of assets with the fair market value of the assets. The revised computation, as per the draft rules for unquoted equity shares, is as follows.
Although the valuation rules are a step in the right direction to tax transfers on the fair market value basis, some issues remain unanswered. The former rules do not cover the valuation for quoted infrequently traded securities other than equity such as convertible/non-convertible debentures, preference shares, etc. The question for such valuation also remains unanswered in the prescribed draft rules.
Deciphering the above formula, component B relates to fair market value of jewellery and artistic work, which would be equivalent to the value it would fetch if sold in the open market on the basis of a valuation report received from a registered valuer, as defined under the Wealth Tax Act, 1957. However, a question that persists is whether the assessing officer can further challenge such valuation report, which may be a subject matter of litigation.
The erstwhile methodology for determining the fair market value of immovable property to be taken as the value adopted/assessed/assessable by authority for payment of stamp duty persists. Considering the current real estate market, one may easily land up in a situation in which the reckoner value, as required to be determined, may be much higher than the actual fair market value of the immovable property. Therefore, the overall valuation may not depict a correct picture and result in overvaluation, when in substance the same property is undervalued.
Further, to add to woes, the draft rules do not provide any flexibility to the transferrer or the recipient of contesting such higher value. Such provisions may pose challenges in case of commercial deals with varied valuations. A juxtaposing opportunity for explaining the value to the assessing officer is provided to the company under the provisions of 56(2)(viib) of the I-T Act.
The other key consideration in terms of the draft rules would include no mention of the term “balance sheet.” This inadvertent omission would logically be corrected in the proposed final rules, as without such reference, one would not be able to determine the value of assets and liabilities as on the date of valuation.
As a welcome move, the draft rules issued by the CBDT for valuing unquoted equity are objective in nature. They are not referring to subjective methods of valuation, such as factoring enterprise value, discounted cash flows, etc. Accordingly, the objective nature of the valuation would substantially reduce litigation in valuations. Another important outcome of the prescribed rules would be its applicability on valuations in relation to indirect transfer of shares in the Indian company.
Although there are certain deficiencies in the rules, the proposed fair valuation for unquoted equity shares is definitely a measure taken by the government towards more transparent and fairer valuations.
With inputs from Yogesh D, Director and Chaitalee Shah, Associate – M&A Tax, PwC