How to value valuation right? It’s time for taxmen to get pragmatic – The Economic Times

lipped from: https://economictimes.indiatimes.com/opinion/et-commentary/how-to-value-valuation-right-its-time-for-taxmen-to-get-pragmatic/articleshow/93060657.cms

Synopsis

Tax authorities tend to challenge the valuation by claiming that the projections used are not realistic. Consequently, they claim that the shares are issued at an excess premium, which should be taxable. This puts a question mark on the commercial wisdom – always subjective to a point, particularly in new-age businesses – and business prospects and investors.

Sanjay Sanghvi

Sanjay Sanghvi

Sanjay Sanghvi is partner, Khaitan & Co

In the digital ecosystem of data-driven business models, ‘valuation’ is crucial for raising funds, restructuring, shareholder exits and paying income-tax (I-T). While there is no set formula for valuation, one needs to be mindful of the specific rules when it comes to valuation of shares for tax purposes.

One such provision under Indian tax law requires shares being issued by a closely held company to an Indian tax resident to be fair valued, and if the actual premium received is higher than such fair value, the excess premium is taxed in the hands of the issuing company as ‘ordinary income’. This provision was introduced to curb the practice of unaccounted money being infused into closely held companies.

The law has prescribed rules to determine ‘fair value’ as per a company’s book value, or by applying the ‘discounted free cash flow’ (DCF) method. The I-T Appellate Tribunal, in a ruling on July 12, dealt with a case (Dayalu Iron & Steel vs Income Tax Officer) in which the taxpayer company issued shares to some shareholders at a premium by valuing the shares following the DCF method. The tax authorities and the first appellate authority had rejected the method and brought a share premium to taxation.

The tribunal, however, held that ‘commercial expediency’ has to be seen from the businessman’s perspective, not from the taxman’s. It also held that ‘commercial wisdom’ of the taxpayer cannot be questioned. The tax authorities, it said, should not have tinkered with the DCF method, which was permissible. The tribunal emphasised that at the time when valuation was made, it was based on reflection of the potential value of the business at that point in time, and keeping in mind various underlying business factors that may change over time.

Under the DCF method, ‘fair value’ of shares is determined on its revenue forecast and the company’s business prospects, estimated growth, market and economic conditions, cost of capital, etc. These aspects are to be estimated by the businessman from a commercial perspective, by applying business judgement.

However, increasingly, where companies opt for the DCF method, tax authorities tend to challenge the valuation by claiming that the projections used are not realistic. Consequently, they claim that the shares are issued at an excess premium, which should be taxable. This puts a question mark on the commercial wisdom – always subjective to a point, particularly in new-age businesses – and business prospects and investors.

The appellate authorities have emphasised that the provision to tax ‘share premium’ was aimed to curb tax avoidance and should not be invoked in normal business transactions where issuance is backed by prescribed valuation. In any case, they cannot challenge the valuation as there is no enabling provision for such challenge under law, and tax authorities can’t sit in judgement of a businessman or investors and determine their revenue forecasts, or gauge the risks and rewards relating to a given business. For valuation of business and shares under the DCF method, the factors are purely commercial.

Another claim generally raised by tax authorities is that the ‘actual position’ is not aligned with the ‘projections’ made at the time of valuation. This claim has also been negated by courts, which held that the valuation needs to be undertaken based on the projections at the time of issuance of shares and can’t be compared with the actuals for the purpose of tax. While some court rulings have clarified the position and appreciated the role and value of commercial wisdom, valuation as per the DCF method continues to be challenged, especially at the tax-assessment level.

Considering that this frequent and unnecessary litigation burdens Indian businesses with heavy costs, a more pragmatic approach should be adopted by tax authorities. It would certainly aid in the ease of doing business.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s