CBDT prescribes Valuation Rules for Slump Sales: Plugging the Gap
Recently the Central Board of Direct Taxes (“CBDT”) released the much-awaited valuation rules for computing capital gains arising from a slump sale (“Valuation Rules”). The Valuation Rules come on the heels of an amendment made earlier this year via the Finance Act, 2021 requiring capital gains from slump sales to be computed with reference to fair market value (“FMV”) of the undertaking being transferred.
A slump sale has been defined as the transfer of one or more undertakings for a lump sum consideration without assigning values to individual assets. By way of a deeming fiction under the provisions of the Income Tax Act 1961 (“ITA”), profits and gains arising from a slump sale are chargeable to tax as capital gains.1
For purposes of computing capital gains from a slump sale, the net worth of the undertaking is deemed to be the cost of acquisition.2 Prior to the Finance Act, 2021, there was no stipulation regarding the determination of the full value of consideration for computing capital gains in case of slump sales. However, the Finance Act 2021 brought about an amendment in this regard which provides that the full value of consideration shall be deemed to be the FMV of the undertaking to be determined as per prescribed rules (“Amendment”). The rules for determining this FMV is what has been prescribed by the Valuation Rules.
The Valuation Rules provide two methods for determining the FMV and the higher of the two shall be considered to be the FMV. The two methods are:
The Valuation Rules provide that the value for computing capital gains in case of slump sales shall be determined as on the date of the slump sale.
In case of transfer of shares and immovable property, the computation provisions under the ITA provide that if the full value of consideration is less than the FMV, then the FMV shall be deemed to be the full value of consideration for the purposes of computing capital gains.3 However, no such provision existed in respect of business transfers by way of slump sales. As such, there were no restrictions on the price at which slump sales could be carried out from a tax computation perspective. This made slump sales a very attractive tool for domestic M&A and restructurings, and for the India leg of multi-jurisdictional M&A.
The Amendment read with the Valuation Rules, by providing that the higher of the actual consideration or the FMV (determined in the prescribed manner) shall be deemed to be the full value of consideration for computing capital gains in slump sales, seek to align the rules pertaining to valuation for transfer of shares and immovable property with that of business transfers by way of slump sales, plugging the gap on the tax arbitrage opportunity that slump sales provided.
As a result, businesses will now be guided by a certain sense of pricing in respect of slump sales, at least insofar as ascertaining the tax implications are concerned. In multi-jurisdictional M&A involving an India-level slump sale, the Valuation Rules will also need to be factored in while undertaking purchase price allocation to Indian assets.
Further, even in terms of valuation of specific assets for FMV1, the attempt has been to align the rules with those for valuation of property for the purposes of transfer of shares and immovable property.
Even though there were no pricing restrictions until now, most slump sales were being carried out at book value. As is evident, the formula for FMV1 is akin to book value except that fair valuation is required to be done for shares and immovable property owned by the undertaking being transferred. Hence, in case of transfer of undertakings that do not contain immovable property / shares, not much has changed in respect of the valuation methodology for slump sales. Further, if the conservative view in respect of applicability of section 56 to slump sales were to be considered, then even with respect to undertakings containing shares and immovable property, not much has changed because of the Valuation Rules since section 56 anyway requires a book value computation similar to the Valuation Rules.
An added complexity arises in case of intra-group restructuring exercises involving slump sales. Such intra-group slump sales may in certain cases be subject to transfer pricing regulations where they are ‘deemed international transactions’ under Section 92B(2) of the ITA. In such cases, a question arises as to whether valuation as per the arm’s length standard under the transfer pricing regulations will need to be undertaken for an intra-group slump sale, or whether the Valuation Rules would apply.
Having said the above, the key feature of a slump sale, which is the primary reason for its attractiveness, i.e. the cost of acquisition is deemed to be the ‘net worth’ of the undertaking still remains. This allows the taxpayer to disregard the cost of acquisition and holding periods of each underlying asset. It permits a claim of the concessional tax rate on long term capital gains to an undertaking that as a whole has been held for three years or longer, regardless of how long the underlying assets may have been held. Owing to this feature, despite the Valuation Rules and the complexities arising therefrom, slump sales are likely to continue to be opted for as a preferred mode for business transfers in India.
1 Section 50B (1), Income Tax Act, 1961
2 Section 50B(2)(i), Income Tax, 1961
3 Sections 50C and 50CA, ITA