Valuation Rules Announced: Transact at Fair Market Value or Pay Taxes!
In our recent analysis of the 2010 Finance Bill, we discussed the proposed amendment to section 56 of the Indian Income Tax Act, 1961 (“ITA”), and how it could be a tax trap for investors if introduced in the present form. In this update we analyse the recently released valuation rules1 relating to the proposed provision.
As per the proposed amendment, when investing companies / firms purchase shares for less than the fair market value, they would be taxed on the difference between the fair market value of shares and the consideration paid. We had pointed out that while certain kinds of share transfers have been excluded from the purview of the provision (for example, those involving public listed companies, transfers that take place in the course of specified kinds of mergers and demergers etc), share acquisitions continue to be covered.
This imposes an indirect transfer pricing requirement on purchase of a company’s shares, even where the transaction takes place within India or between unrelated parties. Some of the examples we had discussed related to investments which are not required to comply with pricing restrictions under alternate legal / regulatory regimes. For example, the provision could impact investments by foreign venture capital investors (“FVCIs”) which are not currently subject to pricing guidelines within the Indian regulatory framework, private placements, rights issues, bonus issues, investments by Indian venture capital funds etc. We had also discussed how the provision could impact certain other kinds of transfers – for example, stock repurchase by an Indian company at lower than fair market value (which may lead to the Indian company being subject to tax on the difference between buyback price and market value), transfer of shares between a parent and subsidiary, which is ordinarily considered an exempt transfer but which may attract the provisions of the proposed amendment and result in tax.
The Indian Government recently announced valuation guidelines on April 8, 2010 (“Valuation Rules”) specifying the methodology of calculation of value of inter alia shares of a company. While the Valuation Rules appear to be quite simple, however this simplicity does leave open some important points which may create issues for taxpayers in the future. As per the Valuation Rules,
· The fair market value of listed shares traded on the stock exchange shall be equal to the value as recorded in the stock exchange.
· The value of listed shares traded off the stock exchange shall be equal to the lowest price of such shares on the valuation date. If there is no trading on the valuation date, the date immediately preceding the valuation date shall be considered to determine the price.
· The formula for calculation of the value of unlisted shares appears to be geared towards using the net asset value methodology based on the difference between assets and liabilities as appearing on the face of the Balance Sheet.
While no formal report is required to be obtained from a merchant banker / accountant with respect to such valuation, the rules require reliance to be placed on the value of assets as per the balance sheet – without specifying whether the balance sheet is required to be audited. Considering that tax authorities may question the manner in which valuation has been done in the event it is based on unaudited results, this rule may result in requirement of additional audit for the company at the time of investment, thus increasing the cost and time of the transaction.
· The value of unlisted shares and securities, other than equity shares in an unlisted company, shall be estimated as per a report from a merchant banker / accountant. This rule would cover preference shares, debentures and other securities. This may add on to the cost of making the investment.
The valuation date is the date of receipt of property (including shares). It is also important to note that the Finance Act 2009 had already introduced an amendment to section 56 relating to investments by individuals at lower than fair market value. The Valuation Rules are also applicable with respect to such investments made by individuals. It is also relevant to note that while these Valuation Rules were not in place last year, tax could not be paid by individuals due to the methodology of valuation not been prescribed. The Government has however not come out with a clarification exempting such individuals from interest penalties for late payments of taxes due.
With the introduction of the Valuation Rules, the next brick has been put in place for implementation of the proposed amendment of section 56. However, the proposed amendment read along with the Valuation Rules still leave some open items which will increase the cost of doing business in India. Investors can only wait and watch and hope that the broad nature of the section 56 amendment will be addressed to factor in the pricing benefits provided under alternative regimes. It does not make sense after all, that the Indian investment regime should give with one hand and take away with the other.
1 NOTIFICATION NO 23/2010, Dated: April 8, 2010