The Hindu Business Line : Valuation in evolution

SHARE valuation can be tricky when shares are not quoted in the market. Issues such as intrinsic worth, brand valuation, earning power, and so on, come into play for fixing share value. And when such shares are transferred, arriving at the market value for working out the resultant capital gains bristles with difficulties.

A high-profile company was searched by the Income-Tax Department and documents were unearthed showing, according to the department, evasion of capital gains tax in respect of transactions with a sister firm in Mauritius.

The company had sold substantial equity shares to the Mauritius-based investment outfit at Rs 50 per share. The buyer was an overseas corporate body owned by the seller's brother.

According to the Department, the documents seized indicated undervaluation of the shares. The share valuation was done by the Department according to its own norms, resulting in a demand of Rs 811 crore.

The Department had also pointed out that the transaction was a part of merger negotiations. The matter is now before the Delhi High Court on a writ petition filed by the company.

Different methods of valuation

How does one evaluate the shares for arriving at capital gains arising out of sale? This question was considered in some detail in a private litigation (Dr Mrs Renuka Datla vs Solvay Pharmaceutical B. V. and Others — 265 ITR 435) that went up to the Supreme Court.

In this case, the Datla couple agreed to sell 4.91 per cent of the shares held by them in Duphar Pharma India Ltd (DPIL), renamed Solvay Pharma India Ltd, and Duphar Interfran Ltd (DIL).

Eminent chartered accountant, Mr Y. H. Malegam, was entrusted with the task of evaluating the intrinsic worth of both the companies — DPIL and DIL — as going concerns and the value of the said 4.91 per cent shares held by the Datlas in the two companies by applying the standard and generally accepted method of valuation. His valuation was to be regarded as final and binding an all the parties. The relevant date for valuation was fixed as March 31, 2001. Mr Malegam submitted his valuation report in September 2002. After assessing the intrinsic worth of the two companies as going concerns, he arrived at the value of 4.91 per cent shares at Rs 8.24 crore.

The sellers disputed this valuation. It was their contention that the shares should be valued on the basis that 4.91 per cent formed part of the combined holding of 25 per cent of the Indian promoters' shareholding.

The buyer was already having more than 60 per cent of share capital of each company. A premium can be attached to the 4.91 per cent of shares if it is to be held that they formed part of 25 per cent of the shares and carried special rights. This will require adding a control premium.

The sellers also contended that the two companies processed brands for original research products of the foreign promoter in pharmaceuticals. The rights over the brands were transferred by the sellers to Dupen Laboratories (P) Ltd and it was urged that the transfer was in breach of contractual obligations under the Trade Mark License Agreement. They wanted a separate value for the brands. A third area of dispute was failure to adopt the discounted cash-flow method.

The Supreme Court had to consider the dispute on valuation. Certain special rights and privileges were attached to the promoters' shareholding and the claim was that the intrinsic worth of the shares should have been assessed by adding the control premium. The litigation itself was resolved through a settlement among the parties at the instance of the court. The terms of settlement contemplated the value of the intrinsic worth of DIL and DPIL as going concerns and the value of 4.91 per cent shareholding by the petitioners had to be worked out on that basis.

The settlement never referred to adding something like a control premium. Such an important aspect, pointed out the apex court, would not have been omitted while framing the terms of settlement had the parties agreed to the valuation on that basis. What has not been said in the terms of settlement in specific and clear terms cannot be superimposed by the court while interpreting the terms of settlement.

The court has to go by the terms of the settlement and since there was no mention about control premium, it declined to give any direction in this regard. The court also pointed out that the brand of drugs stood transferred to Solvay Pharmaceuticals from Dupan Laboratories (P) Ltd and were not the existing assets of the DIL. Such transfer of brands was itself the subject matter of litigation. The question was, therefore, extraneous to the issue of valuation of the shares. The valuer has correctly taken into account data as per the relevant record and there was no error in excluding those brands.

The last objection was to the adoption of the discounted cash-flow method of valuation. This is also known as a future earning based valuation and involves discounting the net free cash flow of a business at an appropriate discounted rate. The valuer has gone by the method of capitalising past earnings and the future maintainable profits based on past performance.

The Supreme Court ruled that no prejudice whatsoever was caused to the transfer of the shares by applying the earning-based method of valuation.

The court has gone by the terms of settlement between the parties. Normally, courts do not attach any value for the control premium. These are matters which have to be considered separately when shares form part of bulk transfers in case of a change in management.

Control premium

In takeovers, negotiations normally proceed on the basis that the control and management of the company will shift. The question often posed is whether in such cases a separate value should be worked out for the controlling interest which goes with the shares. So far, the courts have consistently declined to attach any value for controlling interest.

Thus, in Venkatesh vs CIT (109 Taxman 78), the Madras High Court observed that controlling interest is just an incident of shareholding and has no independent existence. Therefore, the entire consideration for sale of shares is required to be considered for computing capital gains in the hands of the transferor.

No amount can be excluded in computing capital gains from shares on account of consideration attributable to transfer of controlling interest.

The law on share valuation is still in the process of evolution. Different aspects will have to be considered. How are brands to be evaluated? What about goodwill? How are restrictions on transfer imposed by articles of association to be dealt with? These and other issues will have to be thrashed out at the highest level.

(The author is a former Chief Commissioner of Income-tax.)