Perils of multiple methods of valuation in I-T law

Benjamin Graham once said “High Valuations entail high risks”. Section 56(2)(viib) was inserted into the Income-tax Act for curbing the practice of avoiding income tax by obtaining high valuations and parking the excess in the Share Premium Account.

Nick-named “Angel Tax”, the Section came in for much criticism and was charged with killing the entrepreneurial spirit of the start-up ecosystem. Budget 2023 proposed some amendments to the Section and Rule 11UA, a couple of changes were proposed which led to Notification No 81/2023 issued by the Central Board of Direct Taxes on September 25.

The Notification significantly amends Section 56(2)(viib). By including Compulsorily Convertible Preference Shares (CCPS) in its scope, the Notification has allayed investors’ concerns. The Section now includes non-residents also in its scope and adds all the valuation methods being used now — the Section prior to the amendment only spoke of the much-used and abused Discounted Cash Flow technique (DCF) and the Net Asset Value method (NAV).

Comparable company method, probability-weighted expected return method, option pricing method, milestone analysis method and replacement cost methods are all now a part of the literature of Rule 11UA. There is already concern in some quarters whether it would be easy to explain and convince tax officers on these new methods of valuation.

In the past, tax-payers subject to transfer pricing have had many issues with the use of the comparable company method by tax officers while ascertaining the arms-length price for international transactions. It is imperative that the National Academy of Direct Taxes (NADT) conduct training programmes to tax officers on these new valuation methods. In a welcome move, the Notification proposes exemptions to notified entities from specified nations instead of restricting the exemption only to entities registered with the Department for Promotion of Industry and Internal Trade (DPIIT).

The Notification introduces the concept of price-matching and extends the safe harbour provisions to both resident and non-resident investors. In simple terms, price-matching means that the price determined as fair market value by a notified entity can be taken as the FMV for non-notified entities.

To avail this benefit, the amount invested in the next round should not exceed the aggregate consideration received from the notified entity and the prior investment is not more than 90 days earlier.

The 10 per cent safe harbour rule means that if the issue price exceeds the FMV by not more than 10 per cent, the issue price would be accepted as the FMV. As an enabling provision, the Notification keeps provides a 90-day window for the validity of the valuation reports.

Tax officer training

Taxpayers would welcome the amendments to Section 56(2)(viib) and Rule 11A since it allays most of their concerns. However, they would still have a concern on whether tax officers will accept their choice of valuation method and the valuation that it provides.

In the dizzying world of valuation, multiple factors could impact the range of values. With such an eclectic choice of valuation methods, taxpayers could run into issues with tax officers who could choose to reject the chosen valuation method. The Companies Act makes it mandatory for valuation assignments to be done only by registered valuers. These valuers undergo a mandatory course and have to clear an exam to be able to practice the discipline of valuation. Most professional institutes in India have their own valuation organisations.

Apart from merchant bankers, the NADT could collaborate with these organisations to train their officers on the nitty-gritty of valuation. It would be interesting to see the impact of Notification 81/2023 on the quantity, quality and regularity of foreign investments.

The writer is a chartered accountant

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