Non-Business source of Income Section 56(2)(viib)

Non-Business source of Income Section 56(2)(viib) Introduction Section 56 of the Income Tax Act, 1961 brings into the taxation net income which is not taxable under any other head of Income specified in Section 14 items A to E. Thus Section 56 is a residuary head of income. Section 56(2) enumerates the types of income which are chargeable to Income Tax under Section 56(1). From the point of view of the responsibility of a Chartered Accountant under Section 56, we have to consider the clauses (vii), (viia) and (viib) of the Income Tax Act and Rules 11U & 11UA. These rules lay down a framework for determining Fair Market Value (FMV). As per Section 17(1) salary includes perquisites. Subsection (2) of Section 17 enumerates an inclusive list of items which are covered by the term perquisites. Clause (vi) of subsection (2) of Section 17 gives the methodology for determining the perquisite value of specified security or sweat equity allotted or transferred by an employer to the assessee. Para (d) of sub clause (vi) of clause (2) of Section 17 defines Fair Market Value for the purposes of Section 17(2)(vi). This article primarily focuses on the determination of Fair Market Value of unlisted shares and securities under Section 56(2)(vii), 56(2)(viia) Section 56(2)(viib) and Section 17(2) of the Income Tax Act, 1961 The questions which arise on a reading of Section 56 and Section 17 are: 1) What are the general principles governing the valuation of unlisted shares and securities? 2) What are the commonly used valuation methodologies for valuing unlisted shares and securities? 3) Whether one method can be applied to determine fair market value or multiple methods need to be applied? 4) (a) What are the methods prescribed for determination of fair market value under (b) (c) Section 56(2)(vii), 56(2)(viia) Section 56(2)(viib) and Section 17(2) of the Income Tax Act, 1961? Whether the methods prescribed under Section 56(2) are reliable? Whether the methods prescribed under section 56(2)(viib) are in consonance with other laws (eg. FEMA)? 60 Income Tax Review

The basic principles which govern any valuation exercise are: a) Value is derived from the future The investor expects a certain return on his investment. These returns can be generated only by future profits. Thus Valuation of a business is primarily based on future expectations. b) Generally companies in distress would have a value which is close to the sum of Market Value of its assets. In fact, in the case of such companies, the valuation of the Equity may be lower than the sum of the market value of the assets due to transaction cost and time cost in executing the sale of assets. c) Value can change according to the purpose of valuation. eg: A strategic investor will generally pay d) Valuation is affected by macroeconomic and micro economic factors. Thus valuers views on factors like GDP growth rate, interest rates, currency exchange rates, rate value. e) The earning of cyclical firm is volatile and depends on economic cycles. The earnings will be high when the economy is booming, while the earnings will be depressed in recession. Thus while valuing cyclical companies, the valuer has to factor in the state of the economy. f) While valuing illiquid assets like shares of unlisted Companies one has to give due consideration to the illiquidity of the shares. This is known as Discount for illiquidity. This discount varies from 10% to 30% depending on the facts of the case. The Courts in the US and UK have accepted the concept of discount for illiquidity g) Control premium is the additional price a buyer is willing to pay in order to gain control over the management of the company. Thus the valuer has to bear in mind, whether the valuation is for a minority stake or a controlling stake. If the valuation is for a controlling stake, then the valuation ought to be higher than that for a minority stake. h) Finally, it is the quality of management which makes the difference in the value of a company. Quality of Management is a term which is easy to comprehend but to measure in monetary terms. This will Companies under explanation (a)(ii) of clause (viib) of sec. 56(2) of the Income Tax Act, 1961. There are several established and well recognized methods of valuation. Some of the methods are: a) DCF Valuation b) Net Asset based Valuation c) Relative Valuation a) DCF Valuation The general model of DCF valuation involves discounting the future cash flows of the Company. For this method, the valuer requires the future free cash flows of the Company, the growth rate in the terminal year and the discounting rate. b) Net Asset based Valuation It arrives at valuation in terms of book net worth of the company. This method is usually not a good indicator of the value of a going concern as: Income Tax Review 61

It ignores business potential It does not take intangibles into account It is impacted by accounting practices Net Asset based Value is useful only when: the fair value There is threat of survival of the business. This is the method prescribed for valuation of unquoted equity shares under Rule 11UA(c)(b) of the Income Tax Rules, 1962. c) Relative Valuation In Relative Valuation, certain ratios are calculated and compared with the ratios of other similar listed Companies to ascertain fair value on a relative basis. The most commonly used ratios are: Rule 11UA of the Income Tax Rules specifies the method of calculating fair market value. As per Rule 11UA(c)(b), the fair value of unquoted equity shares is equal to the book value. Since the Rule specifies that the book value is equal Value Ratio should be 1. We will now study the Price to Book Value Ratio: following: a Company is charging depreciation on WDV, then in the initial years its book value would be lower than that of an identical Company charging depreciation on Straight line method. do not require significant investment in fixed assets. For example, Companies in Software and e-space have a low fixed asset base. Therefore such Companies tend have negative earnings in the initial few years but very high potential earnings. Such companies also tend to have a high with high return on equity tend to have a The FMV arrived at by different methods would generally lead to different values for the same share. In such a situation, the valuer has to exercise his professional judgment and arrive at a single value based on weights assigned to the values arrived at by different methods. This way, the valuer is able to identify and isolate the outliers. If necessary he can have a relook at the values arrived at by particular method. He is thus able to arrive at a more valuer generally does not depend on a single method but uses multiple methods to value unquoted shares. Income-tax Act, 1961 Section 56(2)(vii) and 56(2)(viia) lays down the provisions for taxation in the hands of recipient of unquoted shares and securities, if certain conditions are not met. Section 56(2)(viib) on the other hand, lays down the ground rules for taxation in the hands of the company which has issued unquoted shares and securities. 62 Income Tax Review

Sec. 56(2)(vii) and Sec. 56(2)(viia) of Income Tax Act, 1961 56(2)(vii): This sub section was inserted by the Finance (No. 2) Act, 2009, w.e.f. 1-10-2009. Sub para (c) inter alia states that where an individual or HUF receives from any person or persons, on or after 1st day of October, 2009, any property other than immovable property (i.e. both listed and unlisted shares), - (i) (ii) Without consideration, the aggregate fair market value of which exceeds fifty thousand rupees, the whole of the aggregate fair market value of such property; For a consideration which is less than the aggregate fair market value of the property by an amount exceeding fifty thousand rupees, the aggregate fair market value of such property as exceeds such consideration: then such income will be chargeable to tax. Further, Explanation (d) of this section, lists out the Capital Assets which are covered under the word Property. As per this sub para Property includes listed and unlisted shares & securities. As per explanation para (b) of this sub section, FMV of a property other than immovable property is the value as may be determined by Rule 11U and 11UA. The 2nd Proviso to this section states that this clause shall not apply to any sum of money or any property received (a) (b) (c) (d) from any relative; or on the occasion of the marriage of the individual; or under a will or by way of inheritance; or in contemplation of death of the payer; or Explanation to clause (20) of section 10; or (f) (g) from any fund or foundation or university or other educational institution or hospital or other medical institution or any trust or institution referred to in clause (23C) of section 10; or from any trust or institution registered under section 12AA. 56(2)(viia): Section 56(2)(viia) is applicable to Firms and Companies in which the public are not substantially interested. If such firms or companies in which public are not substantially interested, receive on or after 1st June 2010 any property being shares of a company in which public are not substantially interested (i.e. only unlisted shares), (i) (ii) Without consideration, the aggregate fair market value of which exceeds fifty thousand rupees, the whole of the aggregate fair market value of such property; For a consideration which is less than the aggregate fair market value of the property by an amount exceeding fifty thousand rupees, the aggregate fair market value of such property as exceeds such consideration: then such income will be chargeable to tax. For this sub-section also, the FMV of unlisted shares and securities will have to be valued as per Rule 11U & 11UA. Rule 11U and Rule 11UA of Income Tax Rules, 1962 The relevant Rule 11U and Rule 11UA are given in Annexure I. As per the said Rule 11UA, the valuation of Shares and Securities is classified into three types: a) FMV of Quoted Shares and Securities: Rule 11UA (c)(a) states that FMV of quoted shares and securities shall be the transaction value if they are received by way of transaction on a recognized stock exchange. If the shares are Income Tax Review 63

received through off market transaction, then the lowest price quoted on the recognized stock exchange on the valuation date or if there is no trading on that day, then the lowest price on the immediately preceding date shall be the FMV. b) FMV of Unquoted Shares and Securities (equity shares): The FMV of unquoted equity shares is basically the book value as per the balance sheet on the valuation date adjusted for advance tax paid and the excess provision for income tax. The valuation date is the date on which the shares are received by the assessee (Rule 11U(j)). Further, balance sheet means the balance sheet as on valuation date. Thus, for every transaction the company will have to draw a balancesheet. While the rule is silent on whether the balance sheet should be an audited balancesheet, it appears that to avoid any dispute regarding the valuation, it would be advisable to have an audited balance-sheet as on the date of valuation. This has cast very onerous responsibility on the company whose shares are subject matter of valuation. Illustration of Valuation: Let us understand the provisions as contained in the above Rules with the help of an illustration Liabilities Amount Assets Amount Shareholder s Funds Non Current Assets Share Capital 500,000 Fixed Assets 650,000 (50,000 equity shares of `10 each fully paid up) Non Current Investments 24,500 Reserves and Surplus 80,000 Long Term Loans and advances 55,000 Non current liabilities Long term borrowings 220,000 Current Liabilities 580,000 729,500 Current Assets Short term borrowings 50,000 Inventories 45,000 Trade payables 61,000 Trade receivables 75,000 Other Provisions Cash and cash equivalents 25,000 Provision for IT 21,500 Other current assets 38,000 Less: Adv Tax 20,000 1,500 112,500 183,000 TOTAL 912,500 TOTAL 912,500 64 Income Tax Review

The fair market value as per Rule 11UA would be as under: (A L) (PV) (PE) = ` 11.63 Where, advance tax 912,500 Less: Paid up Equity Shares (500,000) Less: Reserves other than those set apart towards depreciation (80,000) Less: any amount representing provision for IT, other than amount paid as advance tax under the IT Act, to the extent of the excess over the tax payable with reference to the book Net Assets 81,500 PE - Amount of paid up equity share capital 500,000 PV - Paid up value of such equity shares 10 Appropriateness of the Method: As discussed earlier, the valuation based on book value is on a conservative side and except in the In addition, since it is based on the balance-sheet, the valuation will be less subjective. c) FMV of unquoted shares and securities other than unquoted equity shares: The FMV of unquoted shares and securities other than unquoted equity shares shall be estimated to be the price it would fetch if sold in the open market on the valuation date and the assessee obtains a report from a Category I merchant banker or a Chartered Accountant in respect of such valuation. Thus, for valuation of unquoted shares and securities, other than equity shares there are no prescribed methods which are laid down. This is left to the professional judgement of the valuer. Valuation under section 56(2)(viib) Sec. 56(2)(viib): Where an unlisted company issues shares and receives from any resident person, the consideration which exceeds the face value of such shares, then the difference between the aggregate consideration received and FMV of shares shall be charged to Income from Other Sources. Income Tax Review 65

This clause was inserted by the Finance Act, 2012 w.e.f. 1st April, 2013. As per the clause 56(2)(viib) where an unlisted company issues shares and receives from any resident person, any consideration which exceeds the face value of such shares, then the difference between the aggregate consideration received and FMV of the shares shall be charged to tax. This does not apply to consideration received from: i) Non- residents ii) iii) by a venture capital undertaking from a venture capital company or a venture capital fund from a class of classes of persons, as may While sections 56(2)(vii) and 56(2)(viia) are concerned with consideration being less than the FMV, section 56(2)(viib) brings into the tax net, consideration received by a company, which is in excess of FMV. Under FEMA, shares issued to non residents have to be valued on DCF basis. There are no rules prescribed for valuation of shares issued to Venture Capital Company or Venture Capital Fund. We now have a very incongruent situation where a company desiring to issue shares to residents, non- residents and a venture capital company or venture capital fund on the same day could have three different FMV of the shares. Which of these three FMV s would be fair and which would be not fair or unfair? Such a situation would create an impasse as it would be unfair to existing shareholders as their percentage of dilution would vary according to the type of the investor coming in. it is also unfair to the investor who is saddled with a higher valuation. For the purpose of this clause, the FMV shall be: a) Value as per Rules 11u and 11UA OR b) As may be substantiated by the company based on the value, on the date of issue of shares, of its assets, including intangible assets being goodwill, know-how, patents, copyrights, trademarks, licenses, franchises or any other business or commercial rights of similar nature. Whichever is higher. We have already discussed the valuation as per Rules 11U and 11UA. While these rules base the FMV on the book value of the shares as on the valuation date, Explanation (a)(ii) of section 56(2) (viib) bases the valuation on the market value of its tangible and intangible assets. of tangible assets. Therefore valuing those should not pose a challenge. However intangibles will pose several problems both in This is best illustrated by a case study: Case Study 1: merchant payment using mobile phones and the internet. The company has incurred losses upto 31st barely managed to break even. The book value per share is ` 7 only. The potential for payment using mobile phones is phenomenal, given the large user base. At the same time, there are various challenges, in terms of acceptability by customers, scaling up etc. If the company successfully faces the challenges then it could become a huge success story. If it does not, then it will become bankrupt. 66 Income Tax Review

Taking into consideration the background of the promoters, private investors, who are residents, are willing to invest into the shares of the company. The valuation mutually agreed upon is ` 400 per share, based on DCF method. The book value of the share is only ` 7 per share. The market value of the tangible assets, mainly computers, is ` 5 per share. Thus: FMV on DCF method is ` 400 per share. FMV on the bases of Rule 11U and 11UA is ` 5 per share. In order to arrive at FMV under Explanation (a)(ii) of sec. 56(2)(viib), the valuer will have to firstly identify all the intangible assets, Secondly value each of the intangible assets and lastly total up the value of the tangible and intangible assets. If such total is equal to or more than ` 400 per share, then there would not be any tax liability If however, the total is less than ` 400 per share, say, it is ` 360 per share, then the Company will be liable to pay Income Tax on the difference ` 40 multiplied by the number of shares issued. Valuation under section 17(2)(vi) security or sweat equity shares allotted or transferred, directly or indirectly by the employer or former employer, free of cost or at concessional rate to the assessee. Sub clause (c) states that the value of any specified security or sweat equity shares shall or sweat equity shares, as the case may be, on the date on which the option is exercised by the assessee as reduced by the amount actually paid by, or recovered from, the assessee in respect of such security or shares; As per sub clause (d), FMV means the value determined in accordance with the method as may be prescribed. Surprisingly, no method has been prescribed for determination of FMV under section 17(2)(vi). Therefore, the valuer is free to adopt any method The Valuation methodology prescribed by Rule 11U & Rule 11UA are applicable to Sections 56(2)(vii), 56(2)(viia) and 56(2)(viib). However, sec 56(2)(viib) has alternative basis of valuation based on market value of tangible and intangible assets. At the same time sec. 56(2)(viib) is not applicable to shares issued to Non- Residents and also where consideration is received for shares from a Venture Capital Company or Venture Capital Fund. This makes difficult, the task of company wanting to issue at one point in time shares to Residents, Non-residents and Venture Capital Also, the methodology for determining the market value of intangible assets is neither well established nor are guidelines are issued for valuation of the same. This is therefore bound to lead unnecessary confusion and litigation. It would have been better if the valuation of unlisted equity shares under sec. 56(2) (viib) had been left to the judgement of Accountant along the same lines as has been done for valuation of unquoted shares and securities other than equity shares as per Rule 11UA(c)(c). Income Tax Review 67