(First Published on Taxsutra: https://www.taxsutra.com/dt/experts-corner/valuations-india-cassandras-syndrome-part-2)
Background
Part 1 of this article series[1] dealt with divergence between commercially negotiated valuations on the one hand and regulatory/ tax valuations on the other hand in case of rights issue and preferential issue of equity shares, and preferential issue of compulsorily convertible instruments. This part continues to analyse this divergence further with respect to capital reduction and buybacks.
Theme 1: Capital Reduction of Shares
Companies Act, 2013: Capital reduction of shares involves reduction in either the face value of shares or cancellation of shares, either with or without payout. The said process requires an NCLT approval under section 66 of the Companies Act, 2013. From a valuation perspective, while the provisions of the Companies Act, 2013 do not stipulate any specific valuation principles, given that capital reduction would be approved by an NCLT, the general practice is for companies to obtain a valuation report in case if such capital reduction entails a payout by a company to its shareholders. The underlying principle is that the shareholders should be in a position to approve after ascertaining whether the price at which capital reduction is being undertaken is fair or otherwise, and therefore, a valuation report is required from a commercial perspective.
FEMA (Non-Debt Instruments) Rules, 2019 (“NDI Rules”): Under the NDI Rules, given that the capital reduction would entail extinguishment of shares of an Indian company held by a non-resident, the price at which capital reduction could be undertaken price would be restricted to a maximum cap determined by a CA or cost accountant or a SEBI-registered merchant banker as per internationally accepted pricing methodology. Of course, there is no bar under the NDI Rules, if the capital reduction is undertaken at a price lower than such cap.
Tax – Investors’ Perspective: While detailed tax implications in case of a capital reduction with respect to whether capital loss on capital reduction would be available to the investors was dealt with in an earlier article[2], it would be important to evaluate the interconnect between a commercially agreed price for capital reduction vis-à-vis tax valuation under Rule 11UAA and Rule 11UA read with section 50CA of the Income-tax Act, 1961 (“ITA”). This is so because capital reduction especially in case of cancellation of shares is considered as a “transfer” within the meaning of section 2(47) of the ITA since capital reduction would result in the extinguishment of shares of the company undertaking the capital reduction. Before delving into the specific valuation norms for valuing CCPS or equity shares for the purposes of section 50CA, it is important to note that the said section only applies in case of capital reduction with payout, since the primary condition for trigger of section 50CA is that there should be consideration received or accrued, which would not be so in case of a capital reduction without payout.
- Valuation in case of capital reduction of CCPS or Optionally Convertible Preference Shares: In case of capital reduction of CCPS, Rule 11UAA read with Rule 11UA of the Income-tax Rules, 1962 provides that the underlying actual fair market value of such CCPS (i.e., price that such instrument would ordinarily fetch in the open market), as determined by a CA or a merchant banker, would be considered as deemed consideration in the hands of the investor. Therefore, if the capital reduction with payout is lower than such value so determined by a CA/ merchant banker, then, for the purposes of computing capital gains, the actual fair market value so determined would be deemed to be the full value of consideration.
- Valuation in case of capital reduction of Equity Shares: In case of capital reduction of equity shares, the said valuation rules provide that the adjusted NBV shall be deemed to be the full value of consideration in the hands of the investor, and therefore, any difference in the capital reduction price and the adjusted NBV shall still be subject to capital gains tax in the hands of the investor, if the capital reduction price is lower than the adjusted NBV.
- Conundrum 1 – Capital Reduction by a loss-making company: Consider a scenario where there is a loss-making company, albeit its adjusted NBV is higher than the capital reduction price. This could be so if the company has not otherwise booked losses or created provisions in its books, or the reckoner value of any immovable property held is much higher than the historical carrying amount. Therefore, the underlying valuation of such company could be lower than its adjusted NBV. In such a scenario, even if the capital reduction of equity shares is undertaken at the actual fair market value (say, face value of INR 10), given that the adjusted NBV would be higher (say, INR 100), there could be unwarranted deemed capital gains tax implications in the hands of the investor, assuming that the original investment by the investment (say, INR 50) was lower than the adjusted NBV (i.e., INR 100). Given that section 50CA was introduced with an intention to act as an anti-abuse provision to mitigate the effects of an understated consideration, where the presumption could be that the deficit in consideration is paid through non-banking channels, it begs the question that whether such anti-abuse provision should apply in case of a capital reduction which is backed by a valuation report and due process of law is followed since an NCLT approval would also be required.
- Conundrum 2 – Capital Reduction involving non-residents: In case of capital reduction involving non-residents, the maximum price at which capital reduction could be undertaken would be capped as per the price determined as per internationally accepted pricing methodology under the NDI Rules. The said rules could be much lesser than the adjusted NBV since the price is based as per internationally accepted pricing methodology. Therefore, even if there is a statutory pricing cap under the NDI Rules, it could result in deemed capital gains tax implications in the hands of the investor, which would be an absurd scenario logically, especially when there is a statutory pricing cap under the NDI Rules.
- Conundrum 3 – Representative Assessee Liability in case of capital reduction involving non-residents: In case of a capital reduction involving a non-resident, if the capital reduction results in a deemed capital gains tax liability on account of the difference between the actual consideration paid and the adjusted NBV, the Indian company which undertakes such capital reduction could be deemed to be a representative assessee under section 163 of the ITA for the non-resident, the tax consequences, therefore, would then lie on the Indian company. This would result in the already absurd consequences being compounded in the hands of the Indian company, even though the statutory pricing under NDI Rules and the due process of law through NCLT approval would have otherwise been followed.
Theme 2: Buyback of Equity Shares by an Unlisted Company
Companies Act, 2013: A buyback is a special form of capital reduction, permitted under section 68 of the Companies Act, 2013, subject to various conditions such as maximum buyback permissible is up to 25% of the net worth and 25% of the total number of shares, source of funding should be from reserves/ securities premium, and not from monies raised by issuance of similar kind of shares earlier, maintenance of a debt equity ratio post buyback, cooling off period for issuance of same kind of shares (upto 6 months), and restriction on any further buyback for a period of 12 months. Typically, a buyback would only require board approval (if the buyback is less than 10%) and shareholders’ approval (if the buyback is in excess of 10% but lower than the statutory limit of 25%). The said section does not provide for any valuation principles with respect to a buyback. The underlying principle is that a shareholder would not ordinarily tender his shares under buyback if he does not find the buyback price commercially attractive.
NDI Rules: Under the NDI Rules, given that buyback would essentially entail “transfer” of equity shares of an Indian company by a non-resident to a resident (i.e., company buying back the shares) for the limited purposes of extinguishment of such shares, the buyback price would be restricted to a maximum cap determined by a CA or cost accountant or a SEBI-registered merchant banker as per internationally accepted pricing methodology. Of course, there is no bar under the NDI Rules, if the buyback is undertaken at a price lower than such cap.
Tax – Company’s perspective: Any company undertaking a buyback would be liable to pay tax under section 115QA of the ITA, at the rate of ~23% on the difference between the consideration paid by the company to its shareholders on and the amount received by the company on the issue of such shares. The question from a valuation perspective is whether any buyback undertaken at a value which is lower than the adjusted NBV determined under Rule 11UA read with section 56(2)(x) of the ITA would be liable to tax on such difference between the amount of buyback and the adjusted NBV in the hands of the company undertaking a buyback under section 56(2)(x) of the ITA, given that there would be a purported receipt of shares by the company undertaking a buyback, albeit for the limited purposes of extinguishment of shares upon buyback.
In various decisions[3] by various Income-tax Appellate Tribunals, it was held that a transaction of buyback by the company of its own shares, does not involve the receipt of any property, since a receipt of capital asset (i.e., shares in this case) could become property of a person only if it is the property of any other company, and not of itself. Therefore, a buyback should not be covered by the provisions of section 56(2)(x), even if it is at a value which is less than the adjusted NBV.
Tax – Shareholders perspective: Section 10(34A) of the ITA provides that the consideration received by shareholders from a buyback is exempt from tax in the hands of the shareholders. Therefore, a question arises whether the provisions of section 50CA of the ITA would apply in the hands of the shareholders, if the buyback consideration is less than the adjusted NBV of the unlisted company. Given that section 10(34A) exempts any income arising on account of buyback in the hands of shareholders, the said income should not fall within the charging machinery under section 14 read with section 45 of the ITA. Therefore, the question of applicability of section 50CA, which is a deeming fiction to determine full value of consideration on transfer of shares for the purposes of computing capital gains income, would be rendered otiose.
Summing Up
As seen above, the complex interplay between the regulatory valuation norms (under the Companies Act, 2013 or the NDI Rules), tax valuation norms (under section 50CA or section 56(2)(x) of the ITA) and the commercially negotiated valuation could lead to divergence in the value at which shares are bought back or cancelled. The underlying principle for consideration of the law makers would be that when a due process of law is followed through NCLT approval or under the NDI Rules, over-prescriptive valuation provisions under the tax law would hinder a commercially negotiated transaction.
The next part of this article would deal with the last theme under this article series i.e., transfer of equity shares of an unlisted company, and that of a listed company, and transfer of compulsorily convertible instruments of an unlisted company.
[1] Valuations in India: A Cassandra’s Syndrome – Part 1
[2] Corporate Liposuction – Capital Reduction et al
[3]DCIT v TPS Infrastructure Limited (Delhi Tribunal) [TS-7629-ITAT-2022(DELHI)-O], DCIT v Globe Capital Market Limited (Delhi Tribunal) [TS-8238-ITAT-2023(DELHI)-O], Vora Financial Services P Ltd v ACIT (Mumbai Tribunal) [TS-346-ITAT-2018(Mum)], VITP P Ltd v DCIT (Hyderabad Tribunal), and DCTT v Venture Lighting India Ltd (Chennai Tribunal) [TS-7399-ITAT-2022(CHENNAI)-O]