(First Published on Taxsutra: https://www.taxsutra.com/dt/experts-corner/valuations-india-cassandras-syndrome-part-1)
Background
In various corporate transactions such as primary infusions, secondary transfers, share swaps, buybacks, and capital reductions, there is often a divergence between commercially negotiated valuations on the one hand and regulatory/ tax valuations on the other hand. As Cassandra would view it, this discrepancy can complicate transactions and deemed tax implications, creating a conundrum for businesses and investors.
This article delves into the intricacies of these transactions, highlighting the various regulatory provisions, IndAS aspects, and their implications on valuations.
Theme 1: Primary Infusion through Preferential Allotment:
Scenario 1: Issuance of Equity Shares by an Unlisted Company
Issuance of equity shares by an unlisted company could be through two routes – either i) through preferential allotment[1] to a new investor, or to any particular existing shareholders, but not all; or ii) through rights issue[2] to all the existing shareholders.
Rights Issue: In case of a rights issue, the provisions of Companies Act, 2013 do not require any valuation to be undertaken. The underlying principle is that since the rights issue would be offered to all the existing shareholders in proportion of their shareholding, the rights of the existing shareholders would not be prejudicially affected.
FEMA Perspective: Under FEMA (Non-Debt Instruments) Rules, 2019 (“NDI Rules”), again, since the rights issuance would be to all the existing shareholders, no specific valuation principles are applicable; however, the only condition is that in case of rights issuance by an unlisted company, the price offered to non-resident shareholders should not be less than the price offered to the resident shareholders.
Tax – Investee Company’s Perspective: From a tax perspective, the provisions of section 56(2)(viib) of the Income-tax Act, 1961 (“ITA”) would be applicable from the perspective of the company issuing the shares. The said provisions, inter alia, provide that if the issuance of shares is at a value exceeding the face value, then the resultant share premium should be justified by one of the methods prescribed for valuation of such shares.
Valuation Methods: Valuation methodologies applicable for investment by residents is either the net book value (“NBV”) method or Discounted Cash Flow (“DCF”) method. Further, it also provides that if an investment has been received from a Category I AIF (registered as a venture capital fund) or if it has been received from certain notified[3] specific entities (such as sovereign wealth fund, FPI investors from notified[4] jurisdictions, etc.), then the price should not exceed the price at which such entities have invested.
Non-Resident Investors: For non-resident shareholders, additional valuation methods have been prescribed, viz., comparable company multiple method, option pricing method, probability weight expected return method, milestone analysis method, and replacement cost method.
Therefore, in order for the rights issue not to attract any deemed tax under the above provisions, the pricing of rights issue should be justified in accordance with any of the above methods.
Tax – Investor’s Perspective: Section 56(2)(x) of the ITA provides that any receipt of shares at a price lower than the adjusted NBV method (book value adjusted for underlying reckoner value of immovable properties, market price of listed shares/ securities, and net book value of unlisted companies) will be taxable in the hands of the person receiving such shares on the difference between the consideration and the adjusted NBV. Therefore, any issuance of shares via rights issue should be at a price which is higher than the adjusted NBV of the investee company from the investor’s perspective, but within the price determined under the valuation methodologies under section 56(2)(viib) of the ITA from an investee company’s perspective.
Disproportionate Rights Issuance: One interesting question that comes up is that what if there is a disproportionate rights issue to a particular shareholder where the shareholding of such shareholder increases disproportionately vis-à-vis other shareholders – this could arise in two cases: a) say, there are 5 shareholders, and 4 shareholders do not subscribe to the shares; or b) renunciation of rights by other shareholders in favour of the shareholder subscribing to such shares. In such cases, can the tax authorities contend that the subscribing shareholder has been enriched at the cost of other shareholders, and therefore, taxable in the hands of the subscribing shareholder? In case (a), given that the subscription would be in proportion to the rights of the subscribing shareholder, and is not disproportionate, the provisions of section 56(2)(x) of the ITA should not be applicable. However, in case (b), the tax authorities could contend that the subscribing shareholder was enriched at the cost of other shareholders, and therefore, there is an inadequacy of consideration vis-à-vis such shareholder, since the rights issue would result in higher allotment than the existing shareholding; consequently, the tax authorities could levy tax in the hands of such shareholder. This principle was observed in the cases of Subodh Menon and Sudhir Menon by the Mumbai Tribunal[5]. Irrespective, even in case (a), if it can be proven by the tax authorities that there was an implicit understanding between the shareholders, that only a particular shareholder would subscribe to the rights issue, then the provisions of General Anti-Avoidance Rules (“GAAR”) could still be attracted in the hands of the subscribing shareholder.
Preferential Issue: In case of a preferential issue by an unlisted company, valuation report from a registered value will be required. The underlying principle is that since the preferential issue will be to a particular shareholder or a new investor, to the exclusion of other shareholders, such shareholder/ investor should not be eligible to subscribe to the shares of the investee company at a discount to the fair market value, which would otherwise prejudice the interests of the existing shareholders.
FEMA Perspective: If the subscriber is a non-resident shareholder, then pricing guidelines under Rule 21 of the NDI Rules would be applicable which provides that the issuance price shall not be less than the price worked out by a CA or cost accountant or a SEBI-registered merchant banker as per internationally accepted pricing methodology.
Tax Perspective: From a tax perspective, the provisions of section 56(2)(viib) and section 56(2)(x) of the ITA would be applicable from the perspective of investee company and investor respectively.
Conundrum 1: From an investee company’s perspective, a conundrum arises in case of mismatch of valuation under various methods: For example, if the valuation under Companies Act, 2013 and FEMA is INR 100 per share, then the preferential allotment cannot be less than INR 100 per share. However, in case of resident investors (where FEMA is not relevant, but Companies Act, 2013 is), if the valuation as per DCF is INR 80 per share, then the difference between INR 100 and INR 80 (i.e., the excess between regulatory valuation and tax valuation) could be taxed as unjustified premium in the hands of the investee company. Similarly, for non-resident, if the valuation as per the five additional methods (noted above) is INR 80 per share, then the difference between INR 100 and INR 80 could be taxed as unjustified premium in the hands of the investee company. While a safe harbour of 10% difference between the valuation and the issue price is provided under section 56(2)(viib) of the ITA, it may not still be sufficient to address the difference between the regulatory valuation and the tax valuation.
Conundrum 2: From an investor’s perspective, a conundrum arises in case of distressed acquisitions – consider a scenario where the issue price (say, INR 10 which is the face value, which is also the fair market value as per FEMA/ Companies Act, 2013) is lower than the adjusted net book value (say, INR 25). In such a case, while commercially it may have been agreed upon that the investor will invest in a distressed company as a white knight, the difference in the commercial/ regulatory valuation and the tax valuation could lead to undesirable taxation in the hands of the investor. While the intent of section 56(2)(x) of the ITA was to act as an anti-avoidance measure so as to counter-act against any abuse vis-à-vis receipt of shares/ securities/ other assets under the garb of gifts, commercially negotiated transactions may unwittingly fall under the provisions of section 56(2)(x) of the ITA. This aspect has been dealt in detail later while dealing with transfer of shares between two unrelated parties, where this issue becomes much more pronounced.
Scenario 2: Preferential Issue of Equity Shares by a Listed Company
SEBI ICDR Regulations: Chapter V of the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 (“ICDR Regulations”) deal with preferential issue of shares by a listed company. In case of frequently traded shares[6], the pricing of such preferential issuance shall not be less than the volume weighted average price (“VWAP”) of the last 90 trading days, or 10 trading days whichever is higher. The said price also becomes the floor price under the NDI Rules, in case of a non-resident investor.
Requirements under Companies Act, 2013: Further, given the requirements of the Companies Act, 2013, as seen above, if the VWAP price (say, INR 90) is lower than the price determined by a registered valuer (say, INR 100), then the price determined by the registered valuer (INR 100) would become the floor price instead of the VWAP price.
Tax Perspective: While the provisions of section 56(2)(viib) of the ITA (i.e., justification of share premium) are not applicable to a listed entity, the provisions of section 56(2)(x) of the ITA would still be applicable. However, given that the issuance of shares would be by a listed company, the reference price would not be the adjusted net book value (as is so in case of unlisted companies), but the market price prevailing on the date of issuance – hence, the conundrum stated above becomes exacerbated given that the market price on the date of issuance could be a price different than what has been approved by the board of the listed company. This is so because the reference date for determining price for the preferential allotment would be the date of the board meeting, while the issuance would be subsequent to a shareholders’ resolution, which requires at least 21 days notice. Further, the fact that an in-principle approval from the stock exchanges is required to be taken before allotment of shares could increase the gap between the date of board approval and the date of issuance of shares. Of course, the argument that section 56(2)(x) of the ITA should not apply to a commercially negotiated transaction, especially in case of unrelated parties, should still continue to hold valid; however, this is yet one more scenario where a regulatory valuation and a tax valuation could lead to unintended tax consequences in the hands of the investor.
Scenario 3: Issuance of Compulsorily Convertible Preference Shares (“CCPS”) or Debentures (“CCD”) by an Unlisted Company
In case of issuance of CCPS/ CCD by an unlisted company, the valuation principles prescribed under the provisions of Companies Act, 2013 would apply since the said issuance would provide for a conversion ratio for conversion of CCPS and CCD into equity shares. Given this, the minimum price at which CCPS/ CCD shall be converted into equity shares should be the fair market value of such equity shares on a fully diluted basis. The same principle is prescribed under the NDI Rules as well, in case of non-resident investors.
Conversion Ratio under the NDI Rules: The NDI Rules further provide that the price at the time of conversion shall not be lower than the fair value worked out at the time of issuance of shares. Therefore, there could be a scenario where the conversion ratio determined upfront factors in the price of equity shares at say, INR 100 per share; further, let’s assume that the conversion ratio provides for conversion at fair market value prevailing at the time of conversion. In such a case, say, the fair market value of the unlisted company is INR 110 per share at the time of conversion (i.e., higher than the upfront determination of price at INR 100 per share), then the conversion can be undertaken considering INR 110 per share. However, if the fair market value at the time of conversion is INR 90 per share, then, notwithstanding the drop in valuation of the unlisted company, the minimum price at which the CCPS/ CCD could be converted would be INR 100 per share, resulting in lower equity shares being allotted to the non-resident shareholders. This provision highlights the dilemma for a non-resident investor who has agreed for a conversion to be at fair market value at the time of conversion (i.e., INR 90) and the regulatory valuation (i.e., INR 100), and could deter a non-resident investor from making investments in the form of convertible instruments.
Tax – Investee Company’s Perspective: From the perspective of the investee company, typically, CCPS are issued at face value, and the share premium is implicitly built into the conversion ratio. Therefore, at the time of issuance of shares the provisions of section 56(2)(viib) of the ITA should not apply, since the issue price would not exceed the face value. Similarly, the said provisions should not apply to issuance of CCDs, the provisions of section 56(2)(viib) of the ITA are only applicable to issuance of shares and CCDs are not “shares” under ITA. However, the share premium would need to be justified at the time of conversion under the methods mentioned earlier from the perspective of the investee company.
Tax – Investor’s Perspective: From the perspective of the investor, the provisions of section 56(2)(x) of the ITA would apply at the time of issuance of CCPS and CCDs as well as at the time of conversion into equity shares. The valuation rules for issuance of shares/ securities other than equity shares prescribe that the issuance shall be at or above the actual fair market value of such instruments – this would typically be complied with since the issuance would be as per the fair value determined under either Companies Act, 2013 or FEMA or both. However, at the time of conversion, since unlisted equity shares would be issued, the minimum price at which such shares should be issued would be the adjusted net book value of the unlisted company at the time of conversion, but within the valuation methods under section 56(2)(viib), as seen above. In case the conversion price is lower than the adjusted net book value, then it can lead to unintended tax consequences in the hands of the investor. This again highlights the gap between regulatory valuation and tax valuation, and ideally, the provisions of section 56(2)(x) of the ITA which are anti-abuse provisions, should not be applicable in such scenarios where an unrelated investor has invested in the investee company.
Summing Up
As seen above, the complex interplay between the regulatory valuation norms (under Companies Act, 2013, NDI Rules, or ICDR Regulations), tax valuation norms (under section 56(2)(viib) or section 56(2)(x) of the ITA) and the commercially negotiated valuation could lead to gaps in the value at which shares are issued either by an unlisted company or a listed company. Therefore, it would be only prudent for the law- and policy-makers to take a hiatus from merely introducing differing valuation norms under various laws, and evaluate their need vis-à-vis a commercially negotiated transaction.
The next part of this article would deal with certain other themes such as valuation at the time of transfer of equity shares or convertible instruments, buyback of shares, and capital reduction.
[1] Section 62(1)(c) of the Companies Act, 2013
[2] Section 62(1)(a) of the Companies Act, 2013
[3] Notification No. 29/2023/F. No. 370142/9/2023-TPL (Part-I)
[4] Notification No. 29/2023/F. No. 370142/9/2023-TPL (Part-I)
[5] Sudhir Menon HUF v ACIT [TS-146-ITAT-2014(Mum)]
[6] More than 10% of the total equity shares in the past 240 trading days