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Executive Summary: This Article authored by our Founder Director Sh. Mayank Mohanka, FCA, captures and explains all the nuances and nitty-gritties of prescribed Share Valuation Rules and the Enigma therein from the eyes of both the Investor and the Investee.

Once upon a time, in the ‘Durbar’ of ‘Raja Krishna Dev Raya’, the king of ‘Vijaya Nagar’ Empire, in Southern India, two persons named ‘Vyapari’ and ‘Niveshak’ came for seeking justice, in respect of a dispute arising out of the ‘Mulyankan Pranali’ (valuation rule) prescribed by the kingdom, in respect of accepting and or making investments in business transactions.

Vyapari has commenced his ‘Vyapaar’ (business) 10 years back by inducting a seed capital of 200 ‘swarna mudrayen’ (then prevailing currency), ‘Abhushan’ (precious gems and jewellery) of 300 swarna mudrayen and ‘Bhumi’ (land) and ‘Karkhana’ (factory building) of 500 swarna mudrayen.

In view of severe competition, Vyapari has started incurring some losses since last 2-3 years. So, in order to beat competition, he decided to upgrade his manufacturing technology and for this upgradation he needed some capital investments. In the meanwhile, ‘Niveshak’ was having some investible funds and he wanted to invest the same in the ‘Vyapaar’ of Vyapari.

So, both Vyapari and Niveshak executed a ‘Kararnama’ (an agreement) wherein ‘Niveshak’ will invest his capital funds in the Vyapaar of Vyapari and in return will get a 20% business ownership stake.

Now came the critical question of determination of the consideration for the execution of this business deal. The ‘Lekhakrit Bahikhata’ (audited Balance Sheet) of the Vyapaar (business) of Vyapari, as on the date of agreement appeared as under:

‘Lekhakrit Bahikhata’ (Audited Balance Sheet)

*As per the prescribed ‘Lekha Manak’ (accounting standard), prevalent in the kingdom, the carrying/book values of bhumi (land) & karkhana (factory) and abhushan (gems & jewellery) in the above Balance Sheet had been taken at their respective costs of acquisition/actual purchase costs in the hands of Vyapari. However, the current market value of the said land and factory building, on the date of agreement was 800 mudra and for gems and jewellery, it was 400 mudra.

The ‘Kar-Vibhag’ (Tax Administration Wing) of the Kingdom has prescribed two different ‘Mulyankan Pranali’ (share valuation) Rules respectively for the Vyapari and Niveshak.

The valuation rule as stipulated for the Vyapari was the ‘Shudh Sampatti’ (Net Asset) method based on the ‘Lekhakrit Bhaikhata’ (audited Balance Sheet), on the date of agreement.

Accordingly, the Vyapari has to calculate the valuation of his business, as per the Net Asset Method based on audited Balance Sheet, on the date of above Kararnama (agreement), as under:

So, the valuation of 20% ownership stake of the above business of Vyapari, having the total intrinsic value of 1300 mudras, as per the stipulated Net Asset method based on actual acquisition cost of land, building and gems, in the hands of Vyapari, was coming out at 260 mudras (being 20% of 1300 mudras).

However, the valuation rule as stipulated by the kingdom, for the Niveshak was the ‘Bazaar Mulya Sampatti Avlokan’ (Net Assets based on Market Value) method, according to which, the current market values of land & factory building and gems & jewellery were to be taken in place of their respective acquisition/purchase costs.

Accordingly, the Niveshak has to calculate the valuation of the Vyapari’s business, as per the Net Asset Method based on current market values, on the date of above Kararnama (agreement), as under:

So, the valuation of 20% ownership stake of the above business of Vyapari, having the total market value of 1700 mudras, as per the stipulated Market Value Net Asset method in the hands of Niveshak, was coming out at 340 mudras (being 20% of 1700 mudras).

Therefore, on account of two different prescribed set of valuation rules for the Vyapari and the Niveshak, by the kingdom, the Vyapari couldn’t receive any consideration in excess of 260 mudras, and the Niveshak couldn’t pay any consideration less than 340 mudras, in respect of the 20% business stake. 

So, it is this genuine dilemma and enigma, which has brought both the Vyapari and the Niveshak in Raja Krishnadev Raya’s Rajdurbar, for its much-needed redressal.

Further, the Vyapari has pleaded one more justifiable plea before the king that in order to get a fair value for his business, he should be able to receive consideration for his business based on the current market value of his business assets and not as per their historical/acquisition costs.

The above tale narrated in fiction infact represents the actual dilemma and concern of the investee company and the investor, in the current times, due to two different and contradictory valuation rules prescribed in the Income Tax Rules in section 56(2)(viib) in respect of investee company and in section 56(2)(x)(c) for an investor.

While section 56(2)(x)(c) requires the Investors to acquire shares at a value equal to or higher than the Fair Market Value (FMV) of such shares, section 56(2)(viib) requires the Investee Company to ensure that the shares are not issued at a price higher than the FMV. Both sections provide for an opposite approach for investors and investee company respectively, and the valuation mechanism are also different.

For the purpose of section 56(2)(x), in the hands of investors, the shares are to be valued as per adjusted Net Assets Value (NAV based on circle rates of land & building); and for the purpose of section 56(2)(viib), in the hands of investee company issuing shares, there is a choice between absolute NAV (based on historical acquisition costs of land & building) and DCF method of valuation.

(I) Prescribed Valuation Methodology for Investee Company issuing Shares in Section 56(2)(viib):

The Rule 11UA(2) of the Income Tax Rules, stipulates two methods for Valuation of Unquoted Equity Shares in the hands of Investee Company issuing shares, as under:

(a) The fair market value of unquoted equity shares = (A–L) × (PV), (PE), where,

A= book value of the assets in the balance-sheet as reduced by any amount of tax paid as deduction or collection at source or as advance tax payment as reduced by the amount of tax claimed as refund under the Income-tax Act and any amount shown in the balance-sheet as asset including the unamortized amount of deferred expenditure which does not represent the value of any asset;

L= book value of liabilities shown in the balance-sheet,

PE= total amount of paid-up equity share capital as per balance sheet

PV=the paid-up value of such equity shares

OR,

(b) The fair market value of the unquoted equity shares determined by a merchant banker as per the Discounted Free Cash Flow (DCF) method.

(II) Prescribed Valuation Methodology for Investors investing in Shares [Section 56(2)(x)(c):

The Rule 11UA(1)(c)(b) of the Income Tax Rules, mandates the valuation of unquoted equity shares in the hands of investors, for the purpose of Section 56(2)(x) as under:

1. the fair market value of unquoted equity shares shall be the value, on the valuation date, of such unquoted equity shares as determined in the following manner, namely:

• the fair market value of unquoted equity shares = (A+B+C+D - L)× (PV)/(PE), where,

• A= book value of all the assets (other than Jewellery, artistic work, shares, securities and immovable property) in the balance-sheet as reduced by,

  • any amount of income-tax paid, if any, less the amount of income-tax refund claimed, if any; and

  • any amount shown as asset including the unamortized amount of deferred expenditure which does not represent the value of any asset;

• B = the price which the Jewellery and artistic work would fetch if sold in the open market on the basis of the valuation report obtained from a registered valuer;

• C = fair market value of shares and securities as determined in the manner provided in this rule;

• D = the value adopted or assessed or assessable by any authority of the Government for the purpose of payment of stamp duty in respect of the immovable property;

• L= book value of liabilities shown in the balance sheet

For better clarity and easy understanding, the otherwise lengthy and complicatedly worded prescribed share valuation rules in the Legislature are being presented in a ready referencer tabular form below:

Reason for Adoption of DCF Method of Share Valuation by Investee Company

As per Rule 11UA(2), the Investee Company has the choice to value equity shares by using:

1. Net Assets method considering book values of assets and liabilities as per audited balance sheet (as on transaction date or a date preceding the transaction date); or

2. Discounted Cash Flow (DCF) method determined in accordance with the Valuation Report of an approved Merchant Banker.

However, on account of the different and contradictory prescribed valuation criteria as discussed and demonstrated above, in Rule 11UA(2) for the investee company in section 56(2)(viib) and in Rule 11UA(1)(c)(b) for the investor in section 56(2)(x)(c), practically, the investee company is left with no other option but to adopt DCF method of valuation, in order to ensure that the issue price of shares is higher than or equal to the FMV based on adjusted NAV (circle rate of land & building), computed as per Rule 11UA(1)(c)(b) to ensure simultaneous compliance with section 56(2)(x) of the Act, in the hands of investors.

And when the investee company adopts such DCF method of valuation, the revenue authorities tend to look upon such valuation with suspicion and doubt and more often than not, such cases are picked up for elaborate scrutiny and often end up in costly, time-consuming and cumbersome litigations. It is another thing that various appellate forums have consistently held the share valuations based on DCF method as a fully acceptable and admissible valuation criterion.

The Resolve/Solution to this Enigma/Conundrum

Continuing with our above Tale of Vyapari and Niveshak,

Being puzzled by this dilemma of the Vyapari and the Niveshak, the King Krishna Dev Raya requested his reliable aide and counsellor Pandit Shri Rama Krishna (more popularly known as ‘Tenali Rama’) to resolve this peculiar problem.

Known for his brilliance and intelligence, Pandit Shri Rama Krishna advised a very simple solution to this peculiar problem, keeping in view the justifiable plea of the Vyapari regarding his entitlement to receive consideration equal to the current market value of his business assets.

He asked the king to amend the existing different and contradictory ‘mulyankan pranali’ (valuation rules) and instead legislate one common and uniform valuation rule of ‘Bazar Mulya Sampatti Avlokan’ (Adjusted NAV based on Circle rate of Land & Building) for valuation of the business (shares), and which the King heartily accepted and implemented with immediate effect.

This Article has also been published by Taxmann with the Citation [2022] 145 taxmann.com 272 (Article)