Recently, the Delhi High Court while giving relief to the startups from angel tax ruled that if a proper methodology is followed while valuing a company during valuation rounds, it should not be challenged later.
The Respondent-Assessee, M/s Cinestaan Entertainment Pvt. Ltd. has received share premium from various subscribers/equity partners. These funds were required by the Respondent-Assessee for film production. The shares were issued based on the valuation received from the prescribed expert i.e. a Chartered Accountant who used the discounted cash flow (DCF) method which is one of the methods stipulated under Section 56(2)(viib) read with Rule 11UA(2)(b). Based on the valuation report, the Respondent-Assessee issued shares to various equity partners at a premium.
The AO has disregarded the valuation report of the Respondent-Assessee primarily on the ground that the projections of revenue as considered for the purpose of valuation do not match the actual revenues of subsequent years.
The AO has made additions based on the assumption that the Respondent-Assessee made no efforts to achieve the projection as made out in the valuation report and therefore the share premium received by the Respondent-Assessee is without any basis and contrary to provisions of Section 56(2)(viib) read with Section 2(24)(xvi) of the Act.
The AO held that the Respondent-Assessee has failed to submit any basis of projection. He also held the view that in order to achieve the said projection, the Respondent-Assessee should have invested the share premium amount to earn certain income/return and whereas the Respondent-Assessee made investments in zero percent debentures of its associate company and therefore the basic substance of receiving a high premium is not justified.
AO had issued notice under Section 133(6) to all the investors to seek confirmation, information and documents pertaining to the issuance of shares. Further, the venture agreement between the Respondent-Assessee and the investors was also filed before the AO.
Whether the AO after invoking the deeming provision under Section 56(2)(viib), could have determined the Fair Market Value (FMV) of the premium on the shares issued at nil after rejecting the valuation report given by the Chartered Accountant based on one of the prescribed methods under the Rules adopted by the valuer?
The ITAT thus, after due consideration of the record, concluded that neither the identity, nor the creditworthiness and genuineness of the investors and the pertinent transaction could be doubted. This fact stood fully established, before the AO and has not been disputed or doubted. Therefore, the nature and source of the credit stood accepted.
The ITAT has followed the dicta of the Supreme Court in matters relating to the commercial prudence of an assessee relating to valuation of an asset. The law requires the determination of fair market values as per the prescribed methodology. The Appellant-Revenue had the option to conduct its own valuation and determine FMV on the basis of either the DCF or NAV Method.
The Respondent-Assessee being a start-up company adopted DCF method to value its shares. This was carried out on the basis of information and material available on the date of valuation and projection of future revenue. There is no dispute that methodology adopted by the Respondent-Assessee has been done applying a recognized and accepted method. Since the performance did not match the projections, Revenue sought to challenge the valuation, on that footing. This approach lacks material foundation and is irrational since the valuation is intrinsically based on projections which can be affected by various factors.
Mr. Ajit Sharma, Senior Standing Counsel for the Appellant- Revenue submitted that the learned ITAT has erred in deleting the additions made by the AO as confirmed by the CIT(A). He argued that the Respondent-Assessee was asked to submit the basis of projection/estimated figures as presented in the valuation report.
However, no efforts were made to justify the projection made in the said report under Rule 11UA and for premium as per Section 56(2)(viib) of the Act.
The AO analysed the business profitability of the Respondent-Assessee only to the extent that such profitability was not commensurate with the actual financials provided by the Respondent-Assessee during the course of assessment proceedings. Therefore, the financials of the Respondent-Assessee did not support the business module of the company.
Mr. Sharma further submitted that while there cannot be any dispute on the fact that it is for the entrepreneur to visualize the business based on certain projections and to undertake all kind of risks, but in the case of the Respondent-Assessee, the valuation report projected profits, and whereas the financials represented losses, thereby demonstrating that the actual financials and the valuation report were completely contradictory to each other.
Mr. Ajay Vohra, learned Senior Counsel for the Respondent-Assessee defended the impugned judgment and argued that no substantial question of law arises for consideration.
Mr. Vohra submitted that it is the prerogative of the assessee as to how much capital is to be raised based on its long-term and short-term funding requirements for the purpose of running its business.
It was further submitted that Section 56(2)(viib) of the Act is not applicable to genuine business transactions and that the genuineness and creditworthiness of the strategic investors was not doubted by either the AO or the CIT(A).
Mr. Vohra submitted that sub clause (ii) of explanation to Section 56(2)(viib) is not applicable to the Respondent-Assessee’s case and the assessee was not required to satisfy the Assessing Officer about the valuation done. In accordance with sub clause (i) of explanation, the Respondent-Assessee had an option to carry out a valuation and determine the FMV only on the DCF, which was appropriately followed by the Respondent-Assessee.
The division bench of Justice Sanjeev Narula and Justice Manmohan said, “we cannot lose sight of the fact that the valuer makes forecasts or approximations, based on potential value of business. However, the underline facts and assumptions can undergo change over a period of time. The Courts have repeatedly held that valuation is not an exact science, and therefore cannot be done with arithmetic precision.”
The court added that it is a technical and complex problem which can be appropriately left to the consideration and wisdom of experts in the field of accountancy, having regard to the imponderables which enter the process of valuation of shares. The Appellant-Revenue is unable to demonstrate that the methodology adopted by the Respondent-Assessee is not correct. The AO has simply rejected the valuation of the Respondent-Assessee and failed to provide any alternate fair value of shares.
“As noted in the impugned order and as also pointed out by Mr. Vohra, the shares in the present scenario have not been subscribed to by any sister concern or closely related person, but by outside investors. Indeed, if they have seen certain potential and accepted this valuation, then Appellant-Revenue cannot question their wisdom,” the court said.
Therefore, the court held that the valuation is a question of fact which would depend upon appreciation of material or evidence. The methodology adopted by the Respondent-Assessee, accepted by the learned ITAT, is a conclusion of fact drawn on the basis of material and facts available. The test laid down by the Courts for interfering with the findings of a valuer is not satisfied in the present case, as the Respondent-Assessee adopted a recognized method of valuation and Appellant-Revenue is unable to show that the assessee adopted a demonstrably wrong approach, or that the method of valuation was made on a wholly erroneous basis, or that it committed a mistake which goes to the root of the valuation process.
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