Tax fair valuation rules - Are they fair in M&A context

JANUARY 23, 2021

By Amrish Shah, Madhvi Jajoo & Shubhada Satam

"CHANGE is the only constant"

is no longer an expression. It has been brought to life as the world grapples with the new normal. Global economy is on a declining trend due
to the pandemic, although green shoots of recovery are now seeming to slowly emerge. Mergers and acquisitions (M&A), being a by-product
of the overall economic scenario, have also been on an uptick lately. The recent M&A activity has been directed at increasing liquidity to
revitalise cash starved companies by divesting non-core/ loss making business or acquiring assets/ businesses at discounted prices to expand
inorganically or raise working capital to enable continuity of jobs / employment and help from a fiscal perspective too.

Whilst M&A tools have evolved in the ongoing crisis, existing laws are yet to align with the global situation to facilitate efficient deal making.

Government of India has been proactive in offering incentives to individuals and corporates and has also provided relaxations in tax
compliances. But with the ever-changing economic dynamics there is potentially a need to relook at some tax laws which could foster
seamless M&A activity.

Indian tax authorities have introduced anti-abuse rules time and again, which not only keep a check on the parallel economy but also
streamline tax laws. One such anti-abuse provision is the deemed gift tax on acquisition/ subscription to shares and securities below tax fair
value (computed as per prescribed mechanism under tax rules). For instance, tax fair value of unlisted equity shares is derived upon by
making adjustments to the book net-worth of the said company, as per audited financials as on the date of transaction. Further in case of listed
shares and securities, the tax fair value is derived based on the price at which it is freely traded by the market participants.

These anti-abuse provisions were brought in to counter some prevalent practices, wherein transfer of assets below fair value or for a loss was
compensated in cash or in-kind, which could have gone unaccounted, thereby dodging the scrutiny by tax authorities. To curb such
malpractices, Indian tax authorities enacted these provisions, mandating valuation of the assets being transferred, as per prescribed rules on
the date of such transfer.

Introduction of these rules have been instrumental in guarding against the aforesaid malpractices to a larger extent. However, with changing
economic trends, there may be a need to revisit and suitably modify the said provisions.

Some of the hurdles practically faced by the taxpayers are as under :

1. Convertible instruments

Issue of convertible instruments has been a common practice amongst India Inc., specially where it is proposed to bring PE investors on board.

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Compulsorily Convertible Debentures (CCDs) / Compulsorily Convertible Preference Shares (CCPS) also referred to as compound financial
instruments, are bifurcated between debt and equity in accordance with the Indian Accounting Standards (IndAS), while accounting in the
books of the issuer. The said equity component may be reflected in the Balance Sheet as 'Equity component of the compound financial
instrument' under 'Other Equity'. This creates an interpretational issue with respect to treatment of 'equity component' of compound financial
instruments, for the purpose of valuation under Rule 11UA of the Income-tax Rules, 1962 (IT Rules), i.e. whether CCDs/ CCPS should be
regarded as liability or equity.

While it may not be classified as 'Liability' in the balance sheet, it could be argued that, CCDs/ CCPS retain the character of debt, till converted
into equity shares and accordingly the same should be reduced at full value (including any Securities Premium thereon) while computing net-
asset value as per IT Rules. Further, a strict reading of the terms 'paid-up capital in respect of equity shares' and 'reserves and surplus' under
the Companies Act goes to support the above theory. However, this issue is not free from doubt in absence of precedents providing clear
interpretation. Alternatively, the same should be added to the equity share capital based on the conversion ratio so as to determine the value
of equity shares on a fully diluted basis to match with the commercial reality.

2. Shares with Differential Voting Rights (DVRs)

DVRs are another form of equity instrument wherein equity shares are issued with differential rights in respect to voting, income distribution
etc. There could be ample commercial reasons for assigning differential rights to different class of shareholders. Although companies law and
internationally accepted valuation principles recognise this concept and have specific provisions/ regulations around it, the tax laws in India fail
to recognise the same and treat them like any other normal equity share. This creates an apparent disparity, where the tax fair valuation rules
do not account for variation in rights while valuing securities.

3. Immovable properties

As per internationally accepted valuation methodology, core business assets are not valued separately as they are fundamental to the
business, whilst the surplus non-core assets are typically valued net of tax.

Tax fair valuation rules in India do not distinguish between core business assets and non-core surplus assets. While computing tax fair value,
one needs to also consider valuation of immovable properties (both core and non-core) as per stamp duty /ready reckoner rates. In certain
circumstances, an immovable property may fetch lesser value than its stamp duty value (i.e. FMV) on account of underlying issues such as
restrictions on transfer, slum dwellings in the vicinity, irreparable damage, disputed title/possession, negative covenants imposed by the court
of law on transfer, marketability and encumbrances on property.

These reasons may be beyond the control of the owner-seller but are not considered while determining stamp duty value. Also, the tax fair
value norms in India do not recognise the concept of true business value (as opposed to global practices). This often leads to significantly high
valuation for equity shares of companies as per tax fair value rules, while the true commercial business value (due to factors mentioned
above) maybe much lower. This impact can atleast be lowered by the tax payable by the owner in the event the asset were considered as sold
on the date of transaction.

4. Issue of Shares during pandemic

Due to uncertainty on account of the prolonged pandemic, India Inc. is struggling with dwindling demand, tightening liquidity position and
partial business paralysis. In wake of the unprecedented financial and economic crisis, business valuations have been hit hard, especially in
case of closely held companies (which are also struggling due to negative industry outlook, uncertainty about future prospects, lack of investor
appetite and other business factors), where the DCF valuations are painting a gloomy picture. This may act as a major roadblock in fund
raising, in which case the promoters may have to dilute their stakes significantly to lure investors.

Whilst there has been an attempt by the Tax Authorities to rationalize the anti-abuse provisions for cases impacting public interest (viz. specific
carve out from applicability of tax valuation rules through an amendment to IT Rules vide Notification No. 40/2020/
F. No. 370149/143/2019-TPL dated June 29, 2020 for the Yes Bank Limited Reconstruction Scheme 2020 as defined in Clause (d) to
Explanation to sub rule (3) of Rule 11U AC of IT Rules, other cases like stressed companies under the Insolvency and Bankruptcy Code, 2016
(IBC) are yet to be covered by a similar carve out. There has been an ask from the industry to carve out applicability of tax valuation rules for
companies under the IBC and it remains in the wish-list till date.

5. Other issues

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 a. One of the liabilities to be reduced while computing the net asset value as per Rule 11UA is
'any amount representing provisions made for meeting liabilities, other than ascertained liabilities'.
This gives rise to a dilemma as to what proportion of provision made for Employee's post-retirement benefit could be
considered as ascertained liability for the purpose of computing the net asset value by companies, especially in case of multiple
liabilities of a like nature, thereby causing distortion in valuation.

b. While Rule 11UA puts emphasis on book values of the assets appearing on the face of the balance-sheet for valuation
purpose, there still lies a lot of uncertainty regarding treatment of MAT credit/deferred taxes etc. in absence of certainty about
their future utilization. Similarly, there is no clarification for inclusion / exclusion of tax demand paid under protest by the
taxpayer.

c. The Rule requires procurement of the valuation report as on the transaction date in certain cases, which is practically difficult
since the audited balance-sheet on the transaction date would not be available. Alternatively, like in Companies Act, 2013 and
under SEBI regulations, the reference date can be kept at 30 days prior to the transaction date to ease out requisite
compliances.

While there may be several other issues, the crux here is that the tax fair valuation rules provide static valuation, without much weightage to
practical issues - a perfect example of 'form over substance'. The anti-abuse provisions certainly are praiseworthy, but suitable and timely
recast of the same to harbour bonafide commercial decisions would be a welcome move.

[Amrish Shah is Partner, Madhvi Jajoo is Senior Manager, and Shubhada Satam is Deputy Manager with Deloitte Haskins and Sells
LLP. The views expressed are strictly personal.]

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