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Himachal Pradesh HC Upholds Assessee's Choice of Valuation Method and Clarifies Non-Applicability of Section 56(2)(viib)

Introduction

The Himachal Pradesh High Court (‘HC’), in the case of Principal Commissioner of Income-tax v. I.A. Hydro Energy (P.) Ltd.[i], delivered a landmark judgment that sheds light on the significant aspects of the Income-tax Act, 1961 (‘Act’), particularly concerning the applicability of s. 56(2)(viib) of the Act and the discretion in choosing share valuation methods. The judgment clarifies the boundaries of the assessing officer’s (‘AO’) authority in substituting the valuation method chosen by the assessee and provides when s. 56(2)(viib) of the Act can be invoked.

Brief Facts

  • I.A. Hydro Energy (P.) Ltd. (‘Assessee’) was engaged in the generation and distribution of hydroelectricity. The Assessee issued 2.25 crore equity shares with a face value of Rs. 10 per share and at a premium of Rs. 90 per share. The valuation was done through the discounted cash flow method (‘DCF’) as per r. 11UA of the Income-tax Rules, 1962 (‘ITR’). These shares were issued by converting pre-existing unsecured loans from two companies into share capital.

  • The AO rejected the DCF valuation, deeming it bogus and substituted it with the net asset value (‘NAV’) method. This resulted in a significantly lower valuation of the shares. The AO concluded that the fair market value (‘FMV’) of the shares was much lower than the value determined by the company, leading to an addition under the head ‘Income from Other Sources’ under s. 56(2)(viib) of the Act.

  • Being aggrieved by the AO's decision, the Assessee appealed to the Commissioner of Income Tax [‘CIT(A)’]. The CIT(A) ruled in favour of the company, stating that the DCF method was an acceptable and valid method for share valuation.

  • ·The Revenue then appealed to the Income Tax Appellate Tribunal (‘ITAT’), which upheld the CIT(A)’s decision. The ITAT reaffirmed that the DCF method was appropriate and that s. 56(2)(viib) of the Act was not applicable since the company received no fresh consideration, and the shares were issued against the conversion of existing loans.

  • ·The Revenue then filed the present appeal before the HC. The primary contention was whether the AO was justified in substituting the valuation method chosen by the Assessee and whether s. 56(2)(viib) of the Act applied to the issuance of shares against the conversion of loans.

Held

The HC delivered a detailed judgment addressing the two primary issues: the applicability of s. 56(2)(viib) of the Act and the AO's authority to substitute the valuation method chosen by the taxpayer.

  • Applicability of Section 56(2)(viib)

-   The HC upheld the findings of the CIT(A) and the ITAT, which determined that s. 56(2)(viib) of the Act was not applicable in this case. This section pertains to the taxation of share premiums received by a company when the amount exceeds the FMV of the shares. The HC noted that the assessee did not receive any fresh consideration for the allotment of shares in the relevant assessment year. Instead, the shares were issued in lieu of converting pre-existing unsecured loans into equity.

-   Further, the HC stated that s. 56(2)(viib) of the Act applies only when the company actually receives consideration in the form of money or any other property. Since the conversion of loans into equity did not constitute new consideration, the provisions of s. 56(2)(viib) of the Act were not applicable.

  • Authority to Substitute Valuation Method

-   The HC addressed the issue of the AO substituting the DCF method chosen by the assessee with the NAV method. It also clarified that r. 11UA of the ITR provides taxpayers with the discretion to choose a method for valuing shares. Once the taxpayer has chosen a method and complied with the relevant provisions, the AO does not have the jurisdiction to replace it with an alternative method.

-   The HC further held that the DCF method is an internationally accepted standard for valuing shares and that the assessee had obtained a valuation report from a qualified Chartered Accountant, as per the requirement of r. 11UA of the ITR. The AO’s rejection of the DCF method without substantial justification was deemed beyond its authority.

-   Therefore, the AO can only verify the correctness of the chosen valuation method but cannot impose a different method arbitrarily. The assessment process must be conducted with procedural fairness, and the Assessee should be given the right to choose an appropriate valuation method.

The HC also relied on the decision of Deputy Commissioner of Income Tax, Mumbai v. Credtalpha Alternative Investment Advisors (P.) Ltd.[ii], which held that courts should only examine the validity of the methods adopted by the assessee rather than substitute them for unwarranted reasons.

Our Analysis

In its deliberation, the HC clearly reaffirmed that the taxpayers have the discretion to choose a valuation method for shares as prescribed by r. 11UA of the ITR. This implies that businesses will have the freedom to plan their capital structures without undue interference from tax authorities. Further, by clarifying that s. 56(2)(viib) of the Act applies only when fresh consideration is received in the relevant assessment year. The HC has also set a precedent that the conversion of pre-existing loans into equity does not trigger this provision. Additionally, it is worth noting that the judgment clearly focuses on procedural fairness and adherence to principles of natural justice in tax assessment. By ruling against arbitrary substitutions of valuation methods and unwarranted applications of tax provisions, the HC protects taxpayers from potential misuse of regulatory powers.

 


End Notes

[i] [2024] 163 taxmann.com 408 (Himachal Pradesh).

[ii] [2022] 134 taxmann.com 223 (Mumbai - Trib.).






Authored by Muskaan Jain, Advocate at Metalegal Advocates. The views expressed are personal and do not constitute legal opinion.

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