The Central Board of Direct Taxes has introduced rules to determine the fair market value of unlisted equity shares through notification No. 52 of 2012. The valuation rules, which are now part of the Income Tax Rules, 1962, have been notified in relation to section 56(2)(viib) of the Income Tax Act, 1961, which was introduced earlier in 2012.
According to this provision, when the shares of an unlisted company are issued to a resident at a price that is higher than the fair market value of the shares, the company will be taxed on the difference between the fair market value and the sale price.
The new valuation rules provide companies with the option to determine fair market value in accordance with the existing rules or the discounted free cash flow method. The discounted cash flow analysis, if used, must be conducted by a merchant banker or an accountant.
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Under the existing rules, fair market value is calculated by computing the difference between the book value of a company’s assets (reduced by applicable taxes payable), and the book value of its liabilities (not including certain specified amounts) as shown on its balance sheets. This difference is then multiplied by the ratio between the paid-up value of equity shares and the total number of paid-up equity shares.
Section 56(2)(viib) is particularly relevant when shares are issued at a premium. The new provision is likely to create challenges for start-up businesses and will give rise to additional tax costs.
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The legislative and regulatory update is compiled by Nishith Desai Associates, a Mumbai-based law firm. The authors can be contacted at nishith@nishithdesai.com. Readers should not act on the basis of this information without seeking professional legal advice.
