Relief on interest disallowance under s.36(1)(iii) and fresh NAV-based share valuation under s.56(2)(b)(viib) for closely held company shares

ITAT allowed the assessee's appeal on disallowance of interest under s.36(1)(iii), holding that, given the substantial own funds compared to the investment of Rs. 29.34 crores in its wholly owned subsidiary, no diversion of borrowed funds for non-business purposes was established and following its earlier orders in assessee's own cases, interest disallowance was unwarranted. On the addition under s.56(2)(b)(viib), ITAT held that the lower authorities erred in rejecting the share valuation on technicalities; it set aside the CIT(A)'s order and directed the assessee to furnish a revised valuation report from an independent accountant using NAV based on book value of land, and directed the AO to recompute income accordingly.

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1. ISSUES PRESENTED AND CONSIDERED

1.1 Whether disallowance of interest under section 36(1)(iii) on the ground of diversion of borrowed funds for non-business purposes, in respect of investments and advances to a wholly owned subsidiary, was justified for the relevant assessment years.

1.2 For a particular assessment year, whether the entire share premium received on issue of shares was liable to be taxed under section 56(2)(viib), having regard to the valuation of shares under Rule 11UA, including (i) validity of a DCF-based valuation report signed by the statutory auditor, and (ii) correctness of a NAV-based valuation using market value of land instead of book value.

2. ISSUE-WISE DETAILED ANALYSIS

Issue 1: Disallowance of interest under section 36(1)(iii) on investments/advances to subsidiary

Legal framework (as discussed)

2.1 Section 36(1)(iii) allows deduction of interest paid in respect of capital borrowed for the purposes of business or profession. The expression "for the purpose of business" and the concept of "commercial expediency" were relied upon by the assessee with reference to judicial precedents, and the Tribunal referred to its own earlier decision in the assessee's case applying the presumption regarding use of own funds where sufficient interest-free funds are available.

Interpretation and reasoning

2.2 The Assessing Officer treated investments in equity shares and advances (including share application money) to the wholly owned subsidiary as having been made out of borrowed funds, and disallowed proportionate interest at 12.5% for all four assessment years, on the premise that business loans were diverted for non-business purposes and used to acquire a capital asset.

2.3 The assessee contended that, as on 31.03.2008, it had substantial own funds comprising share capital, share application money and reserves and surplus, aggregating to about Rs. 45.48 crores, whereas the total investment and advances to the subsidiary were significantly lower. It was argued that the Assessing Officer, in the remand report, wrongly focused only on the balance in the profit and loss account and ignored share application money and securities premium as interest-free funds.

2.4 The Tribunal examined the balance sheet as at 31.03.2008 and found that share capital, share application money and reserves and surplus together constituted own funds of Rs. 45.48 crores, while the cumulative investment and advances to the subsidiary were about Rs. 29.34 crores. On these figures, the Tribunal held that the assessee had sufficient own funds to cover the investment and advances to the subsidiary.

2.5 The Tribunal relied on its earlier order in the assessee's own case for prior assessment years, where on substantially identical facts it had held that, in the presence of mixed funds and sufficient interest-free/own funds, a presumption arises that investments/advances to the subsidiary are made out of such interest-free funds, and that disallowance under section 36(1)(iii) was not warranted. That earlier order in turn had applied the principle that when interest-free funds are sufficient to meet the investments, no disallowance of interest can be made in the absence of a specific nexus to borrowed funds.

2.6 Adopting the same reasoning, and finding no defect in the audited financials evidencing the availability of sufficient own funds, the Tribunal concluded that the Assessing Officer and the first appellate authority were wrong in presuming diversion of borrowed funds and in not applying the presumption in favour of use of interest-free funds.

Conclusions

2.7 The Tribunal held that sufficient own funds and interest-free funds were available to the assessee to make the investments and advances in the subsidiary for all the relevant assessment years. Consequently, the disallowance of proportionate interest under section 36(1)(iii) on such investments/advances was unjustified.

2.8 The orders of the first appellate authority sustaining the interest disallowance for all four assessment years were set aside, and the Assessing Officer was directed to recompute the income by allowing the interest expenditure as claimed in the financial statements.

Issue 2: Taxability of share premium under section 56(2)(viib) and valuation under Rule 11UA

Legal framework (as discussed)

2.9 Section 56(2)(viib) provides for taxation of excess consideration received for issue of shares over the fair market value (FMV) as income from other sources. Rule 11UA prescribes the methods for determining FMV, including DCF and NAV methods, and defines "accountant" for the purpose of valuation. Under the applicable Rule 11UA for the relevant year, where the DCF method is adopted, the valuation report must be given by an "accountant" who is not appointed as the statutory auditor under section 44AB or under the Companies Act.

Interpretation and reasoning

2.10 During the relevant assessment year, the assessee issued preferential shares of face value Rs. 100 at a premium of Rs. 400 per share and received share premium of Rs. 31.04 crores. The assessee justified the premium by a DCF-based valuation at Rs. 501.28 per share supported by a certificate from a chartered accountant firm which was also the statutory auditor.

2.11 The Assessing Officer compared actual financial results for subsequent years with the projections used in the DCF valuation and, noting substantial losses as against projected profits, rejected the valuation and added the entire share premium as income from other sources under section 56(2)(viib).

2.12 Before the first appellate authority, the assessee contended that it had adopted a method sanctioned by Rule 11UA and that differences between projections and actuals could not be a ground to discard the DCF valuation. It also furnished an alternative NAV-based valuation computing FMV at Rs. 373.48 per share, in which land was valued at market value instead of book value.

2.13 The first appellate authority held that the DCF-based valuation certificate was not valid under Rule 11UA because it was prepared by the very firm which was the statutory auditor under section 44AB. Referring to the definition of "accountant" in Rule 11UA, it concluded that an auditor so appointed could not act as valuer for this purpose, and therefore the DCF report and the claimed FMV could not be accepted.

2.14 As to the alternative NAV-based valuation, the first appellate authority found that the assessee had not followed the prescribed rule because it had substituted market value for land instead of using book value, and therefore held that the NAV computation was not in conformity with Rule 11UA. On this basis, it rejected both the DCF and NAV valuations and confirmed addition of the entire share premium amount under section 56(2)(viib).

2.15 Before the Tribunal, the assessee argued that the valuation report prepared by a chartered accountant who is otherwise an "accountant" under section 288(2) should not be invalidated merely because he is also the statutory auditor, and that valuation is inherently a matter of estimation which, once supported by a professional report using a prescribed method, should not be discarded purely on technical grounds. It was also submitted that the Department had not produced any counter-valuation.

2.16 The Tribunal noted that the definition of "accountant" for the relevant assessment year in Rule 11UA expressly excluded a person appointed as auditor under section 44AB or under the Companies Act. It therefore agreed with the first appellate authority that a valuation certificate issued by the statutory auditor does not meet the specific requirement of Rule 11UA for DCF-based valuation.

2.17 However, the Tribunal also observed that, in rejecting the assessee's NAV-based valuation, the authorities had relied on technical non-compliance in taking market value of land instead of book value, without adjudicating the valuation on merits. The Tribunal considered that, while the technical requirement regarding book values must be observed, the assessee should be allowed an opportunity to furnish a corrected NAV valuation strictly in accordance with the Rule, and that the valuation under the NAV method could not be rejected in limine on that technical ground alone.

Conclusions

2.18 The Tribunal upheld the view that a DCF valuation report signed by the statutory auditor does not satisfy the definition of "accountant" under Rule 11UA for the relevant year and therefore could not be accepted as a valid DCF-based valuation for determining FMV.

2.19 At the same time, the Tribunal held that the rejection of the assessee's NAV-based valuation solely because land was taken at market value instead of book value was not justified, and that the matter required reconsideration on a corrected NAV basis.

2.20 The Tribunal set aside the order of the first appellate authority on the section 56(2)(viib) addition and directed the assessee to submit a revised valuation report adopting the NAV method strictly using the book value of land and other assets as per Rule 11UA. The Assessing Officer was directed to recompute the assessee's income after considering such revised valuation report, in accordance with law.

2.21 Consequently, for the relevant assessment year, the ground against the addition under section 56(2)(viib) was partly allowed by way of remand to the Assessing Officer with the above directions, while other unpressed grounds were dismissed.

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