TaxTMI 
TaxTMI 
2024 (2) TMI 1035
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....ss premium charged. The addition made by the A.O. and sustained by the CIT-Appeal is unjustified, unwarranted and uncalled for. 2. On the facts and in the circumstances of case, the CIT(A) has erred in sustaining order of the A.O., where in the Ld. Assessing Officer has erred in invoking provision section 56(2)(viib) r.w.r. 11UA of the Income Tax Act. The Invoking provision of section 56(2)(viib) r.w.s. 11UA(1) by the A.O sustained by the CIT-A is unjustified, unwarranted and uncalled for. 3. On the fact and Circumstances of the case, the CIT(A) has erred in sustaining the order of the A.O, wherein the A.O. has erred in making addition, without issuing the show cause notice which is against the principle of natural justice. The order passed against the principle of natural justice as well as proper opportunity of being heard is bad in law and deserves to be annulled. 4. The appellant reserves the right to add, amend or alter any grounds of appeal at any time of hearing." 2. Succinctly stated, the assessee company which is engaged in the business of a builder and developer, had e-filed its return of income for A.Y.2017-18 on 31.10.2017 declaring an inco....
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.... No. of shares Face value @Rs.10/- per share Premium amount @Rs.100/- per share Total Value 1. Adarsh Tradecom Pvt. Ltd. Equity shares 2,73,000 27,30,000 2,73,00,000 3,00,30,000 2. Anand Singhania Preference shares 5,72,700 57,27,000 5,72,70,000 6,29,97,000 3. Priyank Singhania Preference shares 2,05,000 20,50,000 2,05,00,000 2,25,50,000 10,50,700 1,05,07,000 10,50,70,000 11,55,77,000 The A.O, on a perusal of the details, observed, that though the assessee company as per Rule 11UA of the Income Tax Rules, 1962 had furnished a valuation certificate of the equity shares issued by it but had not furnished any such details/certificate for the preference shares that were issued by it. On being queried, the assessee submitted that since no specific method of valuation of preference shares in the case of a private company was prescribed in the Act, hence the value of equity shares had been taken as the value for the preference shares. However, the A.O. did not find favor with the aforesaid explanation of the assessee company. Referring to Rule 11UA of the Income Tax Rules,....
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....sented the value of the equity shares and not that of preference shares. Accordingly, the A.O. rejected the adoption of the value of preference shares as that of equity shares by the assessee company. 6. After rejecting the value of the preference shares that was disclosed by the assessee company, the A.O reworked out their value @ Rs.5/- per share as against that taken by the assessee @110/- per share, observing as under: "14. In light of the above discussion, the valuation taken by the assessee for the preference shares issued to Sh. Anand Singhania and Sh. Priyank Singhania cannot be accepted. Valuation of the preference shares is being calculated on the following basis: The following assumptions have been made to arrive at this valuation. a) That looking at the history of dividend payment which is nil in the last so many years, and also the fact that as per the subscribed conditions that dividend would be paid to the preference shareholders only when it is also paid to the equity shareholders, it is assumed that the assessee pays 10% dividend every alternate year b) That it is redeemed at the end of 20 years at the same value i.e. 110 ....
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....n terms of redemption. Before moving a step ahead, it is important to have a understanding of definition of equity shares and preference shares. Equity shares are long-term financing sources of any company. These shares are issued to general public and are non-redeemable in nature. The share holders reserves the right to vote, share profit and claim assets of the company. On the other hand the preference shares are shares with dividends that are paid out to shareholders before common stock dividends are issued. Preference shares are securities which can be thought of as being mid-way between debt and equity. Preference shareholders do not get a variable return. Rather they get a fixed rate of return like debt holders. Thus, a preference share holder does not face the risks of an equity shareholder and also does not get the slow return of a bond holder. It is somewhere in between these two extremes. For that reason, payments to preference shares are not legally mandatory. If the company makes a profit, they must receive their fixed dividend before the ordinary shareholders are paid. Dividends, in case of preference shareholders are fixed. Hence, there need not be any speculation as ....
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....of shares of a closely held company, at a value which is higher than the Fair Market Value (FMV) of shares of such company. By virtue of section 56(2)(viib) of the Act, it states that, where a company, not being a company in which the public are substantially interested, receives, in any previous year, from any person being a resident, any consideration for issue of shares that exceeds the face value of such shares, the aggregate consideration received for such shares as exceeds the fair market value of the shares shall be deemed to be the income of the concerned company chargeable to tax under the head Income from other Sources for the relevant financial year. Further, the FMV shall be determined as per the methods prescribed under Rule 11UA(2) of the Income-tax Rules, 1962 (Rule). For ready reference, the relevant extract of Rule 11UA(2) is reproduced as under:- (2) Notwithstanding anything contained in sub-clause(b) of clause (c) of subrule (1), the fair market value of unquoted equity shares for the purposes of sub-clause (i) of clause (a) of Explanation to clause (viib) of sub-section (2) of section 56 shall be the value, on the valuation date, of such unquoted equity....
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....method. The moot question arises out is which method is widely adopted for valuation of preference shares. The valuation of preference shares is a very straightforward exercise. Usually preference shares pay a constant dividend. This dividend is the percentage of the face value of the share. The dividend discount model is generally used to measure the value of preference equity in addition to forecasting the value of ordinary equity. Thus, the AO was fully justified in placing secured debt instruments on same footings with preference shares. Therefore, DCF method is most appropriate one for determining true value as per characteristic of the preference shares. This method should have been adopted by the appellant. But the appellant adopted NAV method which is not meant for valuation of preference shares. During the appellant proceedings, the appellant has also furnished valuation of preference shares as on 31.03.2016 & 05.04.2016 by adopting NAV method but not submitted the value as per DCF method as adopted by the AO. Thus, the appellant failed to prove that the valuation done by the AO was incorrect. 3.1.4 Furthermore, the Act does not specify any specific method for det....
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....ference between the total assets and total liabilities as on the date of issuance of shares is divided by total amount of paid up capital of the company and multiplied by paid up value of new shares. In the instant case, given that there are existing equity and preference share capital, paid capital in respect of both of these category of shares shall be considered for determining total paid up capital of the company. In the result, we set-aside the matter to the file of the AO who shall determine the value of the preference shares as per the NAV method based on formula discussed above and such valuation has to be determined as on the date of issuance of such preference shares. In the result, the ground of appeal is allowed for statistical purposes. 3.1.5 Form the above cited decision, it is abundantly clear that the Hon'ble ITAT has directed the AO to determine value of preference shares as per NAV method for the reason that the NAV method was never disputed in the said case, however, in the case of the appellant the NAV method has been rejected from the grass root level i.e. by the AO itself. Therefore, the facts of the case of M/s Ginny Global (supra) are entirely d....
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....shares which is being generally used. Therefore, the AO was correct in adopting DCF method as prescribed in Rule 11UA(2)(b). The method adopted by the appellant was found Faulty, therefore, change of method by the AO is found justified. For these reasons, the judgments relied upon by the appellant are not applicable in its case. 3.1.8 In view of the discussion, the AO was fully justified in determining fair market value of preference shares by DCF method and I do not find any infirmity in the order of the AO. Thus, the addition made by the AO amounting at Rs.8,16,58,500/- is confirmed. Therefore, appeal on these grounds is dismissed." 8. The assessee being aggrieved with the order of the CIT(Appeals) has carried the matter in appeal before us. 9. We have heard the ld. Authorized representatives of both the parties, perused the orders of the lower authorities and the material available on record, as well as considered the judicial pronouncements that have been pressed into service by the Ld. AR to drive home his contentions. 10. Controversy involved in the present appeal lies in a narrow compass, i.e. as to whether or not the preference shares issued by the assesse....
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....erty, shall be determined in the following manner, namely - (a) Xxxxxxxx (b) Xxxxxxxx (c) Xxxxxxxx [(b) the fair market value of unquoted equity shares shall be the value, on the valuation date, of such unquoted equity shares as determined in the following manner, namely:- (A-L) the fair market value of unquoted equity shares = (A-L) (PE) X (PV), where, A = book value of the assets in the balance-sheet as reduced by any amount of tax paid as deduction or collection at source or as advance tax payment as reduced by the amount of tax claimed as refund under the Income-tax Act and any amount shown in the balance-sheet as asset including the unamortized amount of deferred expenditure which does not represent the value of any asset; L = book value of liabilities shown in the balance-sheet, but not including the following amounts, namely:- (i) the paid-up capital in respect of equity shares; (ii) the amount set apart for payment of dividends on preferences shares and equity shares where such dividends have not been declared before the date of transfer at a gene....
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....nce-sheet as asset including the unamortised amount of deferred expenditure which does not represent the value of any asset; L= book value of liabilities shown in the balance-sheet, but not including the following amounts, namely:- (i) the paid-up capital in respect of equity shares; (ii) the amount set apart for payment of dividends on preference shares and equity shares where such dividends have not been declared before the date of transfer at a general body meeting of the company; (iii) reserves and surplus, by whatever name called, even if the resulting figure is negative, other than those set apart towards depreciation; (iv) any amount representing provision for taxation, other than amount of tax paid as deduction or collection at source or as advance tax payment as reduced by the amount of tax claimed as refund under the Income-tax Act, to the extent of the excess over the tax payable with reference to the book profits in accordance with the law applicable thereto; (v) any amount representing provisions made for meeting liabilities, other than ascertained liabilities; (vi) any amount representing contingent liabil....
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....losing held companies from introducing undisclosed money of promotors/directors by issuing shares at a high premium, i.e over and above the book value of the shares of the company, and, thus, by so doing escape the rigors of Section 68 of the Act. Our attention was drawn by the Ld. AR to the Budget Speech, 2012 of the Finance Minister which underlined the objects behind the introduction of Section 56(2)(viib) of the Act, which, inter alia, had put a heavier onus on the closely held companies as regards the funds received from shareholders as well as taxing share premium received more than the FMV. The Ld. A.R., taking us through the Budget Speech of the Finance Minister while introducing the Finance Bill, 2012, wherein the purpose behind the insertion of Section 56(2)(viib) of the Act was explained, submitted that the Hon'ble Supreme Court in the case of K.P Varghese Vs. ITO (1981) 131 ITR 597 (SC), had held, that the intent and purpose for making available a statutory provision can safely be gathered by referring to the Budget Speech of the Finance Minister while introducing the finance bill. The Ld. AR submitted that as in the present case, the subject preference shares had been ....
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....fortify his aforesaid contention, i.e the rigors of Sec. 56(2)(viib) could not be applied to genuine transactions of allotment of shares to promoter directors, had by way of an analogy drawn support from the CBDT Circular No.10/2018 dated 31.12.2018, Page 132 of APB, wherein it was stated that the legislative intent for inserting clause (viia) of Section 56(2) of the Act, an antiabuse provision, was never intended to apply the said provision to fresh issuance of shares by the specified company. At the same time, the Ld. AR in all fairness took us through the CBDT Circular No.02/2019 dated 04.01.2019, Page 133 of APB as per which, the aforesaid CBDT Circular No.10/2018 (supra) was withdrawn. 17. Also, the Ld. AR had pressed into service the order of the ITAT, Delhi in the case of BLP Vayu (Project -1) (P) Ltd. Vs. PCIT (201 ITD 283) (Del.), Page 158 to 165 of APB. It was submitted by the Ld. AR that as in the case before the Tribunal shares were allotted by the assessee company to its 100% holding company, therefore, it was observed that based on a schematic interpretation the deeming provisions of Section 56(2)(viib) of the Act could not have been triggered in such a situation. ....
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....e same based on the value of assets on the date of issue of shares. The Ld. AR submitted that as the assessee company as per "Explanation (a)(ii)" of Section 56(2)(viib) had correctly determined the FMV of the preference shares based on the value of its assets on the date of issue of the said shares, which was as per the mandate of law, therefore, there was no justification for the A.O to have discarded the same and substituted it by the FMV determined by him as per the "dividend discounting method". The Ld. AR submitted that the determination of the FMV of subject preference shares as per the "Net Asset Value" (NAV) method had been accepted by the department in certain cases that have been adjudicated by various benches of the Tribunal. The Ld. AR in support of his aforesaid contention had drawn our attention to the order of the ITAT, Bengaluru in the case of Information Technology Park Ltd. Vs. ITO, ITA Nos. 1357 and 1358/Bang/2018 dated 24.08.2022, Page 194 to 205 of APB. Referring to the aforesaid judicial pronouncement, the Ld. AR submitted that in the said case, the "Net Asset Value" (NAV) method that was adopted for valuing the preference shares was not disputed by the Trans....
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....o paid by them or opt to convert the shares into a similar number of equity shares (1:1), which, thus, would put them in the same shoes as that of equity shareholders. The Ld. AR further submitted that the A.O. had though referred to the fact that the preference shares were convertible but had not considered the said material aspect while determining the FMV of the same. 20. The Ld. AR in support of his aforesaid contention, submitted that now when the preference shares were convertible into equity shares, therefore, the FMV of such shares would be more than the non-convertible shares or debt instruments, a material fact the A.O had ignored while determining the FMV of the same. The Ld. A.R, adverting to the assumption of the A.O. that the assessee company would pay 10% dividend, submitted that now when the terms of allotment of preference shares in itself provided for 100% dividend (i.e. coupon rate of 100%), and the assessee company had a substantial amount of divisible profits of Rs.27 crore as on 31.03.2016, therefore, there was no justification for the A.O to have assumed payment of 10% dividend. Also, the Ld. AR pointed out perversity in the assumption of the A.O. that the....
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....ors which were not correct; and also, ignored certain material aspects, therefore, the determination of the FMV by him suffered from serious infirmities and, thus, could not be accepted. 22. Per contra, the Ld. Departmental Representative (for short 'DR') relied on the orders of the lower authorities. It was submitted by the Ld. DR that as the assessee company had grossly erred in law and facts of the case in adopting the FMV of the equity shares for valuation of the preference shares, therefore, the A.O had rightly rejected the said method of valuation and taken recourse to the "dividend discounting method" for determining the FMV of the subject preference shares that were allotted by the assessee company to S/shri Anand Singhania and Priyank Singhania (supra). The Ld. DR submitted that the CIT(Appeals) had rightly upheld the view taken by the A.O, and the contentions advanced by the Ld. AR in his attempt to dislodge the well reasoned observations of the lower authorities being devoid and bereft of any merit, therefore, did not merit acceptance and were liable to be rejected. 23. We have heard the ld. authorized representatives of both the parties, perused the orders of the ....
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.... AR had taken us through the "Memorandum" explaining the purpose behind the insertion of an analogous provision, i.e Section 56(2)(vii) of the Act vide the Finance Bill, 2010. 27. Admittedly, it is a matter of fact borne from the record that the legislature in all its wisdom had inserted the provisions of Section 56(2)(viib) of the Act as a part of its counter-tax evasion mechanism to deter the generation and use of unaccounted money. Although the contention of the Ld. AR that now when the genuineness of the transactions of issuance of preference shares by the assessee company to its director/ex-director had been proved to the hilt, therefore, there was no justification for the A.O to have triggered the deeming provisions of Section 56(2)(viib) of the Act, i.e a counter tax evasion provision, at first blush appeared to be convincing, but going by the rule of strict literal interpretation that has to be adopted while construing the scope and gamut of a statutory provision the same does not merit acceptance. As Section 56(2)(viib) does not carve out any exception as regards the applicability of the same in a case where the shares are issued to the directors of the company, therefo....
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....s plain, the legislation has to be given effect in its own terms. 28. Based on our aforesaid observations, we are unable to concur with the Ld. AR, who had tried to circumscribe the applicability of Section 56(2)(viib) of the Act by reading in it an exception as regards the applicability of the same to a specific class of persons, which, in the absence of anything to the said effect having been made available on the statute by the legislature cannot be accepted on our part. The Ground of appeal No. 2 is dismissed. B). Re: Factually perverse observations of the A.O while determining FMV of preference shares as per "dividend discounting model": 29. As observed by us hereinabove, the Ld. AR had though assailed the rejection of the "Net Asset value" (NAV) method that was adopted by the assessee company for determining the FMV of the subject preference shares, but at the same time, he had vehemently assailed the observations/assumptions based on which the A.O. had determined/estimated the FMV of the preference shares as per "dividend discounting method" at Rs.5/- per share. Because the assessee company had called into question the factual observations of the A.O while determini....
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....d the fact that the subject preference shares were redeemable within 20 years of allotment at a premium of not less than Rs.100/- each; or shall be converted into similar nature of equity shares. In fact, the period of 20 years is the maximum statutory period for redemption and as per the terms of allotment of preference shares, the entire premium is redeemable. Accordingly, we concur with the claim of the Ld. AR that the observation of the A.O. that the subject preference shares under consideration were redeemable at the end of 20 years at the same value, i.e, Rs.110/- per share is factually incorrect and contrary to the facts discernible from the records. (ii). Convertibility of preference shares into equity shares not considered by the A.O: 32. On a perusal of the terms and conditions based on which the subject preference shares have been issued by the assessee company, it transpires that as per the "Special Resolution" passed in the Extraordinary General Meeting of the assessee company on 04.04.2016, it was specifically provided that the said preference shares shall be redeemed on not less than Rs.110/- each; or it shall be converted into a similar number of fully paid up....
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....t. (iv) Discounted rate of 12% taken by the A.O: 34. As is discernible from the assessment order, the A.O., had adopted a discounting rate of 12%. Ostensibly, the A.O. had observed that as the going rate for secured debt was about 10-11% and that for equity was about 14-15%, therefore, a discount rate of 12% could safely be adopted. At the threshold, we may herein observe that the A.O. had not referred to any comparable instance and had arrived at his aforesaid view based on a general observation. Apart from that, we concur with the Ld. AR that the assumption of the A.O. wherein he had compared the discount rate for secured debt and equity is not only without any basis but also unrealistic. Although, some of the terms of the preference shares match with the debt instruments, but the same on the said standalone basis could not be treated as a simpliciter debt instrument. Accordingly, we find substance in the contention of the Ld. AR that there is no justification for the A.O. in treating preference shares as a debt or a quasi-debt instrument, and thus, consider the discounting rate on that basis for estimating the FMV of the subject preference shares. Also, we find substance i....
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....that were issued on 04.04.2016 to S/shri Anand Singhania and Priyank Singhania, director/ex-director at Rs. 121.58 per share based on the "Net Asset Value" (NAV) method, i.e the same method that was adopted for valuing the equity shares, Page 101 of APB. The aforesaid factual position can safely be gathered from the valuation certificate dated 05.04.2016 obtained by the assessee company from its Chartered accountant, and also, the latter's "affidavit" dated 04.12.2023 that was filed in the course of the proceedings before us. 39. Ostensibly, the A.O was of the view that as the equity and preference shares could not be placed on the same pedestal, therefore, determination of the FMV of the preference shares based on the "Net Asset Value" (NAV) method by the assessee company did not merit acceptance. The A.O., observed, that as the preference shares were quasi-debt instruments, which were differently placed in comparison to equity shares, therefore, the FMV of the same could not be determined in the manner that applied to equity shares. The A.O. was of the view that unlike the preference shareholders while the equity shareholders were the real owners of the company, the preference....
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.... assets, including intangible assets being goodwill, know-how, patents, copyrights, trademarks, licenses, franchises or any other business or commercial rights of similar nature of the assessee company. Admittedly, as stated by the Ld. AR, and rightly so, Sec. 56(2)(viib) - "Explanation (a)" only refers to the valuation of the FMV of shares and does not discriminate between equity shares and preference shares. Also, we concur with the Ld. AR that though Rule 11UA(2)(a) and Rule 11UA(2)(b) prescribe two methods at the option of the assessee for determination of FMV of the unquoted equity shares, viz. (i) book value method; and (ii) discounted free cash flow method; but no method is prescribed for determination of FMV of preference shares, which, as per Rule 11UA(1)(c)(c) shall be estimated to be the price it would fetch if sold in the open market on the valuation date and is supported by a report obtained from a merchant banker or a specified accountant. Accordingly, there is merit in the Ld. AR's contention that the applicability of "Explanation (a)(i)" to Sec. 56(2)(viib) which provides that the FMV of the shares be determined in accordance with the methods as may be prescribed is....
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....in the company, including fixed dividends and preferential treatment upon the exit of the company. In fact, the equity shares are mainly owned by the founders and employees, whereas preferred shares are usually owned by investors in the company. We concur with the A.O. that as the preference shares do not carry any stake in the ownership of the company, therefore, the net asset value of the company represents the value of equity shares and not that of preference shares. We, thus, are persuaded to subscribe to the view taken by the A.O. that the "Net Asset Value" (NAV) could not have been adopted for determining the FMV of the subject preference shares issued by the assessee company to S/sh. Anand Singhania and Priyank Singhania. At the same time, we may herein observe, that the discount rate is to be calculated based on the inherent risk, or is to be obtained from the public market for similar types of financial securities. Although the assessee claims that as the subject preference shares are optionally convertible preference shares, convertible into a similar number of equity shares of the assessee company, therefore, essential characteristic on the exercise of the conversion opt....