Section 56(2) (viib) of the Income-tax Act, 1961 (‘IT Act’) provides that where a closely held company issues shares to a resident taxpayer at a premium and the aggregate consideration exceeds the fair market value (‘FMV’) of the shares, the excess shall be taxed as income of the Company issuing the shares. For computing the FMV, Rule 11UA have been introduced in the Income-tax Rules, 1962 (‘IT Rules’). As per Rule 11UA of the IT Rules, the FMV is to be computed by applying a prescribed formula. This formula requires to consider book value of assets and liabilities as shown in the balance sheet date on the valuation date. The term balance sheet has been defined in Rule 11U of the IT Rules to mean balance sheet drawn up on the valuation date and which has been audited. Rule 11U of the IT Rules also provides that where the balance-sheet on the valuation date is not drawn up, the balance sheet drawn up as of a date immediately preceding the valuation date, which has been approved and adopted at the Annual General Meeting (‘AGM’) of the shareholders of the company shall be considered.
Before shares are issued, generally, a Company may draw up its balance sheet in order to determine its share’s value. However, the same may not be audited when the shares are allotted / issued. Hence, in such cases, a question may arise as to whether the Company adopt the value as per the said un-audited balance sheet or it needs to consider valuation as per the latest audited balance sheet. In this regard, recent, Chandigarh Tax Tribunal1 had an occasion to delve upon whether balance sheet that was drawn on the valuation date,but audited subsequently would be sufficient compliance for the purpose of Rule 11U of the IT Rules. We, at BDO in India, have summarized the ruling and provided our comments on the impact of this decision hereunder.
FACTS OF THE CASE
The Taxpayer, a private limited company, allotted 31,950 shares of Rs 10 each at a premium of Rs 10 to Indian resident person. The allotment was made on 31 March 2016. For the purpose of arriving at the FMV, the taxpayer drawn up a balance sheet as of 31 March 2016 and thereafter arrived at the FMV of shares. These accounts were subsequently audited on 24 August 2016 and there was no change in the financials. However, the Tax Officer rejected the FMV adopted by the Taxpayer on the ground that it is not based on an audited balance sheet. Accordingly, he computed FMV based on the audited balance sheet as of 31 March 2015 and made an addition under section 56(2)(viib) of the IT Act. The taxpayer filed an appeal before the First Appellate Authority who confirmed Tax Officer’s order. Hence, the taxpayer filed an appeal before the Chandigarh Tax Tribunal.
TAX TRIBUNAL RULING
Chandigarh Tax Tribunal held that Rule 11U does not mandate that the balance sheet should also be audited on the date of valuation. Even if the balance sheet is audited subsequently, it would be sufficient compliance of the provisions of Rule 11U(b) of the IT Rules. It also held that in spirit and purpose of the provisions of Rule 11U(b) of the IT Rules, there should not be a material change in the financials of the Balance Sheet after audit so that it may not lose the tenacity and relevance of balance sheet on the valuation date. While coming to this conclusion, the Tax Tribunal made the following observations:
- A bare perusal of the definition of 'balance sheet' would show that for the purpose of determination of FMV under Rule 11UA, the balance sheet should be drawn on the date of valuation and the same should also be audited by the Auditor of the company and in case the balance sheet on the date of valuation is not drawn, the balance sheet drawn on a date immediately preceding the valuation date and audited by the auditors of the company should be considered.
- The two mandatory requirements of Rule 11U(b) of the IT Rules are:
- The Balance Sheet should be drawn on the date of valuation and
- The said Balance Sheet should be duly audited by the Auditor appointed under the provisions of section 224 of the Companies Act, 1956 (now under sections 139 and section 142 of the Companies Act 2013).
- Where the Balance Sheet is not drawn on the date of valuation, the Balance Sheet drawn on a date preceding the date of valuation which has been approved and adopted at the AGM of the shareholders should be considered.
- The definition of the Balance Sheet has two limbs, the first limb applies in a situation where the Balance sheet is drawn on the date of valuation and the second limb of the definition applies in a situation where no Balance Sheet is drawn on the date of valuation. Since, in the taxpayer’s case, the balance sheet was drawn on the date of valuation, it is covered by the first limb of the definition of 'Balance Sheet'. In so far as the condition that the Balance Sheet should be audited by the Auditor of the company, the said condition is also satisfied as the Balance sheet drawn on 31 March 2016 was subsequently audited with purportedly no change in financials.
This is a welcome Ruling. While in this case, the valuation date (i.e. Date when shares were allotted) was 31 March, support of this Ruling could also be taken in instances where the valuation falls on any other date. As per this Ruling, the unaudited balance sheet can be considered for FMV purpose, provided the taxpayer gets it audited subsequently. It is imperative to note Tax Tribunal’s observation that there should not be any material change in the numbers as contained in the unaudited balance sheet and the audited balance sheet. What constitutes ‘material change’ would differ from taxpayer to taxpayer and hence the taxpayer should evaluate this decision based on its set of facts.
1 Electra Paper and Board (P.) Ltd. Vs. ITO (ITA No. 222/Chd/2021)