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  • Anuraag Bukkapatnam

DCF v/s NAV- Examining Valuation Concerns under the Income Tax Act

[Anuraag is a student at NALSAR University of Law.]

The increasing popularity of the show ‘Shark Tank India’ has led to a renewed interest in the world of start-up funding in India. In particular, the negotiation between the sharks and potential recipients of the investment regarding terms of the investment has generally been one of the most exciting segments of the show. A high valuation investment by the sharks is often perceived as a ‘victory’ for the recipients, as the same validates the soundness of their business plan and strategy. However, not many are aware of the manner in which higher valuations could potentially attract the attention of the income tax department. This can take place when the investment received by a company to expand its operations is itself is deemed to be the income of the company and taxed accordingly by the authorities. The same is made possible by virtue of Section 56(2)(viib) and Section 2(24)(xvi) of the Income Tax Act 1961 (IT Act), which brings such share premiums under the scope of ‘income from other sources’.

This article seeks to explore the on-going controversy regarding the appropriate method of valuation to be adopted for the purposes of valuing equity under Section 56(2)(viib) of the IT Act. In particular, the controversy is viewed from the lens of a recent ruling by the Mumbai Income Tax Appellate Tribunal (ITAT) in the case of DCIT v. Creditalpha Alternative Investment Advisors (Creditalpha).

Setting the Context

As financial systems evolve, unscrupulous individuals find ingenious methods to launder their un-accounted wealth and re-route it into the financial system. One method of doing the same is setting up sham companies and routing unaccounted wealth to the company in the form of incoming investments which far exceed the actual value of the company. The investments, therefore, succeeded in taking un-accounted wealth and converting them into legitimate property by characterizing them as ‘share premiums’.

In order to clamp down on such practices, Section 56(2)(viib) was introduced vide the Finance Act 2012 which sought to tax such share premiums. This section is attracted in instances where unlisted companies received investments which exceed the ‘fair market value’ (FMV) of the shares. In such circumstances, the premium received over and above the FMV is brought to tax under the head ‘income from other sources’. This section is applicable only in cases where the genuineness of the transaction is not under question. If the investments in question are not genuine, Section 68 of the IT Act provides for treating the entire investment (including the share premium value) as being income of the recipient. Section 68, however, is beyond the scope of this article.

A perusal of Section 56(2)(viib) shows that the tax liability of the assessee is largely dependent on computing the FMV of the assessee on the date of investment. Rule 11UA(2) of the Income tax Rules 1962 (IT Rules) prescribes two methods of computing the FMV- the net asset value method (NAV) and the discounted cash flow method (DCF). While the former method largely relies on the value of assets while computing FMV, the latter method of valuation focuses on projections of revenue in the coming years based on pre-determined assumptions. While valuation based on NAV can be computed by the assessee itself, DCF valuation has to be done by a merchant banker only. Before looking into the controversy regarding whether the assessing officer (AO) can mandate the usage of any one particular method of valuation, it is useful to look into the merits and demerits of both methods.


The DCF method is essentially a projection of what the company’s business would look like in the subsequent years based on certain assumptions made in the present. As a result, there is scope for variation between the projections and the actual performance of the company. Even if we were to disregard black swan events like the COVID-19 pandemic, the difficulty in making accurate assumptions and considering all relevant factors makes the DCF method inherently prone to variance. In particular, the DCF method runs into difficulties when the inherent nature of the company’s business model does not involve consistent and periodic cash-flow. The NAV method, on the other hand, focuses on valuing the company at a particular point of time. It is much more static in nature, and relies on what the company is rather than what it might be. Therefore, in terms of certainty, the NAV method has an advantage over the DCF method.

That being said, the downside of the NAV method is that it envisions a more traditional business model which is largely dependent on the value of its assets. Newer business which are involved in the provision of services (particularly online) rely far lesser on traditional assets than a manufacturing company might. Besides, investors often base their decision to invest on the prospects of the company rather than its immediate value. In such circumstances therefore, a DCF method would be more appropriate to value the company.

This brings us to the earlier question of which model is the more appropriate valuation method. Going by the merits and de-merits of each method, it is clear that this question does not have a clear cut answer. The right method of valuation would ultimately depend on the unique facts and circumstances of each case. This is why Rule 11UA(2) gives the assessee the option to choose either of the methods of valuation while computing FMV. When the IT Act itself provides a choice between two methods of valuation, can the AO reject a method of valuation adopted by the assessee and replace the same with another method? This was the question before the Mumbai ITAT which recently gave its ruling in the Creditalpha case.

DCIT v/s Creditalpha Alternative Investment Advisors Limited

The factual matrix involved in this case is as follows. The assessee is a private company involved in providing financial and investment advice. It received investments at a premium valuation in the year 2013. The valuation was determine by using the DCF method. In reality, however, the projections turned out to be wrong and the company fell short of its revenue targets. The AO noted that had the assessee used the NAV method of valuation, the fair market value of the shares would be substantially lower (the value would in fact be negative). Therefore, the AO was of the opinion that by using the DCF method, the assessee has artificially increased the FMV of the shares, which has consequently decreased their tax liability. Accordingly, the AO made additions by computing FMV according to the NAV method.

The approach of the AO finds support in the Delhi ITAT ruling in the case of Agro Portfolio v. Income Tax Officer. The AO in this case noted that the rate of return which was assumed by the assessee while preparing the DCF model was abnormally high for its line of business. As a result, the AO formed an opinion that the valuation was incorrect, and proceeded to make additions by adopting a NAV method of valuation instead. The same was upheld by the ITAT which concluded that the assessee was unable to justify their DCF valuation.

Similarly, in the case of TUV Rheinland NIFE Academy v. ITO, the AO noted that there was significant variance between revenue projections made in the DCF model and the actual revenue generated by the assessee. Accordingly, the AO deemed the valuation to be defective and proceeded to make additions on the basis of an NAV method. While upholding the additions, the Bangalore ITAT noted that the merchant banker/chartered accountant relies solely on the figures provided by the assessee while computing the DCF value. In case the DCF valuation is defective, the AO can substitute the same with an NAV based valuation and make suitable additions.

The Mumbai tribunal in Creditalpha, however, did not consider these rulings. Rather, the tribunal largely followed the ratio of the Bombay High Court in the case of Vodafone M Pesa Limited v. PCIT. The High Court in this case held that while the AO has the authority to scrutinize the valuation report, he cannot change the method of valuation which is opted by the assessee. Therefore, if the assessee has adopted a DCF valuation method, any subsequent re-evaluation by the AO must be done under the DCF method itself. Relying on this ratio, the ITAT held that the correctness of the DCF valuation cannot be determined in hindsight based on the actual performance of the company. The correctness of the valuation method can be determined only on the date of the report being prepared. Furthermore, the AO cannot challenge the veracity of the valuation report merely on the ground that the valuation is prepared by the merchant banker based on the data provided by the assessee. This approach has been seen in several other ITAT rulings as well (See this and this for instance).

Concluding Remarks

Rulings such as that in Creditalpha come as a relief for assessees, who can exercise their choice of picking the most appropriate valuation method while seeking investments. That being said, the concerns raised by the department in these cases do have merit. There is no disputing the fact that DCF valuations are a form of projection which are largely dependent on the information provided by the assessee itself. Consistent patterns of high variance between the DCF valuations and the actual revenue generated should lead to re-evaluation of the manner in which the DCF valuations are being computed.

That being said, improving the efficacy of the DCF formula is more in the realm of economics/statistics. Until the formula is re-worked in a manner to better project revenue growth, the department must stick to the letter of the law and allow assessees to exercise their choice under the IT Act. It remains to be seen whether the issue reaches the apex court in light of the many conflicting rulings across tribunals.


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