The Delhi High Court has dismissed an Income Tax Department appeal challenging the valuation of shares issued at a premium by a newly incorporated infrastructure company, holding that the Assessing Officer (AO) could not reject the Discounted Cash Flow (DCF) method merely because it was formally notified under Rule 11UA of the Income Tax Rules after the date on which the shares were issued.
The bench of Justice Dinesh Mehta and Justice Rajneesh Kumar Gupta upheld the concurrent findings of the Commissioner of Income Tax (Appeals) [CIT(A)] and the Income Tax Appellate Tribunal (ITAT), Delhi ‘B’ Bench, which had accepted the assessee’s DCF-based valuation of its shares.
At the outset, the High Court dealt with the Department’s application seeking condonation of a 600-day delay in filing the appeal under Section 5 of the Limitation Act, 1963, read with Section 151 of the Code of Civil Procedure.
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The Department explained that the delay was caused by procedural difficulties, including the resignation of its previous Standing Counsel. The case files remained in the previous counsel’s office for a considerable period before being transferred to the present counsel. Since several appeals had to be filed through the new counsel’s chambers, additional time was consumed.
Although the Court observed that the delay of 600 days was substantial, it found the explanation satisfactory in the circumstances. The Court accordingly condoned the delay and proceeded to examine the substantive tax dispute.
The assessee company was incorporated on December 15, 2011. It had entered into a concession agreement with the National Highways Authority of India (NHAI) on March 5, 2012, for construction of the six-lane Etawah-Chakeri section of NH-2 in Uttar Pradesh under the Design, Build, Finance, Operate and Transfer (DBFOT) model.
On August 29, 2012, the company allotted one crore shares of ₹10 each to its parent companies, Oriental Structural Engineers Projects Ltd. and Oriental Tollways Ltd., at a premium of ₹90 per share.
The valuation of the shares was supported by a valuation report prepared by M/s M. Mehta & Co., Chartered Accountants, dated May 31, 2012. The valuer had adopted the DCF method to arrive at the value of the shares.
The tax dispute arose when the Department questioned whether the consideration received by the assessee for issuing the shares exceeded their fair market value for the purposes of Section 56(2)(viib) read with Section 2(24)(xvi) of the Income Tax Act.
The Additional Commissioner of Income Tax had issued directions under Section 144A, following which the AO examined the valuation adopted by the assessee.
The AO was not satisfied with the DCF valuation and took the view that the assessee should have valued its shares using the Net Asset Value (NAV) method prescribed under Rule 11UA.
While examining the DCF valuation, the AO recalculated the cost of capital and adopted a higher rate. The AO ultimately arrived at a negative DCF value of ₹525.16 crore.
Since the DCF valuation resulted in a negative figure, the AO treated the fair market value as zero under Rule 11UA(2)(b). However, relying on the NAV method, the AO adopted a fair market value of ₹10 per share and proceeded to make an addition of ₹90 crore under Section 56(2)(viib) read with Section 2(24) of the Act.
The assessee challenged the assessment before the CIT(A), which allowed the appeal on April 30, 2019.
The appellate authority held that the assessee’s valuation based on the DCF method was justified and that the AO had erred in arriving at a negative DCF value.
The CIT(A) also relied upon the language of Explanation (a) to Section 56(2)(viib), observing that the provision gave an assessee an option to follow a prescribed valuation method or another method to the satisfaction of the AO.
On that basis, the CIT(A) accepted the assessee’s valuation and held that the value of ₹100 per share, including the ₹90 premium, was justified.
The Department carried the matter to the ITAT.
The Tribunal, in its September 12, 2023 order, affirmed the CIT(A)’s decision. It held that the assessee had discretion in choosing the appropriate valuation method.
The Tribunal also noted that the DCF method was subsequently recognised by the Government through the amendment notified on November 29, 2012. Since DCF was a recognised valuation method and the assessee had adopted it in the relevant assessment year, the Tribunal held that the AO should not have rejected it merely on a technical ground.
The Department thereafter approached the Delhi High Court under Section 260A of the Income Tax Act.
Before the High Court, the Department’s principal contention was based on the timing of the amendment to Rule 11UA.
The shares had been issued on August 29, 2012, whereas the DCF method was introduced into Rule 11UA with effect from November 29, 2012.
According to the Department, since DCF had not been formally recognised under Rule 11UA on the date of issuance of the shares, the assessee could not rely upon that method for determining fair market value.
The Department further argued that the use of the word “shall” in Rule 11UA made the prescribed valuation methodology mandatory. Consequently, according to the Revenue, the AO was justified in rejecting the DCF valuation and applying the NAV method.
The assessee, on the other hand, relied upon the legislative history of Section 56(2) and Rule 11UA.
It argued that although the relevant statutory provision already existed, clause (viib) of Section 56(2) was introduced with effect from April 1, 2013. According to the assessee, when Rule 11UA was originally framed, the Government had prescribed the NAV method without taking into account other established methods of valuing shares, including DCF.
The assessee emphasised that NAV was particularly unsuitable for a newly incorporated company whose valuation depended substantially on future business prospects rather than its existing net assets.
Factors such as market potential, business prospects, the nature of the project and promoter reputation could significantly influence the valuation of shares in a new enterprise. The assessee therefore defended its DCF valuation, which was supported by a Chartered Accountant’s report.
The High Court acknowledged that the Department’s argument initially appeared attractive because the shares had been issued before the DCF method was formally incorporated into Rule 11UA.
However, after examining the statutory scheme and legislative history, the Court rejected the Revenue’s contention.
The Court noted that Rule 11UA was amended on November 29, 2012, to expressly provide for the DCF method, while Section 56(2)(viib) itself came into effect from April 1, 2013.
The Court observed that the subsequent amendment demonstrated that DCF was not an unknown or artificial valuation technique but a recognised method that the Government itself subsequently incorporated into the Rules.
A significant aspect of the judgment is the Court’s recognition of the practical limitations of the NAV method when valuing a newly incorporated company.
The Court observed that the AO could not ignore the realities of the financial and corporate world. In the case of a newly incorporated company, valuation of shares cannot necessarily be based solely on the net assets of the company.
The assessee had adopted the DCF method and issued shares at a ₹90 premium. According to the High Court, the fact that the Government itself amended the Rules in the same year to recognise DCF demonstrated that it was an established valuation method.
The Court further held that if the AO believed that the assessee’s valuation was incorrect, the AO was required to identify specific defects or flaws in the valuation report or in the methodology adopted.
The Court recognised that the word “shall” in Rule 11UA indicated a mandatory provision. However, considering the peculiar facts of the case, including the assessee being a newly incorporated company, its explanation for adopting DCF instead of NAV was found to be valid.
The Court made it clear that simply disagreeing with the valuation adopted by the assessee was not sufficient. The tax authority had to demonstrate why the valuation methodology or its underlying assumptions were defective.
The High Court was particularly critical of the manner in which the AO questioned the expected rate of return used in the DCF computation.
The AO had substituted a higher cost of capital, resulting in a dramatically different valuation.
The High Court held that the AO could identify defects in the methodology adopted by the assessee, but could not simply substitute his own economic assessment of the expected rate of return.
The Court observed that the AO could not “sit in the arm chair of an assessee” and act as an economist for determining the probable or expected rate of return. Such assumptions could be assessed by economists with reference to comparable industrial players, but the AO could not reject a valuation merely because he preferred a different expected return.
One of the key legal observations in the judgment concerns the distinction between a valuation method being “recognised” and being “notified”.
The High Court explained that a method may be recognised because it is accepted by persons engaged in the relevant trade and by experts in the field. A method becomes notified when the legislature or Government formally incorporates it into the applicable statutory framework.
According to the Court, DCF was already a recognised method of valuation when the assessee used it. The Government’s subsequent notification merely formally incorporated that method into Rule 11UA.
The Court found it difficult to accept that an assessee using DCF immediately after November 29, 2012 could be treated as having adopted a justified method, while another assessee using the same recognised method only a few months earlier could be considered to have acted incorrectly merely because of the timing of the notification.
The difference, according to the Court, arose only because of the fortuitous circumstance that the rule was formally notified after the assessee had already issued its shares.
The Court also characterised the valuation methods prescribed under the Rules as procedural in nature.
It held that procedural provisions should not operate in a manner that defeats substantive rights unless there has been a substantial breach or violation of law.
In the present case, the assessee had supported its valuation with a Chartered Accountant’s report and had adopted a recognised valuation methodology. Therefore, the subsequent notification of DCF under the Rules could not be used as a technical basis to invalidate the valuation adopted by the assessee before the notification.
Ultimately, the Delhi High Court found no reason to interfere with the concurrent findings of the CIT(A) and ITAT.
The Court upheld the acceptance of the assessee’s DCF-based valuation and rejected the Department’s challenge to the appellate orders.
The appeal filed under Section 260A of the Income Tax Act consequently failed.
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