The Delhi Bench of the Income Tax Appellate Tribunal (ITAT) has allowed the appeal of Hero Fincorp Limited, deleting a substantial addition of ₹168.30 crore made under Section 56(2)(viib) of the Income Tax Act, 1961, in connection with the valuation of shares issued pursuant to share warrants.

The bench of   Raj Kumar Chauhan (Judicial Member) and S. Rifaur Rahman (Accountant Member) deleted a separate ₹1,16,450 disallowance under Section 14A, holding that the Assessing Officer could not proceed to make a further disallowance under Rule 8D without first recording an appropriate satisfaction regarding the correctness of the assessee’s suo-motu disallowance.

The appeal arose from proceedings involving two principal issues.

The first concerned the disallowance under Section 14A of the Income Tax Act. Hero Fincorp had earned exempt dividend income of ₹1,16,450 during the relevant year and had itself offered a suo-motu disallowance of ₹910 under Section 14A read with Rule 8D.

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The Assessing Officer, however, computed a substantially higher disallowance of ₹56,97,807, taking into consideration the assessee’s investments. The CIT(A) subsequently restricted the disallowance to the amount of exempt income, namely ₹1,16,450. The assessee challenged even this reduced disallowance before the Tribunal.

The second and substantially larger dispute concerned an addition of ₹168,30,67,669.50 under Section 56(2)(viib)relating to share premium.

The case involved 57,65,905 share warrants issued on September 15, 2016, at a face value of ₹10 per warrant and a premium of ₹510.30 per warrant.

The warrants were capable of conversion into an equivalent number of equity shares within 18 months, on or before March 14, 2018. Hero Fincorp received ₹177.94 per warrant as the first call during Assessment Year 2017-18, while the balance amount of ₹332.36 per warrant was received when the warrants were converted into shares during the relevant year. The warrants and resultant shares were allotted to group concerns of the assessee.

For determining the fair market value of the shares, the assessee relied upon a valuation report dated August 16, 2016, which adopted the Discounted Cash Flow (DCF) method and projected the company’s business performance for the period beginning April 1, 2017 and ending March 31, 2021.

The Assessing Officer questioned the DCF valuation primarily because the projected financial figures did not match the actual results subsequently reported by the company.

According to the assessment order, the valuation report had projected turnover of ₹2,577.81 crore for the relevant period, whereas the actual turnover reported in the income-tax return was ₹1,814.03 crore. Similarly, projected profit before tax was ₹621.74 crore compared with an actual figure of ₹247.93 crore.

The Assessing Officer treated these variations as demonstrating that the projections were unrealistic and self-serving. He therefore rejected the DCF-based valuation and adopted the Net Asset Value (NAV) method for determining fair market value.

Under the NAV computation, the fair market value was determined at approximately ₹228.41 per share, compared with the issue price of ₹520.30 per share.

This resulted in a difference of approximately ₹291.90 per share, which, when multiplied by 57,65,905 shares, produced the disputed addition of ₹168,30,67,669.50 under Section 56(2)(viib).

The first appellate authority agreed with the Assessing Officer’s approach.

The CIT(A) accepted that the DCF method itself was not inherently defective but concluded that the underlying revenue projections were unrealistic. According to the CIT(A), the projected revenues lacked sufficient correlation with the company’s past performance and therefore resulted in an unreliable DCF valuation.

The CIT(A) consequently upheld the use of the NAV method and sustained the entire addition made under Section 56(2)(viib).

The assessee challenged the approach of testing a valuation report prepared in 2016 against actual financial performance emerging subsequently.

Hero Fincorp argued that the DCF report had been prepared before the share warrants were allotted and therefore had to be evaluated on the basis of information and circumstances available at the relevant valuation date.

The assessee also relied upon its historical growth to contend that the projections could not be characterised as arbitrary merely because one subsequent year’s actual performance was lower.

According to the submissions recorded by the Tribunal, Hero Fincorp’s revenue had grown by 147% in FY 2015 and 158% in FY 2016, while estimated growth for FY 2017 was 105%. The assessee also pointed to substantial growth in its asset book and profitability.

The assessee further submitted that subsequent performance actually exceeded some of the DCF projections. For Assessment Year 2019-20, actual year-on-year growth was stated to be 67%, against projected growth of 39%. For Assessment Year 2020-21, actual growth was 47%, compared with projected growth of 33%.

The central question before the Tribunal was whether the Revenue could disregard a DCF valuation by simply comparing the projections made in the valuation report with actual financial results that became available later.

The Tribunal answered the question in favour of the assessee.

The Bench noted that the valuation report was obtained on August 16, 2016, before the warrants were issued on September 15, 2016. The warrants were subsequently convertible into equity shares within the stipulated 18-month period. The Assessing Officer, however, compared the projections contained in the 2016 valuation report with audited figures for March 2018 and relied upon the difference to reject the valuation.

The Tribunal found this approach legally unsustainable.

It relied upon judicial precedents recognising that DCF valuation necessarily involves projections and estimates and that subsequent actual performance cannot, by itself, establish that the original valuation was incorrect.

The Bench specifically referred to the Delhi High Court’s decision in PCIT v. A.H. Multisoft (P.) Ltd., under which an expert valuation report cannot be rejected merely on general grounds without identifying a specific material error in the data or methodology. The Tribunal also noted that DCF valuation is not an exact science capable of arithmetic precision.

The Tribunal also referred to the Delhi High Court’s decision in PCIT v. Cinestaan Entertainment Pvt. Ltd.

The principle emerging from that decision, as reproduced in the Tribunal’s order, is that valuation based on a recognised methodology must be examined with reference to the information and material available on the valuation date. A subsequent mismatch between projected and actual performance does not, without more, establish that the valuation was irrational or incorrect.

The Tribunal noted that business projections can be affected by various factors and that valuation is inherently a technical exercise involving estimates and assumptions.

An important factor in the Tribunal’s decision was the historical growth demonstrated by the assessee.

The Bench noted that the lower authorities had characterised the projections as aggressive without adequately examining the company’s past performance.

The Tribunal recorded that revenue growth in FY 2015 and FY 2016 was 147% and 158%, respectively, while estimated growth for FY 2017 was 105%. Similarly, the asset book had recorded significant year-on-year growth, while the projections for subsequent years were not necessarily inconsistent with the historical trajectory.

The Tribunal therefore concluded that the projections could not simply be characterised as exorbitant or aggressive based on the actual results of a single subsequent year.

More importantly, subsequent figures demonstrated that the DCF projections were not uniformly excessive. In later years, actual growth was higher than the projected growth. The Tribunal held that this further weakened the Revenue’s argument that the projections were inherently unrealistic.

After considering the valuation methodology, factual background and judicial precedents, the Tribunal concluded that the CIT(A) was not justified in sustaining the addition.

The Bench expressly held that the Assessing Officer was not justified in making the addition of ₹168,30,67,669.50 and directed that the entire addition be deleted.

This effectively provides substantial relief to Hero Fincorp on the principal tax dispute concerning the share premium valuation.

The Tribunal also delivered an important ruling on the smaller but legally significant Section 14A issue.

Hero Fincorp had voluntarily disallowed ₹910 towards expenditure relating to exempt income. The Assessing Officer did not accept that computation and proceeded to determine a much higher amount under Rule 8D.

The Tribunal examined whether the Assessing Officer had first recorded the satisfaction required under Section 14A(2).

It found that the assessment order did not expressly record satisfaction as to why the assessee’s suo-motu computation was incorrect or inadequate.

The Tribunal relied upon the Delhi High Court’s decisions dealing with Section 14A and Rule 8D and reiterated that an Assessing Officer cannot automatically invoke Rule 8D merely because the assessee has offered a particular amount of disallowance.

The Assessing Officer must examine the assessee’s accounts and arrive at a satisfaction that the assessee’s claim regarding expenditure incurred in relation to exempt income is incorrect or inadequate.

The Tribunal observed that, in the present case, the Assessing Officer had not found fault with the assessee’s computation before proceeding to make a further disallowance. Consequently, recourse to Rule 8D was not available.

The Tribunal accordingly deleted the ₹1,16,450 disallowance sustained by the CIT(A).

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