Learn Everything about Rule 11UA of the Income Tax Act, 1961

If you are someone looking to understand Rule 11UAA of the Income Tax Act, 1961

As it deals with the valuation of the unquoted equity shares so let’s understand the section in further detail!

Introduction to Rule 11UA of the Income Tax Act, 1961

As we have rightly pointed out Rule 11UA of the Income Tax Act, 1961 deals with the provisions relating to the valuation of the unquoted equity shares. This rue is designed in such a way as to ensure the accurate and fair assessment of the value of the shares. 

This Rule establishes a comprehensive and legal framework by taking into consideration numerous factors such as market conditions, liabilities, and assets to determine the true and fair market value of the unquoted equity shares.

What is the importance of Rule 11UA of the Income Tax Act, 1961?

• Aids in taxation: Rule 11UA helps in aiding the taxation of the unquoted equity shares.

• Prevents Understatement: Rule 11UA helps in preventing any kind of an understatement.

• Transparency: With the help of Rule 11UA certain level of transparency in the computation of the capital gains can be ascertained.

• Widens scope of Income from Other Sources: With the help of Rule 11UAA the scope of the income from other sources widens by the incorporation of the provisions for addressing the issue of inadequate consideration or receipt of the property/money without consideration.

What are the Key elements of Rule 11UA Valuation?

• Valuation Formula: The Rule provides the formula for calculating the fair market value of unquoted equity shares by taking into various factors for instance the fair market value of the artistic works, jewelry, book value of the assets, book value of liabilities and the stamp duty valuation of the immovable property.

• Computation of the Capital Gains: Under this Rule, the consideration received from the transfer of the unquoted equity shares is compared to the fair market value determined for the being in accordance with the prescribed manner. If in case the consideration is less than the fair market value then the fair market value is deemed to be the full value of the consideration for the computation of the income under the head “capital gains”.

• The Clarity in the Assets and Liabilities: The main challenge faced by the organisations was with regard to the determination of the inclusion and the exclusion of liabilities and assets with the introduction of this Rule provides the right guidance for some categories but sometimes these assets and liabilities are not categorically defined.

Common Challenges under Rule 11UA of the Income Tax Act, 1961

• Issues with Businesses: Certain businesses have unconventional models that make it difficult to directly fit into the four walls of Rule 11UA.

• Lack of Clarity: This challenge is the extension of the above challenge as Rule 11UA does not encapsulate within itself the real-life scenario which leads the valuers clueless to interpret and apply these Rules in situations where specific solutions are prescribed.

• Fluctuations in the Market Conditions: The constant change in the market conditions impacts directly the fair market value of the unquoted equity shares. This is why it becomes extremely important for the valuer to consider the prevailing market trends and conditions during this valuation process.

Rule 11UA in a Nutshell 

In the case where a person transfers the unquoted equity shares then they are required to pay the Capital Gains Tax which is the difference between the price on which the shares were brought and sold. 

Back in the year, 2017 a substituted Section 11UA of the Income Tax Act was introduced with a view to introducing the Rules related to the valuation of the unquoted equity shares pursuant to Section 56(2)(x) and at the same time also inserted a new Rule 11UAA which provides for the determination of Rules of Fair Market Value for the unquoted shares relevant for Section 50CA of the Income Tax Act, 1961

Section 11UA of the Income Tax Act 1961 deals with the procedure for the determination of the Fair Market Value other than the immovable property. It is the principle of the Rule that the market value of the unquoted equity share is the value on the valuation date of the unquoted shares determined in accordance with the below-mentioned manner:

The Fair Value of the Unquoted Shares = (A-I) x PV / PE

But this Rule was changed in the year 2017 with a new substituted Rule which states that the Fair Market Value of the unquoted equity shares shall be the unquoted shares on the valuation date as determined in the following section:

Fair Market Value of the Unquoted Equity Shares = (A+B+C+D-L) * (PV)/ (PE), where 

• Whereas A stands for the book value of all the assets (other than the immovable property, securities, jewelry, and artistic works) in the balance sheet as reduced by 

1. Any amount shown as an asset by including the unamortized amount of the deferred expenditure that does not represent the value of any asset, and

2. Any amount of the income tax paid, if any, less any amount of the income tax refund claimed, if any

• Whereas B stands for the price that the artistic works or the jewelry would fetch if sold in the open market based on the valuation report obtained from the registered value.

• Whereas C stands for the Fair Market Value of the securities and the shares as determined in this Rule.

• Whereas D stands for the value assessed assessable, or adopted by any authority of the government for the purpose of the payment of the stamp duty in respect of the immovable property.

• Whereas L stands for the book value of the liabilities shown on the balance sheet but does not include the below-mentioned amounts:

• Any amount representing provisions made for meeting liabilities other than the ascertained liabilities.

• Paid-up capital with regards to the equity shares.

• Reserves and Surplus, other than those set toward depreciation even if the resulting figure is negative.

• The amount set apart for the payment of the dividends on the equity shares and the preference shares where these dividends have not been declared before the date of the transfer at a general meeting of the company.

• Any amount representing the contingent liabilities other than the arrears of dividends payable on the cumulative preference shares.

• Any other amount representing the provision for the taxation except the amount of the Income Tax paid and less any amount (if any) of the Income Tax claimed as a refund but to the extent of the excess tax payable in reference to the booked profits in accordance with the applicable laws;

• PV stands for the value of the equity shares.

• PE stands for the amount paid for any equity share capital as depicted in the balance sheet.

Before the amendment to Section 11 of the Income Tax Act, an amendment to Section 56(2) was also done with the insertion of Clause (x) to Section 56 which states that the receipt of money or the specified property by any person for the inadequate consideration or without consideration for any person is liable for tax.

Besides Section 50CA has also been introduced which states that where the consideration for the transfer of shares of a company other than the quoted share is less than the Fair Market Value of such a share, the Fair Market Value in such a circumstance will be determined in accordance with the rules which shall be deemed to be the full market value of consideration for computing income under the head of capital gains.

What were the Earlier Methods used for the Valuation of the Shares?

The earlier methods used for the valuation of the shares were as per the below (which has been discussed in detail below): 

• Net Asset Valuation Method and 
• Discounted Free Cash Flow Method 

What are the approaches used to compute the Fair Market Value of the Unquoted Equity Shares?

• Net Asset Value Method: This approach is usually used where the value of the unquoted equity shares is determined by looking at the net worth of the company and this net worth is calculated by deducing the liabilities from the assets of the company. This is usually ascertained from the balance sheet of the organisation. 

• Discounted Cash Flow: Discounted Cash Flow also known as the DCF method where the fair market value of the unquoted share is calculated as the sum of the present values of all the future cash flows which the organisation expects to generate discounting to the present day at the risk-adjusted discount rate and this discount shows the risk associated with the investment and the time value of the money. 

• Bench Marking with the Shares issued to the Venture Capitalists: This approach assumes that if a Venture Capital Undertaking obtains consideration for the issuance of the shares to a Venture Capital Fund, Venture Capital Company or the Specified Fund of the AIF Category then in such a circumstance the price of the equity shares corresponding to such consideration will be assumed as the Fair Market Value of the equity shares issued to the other investors in the same category. 

What are the approaches used to compute the Fair Market Value of the Unquoted Equity Shares by a Merchant Banker?

• Option Pricing Method: It is the valuation method that uses the estimates of the fair market value of the shares by taking into consideration the value of the option to either purchase or sell the shares in the near future. This method works upon the assumption that the value of the shares is equal to the present value of the expected future cash flows including the option to purchase or sell the shares at any time. In this method, the series of future call options which represent various classes of shares, rights and preferences are assigned a bunch of the future value based on the current equity value which is based on the estimated time to exit, the volatility, and the various features of the equity of the company for instance the liquidation preferences, and the anticipated dividend payouts.  

The mathematical calculation stands as:

C = SN(d1) – Ke – rtN (d2)

Where:

C stands for the Call Option price

S stands for the Current Stock Price 

K stands for Strike Price

Stands  r for = Risk-Free Interest rate 

Stands t for = Time to maturity 

N stands for = A Normal Distribution 

For instance: The Current Stock Price of a share is Rs. 100 and the Strike price of the share is Rs. 105. The risk-free interest rate is 5% and the time of maturity is one year. The Normal distribution is 0.4267

C = SN(d1) – Ke – rtN (d2)

C = 100e-0.02*1*4097-105e-0.05*1*0.3365

Per Share – C = 3.74

• Probability Weighted Expected Return Method: It is the valuation method that estimates the fair market value of the organisation by taking into consideration the different future outcomes and this method works upon the assumption that the value of the company is equal to the present value of its expected future cash flow weighted by the possibility of each result. 

For Instance, the Current Price of XYZ Ltd. is Rs. 100 

In the case of A Scenario: The Share Price has been increased by 15% with the probability of 60%

In the case of B Scenario: The Share price is decreased by 5% with the probability of 40%

The Fair Market Value = Current Share Price + Overall Expected Return 

= Rs. 100 + Rs. 7 (100*7%) 

Per Share Price = Rs. 107 

• Replacement Cost Methods: This method estimates the fair market value of the shares by taking into consideration the cost of replacing the business with a similar business and this method works upon the assumption that a buyer will not pay more for a business than the cost of replacing that business. This method is mainly used for the valuation of unquoted equity shares.

For Instance:

Ten years ago XYZ Ltd. Company bought a piece of machinery for Rs. 30,00,000. After the lapse of the ten years the company is required to decide whether a new machinery should be brought or should they continue with the older one. Now the current value of the machinery stands at Rs. 10,00,000 after deducing the depreciation. Let’s assume that the replacement cost of the same machinery stands for Rs. 20,00,000 then in such a circumstance the Management of XYZ Ltd. should opt for replacing the machinery as it will add more value to their business. 

• Comparable Company Multiple Method: This method is used for investment valuation and financial analysis to determine the financial worth of the company. This method further involves comparing the target organisation with similarly traded companies and this method assumes that the companies with similar characteristics and financial metrics shall have the same valuation.

Under this method of the CCA, the multiples of different companies are calculated as:

Multiple = Valuation Driver/ Valuation Measure 

Where, 

Valuation Driver is like the Revenue, EBIT, EBITDA, P/E

While the Valuation Measure is known as the Enterprise Value 

Enterprise Value = MC+ Total Debt – C

In which, 

MC stands for Market Captalisation, Equal to the current stock price multiplied by the number of outstanding stock shares

Total Debt stands for Equal to the sum of the short-term and the long-term debt

C stands for the Cash and the other cash equivalents, the liquid assets of the company but does not include the marketable securities. 

• Milestone Analysis Method: This method is used for the computation of the fair market value of the shares mainly for start-ups and companies that have a very limited operating history. This valuation method aims to identify specific milestones that the company aims to achieve in the future as it will directly impact the value of the company. 

The steps that are performed for the calculation of the Milestone analysis are;

• Defining the Milestones: The first in the process is to identify the key events which should be measurable, specific, relevant, achievable, and the time-bound

• Establishing the Criteria: the second step in the process is to establish the criteria against these achievements for calculating each milestone. 

• Assigning of the responsibilities: The third step in the process is to assign the responsibilities to individuals as well as to teams for achieving each and every milestone. 

• Assessing the completed milestones: The next step in the process is to assess whether the completed milestone is in line with the pre-determined criteria or not. 

• Adjusting the Project Plan: The next step in the process is to make the necessary adjustments as per the Project Plan if it is required. This can include the reallocation of the necessary resources, reassessing the priorities of the project and revisiting the timelines. 

• Communication of the Progress: The progress of the milestone is every time required to be communicated to the team members, clients, management, and stakeholders.

• Conducting the Milestone Analysis: Lastly, the timely analysis of the progress of the projects is required to be made by the project managers to make informed decisions for keeping the project on track.
   
• Benchmarking of the shares with Notified Entities: This approach assumes that if the notified entity obtains consideration for the issuance of the shares then in such a circumstance the price of the equity shares corresponding to such consideration will be assumed as the Fair Market Value of the equity shares issued to the other investors in the same category. 

Safe Harbour Margin 

The amended Rule 11UA provides for the Safe Harbour Margin by the addition of Rule 11 UA(4) as per this Rule if the valuation of the share is determined in accordance with Rule 11UA (2) by using any of the prescribed methods and there is a difference between such determined value and the issue price of not more than the 10% then in such a circumstance such 10% can be ignored. 

For example, if the shares of ABC Ltd. are valued by the DCFM method prescribed under Rule 11 UA(2) at Rs. 2000 and if the shares are issued at the price of Rs. 2100 then the difference between the issue price and the value of the share will not be added t the income of the company under Section 56(2)(viib) of the Companies Act, 2103. Though, if the difference is more than 10% then the entire difference will be treated as the income of the company under Section 56(2)(viib). However, it is pertinent to note that this Safe Habour Margin Rule is only applicable to Rule 11UA(2) and not Rule 11UA(1).  

Conclusion 

The introduction of Rule 11UA of the Income Tax 1961 has paved the way for the proper computation of the fair market value of the unquoted equity shares as deciding the capital gains was a tedious task but this Rule and the amendment to Section 56 have resolved the issue to some extent. 

Frequently Asked Questions

Q1. What is the Rule section 11UAA Valuation?

Ans 1. The Rule specifies the valuation technique for determining the fair market value of immovable property.

Q2. What is the valuation of shares in case of demerger?

Ans 2. In the case of a demerger, the shareholders continue to hold the shares in the parent as well as the demerged entity.

Q3. Is valuation required for CCPs?

Ans 3. The valuation of the CCPs shall be governed by the provisions of section 56(2) (viib of the Income Tax Act, 1961

Q4. How is valuation calculated?

Ans 4. The traditional method of the calculating the valuation of the company is price-to -book value ratio.

Q5. What is the formula for the valuation of shares?

Ans 5. The formula for the valuation of the shares using the market capitalisation is valuation = share price * the total number of the shares.

Q6. Is the valuation of shares compulsory?

Ans 6. Valuation of the shares helps in assessing the worth of the company involved in the transaction.

Q7. Are valuations valid for 90 days from the date of valuation?

Ans 7. Yes valuations are valid for 90 days from the date of valuation

Q8. What is the time ratio?

Ans 8. The time ratio is the measure of how effectively organisation is using its time to generate sales.

Q9. What is the maximum tenure of CCPs?

Ans 9. The maximum tenure of the CCPs is 20 years.

Q10. Is a valuation fee refundable?

Ans 10. No, the valuation fee is not refundable once paid.