Understand Section 50CA of the Income Tax Act in Detail: Key Features and Impact on Businesses

If you are a business and want to understand Section 50CA of the Income Tax Act, then we have got you covered, as we have tried to explain the concept of Section 50CA in a detail-oriented manner. Let’s move ahead in understanding the same. 

Introduction to Section 50CA of the Income Tax Act 

Section 50CA has been introduced with the Finance Act, 2017, which is a view to tackle the problem related to the undervaluation of shares and assets during the transfer of a company. This Section has caused a lot of turmoil in the businesses and the stakeholders as they are involved in the transfer of the assets and the shares. 

Further, this Section states that the fair market value of such assets and the shares will be considered as the full value of the consideration, which is if the transaction value of these shares or assets is less than their market value, then such difference will be added to the income of the company. 

Such fair market value of the assets and the shares shall be determined in accordance with Rule 11UA of the Income Tax Rules, 1962, as this provides the Rules for the methods of valuation for determining the fair market value of the unquoted equity shares.  

How does Section 50CA impact businesses?

As we have already discussed, with the introduction of Section 50CA, a lot of turmoil has been created amongst the businesses as it has made the transfer of the assets or the shares between the related parties more challenging and complex. Before the introduction of this Section, businesses used to undervalue their assets or shares during the process of the transfer in order to reduce their tax liability. But with this Section, they are now required to ensure that the value of the transaction should not be less than the fair market value of the assets. 

This Section not only ensures the true transaction value of the assets or the shares but also increases the compliance of the businesses. Now, businesses are required to maintain the proper documentation related to the transfer in order to prove that the value of the transaction is not less than the fair market value of the assets. 

A Valuation Report is required to be prepared for the valuation of the assets or the shares from a Registered Valuer and the report is required to be submitted to the Income Tax Department as the Valuation Report acts as proof of the true transaction value. 

What are the Key Features of Section 50CA of the Income Tax Act?

• Applicability: This Section is not limited to only residents of the country instead this is applicable to both residents and non-residents. 

• Transfer of the Shares: Under this section, it is the transfer of the shares instead of the quoted shares. Quoted Share means the shares quoted on the recognised stock exchange regularly from time to time. These shares can be preference shares, equity shares or compulsory equity shares. 

• Consideration: The consideration for the transfer of the assets or the shares should be less than the prescribed fair market value of the shares and this fair market value is required to be determined in accordance with Rule 11UA of the Income Tax Rules (which has been discussed in detail below) 

What are the implications of Section 50CA?

A Buyer is the ultimate purchaser of the shares and they may end up paying a higher amount of the stamp duty on the transfer of the shares this issue arises in cases where the Fair Market Value of the shares is higher than the actual consideration amount or the Fair Market Value of the Shares. 

The issue of double taxation also occurs in cases where the sale consideration of the unquoted shares is less than the fair market value. Section 50CA provides for the adoption of the fair market value as the consideration upon the transfer of the unquoted shares. It is imperative to understand the concept of the Value of the Consideration under Section 50CA and what are the Unquoted Shares.

Value of the Consideration under Section 50CA

If the consideration received from the transfer of the shares is less than the fair market value of the shares, then the market value of the shares will be deemed to be the full value of the consideration for computing the capital gains tax. In simple words, it means that if the actual consideration received is lower than the fair market value, the capital gains tax will be calculated on the fair market value resulting in the higher tax liability for the seller. 

Quoted Shares 

The shares which are quoted on any recognised stock exchange are known as the Quoted Shares. The quotation of these shares are determined on the basis of the current transactions in the ordinary course of the business. 

Example of Section 50CA of the Income Tax Act 

Let’s assume that XYZ International earns long-term capital gains on their sale of 10,000 shares of BCD Private Limited at a price of Rs. 100. Now the fair value computed as per Rule 11UA is Rs. 120. If the cost of the acquisition of the shares is Rs. 10 and no indexation is required the total deemed consideration for Section 50CA should be Rs. 1,200,000

Understand Section 50CA with an example 

Let’s suppose Mr. B owns 1,000 shares in a company and he wants to sell these shares to Mr. H. The actual consideration agreed between them is Rs. 10,00,000. The fair market value of the shares is determined to be Rs. 15,00,000. In this case, Section 50CA of the Income Tax Act comes into the picture and the fair market value of Rs. 15,00,000 will be the full value of the consideration for computing the capital gains tax. 

As a result, Mr. B will be required to pay the capital gains tax on the difference between the fair value of Rs. 15,00,000 and the cost of the acquisition of these shares. This amount can be higher if the actual consideration of Rs. 10,00,000 was taken into consideration. Also, if the stamp duty is required to be paid on the transfer of the shares, Mr. H will be required to pay the stamp duty on the fair market value of Rs. 15,00,000 but he has paid only Rs. 10,00,000 on the shares. 

The Formula for Calculating the Fair Market Value of the Unquoted Equity Shares  

The Formula for computing the fair market value of the Unquoted Equity Shares is:

(A + B+ C + D – L) * (PV)/ (PE) 

Where:

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

1. Any amount that is depicted as an asset by including the unamortised amount of the deferred expenditure that does not represent the asset value and 

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

• B stands for the price that will be fetched by the jewellery or the artistic works if sold in the open market, which is based on the valuation report that is obtained from the registered valuer.

• C stands for the Fair Market Value of the shares and the securities 

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

• L stands for the book value of the liabilities as shown in the balance sheet, which does not include the below-mentioned: 

1. Paid-Up Capital with Regard to the Equity Shares

2. Any amount that represents the contingent liabilities other than the arrears of the dividends payable on the cumulative preference shares. 

3. Any amount that represents the provisions made for meeting of the liabilities other than the ascertained ones.

4. Reserves and Surplus other than those set towards depreciation even though the resultant figures are negative. 

5. The amount which is set aside for the payment of the dividends on the equity shares and the preference shares in which the dividends have not been declared before the date of the transfer in the general meeting of the company. 

6. Any other amount that represents the provision for the purpose of taxation excepting the amount of the paid Income Tax and any amount of the Income Tax claimed as a refund only to the extent of the excess tax payable in respect of the profits booked in accordance with the laws that are applicable to such companies. 

• PV stands for the value of the Equity Shares 

• PE stands for the amount that is paid for any Equity Share Capital as revealed in the Balance Sheet. 

What are the methods of Computing the Fair Market Value of the Unquoted Equity Shares under Rule 11UA of the Income Tax Rules? 

• Discounted Cash Flow: With the help of this method the fair value of the unquoted shares is calculated as the sum of the present value of all the expected future cash flows which a company is expecting to generate by discounting it to the present date at the risk-adjusted discount rate. The discount represents all the associated risks with the investment and the time value of money. 

• Net Asset Value: This method is also known as the NAV and in this method, the value of the unquoted equity shares is calculated by considering the net worth of the company whereas this Net Worth is calculated by deducting the liabilities from the total assets of the organisation which can be ascertained from the balance sheet of the company. 

• Comparable Company Analysis Method: This method is used to evaluate the investment and analyze the financial sound of the company. This method involves the comparison of the target company with other similarly traded companies by taking into consideration that these companies have similar characteristics and financial metrics. 

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

Multiple = Valuation Driver/ Valuation Measure 

Whereas Valuation Driver stands for Revenue, EBIT, EBITDA and P/E

Valuation Measure stands for Enterprise Value

Enterprise Value stands for Market Capitalisation + Total Debt – Cash and other equivalents.

Market Capitalisation is equal to the current price of the stock * number of the outstanding stock shares

Total Debt = Equal to the sum of the Long-Term and Short-Term Debt

• Option Pricing Method: This method estimates the fair market value of the shares which is used by considering the value of the option to purchase or sell the shares in the future. It is assumed in this method that the value of the shares is equal to the present value of the expected future cash flows which includes the option to either sell or purchase the shares. The series of these future call options represent the various classes of the shares and are assigned a bunch of the future value which is based on the equity value. This Equity Value is based on the estimated time to exist and the various features of the equity and the volatility of the company. 

Whereas:

C stands for Call option Price

S stands for Current Stock Price

R stands for Risk-Free Interest Rate 

T stands for Time for the Maturity

N stands for the 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 is 5% and the time of maturity is 1 year and the Normal Distribution is 0.4267

C = SN (d1) – Ke -rtN (d2)

C = 100e – 0.021 * 1 * 4097 – 105e – 0.3365 

Per Share C = 3.74 

• Milestone Analysis Method: In this method, the computation of the fair value of the shares is performed and this method is widely used by companies that have a very minimal history of operating such as start-ups. With this method, it is aimed to identify the specific milestone that the company is aiming to achieve. 

The Steps which are performed for the Analysis in the Milestone Method 

• Defining Milestone: The first step is to identify the key event that is required to be specific, achievable, relevant and measurable for the company and these milestones are required to be achieved in a time-bound manner. 

• Criteria Establishment: The second step in the process after defining the milestone is to establish the criteria against the achievements for calculating each milestone. 

• Assigning of the Responsibilities: The next step in the process is to assign the teams and the individuals responsibilities for achieving the milestones and it is essential for the completed milestones to be evaluated in the light of these pre-determined criteria. 

• Communication of the Progress: It is very much required that the progress of these milestones must be communicated to the team members, individuals, management, stakeholders and the client. 

• Analysis of the Milestone: After the communication of the milestone progress it is essential that these milestones are analysed in a timely manner by the project managers to maing informed decisions in order to keep the project on track. 
• Share Benchmarking: In this method, it is assumed that the entities notified obtain the consideration for the issue of the shares and the price of the equity shares corresponding to the consideration is assumed as the Fair Market Value of the Equity Shares which are issued in the same category of the investors. 

• Probability Weighted Expected Return Method: The method estimates the fair market value of the organisation by taking into consideration the different future outcomes by assuming that the value of the organisation is equal to the present value of its expected cash flow in the future by weighing the possibility of each result. 

The Curent Value of the Company is Rs. 100

Case A: The price of the Share is increased by 15% with a probability of 60%

Case B: Share Price is decreased by 5% with a probability of 40% 

The Fair Maret Value = Current Share Price + Overall Expected Return = Rs. 100 + Rs. 7 (100*7) 

Share Price = Rs. 107 

• Replacement Cost Method: In this method, the fair market value of the shares is arrived at by taking into consideration the cost of replacing the business with a similar business as it is assumed that the buyer will not pay more for a business other than the cost of replacing it. 

Twenty Years ago, XYZ. Ltd company bought a piece of machinery for Rs. 30,00,000 and after the completion of the twenty years, the company is required to decide if a piece of new machinery is to be bought or they shall continue with the older one. Today, the current value of the machinery is Rs. 10,00,000 after deducting the depreciation. Let’s assume that the replacement cost of the same machinery is Rs. 20,00,000. Then, the management of XYZ Ltd. must opt for the replacement of the machinery because it will also add value to the business. 

Conclusion 

Section 50CA has been introduced to curb the practice of the undervaluation of the property or the shares of the company at the time of the transfer. Therefore, it has become essential that the valuation should be performed under Rule 11UA of the Income Tax Act by either a Registered Valuer or a Merchant Banker in order to avoid any undervaluation and the evasion of the taxes. 

Frequently Asked Questions on Section 50CA of Income Tax Act

Q 1. What is the applicability of Section 50CA of the Income Tax Act?

Ans1. Section 50CA is applicable in cases where there is a transfer of the assets or the shares between related parties. 

Q2. What is Section 50c of the Income Tax Act?

Ans2. Section 50c of the Income Tax Act provides for adopting value in accordance with the Stamp Valuation Authority in the case where the sale consideration is less than the determined value.

Q3. What is Rule 50 of the Income Tax Act?

Ans3. Section 50 of the Income Tax Act deals with the capital gain on the Sale of Depreciable Assets. 

Q4. Who can apply for lower deduction certificate?

Ans4. Under Section 197 of the Income Tax Act, if the taxpayer’s tax liability is less than the amount of the TDS that will be deducted from their income, then such a taxpayer can file a FORM 13 to avail of the lower deduction certificate. 

Q5. Is it necessary to reply to show cause notice?

Ans5. Yes, it is absolutely necessary to reply to the show cause notice and if there is any failure to respond to the show cause notice a decision be made by the Income Tax authorities. 

Q6. What is Section 50AA of Income Tax Act?

Ans6. Section 50AA of the Income Tax Act deals with the special provisions for the computation of the capital gain from Specified Mutual Funds and Market-Linked Debentures, categorising these capital gains as Short-Term Gains.

Q7.  Which Form is Senior Citizen Tax Exemption?

Ans7. FORM 15H is the form used for the Senior Citizen Tax Exemption, which is applicable to individuals above 60 years of age. 

Q8. What proof can be submitted for tax exemption?

Ans8. The proof that can be submitted for tax exemption are the Receipts of the Insurance Premium, Rent Receipts, Housing Loan Documents, ELSS Mutual Funds and Public Provident Fund Deposit Receipts. 

Q9. Is Selling of Agricultural land taxable?

Ans9. No, selling of the rural agricultural land is not taxable and income from such agricultural land is exempted. 

Q10. How much is TDS on property sale?

Ans10. It is 1% of the total transaction value, which is the applicable TDS on the sale of the immovable property.