Financial instruments are valued under different laws and regulations such as the Income Tax Act, The Companies Act, and the Foreign Exchange Management Act. Each has different requirements that have to be taken into account.
There is a requirement to value financial instruments under different laws and regulations such as the Companies Act, 2013, the Income Tax Act, 1961, and the Foreign Exchange Management Act, 1999.
Income Tax Act Requirements
The Income Tax Act has made it compulsory for financial instruments to be valued at a fair value. Here are the different sections of the act that have provisions for the same:
- Section 9(1)(i) relating to income deemed to arise or accrue in India
Under Section 9(1)(i) of the Income Tax Act, the transfer of capital assets, whether direct or indirect, will be taxed if they are held by an entity that was incorporated or registered outside India. Under Clause 3 of Rule 11UB, the valuation of shares that are transferred and taxed under Section 9(1)(i) must be done in keeping with globally accepted valuation norms.
- Section 50CA
Under this section of the Income Tax Act, in case the transfer of shares of unquoted companies is lower in comparison with the fair market value (FMV) of these shares calculated in the way specified under Rule 11UAA of the Income Tax Rules, 1961, then the fair value that is calculated must be deemed to be the whole value of consideration in keeping with Section 48 of the Income Tax Act.
- Section 56 relating to income from other sources
The provisions under Section 50CA of the Income Tax Act are applicable to the transferor and the provisions under Section 56 are applicable to the transferee. Under Section 56(2)(viib), if a company that is not one which has substantial interest of the public, issues shares and receives consideration for the same from resident persons, and the consideration received is in excess of the FMV of the shares calculated under Rule 11U and Rule 11UA of the Income Tax Rules, then the company that issues these shares will be taxed on the difference amount.
Moreover, under Section 56(2)(x) of the Income Tax Act, in case a person receives any securities or shares from another person without any consideration or a consideration that is lower than the FMV, then the transferee will be taxed on the difference between the actual consideration and the FMV, if the difference is in excess of Rs.50,000. The FMV under this section is determined in keeping with Rule 11U and Rule 11UA of the Income Tax Rules.
Companies Act Requirements
Under Section 62 of the Companies Act, 2013, regarding the preferential allotment of shares, the value of shares must be calculated in keeping with the Companies (Share Capital and Debentures) Rules, 2014. Listed shares are not covered under this requirement. Various methodologies are prescribed by these rules, and they can be followed to determine the fair value of a company’s shares.
Foreign Exchange Management Act Requirements
‘Capital Instruments’ are defined to include debentures, share warrants, equity shares, and preference shares issued by Indian companies. Paragraph 4 of the master directions on Foreign Investments in India notified under the Foreign Exchange Management Act further elaborates that Indian companies are allowed to receive overseas investments through the issue of capital instruments to investors. Moreover, debentures will include mandatorily, compulsorily, and fully convertible debentures, and the Foreign Exchange Management Act regulates the transfer of these capital instruments.
Under this regulation, non-residents who hold capital instruments of Indian companies are allowed to transfer these instruments to Indian residents or vice-versa through the sale of such instruments at a value determined by the pricing rules. Based on the pricing regulations under the Foreign Exchange Management Act, the transfer of such instruments through sale must take place at an arm’s length price that must be valued based on any globally accepted pricing rules.
Globally accepted pricing rules mainly imply the use of Discounted Cash Methodology. If any other methodology is considered more relevant or appropriate depending upon the condition of the case, it can be applied after an appropriate background of said case is given.