Valuation of unquoted equity shares of investment companies, holding companies, etc. - Guidelines therefor - Income Tax - 118/1973

Circular No. 118 Dated 15/9/1973 Valuation of unquoted equity shares of investment companies, holding companies, etc. - Guidelines therefor CLARIFICATION 1 1. Reference is invited to : ( i ) the Board's Circular No. 2 (WT) of 1967, dated 31-10-1967 [ Clarification 3 ] for valuation of unquoted equity shares ( a ) of investment companies other than those which are substantially holding companies; and ( b ) of investment companies which are substantially holding companies; and ( ii ) the Board's Circular No. 118, dated 15-09-1973 [printed here as Clarification 2 ] (in partial modification of circular dated 31-10-1967) for valuation of unquoted equity shares of investment companies which have wholly-owned subsidiaries. 2. The question of valuation of unquoted equity shares of in vestment companies has been re-examined in the light of the Supreme Court's decision in the case of CGT v. Smt. Kusumben D. Mahadevia [1980] 122 ITR 38. The Board's Circulars dated 31-10-1967 and 15-09-1973 , therefore, stand modified as set out in the succeeding paragraphs. 3. In the light of the above-quoted Supreme Court's decision as also its earlier decision in CWT v. Mahadeo Jalan [1972] 86 ITR 621, the following guidelines are issued for the valuation of unquoted equity shares of investment companies referred to in paragraph 1 above. 1. The principle of combination of the two methods, i.e., the average of— ( a ) the break-up value of shares based on the book value of the assets and liabilities disclosed in the balance sheet; and ( b ) the capitalised value arrived at by applying certain rate of yield of the maintainable profits, has to be discarded. 2. In the case of a company which is a going concern and whose shares are not quoted on the stock exchange, the profits which the company has been making and should be capable of making or, in other words, the profit-earning capacity of the company would ordinarily determine the value of its shares. 3. In the case of a company which is ripe for winding up or if the situation is such that the fluctuations of profits and uncertainty of conditions on the date of valuation prevent any reason able estimation of the profit-earning capacity of the company, the break-up value method will have to be adopted. The later decision of the Supreme Court also refers to its observations in the case of Mahadeo Jalan ( supra ) as under : "....The yield method is the generally applicable method while the break-up method is the one resorted to in exceptional circum stances or where the company is ripe for liquidation...." (p. 634) 4. The question of application of the break-up value method will depend upon the facts and circumstances of the case. One of the cases of exceptional circumstances referred to in ( 3 ) above can be where the assets of the company comprise wholly or mainly of jewellery, precious stones, etc., and the company carries on business of hiring out such assets. In such a case if the income from hiring out of jewellery, gold ornaments, etc., is exception ally low as compared to the normal return expected of these assets, the break-up value method would be more appropriate. 4. For the purpose of para 3( 2 ) above, the following adjustments may be made for working out the maintainable profits : 1. The book profits of the company for the five years immediately preceding the valuation date will be ascertained. 2. Adjustments will be made to the book profits for each of the said five years for all non-recurring and extraordinary items of income and expenditure and losses. 3. Adjustments will be made for expenditure which is not of a revenue nature and is debited in the accounts and for receipts which are revenue receipts and are not accounted for in the profit and loss account. 4. The development rebate/investment allowance, in case it is debited in the books of account, will be added back. 5. The appropriate tax liability of the company on the book profits so determined will be deducted. 6. The profits required for paying dividends on shares with prior rights, i.e., preference shares, shall be excluded. 7. The average of the company's book profits, as adjusted above, will be determined. The rate of capitalisation may be taken at 10 per cent of the maintainable profits of the company in the case of investment companies other than those which derive the major part of their income from house property and 8.5 per cent in the case of investment companies which derive the major part of their income from house property. 5. In the case of unquoted equity shares of investment companies which are substantially but not wholly holding companies, the fair market of the shares will be determined by adding a premium of 10 per cent to the value of shares arrived at on the basis as set out in the preceding paragraph. 6. The valuation of unquoted equity shares of an investment company which has a wholly-owned subsidiary should be worked out on the basis that the parent investment company and wholly-owned subsidiary or subsidiaries were, in fact, one single company, on the same lines as laid down in circular dated 15-9-1973. The rates of yield to be applied would be 10 per cent and 8.5 per cent as mentioned in para 4 above. 7. The above may please be brought to the notice of all the Assessing Officers in your charge. These instructions will apply to all pending assessments and will hold the ground until rules for the valuation of above shares, which are under consideration of the Board, come into force. Circular : No. 332A [ F. No. 326/2/80-WT ], dated 31-03-1982 . CLARIFICATION 2 1. Reference is invited to the instructions contained in the Board's Circular No. 2 (WT) of 1967, dated 31-10-1967 [printed here as Clarification 3 ] regarding valuation of unquoted equity shares of investment companies, holding companies and managing agency companies. 2. In partial modification of the above circular, the directions and instructions of the Board with regard to the valuation of unquoted equity shares of investment companies which have wholly-owned subsidiaries ( i.e., investment companies having one or more companies which are itself 100 per cent subsidiaries), are as follows : 1. In arriving at the estimated price which a share of such company would fetch if sold in open market on the relevant valuation date, its "asset backing" must be carefully computed in accordance with well settled principles, in other words, the valuation should take into account the complete enterprise (consisting of the parent investment company and its wholly-owned subsidiary or subsidiaries) as if they were only one company. In arriving at such computation the reserves of the subsidiary company must necessarily be taken into account. 2. Applying the above principles : ( i ) The value of a share of the parent investment company would have first to be determined on the basis that the parent investment company and its wholly-owned subsidiary or subsidiaries were in fact one single company. This should be done by assimilating and consolidating the balance sheets of the subsidiary companies with the balance sheet of the parent investment company. Care must be taken to ensure that in such assimilation and consolidation, the inter-company balances are correctly adjusted. ( ii ) "Maintainable profits" would have to be aggregated in respect of the parent investment company and its wholly-owned subsidiary or subsidiaries. The capitalised value should then be arrived at by applying a rate of yield of 9 per cent to the aggregated "maintainable profits". The method of calculation of "maintainable profits" in respect of the parent investment company and its wholly-owned subsidiary or subsidiaries should be in accordance with the Board's Circular No. 2 (WT) of 1967, i.e., they should be determined separately in accordance with the said circular and then aggregated. ( iii ) The average of the values arrived at under ( i ) and ( ii ) above would determine the price which the share of the parent investment company would fetch if sold in the open market on the relevant valuation date. 3. It is clarified that para 3 of Circular No. 2 (WT) of 1967 [ Clarification 3 ] will not apply in cases of valuation of shares of a parent investment company which has a wholly-owned subsidiary. 4. The above instructions, which are to be read in partial modification of Circular No. 2 (WT) of 1967 are to be followed and implemented in all matters with immediate effect including pending proceedings. Circular : No. 118 [ F. No. 319/16/73-WT ], dated 15-9-1973 . CLARIFICATION 3 1. The method of valuation of unquoted equity shares of ( i ) investment companies, and ( ii ) holding companies has since been further examined and the following instructions regarding the valuation of unquoted equity shares of ( i ) investment companies, ( ii ) holding companies, and ( iii ) managing agency companies are issued in supersesstion of all the earlier instructions for the guidance of the Wealth-tax Officers. 2. Unquoted equity shares of investment companies other than those which are substantially holding companies - An "investment company" has been defined in rule 1A( g ) of the Wealth-tax Rules, 1957, as a company whose total income consists mainly of income which, if it had been the income of an individual would be regarded as unearned income. Unearned income means all incomes other than "earned income" as defined in the Finance Act of the relevant year. Although the definition of investment company would not cover a banking/insurance company, but to avoid all doubts in the matter, it is clarified that banking and insurance companies will not be treated as investment companies. Their shares will be valued under rule 1D of the Wealth-tax Rules, 1957. The average of ( a ) the break-up value of the shares bases on the book value of the assets and liabilities disclosed in the balance-sheet, and ( b ) the capitalised value arrived at by applying a rate of yield of 9 per cent of its maintainable profits will be taken to represent the fair market value of the shares of an investment company. Maintainable profits of a company should be calculated as under : 1. The book profits of the company for the five years immediately preceding the valuation date will be ascertained. 2. Adjustments will be made to the book profits of each of the said five years for all non-recurring and extraordinary items of income and expenditure and losses. 3. Adjustments will be made for expenditure which is not of a revenue nature and is debited in the accounts and for receipts which are revenue receipts and are not accounted for in the profit and loss account. 4. The development rebate, in case it is debited in the books of account, will be added back. 5. The appropriate tax liability of the company on the book profits so determined will be deducted. 6. The profits required for paying dividends on shares with prior rights, i.e., preference shares, shall be excluded. 7. The average of the company's book profits, as adjusted above, will be determined. The maintainable profits thus arrived at will be capitalised, as stated above, by adopting 9 per cent rate of capitalisation. 3. Unquoted equity shares of investment companies which are substantially holding companies - An investment company whose assets to the extent of 50 per cent or more consist of shares in companies controlled by it, will be treated as a holding company. The fair market value of the shares of an investment company, which is also a holding company, will be determined by adding a premium of 10 per cent to the value of the shares arrived at on the basis set out in the preceding paragraph. 4. Unquoted equity shares of managing agency companies - A managing agency company has been defined in rule 1A( h ) of the Wealth-tax Rules, 1957, as a company the entire income of which or any part thereof is derived by way of managing agency. In the case of companies whose income consists wholly or partly of managing agency commission, the higher of the value arrived at according to ( a ) the break-up value method based on the book value of assets and liabilities disclosed in the balance-sheet, and ( b ) capitalisation of income method is to be adopted as the fair market value of the shares. The capitalised value of managing agency commission income and non-commission income will be deter mined separately in the following manner : The capitalised value of the managing agency commission will be taken as the present (that is, discounted) worth of the net income from this source for the unexpired term of the managing agency. From the maintainable managing agency commission (deter mined on the lines stated in para 2 above), the proportionate tax liability will be deducted and the net commission for the unexpired term of managing agency will be calculated. The present worth of this income will be determined with reference to a compound interest rate of 6 per cent per annum. The maintainable non-commission income (determined on the lines stated in para 2 above) will be capitalised at 10 per cent of capitalisation. The aggregate of the capitalised value of non-commission income and the present worth of the net managing agency income will give the total value of the shares of the company. The value per share will be arrived at by dividing the total capitalised value by the number of shares. Illustration XYZ Ltd. is a managing agency company. Its capital consists of 1,000 shares of Rs. 1,000 each. The unexpired life of the managing agency is four years, commission income is Rs. 1 lakh and net non-commission income is Rs. 2 lakhs. Ascertain the value of the share according to capitalised value method. Rs. Maintainable commission income less expenses 1,00,000 Tax at 65% 65,000 Net maintainable managing agency commission 35,000 The unexpired life of the managing agency on the valuation date is 4 years Present discounted value of Re. 1 per annum of managing agency @ 6% for 4 years 3,465 Capitalised value of the managing agency income 35,000 × 3,465 1,21,275( a ) Maintainable non-commission income less expenses 2,00,000 Less : Tax at 65% 1,30,000 Net maintainable non-commission income at 10% rate of capitalisation 7,00,000( b ) Total capitalised value of all the 1,000 shares ( a + b ) 8,21,275 Value of each share 8,21,275 The value determined above will be compared with the break-up value and the higher of the two will be adopted as the market value. TABLE GIVING THE PRESENT WORTH OF RE. 1 @ 6% RATE OF INTEREST FOR YEARS 1 TO 20 PRESENT VALUE OF RE. 1 PER ANNUM AT 6% INTEREST Years 6% compound interest Years 6% compound interest 1 0.943 11 7.887 2 1.833 12 8.384 3 2.673 13 8.853 4 3.465 14 9.295 5 4.212 15 9.712 6 4.917 16 10.106 7 5.582 17 10.477 8 6.210 18 10.828 9 6.802 19 11.158 10 7.360 20 11.470 Circular : No. 2 (WT) of 1967, dated 31-10-1967 .