Why investors should be wary of pricing guidelines
September, 11th 2017
‘Price is what you pay. Value is what you get’. Most of us would have read this profound quote by Warrant Buffet, one of the most successful investors of all time. The quote lays down the fundamental principle for making investments.
While an investor may use this principle to derive pricing arbitrage while making an investment in securities, regulators and tax authorities globally are using the same principle to tackle regulatory non-compliances or tax avoidance situations.
For the same purpose, Indian regulators have introduced various pricing guidelines for independent and fair determination of ‘value received’ by investors against the actual ‘price paid’ by them. The value so determined is commonly referred to as the fair market value (FMV) of securities under these pricing guidelines.
Why are pricing guidelines relevant?
Indian regulators have framed pricing guidelines with a primary objective to control foreign exchange flowing in and out of India, bringing transparency and fairness to investors and for protecting the interest of various stakeholders of a company. Pricing guidelines are also formulated as an anti-avoidance tax measure.
Who does pricing guidelines impact?
Pricing guidelines impact a number of transactions, including deals in securities, whether undertaken by a nonresident or resident investor, a related or unrelated party, the Indian company issuing shares, etc.
Accordingly, one has to be extremely conscious while entering into any transactions to make sure that the applicable pricing guidelines are complied with.
Transaction in securities by foreign investors
In case of an issue of unlisted shares to a foreign investor under the FDI route, the following pricing guidelines are applicable under the current regulatory and tax framework, which prescribe the minimum price at which the foreign investor can invest:
Exchange control regulations (FEMA) – FMV of shares as per any internationally accepted pricing methodology on an arm’s length basis Income-tax Act, 1961 (IT Act) – FMV based on net asset value—i.e., book assets minus book liabilities (in the manner prescribed)—for equity shares and for securities other than equity; the FMV it would fetch if sold in an open market
Transfer pricing provisions under the IT Act – In case of a transaction between related parties, FMV based on the arm’s length price for the transaction Companies Act, 2013 (Cos. Act) for an Indian company issuing the shares – FMV based on the report obtained from a prescribed valuer.
In case of any transaction related to listed shares, one also has to comply with the pricing guidelines prescribed by the Securities and Exchange Board of India (SEBI). This is typically computed based on the price quoted on a recognised stock exchange in India. For transfer of shares, all of the above pricing guidelines apply, except for pricing under Companies Act. In fact, for transfer of unquoted shares, the FMV under the IT Act will need to be tested both for the transferor (for computing capital gains) as well as for transferee (for deemed income), to avoid any potential taxation of notional income in the hands of both the transferor and the transferee. On the other hand, if the Indian company issues shares to a resident investor above the FMV as prescribed, it would be liable to tax under section 56(2)(viib) of the IT Act. For this purpose, FMV of shares can be undertaken using DCF or NAV method.
In case of issuance of any convertible instrument, the conversion price cannot be lower than the FMV as computed under FEMA and Companies Act. Also, the IT Act is not very clear whether one has to test the FMV guidelines at the time of issuance of such instruments or conversion or both, resulting in further uncertainty in relation to taxation.
The multifold pricing guidelines clearly create a minefield that investors has to be conscious of, as any incorrect (non-compliant) step taken can result into adverse tax and regulatory implications. This minefield becomes even more complex to maneuver if one were to add the requirement of different dates prescribed under the respective pricing guidelines for determination of FMV in respect of a transaction.
Some transactions where pricing guidelines become relevant
Promote structures where, based on the performance of the company, the promoter of the company is entitled to an additional stake, which is typically issued at a nominal value.
Valuation adjustments/anti-dilution events where the investor has agreed to invest at an agreed valuation with a clause that if the company does not achieve its performance milestones, then it will be entitled to some valuation adjustment, resulting into investor getting additional shares in the company without or with nominal consideration.
Distressed situation where the commercially agreed FMV of shares of a distressed company may be lower than its net asset value—i.e., book assets minus book liabilities or in case of listed shares, the price quoted on a recognised stock exchange.
The tax and other regulations seem to deem the ‘value’ that the investor or the buyer or seller is receiving in a transaction. While the intent seems to discourage transactions mainly aimed at circumventing tax and other regulations, unfortunately, there is no exception for genuine transactions between unrelated parties, which are also getting hit as a consequence of these pricing guidelines.