With increasing globalization world over, corporate world has dissolved national boundaries and the multinational enterprises have expanded their footprints worldwide by setting up subsidiaries, joint ventures and other form of enterprises. The growth of these entities although a welcome move, creates complex taxation issues for both tax authorities and the multinational enterprises since diversity in country rules for the taxation of the associated entities of the group cannot be viewed in isolation. In order to tackle the complex issues involved in the transaction between two enterprises of the same group with different tax jurisdiction, the Indian Finance Act 2001 introduced a mechanism on Transfer Pricing (“TP”) under sections 92 to 92F of the Indian Income Tax, 1961 (“the Act”). The Indian TP regulations provide that any income arising from “international transactions” between associated enterprises should be computed having regard to the arm’s length price.
Since the introduction of TP provisions in 2001, India has witnessed a flurry of litigation in TP resulting in enormous adjustments. With increasing number of multi-national companies operating in India and growing number of intra-group cross-border transaction, TP has emerged as one of the significant tax concerns for multinational companies in India. In the recent years, the Indian tax authorities have spotted various issues in relation to cross border transactions amongst the related entities of a multinational group and the view adopted by the assessing officers are becoming more stringent and aggressive.
Given the noticeable trend, the latest in the list which has gained attention is taxing the capital transactions, which basically revolves around the international concept namely, ‘Value Shifting’. Value Shifting is virtual shifting of the market value of the underlying asset without change in its tax values from one party to another, and is viewed as a mechanism by the taxpayers to obviate taxes through various schemes and arrangements. This may be undertaken through stilted arrangement and series of transactions, which often, do not attract substantial tax implications. One such recent example is issuance of shares by a high valued company to an associated entity at a low value.
Some recent changes in Indian Tax Regime
The Indian tax authorities have recently amended the definition of ‘International transaction’ through Finance Bill 2012 to plug such arrangements of issuing shares at a price lower than the arm’s length price. The ambit of TP provisions has been widened by expanding the definition of international transactions to include capital financing; guarantees; any debt arising during course of business; business reorganizations or restructuring irrespective of whether or not the same has an impact on current year’s profits, income, losses or assets; intangible properties including marketing intangibles, human assets, technology related intangibles, etc.
The aforesaid change is further strengthened by the recent Central Board of Direct Taxes (“CBDT”) notification on amended Form 3CEB, an accountants report under section 92E of the Act, to widen the scope of details required to be provided in said report, which inter-alia includes issue of equity shares or marketable securities to its overseas related entities.
From a domestic point of view, specific provisions under section 56(2)(viib) of the Act existed to tax the transferee on issuance of shares by a closely held Indian company for an inadequate consideration. The recently introduced General Anti-Avoidance Rules to counter cases of tax-avoidance practices by the taxpayers would give teeth to the Transfer Pricing Officer (“the TPO”) once implemented.
Nevertheless, the tax authorities have been challenging the valuation and the underlying methodologies adopted by the taxpayer for any transaction and make adjustments to impose higher taxes. With widening of the definition of international transaction for application of TP provisions in India, the arm’s length price for such transactions has become the subject matter of debate in many cases.
The debate gains more significance in light of the new economic reforms and new multinational entities venturing into Indian markets as it creates lot of tax ambiguities.
Some recent controversies
The Finance Ministry has informed the Lok Sabha that in the year 2012-13, 27 cases of undervaluation of shares sale by Indian companies to their associated enterprises had been detected and were subject to TP adjustments, in accordance with the provisions of the Act. The list includes five Essar group companies, Shell India Markets, HSBC Securities, Standard Chartered Securities, Havells India and Patel Engineering.
Some noteworthy TP adjustments have been made in the case of Shell India Markets Private Limited (“Shell India”) and Vodafone India Services Private Limited (“Vodafone India”) for assessment year 2009-10 under section 92 CA of the Act on the issue of undervaluation of shares transferred to their AEs.
The controversy fundamentally revolves around taxation on the undervaluation of shares issued by Shell India to its overseas group entity, more specifically under the extant Indian TP regulations and seeks to tax Shell India on alleged issuance of shares at a discounted rate.
Shell India, having diversified businesses in India, was issued with a TP order from the tax authority alleging that the Company undervalued its shares when raising money from the Shell group entity during the financial year 2008-09. Shell India issued 870 million equity shares at INR 10 each (which was the par value) to Shell Gas BV. During TP audit, the TPO asked Shell India to justify the pricing of the equity shares issued to Shell Gas BV. In response, Shell India justified the price of the equity shares based on discounted cash flow (“DCF”), as provided under the Indian foreign exchange regulations and the value per share was determined at INR 6.93.
The TPO recomputed the price per share, using DCF method, but at INR 183.44 and held that Shell India has transferred its equity shares to its overseas group entity at a price below their fair market value. The difference in valuation, so arrived by TPO, was branded as a ‘loan’ advanced by Shell India to its overseas group entity. While doing so, the TPO also alleged that Shell India ought to have charged interest on the same thereby resulting an overall adjustment to the tune of INR 152bn (equivalent to USD 2.8bn). Consequently, the TPO imposed tax on the short receipt of share capital as well as a notional return calculated on such short receipt.
To challenge the constitutional, jurisdictional, legality, validity and judicial propriety of the TP order, Shell India has filed a writ petition before the Hon’ble Bombay High Court. In its grounds of appeal, Shell India has mentioned that the action of the tax authority is based on misrepresentation of the Act and hence, confiscatory in nature. It further states that the adjustment on account of re-characterization of transaction is not permitted in Indian TP regulations and such an action clouts arbitrariness and unfair besides being illegal and disregard of the fact that as per the corporate and regulatory framework and laws, the alleged shortfall (i.e. so called share premium) can never be received by Shell India as the shares were issued at par value.
This matter is yet to be adjudicated by the Hon’ble High Court and it’s not apt to comment on the righteousness of the case or any facts thereto.
In 2009, Vodafone India issued shares to its AE - Vodafone Teleservices Mauritius. The revenue authority issued an order to Vodafone India alleging that the Indian company underpriced its shares issued to the Mauritius Company by around INR 13bn.
On the lines of Shell India, Vodafone India has also filed a writ petition before the Hon’ble Bombay High Court in relation to the under valuation of shares.
Controversies in controversies
The reference to these cases gains importance owing to couple of reasons. First, is the amount involved on account of TP adjustment made by the tax authority and second, which is more significant, is the aggressive position taken by revenue authority to look beyond the certified valuations for capital transactions and thus, imposing tax on virtual shift in the values and tax the amounts which are not considered to impact income of any of the parties.
Traditionally, the line of argument adopted by taxpayers has been that TP provisions are not applicable to share transactions being capital transactions not having a bearing on profits or rather lacks any income element. However, even after the changed definition of ‘international transactions’, the crux of the issue revolves around the applicability of TP provisions to transactions which do not impact income such as issue of shares.
In the recent times, the positions adopted by the TPO are more rigorous since they have either challenged the valuation methodology adopted by the valuers for determining the share price or challenged the underlying assumptions made for determining such valuations. The focus is to impose tax on any case of issue of shares which is under-valued by treating it as the income of shareholders.
These controversies add another perspective to the TP regime and seek to expand the scope of taxation in India, even in the absence of any specific taxing provisions to that effect. This brings forth a situation wherein taxpayers could face the risk of being penalized due to application of the same valuation method (i.e. DCF) by two different government authorities i.e. foreign exchange control regulators and the tax authorities, albeit using different set of assumptions.
Further, the secondary adjustment (i.e. branding the shortfall of consideration on issue of shares as loan and making adjustment on account of notional interest) would cause extreme hardship to the assesses since these tax adjustment may continue indefinitely, as the said shortfall would never ever be plugged due to the foreign exchange regulations.
What lies ahead?
The controversies created through these TP adjustments have to be seen in a larger perspective from India point of view. The hardships caused to the foreign players making investment in India at the tax assessment stage could act as a serious deterrent to the foreign investment in future.
It is time for all investors to be very methodological in their approach at the time of issue of shares by their Indian group entities and ensure robust assumptions, valuations, documentations, and justifications to address any possible dispute with the tax administration in future.
The new disclosure requirement as mandated by the recent CBDT notification has already caused a stir in corporate circles in light of the huge demand raised on Shell and Vodafone case. And such provisions may make TP compliances more burdensome for the tax assesses, and open doors to invite additional litigations during assessment proceedings.
Do these controversies indicate that the price determination for transaction on issue of shares shall be different for foreign exchange compliances vis-à-vis computing arm’s length price under Indian TP regulations? And could that valuation be again open for challenge by the revenue authority? These are some of the questions that remain unanswered and many more are yet to be unveiled with the extremity of tax litigation in India. We would need these answers not purely from a tax viewpoint but in a larger spectrum of bringing certainty and definitiveness for foreign investors In order to make the climate conducive for foreign investment.
Rakesh Nangia is Managing Partner, Nangia & Co. (assisted by Mr. Nikhil Goenka, Manager, Nangia & Co.)