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Why Share Issuance Cases Lost In The DRP?

Published on Sat, Mar 01,2014 | 17:45, Updated at Wed, Mar 05 at 19:59Source : CNBC-TV18 |   Watch Video :

Like all indirect offshore transfers came to be known as the Vodafone problem, this new tax tangle is better recognized as the Shell problem! Mostly because Shell faces an astronomical 15,000 crore rupee tax demand for having allegedly undervalued shares issued to its parent company. Shell may be the biggest case but it is definitely not the only one. Dozens of such share issuances have been sought to be taxed by the Indian tax department in the past few years. And some of them have already met their fate at the Dispute Resolution Panel or DRP. I don't have confirmed figures, but sources tell me the DRP has already decided on a dozen such cases, including the Essar one - and in all of them the DRP has ruled in favor of the tax department. Eventually, of course this issue will get decided in the Supreme Court - but it's still useful to know on what grounds the DRP ruled in favor of Revenue. To discuss just that, CNBC-TV18's Doshi Doshi spoke to Dinesh Kanabar, Deputy CEO, KPMG and Beni Chatterji, Senior Counsel in the Bombay High Court and Counsel for the Tax Department in many landmark cases.

Doshi: I would like to say two things before we start; one that the media has reported many cases- Essar, HSBC, Standard Chartered, Shell, Vodafone, etc. I am not taking any names in today's discussion, I am only discussing the principle of the matter and the principle seems to be common across most of these cases.

The second bit is that the arguments that I will present to you as the Revenue’s is based on source based information because none of the DRP orders are in the public domain. 

I’m placing in front of you two arguments made by Revenue which seem to have prevailed in the DRP. One on the issue is can share issuance attract transfer pricing provisions? While the Revenue seems to have argued that that Chapter X is a separate code that covers not just real income but notional income as well. Besides the Income Tax Act does not state that only revenue items would be considered as income and to support that argument, they have pointed at capital gains.


Can share issuance attract transfer pricing provisions?

Tax Department says

-          Chapter X is a separate code – covers not just real income but notional income as well

-          I-T Act does not state that only revenue items would be considered as income…ie: capital gains

The second question is - Can such a share issuance be treated as an international transaction? The Department seems to have argued that the nature of a receipt - whether it is a capital receipt or a revenue receipt - has no bearing on the accrual of income for the purpose of Chapter X. Even capital receipts are clearly mandated for examination under the term international transactions as covered under transfer pricing in India. Now, international transactions here refers to the amended definition of international transaction in 92B as per the Finance Act, 2012.


Can share issuance be treated as an international transaction?

Tax Department says

Nature of receipt, whether ‘capital’ or ‘revenue’, has no bearing on the accrual of income under Chapter X - Even ‘capital receipts’ are mandated for examination under ‘international transactions’

How would you respond to both of these arguments made by revenue?

Kanabar: First, you need to put a fact pattern because different fact patterns could lead to different conclusions. So, we take an Indian company which is a wholly-owned subsidiary of a foreign company issuing shares on a rights basis which is subscribed to by the same parent- so there is no value shift happening anywhere. And the question is when such a thing happens, where does income arise? Does any income arise at all because the tenet of Chapter X is to say income arising in an international transaction has to be computed on an arms length basis. I am now not on the capital versus revenue- that's not what I am saying- but when a parent subscribes to further equity shares of its wholly owned subsidiary, does any income arise to anybody at all? That's question number one. 

Second is, assuming that the pricing was not arms length, what would that difference be? So, let us assume that an Indian company issues shares at par- Rs 10 is the par value- and assuming the tax office claim was that it ought to have been issued at Rs 100 and therefore there is an under valuation to the extent of Rs 90. If assuming this Rs 100 was received, where would the Indian company credit it? Would it credit to some income account and therefore has any income escaped any assessment or would it go to a capital reserve account? To your point and you put a very right point to say that is Chapter X a code in itself, is it a charging section, our transactions relating to shares a subject matter?  So, for example there are several cases where the tax officers come back to say that transactions pertaining to shares could result in income. Section 68 is a very classic example.

Doshi: Issuance of shares?

Kanabar: Let me just come back to what I meant. So take Section 68 which says that if an Indian company receives an unduly high premium and is unable to justify and that premium is not received from a venture capital company etc, then it could be treated as income. So, this is really a case of avoidance where under Section 68 you are saying that Indian company issued shares, it ought to have been issued at a particular price.

Doshi: Just to simplify this for our viewers. If we can just deal with the bit of can this be treated as an international transaction and whether jurisprudence says otherwise in this case how would you defend the many private companies that are facing this… (Interrupted by guest)

Kanabar: It would not be an international transaction because this is not a transaction which impacts either profit, income, losses or assets because unless a transaction impacts these four limbs, it cannot be an international transaction. Therefore it is not an international transaction. Therefore I said, first of all there is no income arising; it is not an international transaction under either of these two provisions- so, can you really subject that difference to income in the hands of the Indian company?

Doshi: How would you respond to that?

Chatterji: Section 92 says any income arising out of or from international transaction shall be computed at arm's length price. So, what it says income arising out of international transactions. Now, international transaction is defined – where it is defined - Section 92B. Let’s come to Section 92B(c). It says capital financing, including any type of long-term or short-term borrowing, lending, guarantee, purchase or sale of marketing securities or any type of advance, payments, deferred payments, receivables or other debts arising.


Section 92(1)

Any income arising from an international transaction shall be computed having regard to the arm's length price


Section 92B: Meaning of International Transaction

(c) capital financing, including any type of long-term or short-term borrowing, lending or guarantee, purchase or

sale of marketable securities or any type of advance, payments or deferred payment or receivable or any other debt arising during the course of business;

Doshi: But wouldn’t you say that all of these have to have an impact on profit, income?

Chatterji: There is a sub section (e) - a transaction of business restructuring, reorganizing, entered into by an enterprise with associated enterprise, irrespective of the fact it has a bearing on profit, income, losses, assets of such enterprise at the time of transaction. This is the view; I mean intimately the courts will decide.


Section 92B: Meaning of International Transaction

(e) a transaction of business restructuring or reorganisation, entered into by an enterprise with an associated

enterprise, irrespective of the fact that it has bearing on the profit, income, losses or assets of suchenterprises at the time of the transaction or at any future date;

Doshi: This is not a issuing share capital, it is not a business reorganizing or restructuring. If I was to look at 92B (c), as you pointed out, capital financing- even there if a transaction has to meet the definition of capital financing, it must also meet the requirement of impacting profit, income etc to be considered as an international transaction.

Chatterji: Issuing a share, if it is of less value, the less money is coming to the company. If the same value would have come to the company, that money would have been invested somewhere. Supposing in some company instead of Rs 100, you bring Rs 20; so now Rs 80 is your short fall. If the Rs 100 would have come so that company would have utilized that Rs 100- either some loan would have been paid off, some company would have made profit or they would have parked that money into some fixed deposit or somewhere, they would have earned money or they had put the entire money in business. So the company which we are taking less money they are deprived of that benefit. 

Doshi: So eventually that Rs 80 difference would have come into the tax stream in some fashion or the other.

Chatterji: And that benefit is been transferred to the Associate Enterprise- so how do we calculate it. What I am telling you, the officers sitting in the international taxation department, they are very well qualified.  The thing which is ultimately portrayed is the government of India, tax department they are just a devil; it doesn't happen like that.

Kanabar: So, there are two aspects to that. First aspect is let’s assume that the country and company is indeed deprived of the money. Is that money the income? So as Mr. Chatterji rightly explained that assuming that in this particular case Rs 100 shares were issued at Rs 20, Rs 80 is the short fall. That Rs 80 could have be used for a variety of things. 

Doshi: Variety of economic activities that eventually would get taxed

Kanabar: Now, it is an income on that activity which would be taxed; not Rs 80 and that's the first distinction which we need to make. So, there are two types of adjustments which have been made by the Revenue in these matters. One is to treat this Rs 80 itself as income and that is where I would have principle disagreement to say why would this Rs 80 be income because that's not income of the recipient company. The second adjustment which has been made is the imputed interest on this Rs 80. So what has been done is to say this Rs 80 constitutes a loan to the parent and therefore to the extent it is not received there is income on it which income needs to be taxed in India - that is what we call as secondary adjustment and additionally I need to make two other points. Our transfer pricing regulations are consistent with OECD and what you find all over the world. We have not written some new regulations. Nowhere in the world is there a known case and I refer to known case- so there could be something which I am not aware of-where anybody has ever attempted to tax this difference as income. Second, there are countries which would regard this secondary adjustment and tax it and in fact in the OECD position paper on this subject, India has actually taken an exception to say that the difference ought to be treated as a loan and interest thereon ought to be taxed. So, even before OECD, it is not India's position that this difference be treated as income. The India's position at OECD ought to accept the position that the difference constitutes a loan an imputed income thereon needs to be calculated and taxed in the hands of the company. 

Doshi: But do we have the provisions for the secondary adjustments?

Kanabar: No, currently we don't. 

Doshi: Even that interest actually is difficult for us to tax in this country because according to your assessment and this is what many tax law lawyers and experts tell me that we don't have provisions for secondary adjustments.

Kanabar: Correct

Doshi: I am going to add one more argument to this. The argument that most of us have understood in some of these cases is what Dinesh Kanabar laid out that the difference in valuation is a deemed loan by the Indian subsidiary to the parent and to the extent that that loan would have attracted an interest payment and that interest would have been taxed therefore there needs to be that taxation. The other argument that seems to be emerging and I understand this from sources that have looked at the DRP report is that to get fair market value for an asset is the right of an Indian entity. In not getting fair market value -which is the Department’s allegation here - you are extinguishing part of that right. So, if you were supposed to get 100 and you get only 50 you are extinguishing that remaining 50. In extinguishing that you are creating a transfer. In creating a transfer you would attack the Income Tax Act provisions in this country and therefore the Department believes on the basis of this argument that such transactions can be taxed. Can you explain this a little further to me so that some how I am able to swallow it?


Can share issuance receipts be considered ‘income’ and be taxed?

Tax department says

-          Issuer has right to receive fair market value or arm’s length value for share capital

-          A shortfall in such value represents an extinguished right and hence is a transfer and hence taxable

Chatterji: We have just stated that the Section itself is very clear. It is about the international transaction and the income has very wide connotations. It is all inclusive – you cannot say it is just one thing or the other. It has very wide definitions

Doshi: Even if you are extinguishing a right which is equal to 80 just to take same example that you …. (Interrupted)

Chatterji: What I said is if the country is deprived of that Rs 80 that would have been utilized by the firm.

Doshi: All that Rs 80 cannot amount to tax…. (Interrupted)

Chatterji: But how do we go about it?

Doshi: Some part of that Rs 80 can lead to a tax demand but all of that Rs 80 cannot be taxed; right?

Chatterji: Right; but then if you have not brought it, we will say this is the amount you should have brought it. This is the arms length price that you should have brought it and since you have not brought it, we will tax you that.

Doshi; So we will tax you on Rs 80. We cannot consider all of the Rs 80 as the money …. (Interrupted)

Chatterji: We don’t know how you would have utilized. The company would have utilized in many ways.

Doshi: But it cannot still amount to income right?

Chatterji: But how do we know? How the tax department will know?

Doshi: How would you argue against this argument that this is an extinguishment of a right; hence it attracts Income Tax Act provisions?

Kanabar: What is the right of the Indian company where an Indian company has made issue of shares at a particular price – that is the only right which it has. There cannot be a notional right. There is no provision in law to tax a notional capital gain on the basis of a deemed assumption of a right.

Two points I would like to make to you at this stage. You made a proposition and I would agree with that, that income is a very wide definition and there are aspects of capital which would come in; so capital gains itself. But there is still a distinction and that distinction should never be lost sight of between revenue income, capital income and capital receipt. A capital receipt is nowhere liable to tax and a share premium account is a capital receipt on capital gain.

Number two, there has to be a transfer. An extinguishment of right is indeed a transfer. However if my right – if I am a 100 percent shareholder and I continue to be a shareholder - where is the income arising here? Income will arise when I sell those shares to somebody. Indeed my cost base is then lower. So, assuming that I had Rs 100 share subscribed at Rs 10 or 20 or whatever….. (Interrupted)

Doshi: That will reflect in your capital gains?

Kanabar: Correct; at that point of time, not today.

Chatterji: The moment an AE buy's a share of Indian company for a lesser value according to us it triggers the international taxation. The moment it triggers the Chapter X, Transfer Pricing comes in picture.

Doshi: If you have a base erosion argument, it needs to be a base erosion argument; not a deemed loan argument or an extinguished right argument. It has to be moderated.

Chatterji: But it cannot be moderated here. They will be moderated somewhere, in some court of law. It cannot be moderated here.

Kanabar: Mr Chatterji said that if a parent acquires shares of a subsidiary, it is indeed a transaction if it is at lower price than it ought to be. I would totally agree with him. This is not a question of buying shares. There is a distinction between buying shares and subscribing to shares.  That is the distinction we should not forget because the Indian company is issuing further shares, there is no transfer of any nature.

Doshi: I was going to say that even when Mr Chatterji referenced 92 (B) (C) where he says capital finances includes purchase and sale of marketable securities because the Supreme Court itself has distinguished between what is purchase and what is …. (Interrupted)

Chatterji: Issue is after undervaluing it.

Doshi: So, this goes to the very heart of whether this is really an international transaction or not because it is issue of shares; not the purchase of shares.

Chatterji: That the matter is pending in Supreme Court; that will be decided.

Kanabar: As I said the entire concept of transfer pricing is value shift. Where has value shifted here?

Chatterji: Value shift and base erosion.

Kanabar: I am saying the entire base of shares, I am holding 100 percent of the shares, there is only a numerical change in whichever form and shape you look at it. When I sell those shares the gains will be taxable under Indian laws as they are. So, where is that income which has moved from India to some other country?

Chatterji: If Rs 100 share is being sold, is being subscribed for Rs 20 then definitely the value is being transferred. Benefit is being transferred to AE and there is a base erosion in this country.

Doshi: Mr Kanabar how would you respond to the base erosion allegation?

Kanabar: Base erosion is income which ought to have arisen in India – we discussed that earlier ….. (Interrupted)

Doshi: And we go back to this whole issue of whether this is income at all or not. There is only one case I could find that could have any bearing - even if slim on this - which was a case called the Vijay Electricals case which was decided by the Hyderabad Income Tax Appellate Tribunal where the ITAT said very clearly that – the facts were reverse in this case. It was an Indian parent investing in a foreign subsidiary. The ITAT said that investment in share capital is a capital investment and is not in the nature of an international transaction. So, we keep coming back to the three issues that I have raised, can this attract transfer pricing provisions, is this really an international transaction? How does this qualify as income?


Hyderabad ITAT, Vijai Electricals case  

Investment in share capital…are capital investments and not in the nature of ‘international’ transactions u/s 92B

Relied on AAR in Re Dana Corporation case: Capital investments do not create chargeable income and hence cannot be brought under TP scope  

Chatterji: This is ITAT matter. I have not gone through this. If I go through this matter, I should be able to distinguish it.

Doshi: We have found that in most of theses cases, again source based information, that the DRP has ruled in favor of the Revenue and I am told that most of these decisions read similar.

Chatterji: I don't know.

Doshi: That’s what I am told; even I don't know for a fact. You are saying that the Revenue stands a very good chance in winning this in a court of law.

Chatterji: Yes, of course we will win.

Kanabar: Let me just ask you a question and you mentioned some names I don't want to get into names. What are you asking a foreign company to pay tax on in this case? On income which is never realized, income which is never earned, shift which has not happened. Are we forgetting and I say this there is a big difference between our policy and our implementation of the policy. We are welcoming foreign investment and then when foreign investment happens, are you creating a climate which is making it uncertain.

Chatterji: I keep hearing that foreign investments will not come because of uncertain taxation. Foreign investments comes and certain companies where we have given the notice they have bought the other companies also; they have injected, they have bought the spectrum also, they are coming big way also.

Doshi: Mr. Chatterji is saying a lot without taking a name.

Kanabar: To say that people will come here despite our tax policies and with due respect to everybody is either naive or is arrogant- one of the two and I am very sorry I have to make this comment.

Chatterji: People will come to country if they have profits. If out of investment of USD 1 they make USD 5 they will come here irrespective of anything and they have come here and they are here.

Doshi: I did not expect that the two of you will agree at the end of this discussion because I do know that there are many such cases that will now play out here onwards in court. However I am thankful that both of you have spend some time with us on The Firm to try and explain the various facets of these cases and eventually we will spend the next two years tracking what we are now calling The Shell Problem.


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