EY Tax Alert. Executive summary

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1 07 June 2016 EY Tax Alert Mumbai Tribunal rules contractually agreed fixed return on equity investment is akin to interest on fixed deposit taxable on year-on-year basis Executive summary Tax Alerts cover significant tax news, developments and changes in legislation that affect Indian businesses. They act as technical summaries to keep you on top of the latest tax issues. For more information, please contact your EY advisor. This Tax Alert summarizes a recent ruling of the Mumbai Bench of the Income Tax Appellate Tribunal (Tribunal) in the case of Mahindra Telecommunications Investment Pvt. Ltd. (Taxpayer) [1] on the issue of taxability of contractually agreed fixed return on equity investment. The Taxpayer, an Indian company, invested in 26% equity of another Indian company (ICo) where balance 74% was invested by a foreign company (FCo) under a shareholder agreement (SHA). The SHA ensured income to the Taxpayer by way of call option fee of 5.5% p.a. on equity payable by FCo. The terms of SHA as structured between the parties also ensured a return on 11% p.a. on compounded basis to the Taxpayer by way of share price on exercise of put option against FCo or call option by FCo anytime after three years of SHA or relaxation of Foreign Direct Investment (FDI) limits by Indian government, whichever is earlier. Considering the peculiar terms of SHA which virtually ensured return on equity for the Taxpayer from FCo as part of sale price of equity shares any time in future and irrespective of the actual fair value of the equity shares, the Tribunal concluded that the return was characteristically no different from call option fee of 5.5% payable on annual basis. The return was akin to interest receivable on fixed deposit placed with bank and, hence, taxable on year-on-year basis for taxpayer following mercantile method of accounting. The Tribunal held that the fact that such return was contractually receivable only upon sale of shares pursuant to exercise of put/call option and as part of sale price of shares was not relevant. [1] [TS-296 TRIBUNAL 2016] (Mum)

2 Background and facts FCo is a global telecom player and desired to invest in India at a time when FDI regulations permitted foreign investment in telecom sector up to 74%. FCo entered into a SHA with the Taxpayer who agreed to invest balance 26% in ICo on the terms and conditions as agreed in SHA. The terms of SHA ensured following return to the Taxpayer: A call option 5.5% p.a. on equity investment payable by FCo to Taxpayer on annual basis. Besides, the SHA granted irrevocable call option to FCo and put option to the Taxpayer on the Taxpayer s 26% equity holding at an option price which was determined by SHA at original investment plus 11% p.a.on compounded basis over the period of holding FCo could exercise its call option to increase its holding in ICo to the extent permissible under FDI regulations by requiring the Taxpayer to sell equity shares to FCo or its affiliates at the option price. The Taxpayer could exercise its put option to sell shares at the option price to FCo (or its affiliates) which had right to first refusal. The put and call options could be exercised on or after three years of investment or relaxation of FDI regulations, whichever is earlier. Even if either options are not exercised after three years, the option price shall 11% p.a. on compounded basis till the date of exercise of options at any time after three years. Dispute arose with the Tax Authority on tax treatment of return by way of option price which as per terms of SHA increased every 11% p.a. on compounded basis. The Taxpayer took the position that the return by way of option price would be taxable as capital gains as part of share sale price in the year of sale of shares to FCo (or its affiliates) pursuant to exercise of options as per the terms of SHA. According to the Taxpayer, the structuring of option 11% p.a. on compounded basis was merely a valuation mechanism and no enforceable debt accrued in favour of the Taxpayer until the sale of shares [2]. On the other hand, the Tax Authority asserted that the option price was akin to interest receivable on fixed deposit placed with bank and was taxable on year-on-year basis as revenue 11% p.a. on compounded basis as agreed in SHA. The First Appellate Authority upheld the Tax Authority s view. Being aggrieved, the Taxpayer appealed further to the Tribunal. Issue before the Tribunal Whether return on equity by way of enhanced option price accrues to the Taxpayer from day to day i.e. on the basis of holding period for each taxable year comprised within the holding period of equity shares or it accrues only on the sale of shares on exercise of options by either of the parties?. There was no dispute with the Tax Authority on taxation of annual call option fee of 5.5% p.a. which was offered to tax as Business income on year-onyear basis by the Taxpayer. [2] Reliance placed on E.D. Sassoon and Co. Ltd v. CIT (1954)[26 ITR 27](SC) and CIT v. Canara Bank (1992)[195 ITR 66](Kar).

3 Tribunal ruling The Tribunal ruled in favor of the Tax Authority and held that the return on equity was taxable as revenue income accruing from day to day on the basis of holding period for the following reasons :- Concept of accrual as per Accounting and under Tax laws are in harmony with each other The legal concept of accrual is well settled by a series of Supreme Court (SC) rulings [3] which has equated accrual with vesting of right to receive income in favor of taxpayer. However, the provision of Indian Tax Laws (ITL) which defines scope of total income is subject to other provisions of the ITL including provision which states that income under the heads Profits and gains of business or profession or Income from other sources shall be taxable as per cash or mercantile method of accounting regularly employed by the Taxpayer. The Central Government is empowered to notify Income Computation and Disclosure Standards (ICDS) [4] to be followed by any class of taxpayers or in respect of any class of income. The Taxpayer being a company is bound by mercantile method of accounting and accounting standards (AS) notified under Companies Act as also by ICDS notified under the ITL. Both AS and ICDS define accrual as earning of income or incurrence of expenditure as distinguished from actual receipt or payment thereof. Further, AS-9 requires recognition of interest income on time basis i.e. as it accrues from day-to-day. Furthermore, both AS and ICDS place emphasis on substance over form principle in terms of which accounting treatment and presentation of financial statements of transactions and events should be governed by their substance and not merely by the legal form. [3] Reliance placed on SC rulings in the cases of CIT v. Gajapathy Naidu (1964) 53 ITR 114 (SC) and CIT v. Ashokbhai Chamanbhai (1965) 56 ITR 42 (SC) [4] Earlier known as Tax Accounting Standards The accounting concept of accrual and substance over form principle have force of law since AS/ICDS have been notified under Companies Act/ITL granting them legal mandate. Thus accounting concept of accrual is in agreement with concept of accrual as judicially explained and they are in harmony with each other. A fundamental aspect of such accrual concept is that income does not cease to accrue merely because it is realisable at a future point of time. The Tribunal considered two illustrations for this concept viz. (a) interest accruing on fixed deposit on compounded basis from year to year; and (b) sale price of goods receivable after a credit period. Right to sell shares and right to enhanced option price are two separate distinct rights The terms of SHA made it clear that right to sell shares pursuant to put option and right to enhanced option price compounded 11% p.a. are two distinct and separate rights. Right to sell shares merely determined the point of time of realisation of income whereas right to enhanced option price for the period of holding of shares ensured income to the Taxpayer which accrued on continuous basis corresponding with period of holding. There was no contingency or uncertainty attached to enhanced option price. In fact, there was no material difference between call option fee and enhanced option price. The only difference was call option fee was payable on yearly basis whereas option price was payable on sale of shares which was merely a difference on timing of realization of income. The Tribunal placed emphasis on term of agreement which specified that the parties acknowledged that the option price plus the call option fee represents a reasonable return on equity investment in the ICo.

4 Nature of rights based on substance over form principle The Tribunal placed emphasis on the fact that the parties had agreed for compounded rate of 11% p.a. for increase in option price. Implicit in the concept of compounding is reinvestment of income which accrues in Year 1 such that both principal and interest accrued in Year 1 fetches further interest in Year 2 and so on. The aspect of compounding had to be viewed along with other feature of the SHA in terms of which the actual fair price of the shares of ICo or performance of ICo during holding period was made irrelevant. On a conjoint reading of these aspects, it was clear that, in essence, the nature of financial instrument was that of earning income at a defined (agreed) rate, rather than a promoter investing in an enterprise by undertaking the risk of rise or fall in its value based on actual performance of the enterprise. The equity shares, thus, represented only a medium and manner in which the investment took place, which was parking funds by the investor calculated to yield a definite and stipulated rate of return. Right to receive return on equity accrued on time basis The terms of the SHA made it clear that the right to receive return on 11% p.a. on compounded basis accrued in favor of Taxpayer on day-to-day basis and what was deferred was merely the realization of such income till sale of shares. This was comparable to interest accruing on fixed deposit or trade debt receivable post credit period as illustrated earlier. Even looked at from the perspective of payer of income, the liability to pay return on equity was being incurred by FCo on a day-to-day basis. The investment in equity shares was in substance a financing arrangement Notwithstanding the investment in equity shares i.e. risk capital, the SHA insulated the Taxpayer from any such risks and contractually assured the Taxpayer of a fixed return irrespective of actual fair value of shares. The call option fee and return on equity by way of enhanced option price was inconsistent with investment in equity shares. The investment had to be construed along with terms of SHA which put restrictions on Taxpayer (e.g. Taxpayer had no right to management, could not sell, assign, transfer or otherwise dispose or encumber the shares in any manner). The transfer at pre-determined option price was made essence of the agreement breach whereof would have resulted in termination of agreement. This showed that for all intent and purposes, the investment in shares was an investment for a definite period at a particular return. It was akin to financing arrangement yielding return (income) as a function of time. There was no uncertainty or contingency attached to the accrual. There was also no dispute on reasonable certainty of ultimate collection which could have deferred the accrual as per AS. Return on equity fell within inclusive definition of income Legal enforceability of debt becomes relevant for accrual of income when the basic right to receive income is disputed. Where there is no dispute on taxpayer s right to receive income, the accrual does not stand deferred to the point of time it becomes legally enforceable. Income is inclusively defined for the purposes of the ITL and is a term of wide amplitude such that anything which conforms to notion of gain or benefit in common parlance is within the scope of income. The return on equity by way of enhanced option price was merely an alternative

5 form of call option fee which was admittedly taxable as income. The call option fee was akin to interest. The call option fee and return on equity was comparable to interest on bank deposit which was repayable on maturity along with principal amount. Consistency with matching principle Taxation of return on equity on year-onyear basis was consistent with matching principle of income and expenditure since the Taxpayer had incurred borrowing 10% to 14% for investment in ICo. The interest expenditure on borrowed funds was being allowed as admissible expenditure. Hence, taxation of both call option fee and return on equity on parallel basis against allowance of borrowing cost was justified on matching principle. Comments The present Tribunal ruling is based on peculiar facts and terms of SHA where the Tribunal noted that it virtually granted contractual right to the Taxpayer to earn return on equity akin to interest on fixed deposit. The Tribunal also noted the facts of the case to apply substance over form principle such that the assured compounded return is to be taxed on time basis though its actual realization may be at a future point of time. The ratio of the ruling may be distinguishable in cases where an investor in equity shares is not insulated from the risks of investment and is not assured of a fixed or pre-determined exit price dehors the actual fair value of such shares on the date of exit. The present ruling also highlights the substance over form approach which may be adopted by the Tax Authority even prior to applicability of General Anti-Avoidance Rules (GAAR) provisions which are to become effective from 1 April 2017.

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