India s Bombay High Court rules on applicability of transfer pricing provisions to issuance of shares to associated enterprises

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1 7 November 2014 International Tax Alert News from the Global Tax Desk Network EY Global Tax Alert Library Access both online and pdf versions of all EY Global Tax Alerts. Copy into your web browser: Services/Tax/International- Tax/Tax-alert-library#date India s Bombay High Court rules on applicability of transfer pricing provisions to issuance of shares to associated enterprises Executive summary In Vodafone India Services Private Limited 1 (Taxpayer), India s Bombay High Court (HC) has ruled that the issuance of shares at a premium by the Taxpayer to its nonresident (NR) associated enterprise (AE) does not generate any income from an international transaction; accordingly Indian transfer pricing (TP) provisions are not applicable. The HC held that a difference between a premium and a fair market value (FMV) consideration received in exchange for issuance of shares is not income, as the consideration received for issuance of shares itself is not taxable under the provisions of Indian income tax law (ITL). The HC examined the nature of share transactions and held that income arising from an international transaction is a condition for application of TP provisions. The transaction on capital account or on account of restructuring would become taxable only to the extent it impacts income, i.e., under-reporting of interest received or over-reporting of interest paid or claiming of depreciation. The HC concluded that neither its capital receipts on share issuance to its AE nor the alleged short-fall between the FMV and the issue price of the equity shares can be considered as income as defined in the ITL; consequently, the transaction is not subject to India s TP provisions.

2 Detailed discussion During the financial year , 2 the Taxpayer issued 289,224 equity shares at a premium of INR 8,519 (approx. US$ 142) per share to its AE. However, during the tax audit, the Indian tax authority computed the arm s length price (ALP) of the equity shares by increasing the par value to INR 53,775 (approx. US$ 896). The tax authority treated the difference as income of the Taxpayer. Further, the tax authority made a secondary adjustment by treating the difference between the issued price and ALP as a deemed loan by the Taxpayer to its AE and charged a notional interest of 13.5% for six months, resulting in a TP adjustment of INR billion (approx. US$ million). The Taxpayer filed a writ petition challenging the jurisdiction/ applicability of Indian TP provisions to such transactions before the Bombay HC. The HC remanded the matter to the Dispute Resolution Panel (DRP) to give preliminary findings on whether the assessing office (AO) has jurisdiction to invoke Indian TP provisions on the share transaction. The DRP upheld the adjustment determined by the tax authority and also held that the AO had jurisdiction to invoke Indian TP provisions. The Taxpayer filed a writ petition with the Bombay HC, challenging the TP adjustment. Taxpayer s positions: Indian TP provisions are special provisions relating to avoidance of tax and provide for computation of income arising from international transactions with respect to ALP. In this case, no income arises from considerations received in exchange for issuance of shares. The word income would have to be defined by other provisions of the ITL and the TP provisions are not designed to subject all gross receipts in a transaction as taxable. The term issuance of shares is different from a share transfer; therefore, issuance of shares is not taxable by virtue of capital gain tax provisions as provided in the ITL. The tax authority has proceeded on an assumption that if the notional income i.e., the difference, were received, the Taxpayer would have invested that difference in amount which would have given rise to income. Taxpayer argued that no tax can be charged based on such assumption in the absence of actual income arising. Tax authority s positions: The Indian TP provisions are complete code and not merely mechanical provisions to compute the ALP and it is the benefits concealed in the transaction that are taxable. It is not the share premium which is taxable but the cost incurred by the Taxpayer in passing on a benefit to its AE by issuing shares at a premium that is less than ALP. Based on an analysis of the facts, the HC ruled as follows: The Indian TP provisions only apply to Income arising from an international transaction. Income, in its normal meaning, will not include capital receipts unless it is so specified. The amounts received on issuance of share capital including the premium are on capital account. Absent express legislation, no amount received, accrued or arising on capital account transactions can be subjected to tax as income. The transaction on capital account or on account of restructuring would become taxable only to the extent it impacts income. The amounts in excess of share premium are not income, as no tax is imposed on the amount received as share premium. The reasoning that if the ALP were received, the Taxpayer would be able to invest the amount and earn income cannot be the basis of taxation since it is merely based on an assumption. The tax authority relied on a provision of the ITL meant to cover cases of cost sharing arrangements and/or cost contribution arrangements to argue that differences between the ALP and the price charged for issuance of shares is the benefit conferred upon the holding company. The HC rejected the tax authority s position and held that ignoring words in a statute to achieve a predetermined 2 International Tax Alert Global Tax Desk Network

3 objective is not permissible as the position would require re-drafting the legislation, which is beyond the jurisdiction of the Courts. Determining the ALP is only to arrive at the real income earned. In the absence of subjecting issuance of shares premium to an NR as taxable, TP provisions do not apply. There is conscious intention of the Parliament not to tax amounts received from an NR in exchange for issuing shares, as it would discourage capital inflow from abroad. Implications The approach of the tax authorities in making TP adjustments on transactions involving issuance of shares to AEs has been one of the concerns expressed by several foreign investors. In general, Indian TP provisions apply to income arising from an international transaction. Even if issuance of shares is regarded as an international transaction, TP provisions may not apply to such transactions, as a consideration received is not regarded as income subject to tax. The HC s ruling upholding this view may be welcomed by foreign investors as it is expected to address one of the TP challenges they have been facing in India in recent times. Further, the HC ruling acknowledges that mere reporting of an international transaction would not make such transaction taxable when there is no income arising from such international transaction. This ruling, which comes in the backdrop of the Government s initiatives for encouraging foreign investment, can play a significant role in providing more certainty to foreign investors. Endnotes 1. TS-308-HC-2014 (BOM)-TP-Vodafone India Services. 2. Financial year from 1 April 2008 through 31 March International Tax Alert Global Tax Desk Network 3

4 For additional information with respect to this Alert, please contact the following: Ernst & Young LLP Indian Tax Desk, New York Riad Joseph Mithun D Souza mithun.dsouza@ey.com Ernst & Young LLP Indian Tax Desk, San Jose Neeraj Khubchandani neeraj.khubchandani@ey.com Ernst & Young LLP Indian Tax Desk, Chicago Romit Patel romit.patel1@ey.com Ernst & Young LLP, Asia Pacific Business Group, New York Chris Finnerty chris.finnerty@ey.com Kaz Parsch kazuyo.parsch@ey.com Bee-Khun Yap bee-khun.yap@ey.com Ernst & Young LLP (India), Mumbai Sudhir Kapadia sudhir.kapadia@in.ey.com Ernst & Young LLP ( India), Hyderabad Jayesh Sanghvi jayesh.sanghvi@in.ey.com Global Tax Desk Network of Ernst & Young LLP in the United States Argentina Israel Australia Italy Austria Japan Belgium Luxembourg Brazil Mexico Canada Netherlands China (Mainland) Norway Czech Republic Pan-Africa Denmark Poland Finland Russia France Scandinavia Germany Spain Hong Kong Sweden Hungary Switzerland Iceland Turkey India United Kingdom Ireland Vietnam Asia Pacific Business Group Central European Business Group Eastern European Business Group EMEIA Financial Services Latin American Business Center 4 International Tax Alert Global Tax Desk Network

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