EY Tax Alert. Ahmedabad Tribunal rules on capital gains on call options and transfer pricing aspects. Executive summary

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1 7 February 2018 EY Tax Alert Ahmedabad Tribunal rules on capital gains on call options and transfer pricing aspects 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 Ernst & Young advisor. Executive summary This Tax Alert summarizes a recent ruling of the Ahmedabad Income Tax Appellate Tribunal (Tribunal) in the case of Vodafone India Services [1] (Taxpayer) on the issue of whether termination of call option to buy shares in an Indian company, SMMS Investments (SMMS), which indirectly held shares of an Indian operating company (I Co), results in capital gains and whether such termination qualifies as an international transaction. The Tribunal noted that under the call option, the Taxpayer had a right to either exercise the call option or assign the call option in favor of its associated enterprise (AE). The Tribunal further noted that the Taxpayer did not acquire the shares of SMMS, but exercised the right to nominate the person who could acquire the shares of SMMS. Such right to nominate qualifies as a capital asset under the expanded definition in the Indian Tax Laws (ITL), which covers within its ambit all rights in or in relation to an Indian company. Furthermore, since the right to nominate comes to an end on exercise, such exercise results in a transfer subject to capital gains tax. [1] [2018] 89 taxmann.com 299 (Ahmedabad - Trib.)

2 Page 2 Basis the terms of various agreements entered into between the Taxpayer and its AEs, the Tribunal noted that the Taxpayer which had a right to acquire the shares of SMMS at a price which was much less than the market price, gave up such right in order to facilitate an increase in the indirect shareholding of an overseas associate (BV Co). Such transaction of termination, which had an impact on the profits of the Taxpayer and was carried out basis an understanding or arrangement between the Taxpayer and BV Co, qualifies as an international transaction. In addition, the Tribunal held that the transfer pricing (TP) provisions cease to apply only when a transaction is inherently incapable of producing an income. However, as termination of the call option resulted in a transfer subject to capital gains tax, such capital gains are to be calculated by applying the arm s length price (ALP) determined under the TP provisions. Background An international transaction under the TP provisions of the ITL has been defined as a transaction between two or more AEs, either or both of whom are non-residents (NRs) which, inter alia, has a bearing on the profits, income, losses or assets of such enterprises. A transaction for this purpose means an arrangement, understanding or action in concert, whether or not it is formal or in writing and whether or not it is intended to be enforceable by legal proceedings. Furthermore, under the ITL, a transaction entered into by an enterprise with an unrelated person is treated as a transaction with an AE if there is a prior understanding between such person and the AE of the enterprise or where the terms of the transaction are determined by such person and the AE of the enterprise. Such a transaction is referred to as a deemed international transaction. A capital asset under the ITL has been defined as property of any kind. Furthermore, the ITL was amended to clarify that the term property includes right of management or control or any other rights in an Indian company or rights in relation to an Indian company. Facts The Taxpayer, an Indian company, is an indirect wholly-owned subsidiary (WOS) of a Netherlands entity (BV Co) and is a part of a global group of companies called Vodafone Group (V Group). V Group carried on its telecommunication business in India through an operating company, I Co. All the shares of I Co were indirectly controlled by BV Co through a number of subsidiaries, AEs, call options and other financial arrangements. One such entity through which BV Co indirectly held interest in I Co was Omega Telecom Holdings Pvt Ltd (Omega), an Indian company. Omega held around 5% shares in I Co. Prior to the Taxpayer becoming a part of V Group, it was held by Hutchinson Group (H Group). Furthermore, H Group purchased stake in I Co through various unrelated third parties due to regulatory restrictions in the telecom sector. SMMS was one such company through which H Group acquired interest in I Co. SMMS held around 62% shares in Omega which translated to an indirect interest of 3% stake in I Co. The acquisition of Omega by SMMS was funded through certain loans and capital (equity and preference share) contributed by third party investors (Investors). Investors, thus, became 100% shareholders of SMMS. The loans taken by SMMS were guaranteed by the ultimate parent entity of H Group. It was as a result of transfer of certain intermediary companies holding the Taxpayer by H Group to BV Co that the Taxpayer became an indirect subsidiary of BV Co. The taxability of indirect transfer of I Co shares resulting from this transaction was a matter which was decided by the Supreme Court [2] (SC). [2] VIHBV v. UOI [341 ITR 1]

3 Page 3 The terms of various agreements entered into by the Taxpayer and its AEs, as relevant to acquisition of shares of SMMS, is provided below: Framework Agreement (FA 2007) dated 6 June 2007 In order to ensure that SMMS remained under the control of V Group, the Taxpayer entered into a framework agreement in June 2007 (FA 2007) with the Investors. FA 2007 was entered into with an intent to preserve the priority right of the Taxpayer to acquire equity interest of the Investors in SMMS in anticipation of the revision in sectoral limits under foreign direct investments (FDI), as well as to ensure compliance with the FDI Policy. This was done by securing a call option for the Taxpayer and a put option for the Investors, as explained below: The call option entitled the Taxpayer to buy the entire equity capital of SMMS from the Investors for a consideration of around INR4crores in case the fair market value (FMV) of shares of SMMS was less than INR1500crores, and a marginally higher consideration was payable if the FMV exceeded INR1500crores. Furthermore, the Taxpayer also had a right to assign or transfer the call option to any of its affiliates, without the approval of the Investors. However, the Investors were not authorized to assign the put option without the approval of the Taxpayer, as well as BV Co. BV Co undertook the obligation to ensure that the Taxpayer would fulfil its obligations and, in the event of failure, BV Co would be responsible to fulfil those obligations either by itself or through its nominee. Co holding 75% shares in SMMS. Additionally, SHA 2011 also conferred a right upon the Investors to oblige SMMS to buy back the shares held by the Investors in SMMS within a specified period if such option was exercised by the Investors. The Investors exercised the option of buyback and, consequently, the shareholding of India Hold Co in SMMS increased from 75% to 100%. The combination of FA 2007, TA 2011 and SHA 2011 resulted in an increase in equity interest of BVCo in I Co by around 3%. Given below is a pictorial representation of various agreements, as well as the transactions undertaken as per those agreements: Termination Agreement (TA 2011) dated 24 November 2011 Under TA 2011, the call and put options granted by FA 2007 were agreed to be terminated. A termination fee of around INR21crores was agreed to be paid by the Taxpayer to the Investors in lieu of such termination. In addition, as per the terms of TA 2011, such termination was agreed to become effective on the date on which the Investors would cease to hold 51% or more of paid-up capital of SMMS. Payment made by the Taxpayer to the Investors was not claimed as deduction in the computation of business income of the Taxpayer. Shareholder Agreement (SHA 2011) dated 24 November 2011 Post the termination of the call and put options, SMMS issued shares to another Indian company, India Hold Co, as agreed under SHA Issue of shares resulted in India Hold 1. FA 2007: The Taxpayer held a call option i.e., the right to purchase shares of SMMS from the Investors. The Investors held a put option i.e., the right to sell shares of SMMS to the Taxpayer 2. TA 2011: Call and put options under FA 2007 terminated and the Taxpayer paid ~INR21crores to the Investors for such termination 3. SHA 2011 o Issue of fresh shares by SMMS to India Hold Co o India Hold Co acquired 75% stake in SMMS and the Investors shareholding reduced to 25% o 25% shares of the Investors in SMMS brought back by SMMS o India Hold Co s shareholding in SMMS became 100% Consequential Increase in BV Co s indirect holding in I Co- 100% * 62% * 5 % = ~3% (*Shareholding percentage are approximate figures.)

4 Page 4 Issues before the Tribunal Whether termination of the call option resulted in capital gains in the hands of the Taxpayer. Whether such transaction was an international transaction as per the TP provisions of the ITL. Taxpayer s contentions Whether call option is a capital asset and whether its termination results in capital gains The option available under FA 2007 was a contractual right, and not a property right. Under FA 2007, there was a contractual agreement as to the shares, but, not an interest in the shares. Call options, thus, cannot be treated as capital assets. Pending exercise, options are not property rights and, hence, they do not qualify as capital assets under the ITL. Reliance in this regard was placed on the Bombay High Court [3] (HC) and the SC decision [4] in the Taxpayer s own case for earlier years. The Taxpayer did not exercise the option, but terminated the same. Such termination cannot be treated as exercise. Consequently, there is no question of earning capital gains from termination of call options. Reliance was placed on the SC decision in the case of B. C. Srinivasa Setty [5] to contend that even if a call option is accepted to be a capital asset and its termination as a transfer, in the absence of any cost of acquisition, there will be no capital gains. Furthermore, there needs to be certain consideration for computation of capital gains. The Taxpayer did not receive any consideration on termination, instead a compensation was paid by the Taxpayer to the Investors. Thus, in the absence of a consideration, there cannot be capital gains in the hands of the Taxpayer. Whether the TP provisions apply to termination of option even when there is no consideration and whether such termination results in an international transaction The TP provisions do not create a source of income. The TP provisions are only intended to substitute the ALP for the price charged in an international transaction, which is otherwise chargeable to tax. Since there is no taxable income on termination of the call option, the TP provisions cannot be applied. [3] Vodafone India Services (P.) Ltd v. CIT [385 ITR 169] [4] VIHBV v. UOI [341 ITR 1] [5] (1981) 128 ITR 294 (SC)] The Taxpayer did not receive any consideration for termination. Foregoing of an income cannot be taxed merely because the TP provisions require the ALP to be substituted in place of the consideration agreed to by the parties. Even if it is assumed that there has been an assignment of rights at a price which is different from the ALP, such assignment, being in favor of India Hold Co, there is no shifting of profits outside India. Thus, the TP provisions cannot be invoked. In August 2011, the Investors approached the Taxpayer proposing exit from SMMS. However, the Taxpayer, being a foreign-owned company, any acquisition of shares of SMMS by the Taxpayer would be subject to regulatory approval, thereby delaying the share acquisition process. Accordingly, the parties mutually agreed to terminate FA 2007 by entering into TA The transaction was, thus, as per the commercial terms agreed to between the parties. An increase in the indirect holding of BV Co in I Co on termination of the option cannot be a reason for invoking the TP provisions. Furthermore, irrespective of whether the Taxpayer or India Hold Co acquired an indirect share in I Co, there would be an increase in the indirect holding of BV Co in India. Increase in the indirect shareholding of BV Co was due to three transactions: TA 2011, subscription of shares of SMMS by India Hold Co and buyback of shares held by the Investors in SMMS. The Taxpayer, being a part to only one of the agreements viz., TA 2011, the indirect increase in the shareholding cannot be attributed to the Taxpayer s action. For a transaction to qualify as an international transaction, two conditions need to be satisfied viz., the transaction should be between AEs, and at least one of the AEs should be an NR. TA 2011 was between the Taxpayer and the Investors, both of whom are Indian entities. Thus, the transaction between the two residents would not qualify as an international transaction. The following arguments were made by the Taxpayer in support of independence of the parties/ agreements: BV Co cannot be considered as the directing mind of the Taxpayer and separate legal existence of entities should be respected. Although FA 2007 required prior approval of BV Co for exercise of an option, such approval was merely an administrative exercise to assure that V Group would have a priority right to acquire the stake of the Investors in the event of relaxation of the FDI rules. This cannot be a reason to indicate that the arrangements were controlled by BV Co. Various agreements entered into by V Group were examined by the SC (supra) in the Taxpayer s own case. The interpretation of the agreement, including the scope, amplitude and legal effect, has a binding effect. The SC acknowledged that FA 2007 and TA 2011 were transactions entered into by the relevant

5 Page 5 parties in their own capacities and independent of BV Co and BV Co, being the parent of the Taxpayer, merely acted as a confirming party to the agreements. Hence, BV Co cannot be treated as a party to the arrangement. Miscellaneous arguments Even if the transaction is treated as an international transaction, it is purely an internal transaction resulting in shifting of shareholding from one of the entities of the group to another entity of the group and does not result in any income or advantage to any of the entities of the group. Payment under TA 2011 was a negotiated arm s length commercial consideration agreed to be paid by the Taxpayer to terminate the terms of FA 2007, as also for the delay in termination of FA Such payment should not be co-related with the potential contractual liability that would be required to be made if a call or put option were exercised. At the most, the Tax Authority could have denied a deduction to the Taxpayer in respect of payments made to the Investors. However, as no deduction has been claimed by the Taxpayer, there is no impact on tax and, hence, such a transaction cannot be treated as an international transaction. Without prejudice, the Tax Authority was incorrect in contending that BV Co s indirect shareholding in I Co increased by 3%. Having regard to the fact that BV Co held only 80% shares in India Hold Co, the indirect holding of BV Co would increase only by 2.52%. Tax Authority s contentions Whether call option is a capital asset and whether its termination results in capital gains The definition of a capital asset under the ITL has been expanded by clarifying that the term property includes all the rights in and in relation to an Indian company. The Taxpayer had two rights by virtue of the call option viz., the right to exercise the option of purchasing the shares of SMMS and the right to assign the call option. The right to assign the call option was an absolute right vesting with the Taxpayer. One of the features of the property right is transferability and the Taxpayer has a right to transfer its call option. On termination of the call option, rights held by the Taxpayer ceased to exist. Thus, the rights of the Taxpayer stand extinguished/relinquished. This results in exercise of the option. Exercise of an option connotes an active action on the part of the Taxpayer, which can take numerous forms. For instance, exercise resulting in transfer, exercise resulting in extinguishment or exercise resulting in relinquishment. Though the SC, in the Taxpayer s own case for previous years, had held that options are contractual rights and, hence, do not qualify as property, the definition of property under the ITL has since been amended to include any rights in relation to an Indian company. Furthermore, the SC decision is distinguishable as there was no expressed termination of option rights then, as in the present case. Whether termination of call option results in an international transaction The call options entitled the Taxpayer to acquire an indirect stake in I Co, whose value was around INR1500crores, for a comparatively small consideration of around INR4crores through exercise of a call option. However, the Taxpayer gave up this right under TA 2011, without receiving any consideration in return. This transaction, thus, clearly had an impact on the profits and losses of the Taxpayer. Although the transaction, per se, was between residents, various agreements entered into by the parties indicate that the terms of the transaction were, in essence, decided by BV Co. Thus, such loss was incurred as a result of termination of the call option basis an arrangement or understanding and by acting in concert with BV Co and its affiliates. Thus, such a transaction would qualify as a deemed international transaction. The following arguments were provided by the Tax Authority in support of its proposition that there was an understanding between the Taxpayer and BV Co and its affiliates: TA 2011 provided that the agreement would be effective from the date on which the Investors would cease to hold equity capital of SMMS. Thus, the termination was, in substance, a transaction of transfer of the call option rights by the Taxpayer in favor of its AE, BV Co. In terms of FA 2007, BV Co was responsible to ensure that the Taxpayer would fulfil its obligations. In the event that the Taxpayer failed to fulfil its obligations, BV Co would be responsible to fulfil those obligations either by itself or through its nominee. As per FA 2007, the put option of the Investors could not have been exercised without the approval of BV Co, which indicated that the terms of FA 2007 were, in essence, decided by BV Co which had total control or veto on the exercise of option rights. The Investors were merely financial investors, holding the investments in a fiduciary capacity, rather than in an investor s capacity, as the shares of SMMS were acquired with the financial support from V Group.

6 Page 6 Alternatively, it was contended that the transaction, in essence, was a transaction between BV Co and the Taxpayer, by which BV Co directed the Taxpayer to exercise the options in favor of BV Co. Since the Taxpayer is a resident and BV Co is an NR, such transaction qualifies as an international transaction. Tribunal s ruling Whether call option is a capital asset A retrospective amendment was made to the definition of property under the ITL to include any rights in an Indian company, as well as rights in relation to an Indian company. This amendment, thus, enlarged the scope of the term capital asset to include rights in and in relation to an Indian company. The call option held by the Taxpayer under FA 2007 granted the following rights to the Taxpayer: Right to buy entire equity capital of SMMS at an agreed price. Right to nominate a person for assignment of call options. The two rights granted under FA 2007 are independent rights, in the sense that if one of the rights is exercised, the other right would become infructuous. In essence, the Taxpayer had a right to nominate who could acquire shares of SMMS at the agreed price. In the present case, the Taxpayer did not acquire the shares of SMMS, but exercised the right to nominate the person who could acquire the share of SMMS. Such right clearly falls within the expanded definition of capital asset under the ITL. Undisputedly, the facts before the SC in the Taxpayer s case for earlier years did not involve nomination or assignment and, hence, the question of whether a right to nominate can be treated as a capital asset was never considered by the SC. Without prejudice, post the amendment to the ITL, the SC s decision stating that pending exercise, an option does not qualify as a capital asset, is no longer applicable. Whether there is a transfer of a capital asset The Taxpayer had exercised the right of nomination under the call option. Once the right is exercised, its existence comes to an end. Hence, exercise of right to nominate results in transfer of a capital asset under the ITL. Whether the call option has a cost of acquisition All the agreements entered into by the parties are to be read together to understand the actual transaction. Prior to terminating FA 2007, the Taxpayer had purchased certain cashless options from the Investors for a consideration of around INR62crores. Furthermore, the Taxpayer paid a sum of around INR21crores to terminate FA Thus, under the overall arrangement, a sum of around INR83crores [6] was paid by the Taxpayer. Since the payment has been under the same set of agreements which entitled the Taxpayer to buy the shares of SMMS or nominate an affiliate to buy the shares, the amount paid under these agreements viz., ~INR83crores is to be considered as the cost of such rights. Whether the TP provisions apply in the absence of a consideration The TP provisions enable determination of the ALP for an international transaction and, hence, they have a role to play in computation of income. As long as a transaction is capable of producing an income, the TP provisions will apply to compute the income in accordance with ALP. The termination resulted in an income in the form of capital gains and such income has to be computed having regard to the ALP of the transaction. Even in case where there is zero income but application of the ALP results in a consideration being assigned, then the income i.e., capital gains in this case, is to be computed basis such ALP. The Taxpayer had a right to purchase shares of I Co, which were worth INR1500crores, for a small consideration of ~INR4crores. Such a right was given up by the Taxpayer under TA Thus, there was a transfer of a valuable right for zero consideration. It is precisely for this reason that the income of the Taxpayer is to be computed basis the ALP principles. The TP provisions cease to apply only when a transaction is inherently incapable of producing an income and is applicable in cases where income is not reported or if an income is not taken into account in computation of taxable income. Reliance in this regard was placed on a Special Bench decision in the case of Instrumentarium Corporation Ltd. [7] The Bombay HC decision in the Taxpayer s own case for earlier years [8] was concerned with determination of the ALP of shares issued by the Taxpayer, which was admittedly a transaction on capital account. It is a settled proposition that capital receipts cannot be brought to tax in the absence of a specific enabling provision. In other words, the ALP adjustment was proposed in respect of an item of income which could never be brought to tax. Thus, the ratio of that decision is not applicable in the present facts of the case. Whether there is an international transaction A combined reading of the terms international transaction and transaction under the ITL requires satisfaction of three conditions for a transaction to qualify as an international transaction: [6] INR 83 crores was arrived at as a sum of INR 21 crores paid on termination and INR 62 crores paid by Taxpayer to investors for purchase of certain other cashless call options [7] [171 taxmann.com 193] [8] Vodafone India Services Pvt Ltd v. ACIT [(2014) 368 ITR 1 (Bom)]

7 Page 7 There should be an arrangement, understanding or action in concert. The arrangement, understanding or action in concert should be between two or more AEs, either or both of whom are NRs. Miscellaneous The right assigned by the Taxpayer was for purchase of shares of SMMS. SMMS held nearly 3% shares in I Co through Omega. It is this 3% indirect stake in I Co which is relevant for determination of the ALP. The arrangement, understanding or action in concert should have a bearing on profits, income, losses or assets of such enterprises. The amount paid to the Investors was debited in the books and this had an impact on the profits of the Taxpayer. Thus, it qualifies as an international transaction. For the following reasons, there existed an arrangement/understanding or action in concert between the parties, some of which were NRs: Perusal of various agreements portrays that shares of I Co were purchased by V Group and parked in an entity which was owned by unrelated entities. However, all the ownership rights of the unrelated parties were subject to certain degree of control by V Group. The Taxpayer entered into FA 2007 with the Investors, as per which the Taxpayer was granted a right to purchase the shares of SMMS from the Investors for a consideration equivalent to the Investors equity investments in SMMS. FA 2007 was entered into by the Taxpayer in order to ensure that SMMS remained within the control of V Group and the Investors were merely acting on behalf of V Group. The price at which the shares were agreed to be purchased by the Taxpayer reflected a mere compensation for the services of the Investors, rather than the FMV of the shares, which was around INR1500crores. TA 2011 was designed to ensure smooth transition of control of I Co to India Hold Co. Thus, the transaction was not a pure termination of option, but transfer of shareholdings in SMMS to India Hold Co (indirectly held by BV Co) at a fraction of its market worth. Since the termination of the options resulted in a loss for the Taxpayer and such loss was due to an arrangement, understanding and action in concert between various parties, many of whom were NRs, the transaction qualifies as an international transaction. Without prejudice, the fact that the Taxpayer gave up its rights to acquire an indirect stake in I Co for a small consideration of ~INR4crores to facilitate BV Co to acquire such interest, supports the proposition that the terms of the agreements were approved and decided by BV Co. Thus, the transaction will also qualify as a deemed international transaction.

8 Page 8 Comments The Tribunal noted that the Taxpayer had two rights under the call option viz., the right to acquire the shares and the right to nominate the person who could acquire the shares and ruled that such right would be covered by the amended definition of capital asset under the ITL, which is wide enough to cover any right in an Indian company or right in relation to an Indian company. The Tribunal held that the SC decision in the Taxpayer s own case for previous years, which had held that options are contractual rights and, hence, not capital asset, is no more a good law in light of the expanded definition of capital asset under the ITL. The argument of the Taxpayer that the right was a no-cost asset and, hence, the charge was not triggered by virtue of the SC decision in the case of B.C. Srinivasa Shetty (supra), was rejected by the Tribunal. The payments for termination of the call option and acquiring a cashless call option were held to be the cost of acquisition by the Tribunal. Furthermore, while the transactions, per se, were between residents, the Tribunal held that such transaction qualifies as an international transaction basis the substance of the overall arrangement between the AEs. The Tribunal also observed that the existence of a legal right under an agreement is not a prerequisite in evaluating the existence of an arrangement for the purposes of international transactions. This ruling highlights the adoption of substance over form principle by considering the impact of the overall framework of the arrangement between the parties. The judicial view on applicability of the TP provisions in case where there is no consideration, has been divided. While, in some of the decisions [9],Courts have held that the TP provisions may not apply in a case where no consideration or no price is envisaged by the parties, on the other hand, in some of the decisions [10], the TP provisions were invoked to determine the ALP of a transaction in which no consideration was envisaged by the parties. Most recently, the Special Bench decision in the case of Instrumentarium [11] (supra), the ALP adjustment was upheld in respect of interest-free loans. In the present case, the Tribunal further clarifies that, as long as a transaction is capable of producing an income, the TP provisions will apply to compute the income as per the arm s length principle. The Tribunal s ruling deals with peculiar facts and taxpayers will have to evaluate the impact of the principles laid down by the Tribunal in light of the facts of their own cases. [9] 1Illustratively, Vanenburg Group BV [289 ITR 464 (AAR)], Dana Corporation [227 CTR 441 (AAR)], [10] Perot Systems [130 TTJ 685] and Tata Autocomp Systems Limited [52 SOT 48]. [11] 71 taxmann.com 193

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