21 April 2014 EY Tax Alert Mumbai Tribunal rules write-down of investment loss allowable if a direct and proximate nexus exists with a business 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 Income Tax Appellate Tribunal (Tribunal) in the case of Tata Communications Ltd. [1] (Taxpayer). The Taxpayer is in the business of providing international telecommunication services in India and holds investments in the shares of a company incorporated in the UK (UKCo). UKCo was set up to establish and operate a satellite-based mobile telecommunication system which would provide connectivity in any part of the world. However, due to inadequacy of funds, UKCo filed for bankruptcy, which resulted in a fall in the value of its shares. The issue was whether such a fall could be claimed as allowable against business income under the Indian Tax Laws (ITL). The Tribunal, on the facts of the case, ruled that a fall in the value of shares is not permissible to be reduced from business income, as the investment does not have a direct or proximate nexus with the business activity, but only remotely aids the Taxpayer. [1] Formerly known as Videsh Sanchar Nigam Ltd. [TS-210-ITAT-2014(Mum)]
Facts and background Under the ITL, a taxpayer can claim deduction against taxable business profits under either: (a) deduction mechanism; or (b) loss mechanism, both being mutually exclusive. Under deduction mechanism, only expenditure which is incurred wholly and exclusively for the purpose of business is allowable while computing business income. On the other hand, under loss mechanism, business loss incurred in the course of conduct of business is permissible as deduction. The Taxpayer, an Indian company, then controlled by the Government of India (GOI), was engaged in providing international telecommunication services in India. The Taxpayer was a member of the International Maritime Satellite Organization, UK (INMARSAT), a body comprising telecommunication companies/authorities from various countries. INMARSAT was established to provide necessary space segment for improving maritime connections, aeronautical and land mobile connections. INMARSAT was financed by each of the signatories, of which, the Taxpayer was also a stakeholder. To diversify and advance its existing business into global mobile personal communication on satellite, INMARSAT incorporated a company in the UK (UKCo). UKCo s goal was to establish and operate a satellite-based mobile telecommunication system based on a technology which aimed at providing mobile communication to users throughout the world, including rural areas/difficult terrain not covered by existing networks, and to have global roaming with a single number. In order to sustain and retain its position in the field of international telecommunications, the Taxpayer, as a prudent business entity, invested in the shares of UKCo to take advantage of the cutting edge technology. The expected benefits included participation in the latest technology, positioning the Taxpayer as a market leader in mobile communications, spread of technology in rural areas/difficult terrain not covered by existing networks, and opportunities to market services based on UKCo s technology as a national wholesale service provider. The Taxpayer sought the approval of the GOI prior to making an investment in UKCo. The GOI granted conditional approval, subject to UKCo locating one of the Satellite Access Nodes (SAN) in India. Furthermore, the approval also clarified that the Taxpayer should keep its option to pull out in case UKCo failed to provide a SAN in India. Accordingly, UKCo set up a SAN while entrusting operation/ maintenance of the SAN to the Taxpayer. The income from the SAN was offered and taxed as business income of the Taxpayer. Due to other technological advancements in the telecommunications sector, there was a failure of UKCo s business model. The participants, therefore, shied away from investing any further amount in UKCo. As UKCo was not in a position to raise funds for its project, it, consequently, filed a bankruptcy petition in a US court. Under the restructuring plan, UKCo was directed to be liquidated and a new company (NewCo) was to be incorporated. By virtue of this, the Taxpayer got an allotment of a small number of shares in NewCo, which, however, resulted in a substantial erosion of the value of the Taxpayer s investment in UKCo. Accordingly, the Taxpayer claimed the fall in the value of investment under the loss mechanism of the ITL against taxable business profits in the tax year in which UKCo had filed for bankruptcy. The Tax Authority, however, denied deduction of such a fall in the value of investment against business income. This proposition was also upheld by the First Appellate Authority. Aggrieved, the Taxpayer appealed before the Tribunal.
Taxpayer s contentions liability, was allowable under the loss mechanism. The Taxpayer claimed that the fall in the value of shares of UKCo should be allowable under the loss mechanism of the ITL as: The Taxpayer was engaged in the business of international telecommunication services. The investment in shares of UKCo was a prudent business decision to be a part of cutting edge technology, and in order to sustain and retain its position in the telecommunications arena. The investment was with a view to avail a new telecommunication network/ satellite-based mobile telecommunication system which permitted transmission of voice, data, images, electronic signals etc. The technology would enable the Taxpayer to provide mobile communications to users throughout the world, including rural areas/difficult terrain which were not covered by existing networks. The GOI would not have granted approval if the investment was merely to earn dividend/interest and which had no business interest/commercial expediency. Furthermore, the approval was accorded on the condition that a SAN would be located in India and, if there was a failure to do so, then, the Taxpayer could have pulled out. Furthermore, meaningful income was earned from operation of the SAN, which clearly indicates that the investment was for business purpose and commercial expediency and not a mere financial investment to earn dividend. Various documents such as the GOI approvals, Board of Directors report, notes appended to financials etc., clearly indicate direct nexus of the investment with the core business of the Taxpayer. Investment in UKCo was, thus, only for business purpose and did not give rise to any capital asset/benefit of enduring nature. Nature of business expediency could vary from case to case but what is important is that there must be an underlying motive to subserve business interest. Thus, the loss on account of bankruptcy and the subsequent restructuring plan, being an ascertained Tax Authority s contentions The Tax Authority rejected the Taxpayer s claim while computing its business income. The rationale was that: The Taxpayer treated the shares of UKCo as a long-term investment in its balance sheet and, thus, a capital asset. Furthermore, the shares were not sold or transferred, but the value of shares was reduced due to bankruptcy of UKCo and there was no explicit business activity leading to such loss in value. UKCo had not given any assurances/ guarantees that, by investing in its shares, the Taxpayer would avail a preferential treatment or obtain any business. Thus, the loss had no connection with the business activity of the Taxpayer. In the absence of a direct nexus between the investment and the income earned and also that the Taxpayer had failed to establish that any income had been earned from UKCo by virtue of the investment in its shares, the loss would not be allowable against business income. Tribunal s ruling The issue which arises is whether loss due to bankruptcy of UKCo, resulting in reduction in value of its shares as held by the Taxpayer, is an allowable claim under either the deduction mechanism or loss mechanism of the ITL. So far as the deduction mechanism is concerned, reduction in the value of shares of UKCo would not fall in the category of business expenditure, as it was an investment in shares and not an expenditure laid out or claimed by the Taxpayer as wholly and exclusively for the purpose of its business. Accordingly, claim under the deduction mechanism is ruled out. As regards the loss mechanism, claim of business loss depends on whether the loss springs directly from the carrying on
of business and is incidental thereto [2]. Thus, if there is a direct and proximate nexus between the business operation and the investment and the loss arising therefrom is incidental to the business operations, then, the loss is deductible, being the direct outcome of business operations. However, in the absence of a direct/proximate nexus, the loss is not eligible to be reduced from business income. Thus, the purpose of investment, at the most, can be said to be for acquiring or having access to new advanced technology in the mobile telecommunications system, which could be treated as an acquisition of a new and modern profit-making apparatus. Thus, loss on account of a fall in the value of investment is not eligible for deduction under the loss mechanism of the ITL. In the facts of this case, the decision of the Taxpayer to invest in shares of UKCo was not with a motive to earn dividend, rather, the purpose was to have an advantage of the new mobile telecommunication system and an access to the SAN that was to be located in India. Furthermore, the approval of the GOI also indicates the business motive. However, the nexus between the investment and the Taxpayer s business is only remote. The investment in itself has not resulted in additional business to the Taxpayer but has only created a scope for access to an advanced technology. The investment is merely to avail an enduring benefit of access to the technology by excluding other competitors, and not for directly procuring any additional business from UKCo. Furthermore, locating the SAN in India in itself is not a business transaction for the Taxpayer but is merely facilitating expansion of business in a new area of telecommunications and, therefore, there is no direct or proximate nexus between the investment and the existing business operations of the Taxpayer. At the time of acquisition of shares, the investment was undisputedly treated as capital by the Taxpayer. The treatment of investment in the books of account is not the sole criteria for disallowing the Taxpayer s claim. The loss on investment cannot, however, be regarded as being in the course of the Taxpayer s business activity. Comments This ruling highlights that loss arising on account of investment having a direct and proximate nexus with the business is tax deductible, despite the fact that the investment was regarded as a capital asset in the books of account. In the present case, the Tribunal has categorically observed that the method of accounting of investments in the books of account should not have a bearing while evaluating deductibility under the ITL. On the facts of the case, the Tribunal, however, denied deduction in respect of a fall in the value of the investment as, in the view of the Tribunal, the requisite test of direct and proximate nexus with the existing business of the Taxpayer was not present. [2] Badridas Daga [(34 ITR 10) (SC)]
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