In a very interesting decision that could have significant implications for restructuring companies, the Authority for Advance Rulings [“AAR”] has discussed several controversies in connection with restructuring schemes. The decision, Re Dana Corporation (decided November 30, 2009), is available here.
The applicant, Dana Corporation, was incorporated in the USA. As part of its extensive worldwide operations, it owned shares in three Indian companies, all of which were its subsidiaries. In 2007, Dana Corporation filed for reorganisation under Chapter 11 of the Bankruptcy Code of the United States. Under American law, a Chapter 11 reorganisation bankruptcy allows the business to continue, and the company’s debt obligations are reorganised under the supervision of the Bankruptcy Court. Under the scheme approved by the Bankruptcy Court, a new holding company was created [Dana Holding Companies, or DHC], to which Dana Corporation was required to transfer the shares it held in the three Indian companies. This transfer was effected indirectly – Dana Corporation transferred its holding in the Indian companies to another group company called Dana World Trade Corporation, which was controlled by DHC. Subsequently Dana Corporation merged with Dana Companies LLC, and ceased to exist as an independent entity.
The question that arose was whether the transfer of shares in the three Indian companies by Dana Corporation to Dana World Trade Corporation was taxable in India. The applicable provision in the Income Tax Act, 1961, is Section 45 – the provision on capital gains. To charge a transaction to capital gains, it is necessary to establish “profits and gains” that “arise from the transfer of a capital asset”. The computation provision is s. 48.
The applicant argued before the AAR that this transfer was not for consideration, since its object was merely to comply with the requirements of the bankruptcy reorganisation scheme. It then relied on the well-known principle that a charging section cannot be invoked when the computation provision fails (CIT v. BC Srinivasa Shetty, 128 ITR 294). The Revenue argued that the expression transfer, defined in s. 2(47) of the Act, includes transfers by operation of law and transfers under the order of a court. It further argued that the consideration for such transactions is the agreement of the holding company to participate in the reorganisation scheme. Consequently, the Revenue contended that consideration could be determined through transfer pricing provisions, and particularly by resorting to the arm’s length price mechanism prescribed in s. 92 of the Act.
The AAR formulated two questions to decide the issue: first, whether any profit or gain arose to Dana Corporation as a result of transferring its holding in the Indian companies to Dana World Trade Corporation, and secondly, whether any “amount” was received by or accrued to Dana Corporation as a result of the transfer. The Authority rejected the Revenue’s contentions on both questions. In doing so, the Authority referred to what is known as the “real income principle”, and observed “the profits or gains under the Income Tax Act must be understood in the sense of real profits or gains, on the basis of ordinary commercial principles on which the actual profits are computed [emphasis mine].” Applying this principle, the Authority held that s. 45 does not apply unless the profit or gain is a “distinctly and clearly identifiable component of the transaction”, and that “there must be a causal nexus between the transfer of capital asset and the profit or gain…”
Analysing these “ordinary commercial principles” of a company reorganisation, the Authority held that the transfer is bereft of “consideration”, because the transfer of shares in furtherance of a reorganisation scheme is not understood commercially as a “bargain” for reciprocal services. The Authority also held that the transferor receives “no profit or gain” because the reorganisation plan is “in the overall interests of its business and that there is a certain business advantage to the applicant has no bearing on the point whether any consideration has in fact been received or accrued on the transfer of shares”.
Finally, in what could potentially have expanded the scope of transfer pricing provisions, the Revenue argued that income has to be computed on arm’s length basis regardless of whether there is consideration. The Authority rightly rejected this contention, noting that s. 92 begins with the words “any income arising from an international transaction shall be computed having regard to arm’s length price”, clearly implying income must arise in the first place. The Authority correctly noted that s. 92 cannot be used to levy capital gains on a transaction that does not satisfy the ingredients of s. 45 in the first place.
I believe that three important conclusions follow from this discussion. First, the Authority’s reference to the “real income” principle is controversial. The real income principle was articulated by Indian courts most prominently in the context of “sticky loans” – banks argued that some loans are so clearly non-performing assets that interest need not be credited as income, although the loans had not been written off either. We have briefly discussed this controversy in a previous post. The real income principle has usually been regarded as subject to the provisions of the Act – in that sense, it is merely a guide to interpretation and does not impose a substantive limitation on the power of the legislature to enact tax laws. In that context, approving the real income principle in the context of capital gains along with express observations that consideration must be “real” and not “notional” is likely to generate some controversy.
Secondly, it was not argued before the Authority that a transfer of shares pursuant to an amalgamation or merger scheme does not constitute a transfer as defined in the Income Tax Act, although there is some support for this proposition in Indian law. Some cases have held that the transfer of shares in accordance with a scheme under ss. 391-6 of the Companies Act does not constitute a transfer for the purposes of the Act (CIT v. Rasiklal Maneklal, 177 ITR 198, CIT v. Amin, 106 ITR 368, CIT v. MCTM Corporation, 22 ITR 524 and CIT v. Master Raghuveer Trust, 151 ITR 368). The basis of these decisions was that a transferor in these circumstances does not receive the asset “by operation of any transaction” but “in satisfaction” of a pre-existing right – in short, that there is no consideration. There is, however, uncertainty as to this position, and the scope of the Supreme Court’s decision in CIT v. Grace Collins ((2001) 3 SCC 430), apparently to the contrary, is not entirely clear. Finally, the Authority appears to have clearly reached the correct conclusion as to the applicability of transfer pricing provisions.
All in all, the controversy over tax implications of amalgamations and mergers, whether under Indian law or otherwise, looks set to continue.