Over the last couple of years, Indian subsidiaries of multinational companies have been faced with the unique tax issue pertaining to the issuance of shares to their parent companies. The tax department has questioned the valuation on which shares have been issued by the Indian subsidiaries and sought to apply the transfer pricing provisions under the Income Tax Act, 1961 (the Act) to impute additional tax burden through a recharacterization of the transactions. This has resulted in considerable litigation.
Of recent significance is the judgment of a division bench of the Bombay High Court on October 10, 2014 in Vodafone India Services Pvt. Ltd. v. Union of India, which is subject to a preliminary analysis in this post. In this case, Vodafone India (the subsidiary), a wholly owned subsidiary of Vodafone Tele-Services (India) Holdings Limited (the holding company) issued shares of a face value of Rs. 10 each at a premium of Rs. 8,509 per share to the holding company. The price was arrived at based on the methodology prescribed by the Controller of Capital Issues (CCI). However, the income tax department questioned the transaction on the ground that Vodafone India ought to have valued each share at Rs. 53,775, and on that basis there was a shortfall in premium to the extent of Rs. 45,256 resulting in an aggregate shortfall of Rs. 1,308.91 crores for all of the shares so issued. The income tax department sought to treat the aggregate shortfall as income of Vodafone India as income, as a consequence of which the amount was to be treated as a deemed loan given by the holding company to Vodafone India upon which interest was chargeable as income.
Vodafone India challenged the income tax department’s position through a writ petition before the Bombay High Court on the principal ground that the shortfall does not constitute income and also that Chapter X of the Act relating to transfer pricing was not applicable to this case due to which the transfer pricing officer (TPO) did not possess jurisdiction. The High Court referred the jurisdictional issue to the dispute resolution panel (DRP) which was already seized of the matter. After consideration of the issues, the DRP passed an order dated February 11, 2014 holding that the income tax department had the jurisdiction to consider the issue of shares by Vodafone India to its holding company and also to tax the shortfall as income. It is against this order that Vodafone India preferred a writ petition to the Bombay High Court that resulted in its present judgment.
The primary question before the Court related to the applicability of Chapter X of the Act. This is because that chapter in certain circumstances permits the revenue to impute an “arm’s length price” in case of an international transaction. The Court began by observing that a “plain reading of Section 92(1) of the Act very clearly brings out that income arising from an International Transaction is a condition precedent for application of Chapter X of the Act”. Hence, the narrow issue was whether the issue of shares by Vodafone India to the holding company gave rise to “income”: whether the nature of the transaction made it one of a capital transaction or revenue transaction.
On this basis, the Court embarked on an analysis of the meaning of “income”, especially where it involved capital receipts. It found based on an interpretation of section 2(24) of the Income Tax Act that “income will not in its normal meaning include capital receipts unless it is so specified, as in Section 2(23)(vi) of the Act”. Since an issue of shares is a transaction on the capital account, the premium cannot be treated as income. The Court also drew a contrast with Section 56(2)(viib) of the Act where a capital transaction is deemed by legal fiction to amount to income. However, that provision applies only to premium received from a resident and that too where that premium is in excess of the fair market value of the shares. The Vodafone case was far from that scenario because the premium was less than the alleged fair value of the shares, and that too received from a non-resident. One can glean from the analysis of the Court another difference which is that in Section 56(2)(viib) there is an actual receipt of the excess of amount, whereas in this case there is only an imputed amount of the difference without any actual receipt. On this ground, the Court unequivocally concluded that neither the capital receipts in the form of the issue price (par value plus premium) nor the imputed difference with the fair market value could be considered income for the purpose of the Act.
Given the absence of “income”, which expression was supplied with a narrow interpretation by the court (consistent with reading of tax statutes), the Court was able to quickly conclude on the inapplicability of Chapter X of the Income Tax Act relating to transfer pricing and arm’s length determination of income from international transaction. While a number of arguments were made by counsel representing both Vodafone India as well as the tax department on the interpretation of Chapter X (particularly the definition of International Transaction in Section 92B(1)), the Court dealt with those arguments in a more concise fashion given its conclusion as to the absence of “income”, which is a prerequisite for the application of the Chapter.
This pronouncement of the Bombay High Court is welcome. First, from a legal perspective, issuance of shares and infusion of funds into companies constitute a capital transaction. In case such a transaction is to be taxed, the charging provision must be clear to extend to such. It is not permissible for the revenue to stretch the law to subsume such transactions within its fold.
Second, the judgment also induces a level of certainty in the taxability of such transactions. The ability of the revenue to tax them has caused consternation among foreign investors. As we have previously discussed on this Blog, the power of courts to recharacterize transactions must be exercised very carefully so as to preserve certainty to the extent feasible. If courts adopt a carefree approach to altering the substance of the transaction (for example in this case from equity to part-debt), that would affect a conducive atmosphere for business. It is only in cases where there is blatant abuse of policy that courts must embark upon such approach, that too in a careful and considered manner.
Although some clarity has emerged for share issuances by Indian subsidiaries of foreign parent companies, it may very well be temporary in case the tax department decides to prefer an appeal against the ruling to the Supreme Court. But, for now, the ruling may benefit several other companies that have found themselves in a similar predicament.