To what extent can transfer pricing provisions be attracted to cross-border
investments in Indian subsidiaries? Can the issuance of shares at a price lower
than market price be grounds for a transfer pricing adjustment? This question
(amongst other hotly debated Indian tax issues, such as those relating to
retrospective Indian tax on indirect transfers) is beginning to assume growing
prominence on account of the recent high profile transfer pricing adjustment of
over Rs. 150 billion on a Shell group entity in India. Reports
state that proceedings have also been initiated against HSBC Securities, Standard Chartered Securities and Vodafone on similar grounds, and that Shell has recently filed a writ petition before the Bombay High Court challenging the jurisdiction of revenue authorities to make this adjustment.
Considering the wide-ranging impact such an approach could have on capital inflows into India, we examine below a recent decision of the Income Tax Appellate Tribunal ("Tribunal") in M/s Vijai Electricals Ltd. v. Additional Commissioner of Income Tax1, which deals with a similar question.
In the initial scrutiny assessment, the issue of whether transfer pricing provisions are attracted to capital investments was not examined. Subsequently, the Commissioner of Income Tax sought to revise the scrutiny assessment under section 263 of the Income Tax Act, 1961 ("Act"). Revisionary jurisdiction under that section can be exercised when the Commissioner is satisfied that the order of assessment is "erroneous" and "prejudicial to the interests of the revenue". The Commissioner found that the assessment order was indeed erroneous and prejudicial as no transfer pricing analysis was conducted. He held that investment into subsidiaries is an "international transaction" within the scope of Indian transfer pricing rules. He hence directed the Assessing Officer to refer the matter for a transfer pricing analysis to determine whether the outbound investments were on an arms' length basis. This order of the Commissioner was challenged by the taxpayer before the Tribunal.
Before the Tribunal, it was contended on behalf of the taxpayer that capital investments were not within the scope of an "international transaction" defined under section 92B of the Act, and only international transactions could be within the scope of transfer pricing analysis. It was argued that investment in capital was distinct from the sale of shares, and that while the latter might be an international transaction, the former was not. The taxpayer also argued on the basis of a Circular of the Central Board of Direct Taxes2, the highest administrative authority on income tax matters in India, and on the basis of a ruling of the Authority for Advance Rulings in Re Dana Corporation3 that transfer pricing provisions only apply if there is chargeable income resulting from the transaction. Capital investments, which do not create chargeable income, cannot therefore be brought within the scope of transfer pricing provisions.
The Tribunal held in favour of the taxpayer. In a somewhat laconic order, it held that investments in share capital outside India were in the nature of capital investments, and such transactions are not in the nature of "international transactions" within the meaning of section 92B of the Act.
Firstly, there is the issue of transfer pricing provisions being attracted only when the transaction results in chargeable income, a position that the Tribunal appears to have accepted although the reasoning has not been elaborately discussed in the order. Support for this position can be found in the language of section 92B, which defines an "international transaction" to mean "a transaction between two or more associated enterprises, either or both of whom are non-residents, in the nature of purchase, sale or lease of tangible or intangible property, or provision of services, or lending or borrowing money, or any other transaction having a bearing on the profits, income, losses or assets of such enterprises...".
Under section 92 which specifies arm's length price requirements, transfer pricing provisions are only applicable to international transactions falling within the definition under section 92B. In its ruling in Dana, the Authority for Advance Rulings had stated that section 92 is not an independent charging provision, and that transfer pricing provisions do not bring about a charge of tax where none otherwise existed.4 However, advance rulings are only binding on the parties involved and therefore we may place limited reliance on Dana. Further, there are conflicting decisions5 on this issue which imply that chargeable income is not in fact a pre-requisite for transfer pricing to apply. Such a position may be on the basis that the "bearing on the profits" under the residuary part of section 92B is not specifically applied to the previous transactions such as purchase, sale, lease etc. However, such an interpretation ignores the fact that the term "any other" transaction would imply that all of the previous arrangements would have to have an impact on the profits in order to be considered "international transactions". This approach is also contrary to the spirit of transfer pricing provisions as a protection against base erosion.
This brings us to the second and related issue: where capital investments could be said to fall within the framework contained in section 92B, if they do not fall within the residuary catchall provision. Under section 92B, an "international transaction" is defined to mean "a transaction between two or more associated enterprises, either or both of whom are non-residents, in the nature of purchase, sale or lease of tangible or intangible property, or provision of services, or lending or borrowing money, or any other transaction having a bearing on the profits, income, losses or assets of such enterprises...". Further, the Explanation introduced to section 92B in 2012 (with retrospective effect from 2002) contains an inclusive definition of "international transaction" which includes "capital financing... including ... purchase or sale of marketable securities...".
An "issuance" of shares is distinct from the "purchase" of shares. The conceptual distinction between the two was noted by the English Court of Appeal when it said "[T]he word 'purchase' cannot with propriety be applied to the legal transaction under which a person by the machinery of application and allotment, becomes a share holder in the company. He does not purchase anything when he does that... the difference between the issue of a share to a subscriber and the purchase of a share from an existing shareholder is the difference between the creation and the transfer of a chose in action. The two legal transactions of the creation of a chose in action and the purchase of a chose in action are quite different in conception and in result..."6 This principle has been applied by the Supreme Court of India also.7 A "purchase" requires an asset to first be in existence. In the case of an allotment, as held by the Supreme Court in Jalan's case, there shares do not exist at all until they are allotted. Therefore, a share subscription may not be considered a "purchase".
Although the term "capital financing" is wide enough to include share subscription as well, the transactions contemplated in the provision, including borrowing, lending, guarantee, purchase, sale, or any type of advance, payment or deferred payment or debt arising during the course of business, appear to be applicable to funding transactions capable of having a "bearing on profits" as required by section 92B rather than a capital subscription. We would also need to consider the impact of clause (e) of the Explanation which states that: an 'international transaction' includes"... a transaction of business restructuring... irrespective of the fact that it has bearing on the profit, income, losses or assets of such enterprises at the time of the transaction or at any future date...". In the absence of a specific carve-out relating to the bearing on profits, it may be stated that a capital financing transaction would need to have a bearing on profits to be considered an international transaction within section 92B(1).
Therefore, it is unclear how a subscription to shares could be brought within the purview of the transfer pricing provisions under the current regime of the Act.
This question is of relevance, particularly in an Indian cross-border investment context on account of currency control regulations which prescribe minimum pricing requirements for inbound investment into India. Can Shell India be said to have any notional income in spite of compliance with minimum pricing requirements? To allow for such a capture of notional income would also not be in accordance with the international approach, which does not contemplate inclusion of share subscription amounts within the transfer pricing net.
While there is little clarity on the grounds which the tax department will be taking in the pending cases of undervaluation of shares, the Central Board of Direct Taxes recently released9 an amended Form 3CEB (dealing with 'particulars relating to international transactions and specified domestic transactions...'), which includes capital investments in the list of international transactions which attract a transfer pricing analysis. It appears that the revenue authorities are seeking to include such transactions by a process of amendment. While Form cannot give powers to the Revenue when the Act does not, ultimately, the issue of applicability of transfer pricing to intergroup share subscriptions seems destined for the higher courts.
2 Circular No. 14 dated November 22, 2011.
3 321 ITR 178 (AAR). Reliance was also placed on the ruling in Re Amiantit International Holdings 322 ITR 678 (AAR).
4 However, contrary views have also been taken. For example, notional interest on interest-free loans has been held to be chargeable in India, by using transfer pricing provisions: see Perot Systems v. DCIT ITA 2320/De/2008. It could be argued that taxing of interest-free loans is only a matter of quantification of the appropriate price of the loan, and not a new charge of tax as such, and these decisions do not affect the general principle that transfer pricing provisions do not create a new charge where none existed before.
5 For example, see the Ruling of the Authority for Advance Rulings in Re Castleton Investment, AAR 999 of 2010. This can be contrasted with the Ruling in Re Praxair, 326 ITR 276 (AAR).
6 I Re V.G.M. Holdings [1942] 1 All ER 224.
7 Sri Gopal Jalan v. Calcutta Stock Exchange AIR 1964 SC 250
8 It has been held that under Section 92C read with Rule 10B, ALP must be established only by one of the methods prescribed. See, for a recent illustration of this principle, Greaves Cotton v. ITO ITA 3103/Mum/2011, decided on February 8, 2013.
9 CBDT Notification No. 41 dated June 10, 2013. One of the particulars now required to be filled up is: "Has the taxpayer entered into any international transaction(s) in respect of purchase or sale of marketable securities or issue of equity shares including transactions specified in Explanation (i)(c ) below section 92B (2)?"
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
state that proceedings have also been initiated against HSBC Securities, Standard Chartered Securities and Vodafone on similar grounds, and that Shell has recently filed a writ petition before the Bombay High Court challenging the jurisdiction of revenue authorities to make this adjustment.
Considering the wide-ranging impact such an approach could have on capital inflows into India, we examine below a recent decision of the Income Tax Appellate Tribunal ("Tribunal") in M/s Vijai Electricals Ltd. v. Additional Commissioner of Income Tax1, which deals with a similar question.
BACKGROUND
In this case, the Hyderabad bench of the Tribunal was concerned with an Indian resident company which had invested amounts in its subsidiaries in Brazil and Mexico. Unlike in the case of Shell (where investments were made into the Indian company by a non-resident), this was a case of an outbound investment from India.In the initial scrutiny assessment, the issue of whether transfer pricing provisions are attracted to capital investments was not examined. Subsequently, the Commissioner of Income Tax sought to revise the scrutiny assessment under section 263 of the Income Tax Act, 1961 ("Act"). Revisionary jurisdiction under that section can be exercised when the Commissioner is satisfied that the order of assessment is "erroneous" and "prejudicial to the interests of the revenue". The Commissioner found that the assessment order was indeed erroneous and prejudicial as no transfer pricing analysis was conducted. He held that investment into subsidiaries is an "international transaction" within the scope of Indian transfer pricing rules. He hence directed the Assessing Officer to refer the matter for a transfer pricing analysis to determine whether the outbound investments were on an arms' length basis. This order of the Commissioner was challenged by the taxpayer before the Tribunal.
Before the Tribunal, it was contended on behalf of the taxpayer that capital investments were not within the scope of an "international transaction" defined under section 92B of the Act, and only international transactions could be within the scope of transfer pricing analysis. It was argued that investment in capital was distinct from the sale of shares, and that while the latter might be an international transaction, the former was not. The taxpayer also argued on the basis of a Circular of the Central Board of Direct Taxes2, the highest administrative authority on income tax matters in India, and on the basis of a ruling of the Authority for Advance Rulings in Re Dana Corporation3 that transfer pricing provisions only apply if there is chargeable income resulting from the transaction. Capital investments, which do not create chargeable income, cannot therefore be brought within the scope of transfer pricing provisions.
The Tribunal held in favour of the taxpayer. In a somewhat laconic order, it held that investments in share capital outside India were in the nature of capital investments, and such transactions are not in the nature of "international transactions" within the meaning of section 92B of the Act.
ANALYSIS OF INDIAN TRANSFER PRICING FRAMEWORK
While the decision dealt with a fact situation of investments made by an Indian company outside India, the essential arguments successfully employed by the taxpayer are more wide-ranging in application, and would also be relevant in the context of investments made into India.Firstly, there is the issue of transfer pricing provisions being attracted only when the transaction results in chargeable income, a position that the Tribunal appears to have accepted although the reasoning has not been elaborately discussed in the order. Support for this position can be found in the language of section 92B, which defines an "international transaction" to mean "a transaction between two or more associated enterprises, either or both of whom are non-residents, in the nature of purchase, sale or lease of tangible or intangible property, or provision of services, or lending or borrowing money, or any other transaction having a bearing on the profits, income, losses or assets of such enterprises...".
Under section 92 which specifies arm's length price requirements, transfer pricing provisions are only applicable to international transactions falling within the definition under section 92B. In its ruling in Dana, the Authority for Advance Rulings had stated that section 92 is not an independent charging provision, and that transfer pricing provisions do not bring about a charge of tax where none otherwise existed.4 However, advance rulings are only binding on the parties involved and therefore we may place limited reliance on Dana. Further, there are conflicting decisions5 on this issue which imply that chargeable income is not in fact a pre-requisite for transfer pricing to apply. Such a position may be on the basis that the "bearing on the profits" under the residuary part of section 92B is not specifically applied to the previous transactions such as purchase, sale, lease etc. However, such an interpretation ignores the fact that the term "any other" transaction would imply that all of the previous arrangements would have to have an impact on the profits in order to be considered "international transactions". This approach is also contrary to the spirit of transfer pricing provisions as a protection against base erosion.
This brings us to the second and related issue: where capital investments could be said to fall within the framework contained in section 92B, if they do not fall within the residuary catchall provision. Under section 92B, an "international transaction" is defined to mean "a transaction between two or more associated enterprises, either or both of whom are non-residents, in the nature of purchase, sale or lease of tangible or intangible property, or provision of services, or lending or borrowing money, or any other transaction having a bearing on the profits, income, losses or assets of such enterprises...". Further, the Explanation introduced to section 92B in 2012 (with retrospective effect from 2002) contains an inclusive definition of "international transaction" which includes "capital financing... including ... purchase or sale of marketable securities...".
An "issuance" of shares is distinct from the "purchase" of shares. The conceptual distinction between the two was noted by the English Court of Appeal when it said "[T]he word 'purchase' cannot with propriety be applied to the legal transaction under which a person by the machinery of application and allotment, becomes a share holder in the company. He does not purchase anything when he does that... the difference between the issue of a share to a subscriber and the purchase of a share from an existing shareholder is the difference between the creation and the transfer of a chose in action. The two legal transactions of the creation of a chose in action and the purchase of a chose in action are quite different in conception and in result..."6 This principle has been applied by the Supreme Court of India also.7 A "purchase" requires an asset to first be in existence. In the case of an allotment, as held by the Supreme Court in Jalan's case, there shares do not exist at all until they are allotted. Therefore, a share subscription may not be considered a "purchase".
Although the term "capital financing" is wide enough to include share subscription as well, the transactions contemplated in the provision, including borrowing, lending, guarantee, purchase, sale, or any type of advance, payment or deferred payment or debt arising during the course of business, appear to be applicable to funding transactions capable of having a "bearing on profits" as required by section 92B rather than a capital subscription. We would also need to consider the impact of clause (e) of the Explanation which states that: an 'international transaction' includes"... a transaction of business restructuring... irrespective of the fact that it has bearing on the profit, income, losses or assets of such enterprises at the time of the transaction or at any future date...". In the absence of a specific carve-out relating to the bearing on profits, it may be stated that a capital financing transaction would need to have a bearing on profits to be considered an international transaction within section 92B(1).
Therefore, it is unclear how a subscription to shares could be brought within the purview of the transfer pricing provisions under the current regime of the Act.
IMPACT ON PENDING CASES ON UNDERVALUATION OF SHARES
The facts before the Tribunal provided an opportunity to highlight an important aspect, which is not limited to investments by an Indian company, but also to investments into an Indian company. The Explanation to section 92B was inserted only in 2012, and as of now, there has not been detailed discussion of the scope of the amendments at the appellate levels. The Hyderabad Bench of the Tribunal chose to base its decision on the aspect that an international transaction must have some bearing on the income (and must result in chargeable income). However, it needs to be considered that even if such transactions are held to be international transactions, that would not automatically result in additions to income. Ultimately, the question would still arise as to whether it can be shown, by one of the prescribed methods of computation of arms' length price8, that the transaction was not at arms' length, and that it resulted in income chargeable to tax in India. How can it be said that an Indian company derives income by issuing shares at a lower price?This question is of relevance, particularly in an Indian cross-border investment context on account of currency control regulations which prescribe minimum pricing requirements for inbound investment into India. Can Shell India be said to have any notional income in spite of compliance with minimum pricing requirements? To allow for such a capture of notional income would also not be in accordance with the international approach, which does not contemplate inclusion of share subscription amounts within the transfer pricing net.
While there is little clarity on the grounds which the tax department will be taking in the pending cases of undervaluation of shares, the Central Board of Direct Taxes recently released9 an amended Form 3CEB (dealing with 'particulars relating to international transactions and specified domestic transactions...'), which includes capital investments in the list of international transactions which attract a transfer pricing analysis. It appears that the revenue authorities are seeking to include such transactions by a process of amendment. While Form cannot give powers to the Revenue when the Act does not, ultimately, the issue of applicability of transfer pricing to intergroup share subscriptions seems destined for the higher courts.
Footnotes
1 ITA 842/Hyd/2012.2 Circular No. 14 dated November 22, 2011.
3 321 ITR 178 (AAR). Reliance was also placed on the ruling in Re Amiantit International Holdings 322 ITR 678 (AAR).
4 However, contrary views have also been taken. For example, notional interest on interest-free loans has been held to be chargeable in India, by using transfer pricing provisions: see Perot Systems v. DCIT ITA 2320/De/2008. It could be argued that taxing of interest-free loans is only a matter of quantification of the appropriate price of the loan, and not a new charge of tax as such, and these decisions do not affect the general principle that transfer pricing provisions do not create a new charge where none existed before.
5 For example, see the Ruling of the Authority for Advance Rulings in Re Castleton Investment, AAR 999 of 2010. This can be contrasted with the Ruling in Re Praxair, 326 ITR 276 (AAR).
6 I Re V.G.M. Holdings [1942] 1 All ER 224.
7 Sri Gopal Jalan v. Calcutta Stock Exchange AIR 1964 SC 250
8 It has been held that under Section 92C read with Rule 10B, ALP must be established only by one of the methods prescribed. See, for a recent illustration of this principle, Greaves Cotton v. ITO ITA 3103/Mum/2011, decided on February 8, 2013.
9 CBDT Notification No. 41 dated June 10, 2013. One of the particulars now required to be filled up is: "Has the taxpayer entered into any international transaction(s) in respect of purchase or sale of marketable securities or issue of equity shares including transactions specified in Explanation (i)(c ) below section 92B (2)?"
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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