As per the Income Tax Act, any income, expenses arising from an international transaction or specified domestic transaction with an Associated Enterprise(AE) shall be computed having regard to arm's length price. Accordingly, it is imperative for the Finance controller to understand certain terminologies governing the Indian Transfer Pricing Regulations.
1. Associated Enterprise:
Two companies can be said to be AEs when there is direct or indirect participation in management, control or capital by one enterprise in other enterprise or by the same person in two enterprises. The participation in management, control or capital can be through direct or indirect equity holding, control over the board of directors, or appointment of one or more executive directors by one enterprise in other enterprise or by the same person in two enterprises.
Situations like granting of loan more than 51% of the book value of assets, giving guarantee of more than 10% of the total borrowings of the other Company, complete dependence on know-how, patent, etc. of the other Company, or purchase of raw materials from the other Company greater than 90% of the total raw material purchased by the Company during the year, or one entity has more than 10% of the beneficial interest in a partnership firm, association of persons or body of individuals triggers the deemed fiction and the two entities will be deemed to be AE irrespective of the fact that there is no direct or indirect participation in management, control or capital within the enterprises to enterprises.
Role of Finance controller:
The prime-facie role of a Finance controller is to identify all the AEs with whom the Company has transacted during the year. There are likely chances that some of the entities which are falling under the deeming fiction might go unnoticed to the auditors. Finance controller should ensure and identify the AEs to enable the Auditors to assess the compliance of Transfer Pricing provisions.
2. International Transaction:
An international transaction means a transaction between two or more AEs, 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, and shall include a mutual agreement or arrangement between two or more AEs for the allocation or apportionment of, or any contribution to, any cost or expense incurred or to be incurred in connection with a benefit, service or facility provided or to be provided to any one or more of such enterprises.
Finance Act 2012 has clarified that an international transaction shall also include the following:
o Capital financing, including any type of long-term or short-term borrowing, lending or guarantee, purchase or sale of marketable securities or any type of advance, payments or deferred payment or receivable or any other debt arising during the course of business;
o Provision of services, including provision of market research, market development, marketing management, administration, technical service, repairs, design, consultation, agency, scientific research, legal or accounting service;
o A transaction of business restructuring or reorganization, entered into by an enterprise with an AE, 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;
o Further, Finance Act 2012 has also clarified that an intangible asset shall also include marketing related intangible such as trademarks, trade names, brand names, logos, etc; technology related intangible such as process patent, patent application, technical documents and know-how; artistic related intangible such as literary works and copyrights, musical compositions; data processing related intangibles such as proprietary computer software, software copyrights, automated databases; engineering related intangible such as industrial design, product patent, trade secrets, engineering drawings and schematics, blueprints; customer related intangible such as customer list, customer contracts; goodwill related intangible such as institutional goodwill; professional practice goodwill, celebrity goodwill, etc.
Whenever a Company is proposing to enter into any of the above international transactions, Finance controller should liaise with the Finance Director or the Chief Financial Officer of the Company and ensure that an appropriate advise from a transfer pricing specialist has been taken as to what should be an appropriate arm's length price for entering into such international transactions.
When such transaction is a continuous transaction, the Finance controller should liaise with the Finance Director or the Chief Financial Officer and ensure revisiting their pricing model on a reasonable concurrent level so as to demonstrate to the tax authorities that the transfer pricing documentation are maintained on a contemporaneous basis.
3. Specified Domestic Transaction:
Transfer Pricing (TP) until now was applicable to companies having cross border transactions with their AE. However, Finance Bill 2012, honoring the supreme court ruling in case of CIT vs. M/S Glaxo Smithkline Asia (P) Ltd. (Special Leave to Appeal (Civil) No(s).18121/2007), expanded the ambit of TP to specified domestic transactions w.e.f 01 April 2013.
Transactions covered under the ambit of domestic transfer pricing:
o Any expenditure in respect of which payment is made or is to be made to a person referred to in Section 40A(2)(b) of the IT Act;
o Any transaction that is referred to in Section 80A;
o Any transfer of goods or services referred to in Section 80-IA(8) i.e. applicable to companies operating as industrial undertaking or enterprises engaged in infrastructure development;
o Any business transacted between the assessee and other person as referred to in section 80-IA(10);
o Any transaction, referred to in any other section under Chapter VI-A or section 10AA, to which provisions of sub-section (8) or sub-section (10) of section 80-IA are applicable;
o Any other transaction, as may be prescribed by the board.
Provided that the aggregate value of the transaction entered into by the assessee with its domestic AE exceeds Rs. 5 crore.
Implication of such amendment by Finance Act, 2012:
All the transactions entered into by the taxpayers operating in Special Economic Zones ('SEZs'); taxpayers entering into transactions with certain related parties specified under section 40A(2) and all the taxpayers claiming profit based deductions for undertaking specified business activities (under section 80A, 80- IA, etc.) will be covered.
The most likely affected industries are industries operating in SEZs, infrastructure developers and / or infrastructure operators, telecom services industries, industrial park developers, power generations or transmission, etc. Apart from these industries, the business conglomerates having significant intra-group transactions would be impacted.
Most likely transactions under the scanner of the TP Authorities would be:
o Interest Free Loans to group companies;
o Granting of Corporate Guarantees / Performance Guarantees by Parent Company to its subsidiaries;
o Intra-group purchase / sell / service transactions;
o Payment made to key personnel of the group companies;
Payment made to relatives of key personnel of the group companies.
Role of a Finance controller:
Companies which did not have international transactions till date, however had domestic transactions with related parties, were not governed by the Indian TPR. However, now since the domestic transfer pricing regulations are in place, Finance controller of the companies who have domestic transaction with its related parties equal to or more than Rs. 5 crore or companies whose present domestic transaction less than Rs. 5 crore but is likely to increase beyond Rs. 5 crore in the financial year 2012-13 are advised to validate their present business model and pricing methodology from a transfer pricing perspective which will enable them to take corrective actions, if necessary.
4. Arm's Length Price:
An arm's length price, is a price at which a transaction is entered into by a Company with a third party under normal market / economic conditions, i.e. without the influence of the relation between the parties. The principle of arm's length pricing requires a Company to enter into a transaction with its AE similar to a transaction it has entered into or would have entered into with a third party under uncontrolled conditions.
Role of a Finance controller:
The role of the Finance controller is to ensure that all the transactions which are entered into by a Company with its AE should be entered into having regards to arm's length price. If the transactions are found not to be at arm's length, the Company might face huge transfer pricing additions during the transfer pricing assessments.
Check List for a Finance controller to ensure appropriate compliance of Transfer Pricing Regulation:
1. During the financial year, liaise with the Financial Director or the Chief Financial Officer to identify the list of AEs and determine the value of International Transactions or specified domestic transactions.
2. Revisit the existing business model and transfer pricing methodology atleast once in a year to ensure that the transactions of the Company with its AEs are at arm's length to justify contemporaneous nature of transfer pricing business model.
Some Points to note about domestic transfer pricing
· Transfer pricing regulations, which were hitherto applicable only to international transactions, have been extended vide Finance Act2012 and are applicable from Assessment Year 2013-14 onwards.
· transactions covered for the purposes are as referred in section 40A, Chapter VI-A and section 10AA.There are six limbs to the definition.
· All of the compliance requirements relating to transfer pricing documentation, accountant's report, etc shall equally apply to specified domestic transactions as they do for international transactions amongst associated enterprises.
· The threshold limit for attracting the provisions is 5 crore Rs.
Transfer pricing Study Report
It is a study which can be documented considering the international transactions between the two or more
To substantiate the international transactions, the following are required to be studied while keeping in view of the international transfer pricing:
· Brief profile and nature of business of the Indian company ;
· Brief Profile and nature of business of the foreign entity or associated enterprises;
· Details of international transactions;
· F A R Analysis ( i.e. Functions, Assets and Risks Analysis );
· Industry Analysis of the tested party;
· Economic Analysis (i.e. Selection of Most Appropriate Method)
Application of Most appropriate method
Analysis under CUP or TNMM or CPM or RPM or PSM etc.
(if it is under TNMM, data analysis and research is to be done from the public data bases)
Conclusion substantiating the pricing of the tested party for each international transaction.
If the above is in order, then proper study on transfer pricing is completed on each international
transaction under any of the specified methods and we can conclude that the pricing is at Arm’s
TRANSFER PRICING ADJUSTMENTS BY TPO AND LITIGATION OF SAME
Associate Enterprise: 92A
•Direct Control/Control through intermediary
•Holding 26% of voting power
•Advance of not less than 51% of the total assets of borrowing company.
•Guarantees not less than 10% on behalf of borrower
•Appointment of more than 50% of the BoD
•Dependence for 90% or more of the total raw material or other consumables
International Transactions: 92B
Arm’s Length Price: 92C
· Comparable uncontrolled price method
· Resale price method
· Cost plus method
· Profit split method
Safe Harbour Rules under Transfer Pricing Regulation in India
“In order to reduce the number of transfer pricing audits and prolonged disputes, a new section 92CB has been inserted to provide that the determination of arm’s length price under section 92C or section 92CA shall be subject to Safe Harbour rules.”
The Finance (No. 2) Act 2009 introduced the provisions in the Income Tax Law that empowered the Central Board of Direct Taxes (CBDT) to issue transfer pricing Safe Harbour Rules. The CBDT on 14th August 2013 released draft safe harbor rules for public comments. After consideration comments of various stakeholders on 18th September 2013, the CBDT issued the final Safe Harbour Rules.
Section 92CB of the Act defines the term Safe Harbour as “circumstances under which the income-tax authorities shall accept the transfer pricing declared by the assessee.” The Rule provides minimum operating profit margin in relation to operating expenses a taxpayer is expected to earn for certain categories of international transactions , that will acceptable to the income tax authorities as arm’s length price (ALP) . The rule also provides acceptable norms for certain categories of financial transactions such as intra-group loans made or guarantees provided to non-resident affiliates of an Indian tax payers. The safe harbor rules, optional for a taxpayer, contains the conditions and circumstances under which norms / margins would be accepted by the tax authorities and the related compliance obligations.
The safe harbour rule are not arm’s length prices, but in the nature of presumptive taxation, which generally enthuse taxpayers to opt for the same, as a compromise for not having to be involved in protracted litigation. Safe harbor typically include a premium payable by taxpayers for avoiding disputes and protracted litigations. Safe harbours may broadly take two forms (a) outright exclusion by setting thresholds; or (b) simplification of provisions by designating range, within which prices/profits should fall.
Applicable Safe Harbour Transfer Price
New rules 10TA to 10TG contains the procedure for adopting safe harbour, the transfer price to be adopted, the compliance procedures upon adoption of safe harbors and circumstances in which a safe harbor adopted may be held to be invalid. Eligible International Transactions and applicable safe harbour transfer price subject to the ceilings/circumstances stated as under: –
Eligible international transaction
Threshold limit prescribed
Safe harbor margin
Provision of software development services &information technology enabled services with insignificant risks
Up to Rs 500 Crore
20 % or more on total operatingcosts
Above Rs 500 Crore
22 % or more on total operating costs
Provision of knowledge processes outsourcing services with insignificant risks
25 % or more on total operating costs
Advancing of intra-group loan to a nonresident wholly owned subsidiary
Interest rate equal to or greater than the base rate of SBI as on 30th June of relevant previous year
Up to Rs 50 Crore
Plus 150 basis points
Above Rs 50 Crore
Plus 150 basis points
Providing explicit corporate guarantee to wholly owned subsidiary (WOS)
The commission or fee declared in relation to the international transaction is
Up to Rs 100 Crore
at the rate of 2% or more per annum on the amount guaranteed
Above Rs 100 Crore, provided the WOS has been rated to be of adequate to highest safety by a rating agency registered with SEBI
at the rate of 1.75% or more per annum on the amount guaranteed
Provision of specified contract R&D services wholly or partly relating to software development with insignificant risks
30% or more on total operating costs
Provision of contract R&D services wholly or partly relating to generic pharmaceutical drugs with insignificant risks
29% or more on total operating costs
Manufacture and export of core autocomponents
12% or more on total operating costs
Manufacture and export of noncore auto components where 90% or more of total turnover during the relevant previous year is in the nature of original equipment manufacturer (OEM) sales
8.5% or more on total operating costs
Validity for five years
The transfer price contained in the safe harbor rules shall be applicable for five years beginning from financial year (FY) 2012-13. The taxpayer has flexibility in electing the years to be governed by the safe harbor rules within the five year period. Where a taxpayer’s transfer price is accepted by the Tax Authority under the safe harbor rules, the taxpayer shall not be entitled to invoke the mutual agreement procedure (MAP) under an applicable tax treaty.
Filling of form 3CEFA
Any taxpayer who has entered into an eligible international transaction and who wishes to exercise the option to be governed by the safe harbour rules is required to file a specified form (Form 3CEFA). Form 3CEFA requires the taxpayer to declare the following:
· Transaction entered with an AE is an eligible international transaction;
· Quantum of the international transaction;
· Whether the AEs country or territory is a no tax or low tax country or territory; and
· Operating profit margin/transfer price.
Timelines for Tax Authorities
The rules also provide timelines within which the tax authorities need to take action on the option exercised by the taxpayer. These are:
Reference by AO to TPO to determine eligibility of assessee or international transaction or both for purposes of the safe harbor
Two months from the end of the month in which Form 3CEFA is received by AO
TPO to pass an order after determining validity or otherwise of the option exercised by the assessee
Two months from the end of the month in which reference from AO is received
Commissioner to pass an order with respect to the validity or otherwise of the option exercised by the assessee
Two months from the end of the month in which the objections filed by the assessee are received
Benefits of Safe Harbour
Safe harbours carry certain benefits which are described below:
· Compliance Simplicity: Safe harbours tend to substitute simplified requirements in place of existing regulations, thereby reducing compliance burden and associated costs for eligible taxpayers, who would otherwise be obligated to dedicate resources and time to collect, analyze and maintain extensive data to support their inter-company transactions.
· Certainty & Reduce Litigation: Electing safe harbours may grant a greater sense of assurance to taxpayers regarding acceptability of their transfer price by the tax authorities without onerous audits. This conserves administrative and monetary resources for both the taxpayer and the tax administration.
· Administrative Simplicity: Since tax administrations would be required to carry out only a minimal examination in respect of taxpayers opting for safe harbours, they can channelize their efforts to examine more complex and high-risk transactions and taxpayers.
While safe harbours generally are beneficial, their availability is not without concerns, some of which are:
· High Margins/Price: Some of the rates are very high and reflect neither industry benchmarks nor the current economic environment.
· Risk of double taxation: When adopted unilaterally, safe harbours pose risk of double taxation since reporting of higher than arm’s length level of income in one jurisdiction (to comply with safe harbour levels) need not be necessarily accepted by the tax administration in the other jurisdiction.
· Impose Burden: Safe harbour rules continue to impose the burden of maintaining transfer pricing documentation on taxpayers opting for it. Excluding taxpayers transacting with low tax or no tax countries from the ambit of safe harbour rules creates a further exception.
· Risk of Subjectivity & Litigation: The industry at large feels that segregating IT services into software services and contract R&D services is complicated since many of the activities may be overlapping and would require a more technical analysis than envisaged in the rules.
Transfer Pricing is often identified as one of the most serious tax issues facing corporate in India. In the face of growing uncertainty and litigation, the Government’s announcement of safe harbour rules has been welcomed by all quarters. However, doubts remain on whether these rules will entirely help achieve the stated objectives of reduced Transfer Pricing disputes and usher in more certainty unless resolved appropriately. Therefore, the safe harbour regime to successfully work in India would needed effective implementation measures by the tax authorities.
Sixth Method of transfer pricing
The TPR in India were inserted in the tax statue with effect from Financial Year (‘FY’) 2001-02 whereby six methods have been prescribed ie i) Comparable Uncontrolled Price Method; ii) Resale Price Method; iii) Cost Plus Method; iv) Profit Split Method; v) Transactional Net Margin Method; and vi) such other method as may be prescribed by the Board.
For the first time since the introduction of TPR in the India, the CBDT has introduced the sixth method by way of Notification No 18/2012, dated May 23, 2012 thereby inserting Rule 10AB (‘Rule’) to the Income-tax Rules, 1962.
The new method may be split into two parts:
(i) ‘any method which takes into account the price which has been charged or paid; or
(ii) ‘any method which takes into account the price which would have been charged or paid
Post Finance Act, 2012 the scope of Indian Transfer Pricing regulations has been significantly expanded – business re-structuring, transfer of intangibles (including transfer of employees or workforce) and even domestic related party transactions have been expressly brought within the ambit of Transfer Pricing regulations.
In the absence of the Sixth Method, a moot point could have been the choice of method for valuing such complex transactions. The introduction of the open-ended Sixth Method solves this problem in one stroke.
Transfer Pricing : Ever Evolving with new concepts : OECD BEPS , Formulary apportionment
Transfer pricing - OECD Base Erosion and Profit Shifting Action Plan
Amid growing global concern regarding tax evasion, the OECD has developed a report on national tax laws that have not kept pace with the globalization of corporations and the digital economy, leaving gaps that can be exploited by multinational corporations to reduce their taxes artificially. The report, which was produced at the request of the G20, concludes that current rules provide opportunities to associate more profits with legal constructs and intangible rights and obligations, and to shift risk intra-group legally.
On July 19, 2013, the OECD subsequently introduced an Action Plan on Base Erosion and Profit Shifting to address the concerns raised by the report, presenting the findings at a meeting of G20 Ministers of Finance and Governors of Central Banks in Moscow. Quickly known as BEPS (Base Erosion and Profit Shifting), the ambitious plan sets out to amend domestic legislation, tax treaties and transfer pricing rules, identifying 15 specific actions that will give governments the domestic and international instruments to prevent corporations from paying little or no taxes. It aims to provide comprehensive strategies for countries concerned that current tax rules in some locations allow for the allocation of taxable profits to locations different from those where the actual business activity takes place.
The actions outlined in the plan will be delivered in the coming 18 to 24 months by the joint OECD/G20 BEPS Project, which involves all OECD members and G20 countries on an equal footing. To ensure that the actions can be implemented quickly, a multilateral instrument will also be developed for interested countries to amend their existing network of bilateral treaties.
The 15 Point Plan, with target completion dates, is summarized below. Full detail is available in Table A.1 of the OECD BEPS Plan.
1. Address the tax challenges of the digital economy (to be completed by September 2014)
2. Neutralize the effects of hybrid mismatch arrangements (to be completed by September 2014)
3. Strengthen controlled foreign company (CFC) rules (to be implemented as of September 2015)
4. Limit base erosion via interest deductions and other financial payments (to be implemented by September/December 2015)
5. Counter harmful tax practices more effectively, taking into account transparency and substance (to be completed by September 2014/December 2015)
6. Prevent treaty abuse (to be completed by September 2014)
7. Prevent the artificial avoidance of permanent establishment (PE) status (to be implemented by September 2015)
8. Develop rules to prevent BEPS by moving intangibles among group members (to be completed by September 2014/2015)
9. Develop rules to prevent BEPS by transferring risks among, or allocating excessive capital to, group members (to be completed by September 2014/2015)
10. Develop rules to prevent BEPS by engaging in transactions which would not, or would only very rarely, occur between third parties (to be completed by September 2015)
11. Establish methodologies to collect and analyze data on BEPS and the actions to address it (to be completed by September 2015)
12. Require taxpayers to disclose their aggressive tax planning arrangements (to be completed by September 2015)
13. Re-examine transfer pricing documentation (to be completed by September 2014)
14. Make dispute resolution mechanisms more effective (to be completed by September 2015)
15. Develop a multilateral instrument to enable jurisdictions that wish to do so to implement measures developed in the course of the work on BEPS and amend bilateral tax treaties.
As this highly ambitious effort develops, it will have obvious impact on the tax planning efforts of multinationals.
Arms Length Price vs Formulary Apportionment
Formulary apportionment is a method of allocating profit earned (or loss incurred) by a corporation or corporate group to a particular tax jurisdiction in which the corporation or group has a taxable presence. It is an alternative to separate entity accounting, under which a branch or subsidiary within the jurisdiction is accounted for as a separate entity, requiring prices for transactions with other parts of the corporation or group to be assigned according to the arm's length standard commonly used in transfer pricing. In contrast, formulary apportionment attributes the corporation's total worldwide profit (or loss) to each jurisdiction, based on factors such as the proportion of sales, assets or payroll in that jurisdiction. When applied to a corporate group, formulary apportionment requires combined reporting of the group's results. The parent and all of its subsidiaries are viewed as though they were a single entity (unitary combination), and the method is then also known as worldwide unitary taxation. In the US, most states have adopted water's edge combined reporting which restricts the taxable group to just US domestic corporations and excludes "overseas business organization", i.e., unitary foreign affiliates and foreign parents.
Arm’s length Vs Formulary apportionment
Arm’s length method is mostly used worldwide, and allows for MNE’s (Multi NationalEnterprises) to take advantage of all tax jurisdictions such as low-tax and no-tax. Formulary apportionment would eliminate utilizing those low-tax countries, eliminating any income they receive from outside investors, yet helping to deter the opportunity to produce fraudulent results internally for the corporation using these methods. Arm’s length takes each subsidiary in an MNE’s corporate structure and figures out sales, operations, goods etc. to create a tax for the organization within that country, essentially funneling profits upwards into the MNE’s corporate headquarters.
Formulary apportionment would essentially take a formula approach and level playing field so that all subsidiaries are dealt with equally. Thus avoiding the heavy overhead where transfer pricing is concerned
Arm’s length method is internationally recognized to be the acceptable method of transfer pricing for MNE’s (Multi-national Enterprises).
The arm’s length principle states “transactions between associated enterprises should not be distorted by the special relationship that exists between parties, as such the arm’s length principle is neutral”.
That neutrality is then built upon by local jurisdictions and pricing is mandated by local law. Most countries follow their own transfer pricing treaties and legislation, which follows the OECD guidelines,that allows for transparency. What is most disturbing is the fact that despite the transparency established by theOECD guidelines, it still leaves room for dishonesty and uncanny opportunity to fudge numberswithin an organization.
While still in its technical infancy, formulary apportionment has great potential to become a cost effective alternative to the arm’s length method, minimizing theexpense for the actual calculations of the prices and additional figures. The apportionmentmethod finds its origin in the intrinsic difficulty of attributing income in a satisfactory way bysource. The theoretical background relies on the assumption that certain elements of a businessfairly reflect the measure of the tax to be attributed to a particular state.
When looking at the arms length method, one cannot help to wonder if there is a much moreefficient method of handling the transfer pricing policies of each individual nation. Many havespeculated that formulary apportionment is an alternative that would be more efficient and wouldhelp to even the business field by essentially eliminating the need for businesses to put their structures in a low-tax or no-tax jurisdiction. With the formulary apportionment, it spreads the burden across the business structure more evenly, alleviating the necessary legislation to governthese proceedings.
Examining the two methods is first essential to understanding what and how each could help or hinder a business distribution of profits within each jurisdiction that is applicable. Let usexamine formulary apportionment, also known as unitary taxation, with an open mind.
Under formulary apportionment, the profits of various branches of an enterprise or the variouscorporations of a group are not calculated as if the branches or subsidiaries were distinct andseparate entities dealing at arm's length with each other, but rather the entire group is regarded asa unity. Both domestic and foreign parts of a unitary business are included, but intercompanytransactions are excluded to prevent the double-counting of income or expense.
There are several opinions on which method is better, how can we decide which method is moreeffective and what is the criterions of the method that best fits all situations. As of right now,arm’s length method for MNE is the most widely used method domestically and internationally.But what constitutes that method and how does it perform across borders without really hurtinginternational trade and international business.
Transfer pricing of transations of MNCs in India : Nokia Vodafone Shell Cap Gemini
Vodafone Tax Case - The journey from May 2010 to 8th Oct 2015
First, the then finance minister Pranab Mukherjee was pilloried for making a retrospective amendment in 2012 to get a capital gains tax of Rs 12,000 crore from Hutchison of Hong Kong which sold its telecom business to Vodafone through a convoluted and contrived transaction in Cayman Islands.
The Bombay High Court upheld the vicarious tax claim on Vodafone in its capacity as representative assessee but the Supreme Court upturned it on the limited ground that Section 9 (1) of the Income-Tax Act that deemed certain foreign incomes as Indian failed to specifically includes transfer of controlling interests in Indian companies consummated abroad.
The apex court said business connection rule wasn’t elastic enough to rope in share transfers giving rise to capital gains. Mukherjee only took the cue from the apex court to supply the power to tax authorities retrospectively by filling the void but gung-ho market fundamentalists cried foul and Mukherjee was kicked upstairs to the office of President by the UPA.
The Vodafone retrospective amendment came as a convenient handle for vested interests to mount a vicious campaign that went to the extent of branding India as tax terrorist state. What followed was needless coyness bordering on self-flagellation.
The Bombay High Court last year virtually disowned our transfer pricing code enshrined in our income tax law without striking down the provisions when it said in Vodafone (a different case) and Shell cases that there was no tax avoidance and transfer pricing rules could not be invoked when foreign parents of Indian subsidiaries helped themselves to shares of the latter at throwaway prices.
The Court found substance in the self-serving argument that these were capital transactions. Touché!
The law says clearly that the transfer pricing regime is designed to frustrate tax avoidance and can go to the extent of reaching out to transactions that are capital in nature to get to the bottom of the truth.
The department rightly contended that MNCs arm-twisted their subsidiaries to pay less for their products and service and in lieu thereof allot shares dirt cheap. Surprisingly, the attorney general advised the government not to appeal to the Supreme Court so the government could worm back into the hearts of foreign investors.
Now comes yet another verdict from the Bombay High Court, this one once again involving Vodafone on a matter involving sale of its Indian call centers to Hutch. The Tribunal had upheld the department’s claim that this was an international transaction and hence came under the mischief of the transfer pricing regime but the Bombay High Court on 8 October 2015 has ruled that the transaction wasn’t international in the first place.
The subject matter of the transaction may be located in India but at least one party is a non-resident so as to give it an international status. Hence the department’s hands are once again tied - it cannot reach out to the huge capital gains of the order of Rs 8,500 crore. It remains to be seen if the government would once again refrain from appealing to the Apex Court lest it is branded business unfriendly.
The Vodafone Tax Dispute — Judgment of the Bombay High Court
Article Details :
The tax dispute between the Indian Tax Authorities and Vodafone in connection with taxability of the $ 11.2 billion Hutch-Vodafone deal is one of the biggest controversies in Indian multijurisdictional M&A history. The quantum of tax demand by the Indian Revenue Authorities in this particular case could be around Rs.12,000 crore plus interest. Further, the outcome of this dispute could also have implications on other similar cross-border deals being scrutinised by the Indian Tax Authorities for possible loss of tax revenue. As a result, the developments of this case are being closely followed by many multinationals, M&A consultants and even by the International business and tax fraternity.
We have summarised below the key aspects of the recent landmark judgment of the Bombay High Court on the Vodafone tax dispute and have also given our personal comments on some of the questions generally being raised by fellow professionals post this judgment.
Background of the case :
In December, 2006, Hutchison Telecommunications International Ltd. (HTIL), a company incorporated in Cayman Islands and having its principal executive office at Hong Kong, held 66.9848% interest in an Indian company, Hutchison Essar Ltd. (HEL) through a maze of subsidiaries in British Virgin Islands, Cayman Islands and Mauritius (around 15 offshore companies) and through complicated ‘option’ agreements with a number of Indian companies. HEL along with its Indian subsidiaries held licences for providing cellular services in 23 telecom circles in India. The balance 33.0152% interest in HEL was held by the Essar Group of Companies.
Vodafone (through its Netherlands entity) entered into a share purchase agreement with HTIL in February 2007 to acquire the said 66.9848% interest in Hutchison Essar Ltd. and it claims to have acquired the same through purchase of the solitary share of a Cayman Island company of the Hutch Group [viz., CGP Investments (Holdings) Ltd. (CGP)].
The Indian Revenue Authorities alleged that Vodafone International Holdings B.V., Netherlands (Vodafone BV) had failed to withhold income-tax on the payment of consideration made to HTIL and, hence, sought to assess tax in its hands as a taxpayer in default and it issued a notice to Vodafone.
Vodafone BV had challenged the issue of this notice before the Bombay High Court and the case was decided against it. Vodafone filed a petition before the Supreme Court (SC); however, the same was dismissed by the SC and it directed the Revenue Authorities to decide whether it had jurisdiction to tax the transaction and it also said that if the issue was decided against Vodafone BV, Vodafone BV was entitled to challenge it as a question of law before the High Court.
The Revenue Authorities by an order in May 2010 held that it had jurisdiction to treat Vodafone BV as an assessee in default u/s.201 of the Income-tax Act, 1961 for failure to deduct tax at source.
This order was challenged by Vodafone BV before the Bombay High Court, by a writ petition. The key issue before the HC was whether the Indian Revenue Authorities have the jurisdiction to proceed against Vodafone BV and tax the transaction.
Primary contention of Vodafone :
The basic contention of Vodafone was that the transaction represents a transfer of a share (which is a capital asset) of a Cayman Island company, i.e., CGP. CGP through its downstream subsidiaries, directly or indirectly controlled equity interest in HEL. Any gain arising to the transferor or to any other person out of this transfer of a share of CGP is not taxable in India because the asset (i.e., share) is not situated in India.
Primary contention of Revenue :
The contention of the Revenue is that the share purchase agreement between HTIL and Vodafone and other transaction documents establishes that the subject-matter of the transaction is not merely the transfer of one share of CGP situated in Cayman Islands as contended by Vodafone. The transaction constitutes a transfer of the composite rights of HTIL in HEL as a result of the divestment of HTIL’s rights, which paved the way for Vodafone to step into the shoes of HTIL. Such transaction has a sufficient territorial nexus to India and is chargeable to tax under the Income-tax Act, 1961.
Decision of Bombay High Court :
The High Court dismissed the petition of Vodafone BV and has accepted the argument of the Income tax Authorities that the transaction in question had a significant nexus with India and the proceedings initiated by it cannot be held to lack jurisdiction.
(i) The key aspects observed by the High Court :
Before analysing the facts of the instant case, the High Court made observations on certain general principles, some of which are given below :
- Tax planning is legitimate so long as the assessee does not resort to a colourable device or a sham transaction with a view to evade taxes;
- A controlling interest which a shareholder acquires is an incident of the holding of shares and has no separate or identifiable existence distinct from the shareholding;
- S. 195(1) of the Income-tax Act, 1961 provides for a tentative deduction of income-tax, subject to a regular assessment;
- The Parliament, while imposing a liability to deduct tax has designedly imposed it on a person and has not restricted it to a resident and the Court will not imply a restriction not imposed by legislation.
(ii) Analysis of facts :
The High Court analysed the various agreements entered into by the parties (like share purchase agreement between HTIL and Vodafone BV, term sheet agreement between HTIL and Essar group for regulating the affairs of HEL which was later replaced by a similar term sheet agreement between Vodafone and Essar group, brand licence agreement granting a non-transferable royalty-free right to Vodafone BV to use IPRs for a certain period, agreement for assignment of loans to Vodafone BV, framework agreements for option rights, etc.) and the various disclosures made by the parties (like disclosures made by HTIL in its annual reports, disclosures made by Vodafone in its offer letter, disclosures made by Vodafone before the FIPB, etc.) for ascertaining the subject-matter of the transaction and the business understanding of the parties to the transaction.
(iii) Conclusions :
Based on the analysis of the above documents and disclosures, the High Court held that :
The transaction between HTIL and Vodafone BV was structured so as to achieve the object of discontinuing the operations of HTIL in relation to the Indian mobile telecommunication operations by transferring the rights and entitlements of HTIL to Vodafone BV. HEL was at all times intended to be the target company and a transfer of the controlling interest in HEL was the purpose which was achieved by the transaction. The due diligence report of Ernst & Young also emphasises this and it also suggests that the transfer of the solitary share of CGP, a Cayman Islands company was put into place at the behest of HTIL, subsequently as a mode of effectuating the goal.
The rights under the option agreements were created in consideration of HTIL financing such Indian companies for making their investments in HEL. The benefit of those option agreements with Indian companies had to be transferred to Vodafone BV as an integral part of the transfer of control over HEL.
The transfer of the CGP share was not adequate in itself to consummate the transaction. The transactional documents are not merely incidental or consequential to the transfer of the CGP share, but recognised independently the rights and entitlements of HTIL in the Indian business, which were being transferred to Vodafone BV. These rights and entitlements constitute in themselves capital assets.
For Income-tax Law what is relevant is the place from which or the source from which the profits or gains have generated or have accrued or arisen to the seller. If there was no divestment or relinquishment of HTIL’s interest in India, there was no occasion for the income to arise. The real taxable event is the divestment of HTIL’s interests which comprises in itself various facets or components which include a transfer of interests in different group entities.
Apportionment of the consideration lies within the jurisdiction of the Assessing Officer during the course of the assessment proceedings. Such an enquiry would lie outside the realm of the present proceedings.
The transaction between HTIL and Vodafone BV had a sufficient nexus with Indian fiscal jurisdiction. The essence of the transaction was a change in the controlling interest in HEL which constituted a source of income in India. Accordingly, Indian Tax Authorities have acted within their jurisdiction in initiating the proceedings against the Petitioner for not deducting tax at source. As regards the withholding obligation on a non-resident, the High Court held that once the nexus with Indian fiscal jurisdiction is shown to exist, the provisions of S. 195 would operate.
Issues involved and our view :
1. Whether all offshore share transactions which indirectly involve transfer of underlying Indian assets are taxable in India ?
Ever since the Indian Revenue Authorities initiated proceedings against Vodafone, we have been hearing this concern from everyone including many international tax experts that how can the Indian Revenue Authorities tax a transaction of sale of shares of a foreign company by one non-resident to another non-resident by taking an argument that pursuant to such sale of shares, underlying assets in India get transferred ?
We believe that in the instant case, the Revenue is not seeking to tax the transaction in India on the ground that there is an indirect transfer of underlying assets situated in India on account of a transaction of transfer of shares of a foreign company. It seems that the Revenue’s contention is that on evaluation of the various transaction documents executed by HTIL and Vodafone, it can be established that the transaction itself is for transfer of composite rights including, in particular, rights under a joint venture agreement (which constitute a capital asset situated in India) and the transfer of share of an overseas company is only a mode for facilitating the transaction.
It has to be accepted that for evaluating the taxability of a transaction, one needs to first understand the true nature and character of a transaction.
The High Court before analysing the facts in the instant case, laid down the general principle that legal effect of a transaction cannot be ignored in search of ‘substance’ over ‘form’. However, the High Court has also rightly held that in assessing the true nature and character of a transaction, the label which parties may ascribe to the transaction is not determinative of its character. The nature of the transaction (i.e., ‘form’ of the transaction) has to be ascertained from the covenants of the contract and from the surrounding circumstances. The subject matter of the transaction must be viewed from a commercial and realistic perspective. The terms of the transaction are to be interpreted by applying rules of ordinary and natural construction.
After going through the facts available on record, including various public disclosures made by the Hutch and Vodafone Group and share purchase agreement and other transaction documents entered into between the parties, which have been very well analysed by the High Court in its judgment, there is no doubt in the mind of the High Court that the subject-matter of the transaction in the instant case, even in ‘form’, is not one share of the Cayman Islands Company, but it is a transfer of controlling interest (including various rights and entitlements) in HEL, India. As noted by the High Court, the acquisition of one share of the Cayman Islands company was only a mode chosen by the parties to facilitate the process.
The High Court thus rejected the submission of Vodafone that the transaction involves merely a sale of a share of a foreign company, which is a capital asset situated outside India and all that was transferred was that which was attached to and emanated from such solitary share. The High Court also noted that it was based on such false hypothesis that it was being urged by Vodafone that the rights and entitlements which flow out of the holding of a share cannot be dissected from the ownership of the share.
Thus, it is based on the detailed evaluation of the specific facts and documents of this transaction that the High Court finally concluded that the real taxable event is the divestment of HTIL’s interests in India and it accepted the argument of the Revenue that the transaction in question had a significant nexus with India and the proceedings initiated by it cannot be held to lack jurisdiction.
Hence, the High Court ruling does not at all hold that offshore share transactions which indirectly involve transfer of underlying Indian assets can be taxed in India.
2. Whether withholding is required on the entire consideration or there needs to be an apportionment ?
The High Court has held that an enquiry on the aspect of apportionment of the total consideration would lie outside the purview of the proceedings before it and the aspect of apportionment lies within the jurisdiction of the Assessing Officer during the course of the assessment proceedings. Thus, it would be for the Assessing Officer to determine during the course of assessment proceedings whether there is any income out of the total consideration which cannot be said to have accrued or arisen in India or cannot be deemed to have accrued or arisen in India and hence cannot be taxed in India. The observations clearly relate to ‘assessment’ and not to deduction of tax.
It would also be relevant to note that the High Court while laying down the principles governing the interpretation of the provisions of S. 195 held that S. 195(1) provides for a tentative deduction of income tax, subject to a regular assessment.
The High Court has only held that the composite payment by Vodafone had nexus with and included payment giving rise to income accruing or arising in India. Consequently, the High Court has decided the question before it, viz., whether the Indian Tax Authorities have the jurisdiction to take action against Vodafone for having made the payment without deducting tax as it was required to do u/s.195.
The High Court has not gone into, nor made any observations or given any decision about whether the whole or part of the payment would be liable to deduction of tax, the rate at which tax is to be deducted, etc. The High Court was not required to and has expressed absolutely no views on any of these matters which the Officer has to adjudicate.
3. Is there an inconsistency in the observation made by the High Court on the aspect of controlling interest not being a capital asset and its final conclusion ?
The High Court before analysing the facts in the instant case, laid down the general principle that the controlling interest which a shareholder acquires is an incident of the holding of shares and has no separate or identifiable existence distinct from the shareholding. After a detailed evaluation of the specific facts and documents of this transaction, the High Court finally concluded that the essence of the transaction was a change in the controlling interest in HEL which constituted a source of income in India. With due respect to the High Court, is there an inconsistency in the observation made by the High Court and its final conclusion ?
In our view, there is no inconsistency, as the entire order needs to be read harmoniously. The term ‘controlling interest’ in the general principle laid down by the High Court that ‘the controlling interest which a shareholder acquires is an incident of the holding of shares and has no separate or identifiable existence distinct from the shareholding’ seems to refer to controlling interest acquired as an incidence of acquisition of a particular number of shares. The High Court has not made any general observations about a case where the subject matter of the transfer is the ‘controlling interest’ and the requisite number of shares are transferred or delivered, directly or indirectly, for achieving the transfer of the ‘controlling interest’. In any case, the term ‘controlling interest’ used by the High Court in its final conclusion represents the entire business interest of HTIL in the Indian mobile telecommunication operations, i.e., HTIL’s interest in HEL, which includes (a) Equity interest of 42.34% held by HTIL through its subsidiaries (b) Equity interest of 9.58% held by HTIL through minority equity holdings of its subsidiaries in certain Indian companies which in turn held equity interest in HEL (c) Rights (and call and put options) representing HTIL’s economic interest in 15.03% equity of HEL (d) Assignment of loans (e) Other rights and entitlements.
Further to the above, it may also be worthwhile to evaluate if the above general principle will hold good in a situation where the transaction between the parties incidentally results in the acquisition of controlling interest in a subsidiary company (say, an Indian company) as a consequence of transferring shares of an overseas parent company. The same does not seem to have been evaluated by the High Court in the instant case, may be because such evaluation was not necessary here as the transaction was for transfer of entire business interest in HEL which included various rights and entitlements which anyway could not have been transferred in the manner in which they were transferred by the transfer of one share of CGP and the consideration was for the transfer of such entire business interest as a package.
4. Will the Vodafone case create a negative perception of India in the eyes of foreign investors ?
As could be seen from the High Court order, the action of the Indian Tax Authorities in this particular case is based on a proper and detailed analysis of the facts and circumstances of this case and the relevant provisions under the domestic Income-tax law which are very widely worded. It is important to note that no tax treaty is applicable in this particular case and hence it is not a case that the Indian Government is not honouring its commitment to foreign investors by proposing to tax the impugned transaction in the case of Vodafone. Also, here it is not the claim of Vodafone that there is double taxation on the income from the transfer of controlling interest in HEL. Further, it has to be appreciated that tax cost is only one of the various costs of a business and business decisions are not taken entirely on the basis of tax cost.
The order of the High Court has not been stayed by the Supreme Court, on the contrary the Supreme Court directed the Income-tax Department to pass an order to quantify the tax liability. Thus, the action of the tax authorities in this particular case has not only been held as reasonable and not without substance, but also legal, and it will be taken in the right perspective by foreign investors and it should not have an adverse impact on M&A activity in India.
T. P. Ostwal
The Vodafone Tax Dispute — A Landmark Judgment of the Bombay High Court