Share subscription and application of transfer pricing provisions: High Court directs tax authorities to reconsider the issue
The issue of applicability of transfer pricing on subscription to shares has been a contentious issue in the recent past. As per the Finance Act, 2013, the issuance of shares at more than fair market value to Indian residents has been brought to tax in the hands of the issuing company. Similarly, the receipt of shares at less than fair market value had been brought into the tax net earlier. However, the tax authorities have been seeking to apply transfer pricing provisions in respect of any shares issued even prior to the amendments and even in respect of matters not covered within the scope of the amendments.
The Bombay High Court (“High Court”) considered the issue of the applicability of transfer pricing provisions to such share subscription transactions in its recent decision in Vodafone India Services Pvt. Ltd. v. Union of India & Ors.1 While it did not provide any conclusive opinion on the matter, it ruled that the tax authorities were bound to consider this preliminary issue before proceeding with ascertaining tax liability of a tax payer (“Judgment”).
The Judgment highlights the importance of incorporating principles of administrative law and constitutional law while preparing responses to the tax authorities. Further, the Judgment makes it mandatory for the Income Tax Department to consider preliminary points prior to proceeding with computation of income.
Vodafone India Services Private Limited (“Vodafone India”), a wholly owned subsidiary of Mauritian entity Vodafone Tele-Services (India) Holdings Ltd. (“Vodafone Mauritius”), issued 289,224 equity shares of face value of Rs. 10 each at a premium of Rs. 8,591 per share in August 2008 (“Issue of Shares”). The Issue of Shares was undertaken in compliance with India’s foreign exchange laws and was reported in Vodafone India’s annual tax return and in Form 3CEB, as per section 92E of the Income Tax Act, 1961 (“ITA”), being the auditor’s report (“Auditors Report”). The Auditors Report also contained a note stating that this transaction was only specified as a matter of abundant caution and did not affect the income of Vodafone India.
On December 14, 2012, the Transfer Pricing Officer (“TPO”) issued a show cause notice (“SCN”) to Vodafone India as to why the Issue of Shares should not be computed based on the arms-length-price (“ALP”). In the SCN, the TPO raised the following points:
Vodafone India disputed the SCN on the ground that the SCN was without jurisdiction since transfer pricing provisions were not applicable to the Issue of Shares. Relying on the principle of real income, Vodafone India contended that the TPO lacked jurisdiction to tax notional income by re-characterizing a transaction. The TPO in his order under section 92CA of the ITA (“TPO Order”) rejected the objections of Vodafone India on the ground that Explanation (i)(c) to Section 92B provided that capital financing was an international transaction and consequently, that the Issue of Shares was an international transaction. Since the Issue of Shares was at a premium lower than what was due, it was held that there should be an appropriate adjustment for the same. Further, it was held that the deficit amount should be treated as a loan and that this loan would attract interest. Thus, a total transfer pricing adjustment for the deficit premium and the interest on loan of Rs. 13.972 Billion (“TP Adjustment”) was determined.
In view of the TPO Order, the Assessing Officer (“AO”) issued a show cause notice under section 142 (1) (inquiry before assessment) inquiring as to why the TP Adjustment of Rs. 13.972 Billion should not be added to the total income. Vodafone India reiterated the objections that it had raised to the SCN issued by the TPO. On March 22, 2013, the AO passed an assessment order adding this TP Adjustment to the income. Importantly, the AO did not consider the objections raised by Vodafone India in its reply relating to the issue of jurisdiction and proceeded to pass a draft assessment order under section 143 (3) read with section 144 C (1) of the ITA (“Assessment Order”). Aggrieved by this, the Assessment Order and the TPO Order were challenged by Vodafone India in a writ petition before the High Court. Vodafone India also filed a statutory appeal before the Dispute Resolution Panel (“DRP”) only on the merits of the case.
Contentions in the High Court
Vodafone India’s contentions
The principal contention of Vodafone India was that the transfer pricing provisions were merely machinery provisions and in the absence of a charging provision bringing subscription of shares to tax, transfer pricing provisions cannot be invoked. Since the ITA specifically sets out the heads of income which are brought to tax, Vodafone India argued that if a receipt did not fall within the categories set out in section 14 of the ITA (which sets out the heads of income), such receipt could not be brought to tax. Further, Vodafone India also contended that the legislative intent of the transfer pricing provisions made it amply clear that the provisions were to be made applicable to avoidance of tax with respect to taxable income. Vodafone India also relied on the fact that the Marginal Note to section 92 indicated that section 92 was only a machinery provision and not a charging section.
Vodafone India proceeded to argue that subscription of shares has always been treated as a capital receipt and did not give rise to income. It relied on the fact the Supreme Court’s recognition of this fact in Khoday Distilleries Ltd. v. CIT2, which the brought out the difference between ‘creation’ of an asset and ‘transfer’ of an asset and argued that in case of issuance of shares, it is a creation of an asset and not a transfer. Further, Vodafone India contended that the tax was payable only on the basis of real income and not on the basis of hypothetical income. It was argued that by trying to bring the subscription of shares into the transfer pricing net, what was sought to be taxed was hypothetical income.
Vodafone India further sought to rely upon the amendments in 2013 which brought to tax the issue of shares at more than fair market value and contended that such provisions were introduced only with effect from April 1, 2013 and hence could not be applied in the present case.
Vodafone India also contended that there was a breach of principles of natural justice and hence a fundamental jurisdictional error. It contended that neither the TPO nor the Assessing Officer had actually determined on jurisdiction issue and had passed the respective orders without considering the arguments put forth by Vodafone India.
It also contended that an appeal to the DRP would not have been effective as one of the members of the DRP was a Director of Income Tax and it would be akin to an appeal from Caesar to Caesar’s wife. Consequently, the appropriate mode of relief could only be sought in a writ petition and not a statutory appeal.
Income Tax Department’s contentions
The Income Tax Department argued that the contentions raised by Vodafone India could have been raised before the DRP and the DRP was competent to examine issues relating to jurisdiction as well. They contended that there was an alternate efficacious remedy available and under such circumstances, the appropriate forum to raise all the issues would have been the DRP.
They further contended that the variation of ALP on the basis of the TPO’s computation was part of notional income and no statutory provision was required to tax the same. It was further submitted that admittedly, the Issue of Shares was an international transaction and consequently, the difference arising out of applying ALP to Issue of Shares would have to be taxed as affecting income.
The Income Tax Department also contended that in any event, section 92CA (1) of the ITA did not envisage providing an assessee an opportunity of being heard before referring a matter to the TPO.
Maintainability and alternate efficacious remedy
The High Court ruled that the TPO and the AO had failed to address the jurisdictional objection of Vodafone India and had failed to address the preliminary objections of Vodafone India. Consequently, it held that the petition was maintainable. The High Court further discussed the powers of the DRP and held that such power extended to not confirming an order passed by the TPO. The High Court held that the DRP was bound to consider jurisdictional objections as well, including the contention that income was not affected by the international transaction. Although the High Court held the DRP to be an alternate efficacious remedy, it addressed the issue of procedure to be followed by an AO in respect of international transactions.
Hearing before reference to TPO
The High Court held that an AO was bound to deal with objections of an assessee relating to jurisdiction since the reference to the TPO would be academic if the determination of ALP does not affect the income. Therefore, in a case where the AO is referring a transaction to the TPO, before such referral, it was held that the AO is bound to first determine the issue of income arising and/or being affected by determination of ALP. In view of this requirement, the condition of complying with principles of natural justice was read into section 92CA (1) of the ITA. The High Court held that where a tax payer has raised a jurisdictional objection, the AO was bound to grant an opportunity of being heard.
Since a statutory proceeding was pending before the DRP, the High Court declined to set aside the Assessment Order and the TPO Order and instead observed that the DRP should consider these preliminary objections before proceedings with the merits of the case.
Proceedings before DRP
The High Court held that proceedings before the DRP were an extension of assessment proceedings and were not appeal proceedings but was in the nature of a correction mechanism. The High Court held that since the DRP was not an appellate authority, the presence of an officer who had approved the reference to the TPO would not affect proceedings before the DRP. It further went on to state that the issue of jurisdiction could be raised before the DRP and directed the DRP to rule on the issue of jurisdictions within 2 months after the Petitioner filed its objections on the question of jurisdiction.
Observations on merits
Vodafone India had addressed the High Court extensively on merits on the issue relating to applicability of transfer pricing provisions to the transaction as well as arguing that the Issue of Shares was computed on the basis of fair market value of equity shares in accordance with the formula provided under the Capital Shares (Control Act), 1947. Although Vodafone India had made compelling arguments, the High Court refrained from making any observations with respect to the merits of the case as proceedings were pending before the DRP. The High Court however observed that the failure of the Assessing Officer in not having examined the issue is in itself an illegality.
Substantive transfer pricing provisions
Fundamentally, when a company owns 100% of the share capital in another company, it is immaterial as to what price additional shares are issued. It is illogical and begs to answer the question as to why and how such transactions can be brought to the tax net by application of transfer pricing provisions. A wider issue that also needs to be addressed is whether transfer pricing provisions, which are essentially in the nature of anti-abuse provisions, should be applied indiscriminately without appreciating commercial realities as in the instant case. In case of a capital investment in a wholly owned subsidiary, the question of abuse cannot really arise. Admittedly, transfer pricing provisions are to prevent mispricing or allocation of income in a manner that is prejudicial to revenue. However, in the instant case, as submitted by Vodafone India, fundamentally, when there is an investment in the capital of a company, there is no income to begin with.
The mode of re-characterization employed by the tax authorities is neither provided for under explicit provisions of law nor can it conceivably arise directly as a result of the Issue of Shares. It is important to note that Article 265 of the Constitution of India provides that no taxes shall be levied or collected without authority of law. The High Court, while asking the DRP to decide on the matter, has passed some pertinent observations including noting that “Not a single authority has so far dealt with this issue and even the learned counsel for the revenue did not address us even briefly on merits of this controversy to show plausible prima-facie defence.”
The Judgment has ensured that principles of natural justice are to be complied with even when the provision of the ITA does not expressly provide for the same. This would enable a tax payer to expeditiously resolve tax disputes prior to litigating issues in appellate proceedings. The Judgment also provides clarity on the nature of proceedings before the DRP and the powers of the DRP in that regard. The Judgments makes it incumbent on the AO to ensure that before transfer pricing provisions are applied, the AO will have to determine that there is an impact or potential impact on computation of income before a reference is made to the TPO. These small measures could help in narrowing the point of conflict between a tax payer and the Income Tax Department. High Court’s observation that Vodafone India would have the right to challenge the order of the DRP rejecting the jurisdictional points on the TPO Order and the Assessment Order is also a welcome sign as it ensures that a tax payer does not have to wait for an order on the merits of a tax dispute before challenging the same.
Mr. Nani Palkhivala, in his commentary on ITA3 stated “Every Government has a right to levy taxes. But no Government has the right, in the process of extracting tax, to cause misery and harassment to the tax payer and the gnawing feeling that he is made a victim of palpable injustice”. The High Court has observed that the tax authorities would do well to keep the above sage advice in mind while dealing with the assessee. The High Court has recognized serious lapses in the methodology of disposing off the matter by the AO and TPO and it is hoped that such lapses are corrected by the DRP after giving effect to due process and principles of natural justice.
1 Writ Petition No. 1877 of 2013 decided on November 29, 2013.
2 (2009) 1 SCC 256.
3 Preface to Law and Practice of Income Tax by Kanga & Palkhivala, 8th Edition.