Issuance of Shares and Transfer Pricing: An Analysis of Vodafone India Services Pvt. Ltd. v. Union of India & Ors – Part II

In the last post we saw that issuance of shares cannot be subjected to transfer pricing provisions of Income Tax Act. Continuing from this, in this post I will discuss hypothetical stimulation of arguments on merits of the Vodafone judgement. In this regard, two issues are discussed viz. first, whether Revenue was right in making the addition of notional interest by treating the addition on the subscription of the shares as deemed loan. Second, whether the Discounted Cash Flow (DCF) is the most appropriate method for the valuation of the shares or Net Asset Value (NAV).

Before doing so, it is notified that relying on Vodafone judgement, a Mumbai High Court bench of justices M S Sanklecha and SC Gupte on a petition filed by Shell India Markets upheld that issuance of share does not generate ‘income’. It is anticipated that Revenue is likely to approach Supreme Court. In this context, the arguments on merits become significant as even if SC overrules Shell India, revenue would not be able to impose notional interest.

Whether Revenue was right in making the addition of notional interest by treating the addition on the subscription of the shares as deemed loan.

An adjustment for the notional interest by re-characterization of equity into debt (as done in the present case) is referred to as “secondary adjustment” in the parlance of Transfer Pricing. Secondary adjustment creates a constructive transaction such as constructive loan, constructive dividend, constructive equity distribution etc.

With respect to applicability of secondary adjustment principles, the OECD has clarified in its commentary on Article 9 of the model treaty convention that sovereign countries can opt for secondary adjustments, if permissible under their domestic tax laws. Following this view, Canada, Korea, South Africa, 9 EU members (Austria, Bulgaria, Denmark, Germany, France, Luxemburg, Netherlands, Slovenia and Spain) have incorporated such provision in their respective taxing statute.

Currently, India does not have any express or specific provision for inflicting the secondary adjustment in Transfer Pricing rules and therefore the TPO/AO cannot impose notional interest by treating alleged unpaid money as loan. This view was recently confirmed by Mumbai ITAT tribunal in PMP Auto Components Pvt. Ltd. v. DCIT.[1]

However, it must be noted that re-characterization is permissible under Chapter X-A (General Anti-Avoidance Rules) of the Income Tax Act which is not in force yet. It would be interesting to see whether GAAR being a general law on tax-avoidance can capture transactions held permissible by Specific Anti-Avoidance Rule i.e. Transfer Pricing (Chapter-X).

Levy of penalty under section 271G by transfer pricing officers

Assuming the said transaction between V-India and V-Mauritius is hit by TP, the appropriate recourse of by the Assessing Officer or the Commissioner (Appeals) should have been levy of penalty under Section 271G of the Act and not secondary adjustment. [Finance (No. 2) Act, 2014 has amended section 271G to include Transfer Pricing Officer in addition to AO or Commissioner. This amendment will take effect from 1st October, 2014.]

V-India as against these penalties would have been validly arguing that arm’s length price was calculated in good faith and due diligence was taken while using NAV method for valuation of shares. With this I move on to the next issue regarding appropriate method for valuation of shares.

Whether the Discounted cash Flow is the most appropriate method for the valuation of the shares or Net Asset Value

 In case of long-term investment in the 100% subsidiary (as opposed to investment for capital gains), the valuation should be future prospective earning on the capital and should not be based on the present net worth of the subsidiary. This contention was accepted by the Mumbai ITAT tribunal in PMP Auto Components Pvt. Ltd. v. DCIT.[2] In this respect the Revenue was correct in applying DCF method as opposed to NAV. However, DCF method is surrounded by the clouds of legal uncertainty as it works on too many unruly economic assumptions. Consequently, it's vires may be challenged on the basis of arbitrary exercise of power.

---

[1] [TS-263-ITAT-2014(Mum)-TP]

[2] Id.