After the Bombay High Court earlier this month struck down tax authorities move to tax Vodafone India for selling shares at a discount to its overseas parent, the finance ministry is considering making prospective changes in the law to tax any shortfall or premium on the fair value of shares that change hands in cross-border capital transactions, according to sources.
The proposed amendment will, however not affect the 25 cases already in courts including those of Shell India Markets, Essar group companies, Bharti Airtel and the two Vodafone cases on which the court has already given its verdict.
On October 10 and 13, the court had set aside separate show cause notices to Vodafone India Services Pvt Ltd seeking to add about R5,000 crore to its income for two financial years, 2008-09 and 2009-10 on account of the alleged undervaluation of shares sold to its Singapore parent. The courts justification was that the law does not expressly classify as income any shortfall or premium involved in international capital transactions between associated enterprises.
The finance ministrys idea is to introduce an express provision to support such tax claims in section 2 (24) of the Income Tax Act that enumerates specified profits, gains and capital gains that are taxed as income.
In the case of domestic transactions, share premium received by closely held entities had been made taxable from April 1, 2013, by bringing it under the classification of income from other sources, although it is in the nature of a capital
This legal fiction classifying share premium as income is unique to India, said Vijay Iyer, National Leader for Transfer Pricing, EY. The intent in this case was to discourage shifting of corporate income to closely held entities of promoters by way of paying huge premiums for the shares of those promoter held entities. Also, from June 2010 onwards, the law allows taxation of shortfall in fair market value of shares involved in transactions between closely held firms, treating it as income from other sources.
Sources explained the Bombay High Court ruled in favour of Vodafone in the absence of any such express provision in law covering cross-border share deals at prices below the fair value of the shares. We will examine the court order once we get comments from the assessing officer. If any clarifications are needed in the Income Tax Act on income directly or indirectly attributable to certain share transactions, we will make them, said a person privy to the government's thinking.
Another person closely associated with the Vodafone case said that the Income Tax Department has little choice than appealing against the High Court order to the Supreme Court, considering the high stakes involved. There are about 25 other pending tax disputes on intra-group share sales, some of which involve very high additions to taxable income.
After the I-T Department started issuing show cause notices to MNCs for alleged mispricing of shares sold to global parents, many companies made it part of their due diligence to go for advance pricing agreements with the tax department on the valuation to avoid a future tax dispute.
Recharacterising a capital receipt as income is a rare practice among tax authorities although there are a few countries that provide for it in their thin capitalization rules. Those rules are meant to discourage setting up companies with very limited equity and excessive borrowings which would deny the authorities revenue from dividend taxes, while deductions on interest cost would keep corporate income tax incidence low. India does not have such norms in tax law. Levying tax on capital would not auger well for foreign direct investment. It goes against the spirit of everything the government is doing to win back investor confidence, said Amit Maheshwari, partner, Ashok Maheshwary & Associates.
In the case of Vodafone India, the tax department considered the gap between issue price of shares and what it deemed as its fair value, as income, treating it as the cost of fiscal benefit extended to the parent. The department attempted to present this gap as a loan extended to the foreign parent on which the Indian unit stands to gain taxable interest income. It relied on the norm that income from international transactions have to be determined having regard to their arms length price (fair market value of shares in this case). The revenue departme-nts approach was unprecedented, not in line with business realities, certainly not founded in law, said SP Singh, Senior Director at Deloitte in India.