Global Tax Alert
15 October 2014
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News from Transfer Pricing
Bombay High Court rules
on applicability of transfer
pricing provisions to issue
of shares to associated
enterprises
Executive summary
This Tax Alert summarizes the decision on 10 October 2014 of the Bombay High
Court (HC) in the case of Vodafone India Services Private Limited1 (Taxpayer). The
issue before the HC was whether the Indian transfer pricing (TP) provisions are
applicable to the Taxpayers issue of shares to its associated enterprise (AE) and
whether the Indian Tax Authorities have jurisdiction under the Indian Tax Laws (ITL)
to tax a short-fall between the alleged fair market value (FMV) of the shares and the
issue price of the equity shares.
In the instant case, during the financial year (FY) 2008-09 the Taxpayer issued
289,224 equity shares of face value of INR10 each at a premium of INR8,519
(approx. US$142) per share to its AE in accordance with the methodology prescribed
for capital issues by the Government of India under the exchange control regulations.
However, during the course of audit proceedings, the Tax Authorities proceeded
to compute the arms length price (ALP) of the equity shares and enhanced the
value of each share to INR53,775 (approx. US$896). The Tax Authorities treated
the difference in the value of shares as income of the Taxpayer and also, made a
secondary adjustment by treating the short receipt of consideration for issue of
shares as a deemed loan by the Taxpayer to its AE and charged a notional interest
on the same. Accordingly, a TP adjustment of INR13.97 billion (approx. US$232.88
million) was determined.
The HC in this case, examined the nature of share issue transactions and held that
income arising from an international transaction is a condition precedent for
application of TP provisions. The transaction on capital account or on account of
 restructuring would become taxable
to the extent it impacts income i.e.,
under reporting of interest received
or over reporting of interest paid
or claiming of depreciation. The HC
found substance in the Taxpayers
case that neither its capital receipts
on issue of equity shares to its AE
nor the alleged short-fall between
the FMV of its equity shares and
the issue price of the equity shares
can be considered as income within
the meaning of the expression as
defined in the ITL and hence not
subject to TP provisions in India.
Further, the HC held that the entire
exercise of taxing the short receipt
of consideration for issue of shares
fails, as the consideration received
for issue of shares itself is not
taxable under the provisions of ITL.
Ruling in favor of the Taxpayer, the
HC concluded that in the present
facts, issue of shares at a premium
by the Taxpayer to its nonresident
AE does not give rise to any income
from the reported international
transaction and thus, Indian TP
provisions are not applicable in
sucha case.
Detailed discussion
Background
The Taxpayer, a wholly owned
subsidiary of Vodafone Tele-Services
(India) Holdings Ltd. (Vodafone
Mauritius), issued 289,224 equity
shares of face value of INR10
each at a premium of INR8,519
(approx. US$142) per share in
August 2008. The FMV of the issue
of equity shares was determined
by the Taxpayer in accordance with
the methodology prescribed for
capital issues by the Government
of India under the exchange control
2 Global Tax Alert Transfer pricing
regulations and was reported in the
companys TP Accountants Report
(Form 3CEB) as an international
transaction undertaken by Taxpayer.
The accountants report also
contained a note stating that this
transaction was only reported as
a matter of abundant caution and
did not affect the income of the
Taxpayer.
However, the transfer pricing officer
(TPO) issued a showcause notice to
the Taxpayer as to why consideration
for such issue of shares should
not be computed having regard to
the ALP. The Taxpayer contended
in all its responses that the Indian
TP provisions are not applicable
to the issue of equity shares and
the notice was without jurisdiction
of the TPO. However, the TPO
proceeded to compute the ALP of
the share issue transaction stating
that the Assessing Officer (AO)
would determine whether any
income had arisen or been affected
by the international transaction and
accordingly, enhanced the value of
each share to INR53,775 (approx.
US$896). The TPO treated the
difference in the value of shares as
income of the Taxpayer. Further,
the TPO made a secondary
adjustment by treating the short
receipt of consideration for issue
of shares as a deemed loan by the
Taxpayer to its AE and charged
a notional interest of 13.5% for
six months. Accordingly, a TP
adjustment of INR13.97 billion
(approx. US$232.88 million) was
determined.
The AO confirmed the position
adopted by the TPO in its draft
assessment order without dealing
with the Taxpayers principal
contention that the Indian TP
provisions would not apply to
issues of equity shares to AEs.
The Taxpayer then filed a writ
petition challenging the jurisdiction/
applicability of Indian TP provisions
to such transactions before the
Bombay HC. However, the HC
remanded the matter to the
Dispute Resolution Panel (DRP), an
alternate dispute resolution panel,
to give preliminary findings on
whether the AO has jurisdiction to
invoke Indian TP provisions to the
said transaction.
The DRP upheld the adjustment
determined by the Tax Authorities
and held that the short-fall in the
receipt of the premium is income
arising from issue of shares
and also held that the AO has
jurisdiction to invoke Indian TP
provisions. The Taxpayer filed a
writ petition with the Bombay HC
challenging the TP adjustment.
Taxpayers arguments
The Taxpayer contended before the
HC that the Indian TP provisions
are special provisions relating to
avoidance of tax and provide for
computation of income arising
from international transactions
with respect to ALP. Hence, it was
submitted that for application of
Indian TP provisions, income
should arise from an international
transaction, however, in the instant
case, no income arises from issue
of equity shares and share premium
thereon by the Taxpayer to its AE.
Further, the Taxpayer contended
that the word income would have
to be understood as defined by
other provisions of the ITL and the
TP provisions are not designed to
make taxable all sums involved in
a transaction, which are otherwise
not taxable. The Taxpayer also
differentiated the issue of shares
from transfer of shares and
contended that such issue of shares
is not taxable by virtue of capital
gain tax provisions as envisaged
in the ITL. Reference was made
to provisions in the ITL relating to
taxation of share premium received
from a resident Taxpayer in excess
of FMV of the shares and thus, it
was submitted that there is absence
of intent to tax the issue of shares
below the alleged FMV in the ITL.
The taxpayer also argued that Tax
Authorities have proceeded on an
assumption, surmise or conjecture
that in case the notional income
i.e., the amount of share premium
forgone was received, the Taxpayer
would have invested the same, giving
rise to income. Taxpayer argued
that no tax can be charged based
on assumption or conjecture in the
absence of any such income arising.
Tax Authorities arguments
The Tax Authorities supported the
impugned directions of the DRP
on completely new grounds and
refused to make any submission
on the merits of the jurisdictional
issue. However, HC asked the
Tax Authorities to file an affidavit
indicating the new grounds of
support to the impugned directions
of DRP as the same would give
an opportunity to the Taxpayer to
alsorespond.
Accordingly, the Tax Authorities
filed an affidavit and contended
that the Indian TP provisions are
complete code and not merely
machinery provisions to compute
the ALP and it is the hidden benefit
in the transaction that is taxable.
Accordingly, it was claimed that
share premium is not being taxed
but is the cost incurred by the
Taxpayer in passing on a benefit
to its AE by issue of shares at a
premium less than ALP.
Ruling of the HC
Interpretation of the term income
and applicability of TP provisions
The HC held that income arising
from an international transaction
is a condition precedent for
application of TP provisions. While
interpreting the term income,
the HC held that the ITL defines
the term income in an inclusive
manner. Income, in its normal
meaning, will not include capital
receipts unless it is so specified. The
amounts received on issue of share
capital including the premium are on
capital account. In this case, what is
being sought to be taxed is capital
not received from a nonresident
i.e., premium allegedly not received
on application of ALP. Therefore,
absent express legislation, no
amount received, accrued or arising
on capital account transactions can
be subjected to tax as income.
The HC further held that the
transaction on capital account or
on account of restructuring would
become taxable to the extent it
impacts income i.e., under reporting
of interest received or over reporting
of interest paid or claiming of
depreciation. It is that income which
is to be determined having regard
to the ALP and it is not a tax on
the capital receipts. In any case,
the entire exercise of taxing the
amounts allegedly not received as
Global Tax Alert Transfer pricing
share premium fails, as no tax is
charged on the amount received as
share premium. The TP provisions
are invoked to ensure that the
transaction is taxed only on working
out the income after arriving at the
ALP of the transaction. This is only to
ensure that there is no manipulation
of prices/consideration between AEs.
The entire consideration received
would not be a subject matter of
taxation.
In view of the above, the HC found
substance in the Taxpayers case
that neither the capital receipts
received by the Taxpayer on issue of
equity shares to its AE nor the short-
fall between the alleged FMV of its
equity shares and the issue price of
the equity shares can be considered
as income within the meaning of
the expression as defined in the
ITL and hence not subject to TP
provisions in India. The HC also held
that the reasoning that if the ALP
were received, the Taxpayer would
be able to invest the same and
earn income, proceeds on a mere
surmise/assumption and that this
cannot be the basis of taxation.
Interpretation of Section 92(2)
Section 92(2) of the ITL deals with
a situation where two or more
AEs enter into an arrangement
whereby they are to receive any
benefit, service or facility then
the allocation, apportionment or
contribution of the corresponding
cost or expenditure is to be
determined for each AE based on
ALP. It is generally understood that
this section is meant to cover cases
of cost sharing arrangements and/
or cost contribution arrangements.
The Tax Authorities relied on this
3
 section of the code to argue that
differences between the ALP and
the price charged for issue of
shares is the benefit conferred
upon the holding company. Thus,
the passing of the benefit to the
holding company is the cost to the
Taxpayer, which should be taxed.
The HC rejected the submission
of the Tax Authorities and held
that ignoring words in a statute to
achieve a predetermined objective
is not permissible and the same
would amount to re-drafting
the legislation, which is beyond
the jurisdiction of the Courts.
Section92(2) would have no
application in cases like the present
one, where there is no occasion to
allocate, apportion or contribute
any cost and/or expenses between
the Taxpayer and its AE.
Interpretation of TP provisions
The HC rejected the contention of
the Tax Authorities that in view of
the TP provisions, notional income
is to be taxed and real income is
not relevant. The HC held that the
entire exercise of determining the
ALP is only to arrive at the real
income earned. The HC held that
the TP provisions laid out in the
ITL are in the nature of machinery
or computational provisions to
arrive at the ALP of a transaction
between AEs. Even income arising
from international transactions
between AEs must satisfy the test
of income under the ITL and
must find its home under one of
thecharging provisions.
Endnote
1. TS-308-HC-2014(BOM)-TP-Vodafone India Services.
4 Global Tax Alert Transfer pricing
It is a re-computation exercise to
be carried out only when income
arises in case of an international
transaction between AEs. It does
not warrant re-computation of a
consideration received/given on
capital account except in cases
of interest paid/received on loans
taken/given, depreciation taken
on machinery, etc. Thus, in the
absence of a charging provision to
tax issue of shares at a premium
to a nonresident, the occasion
to invoke the computational TP
provisions does not arise.
Further, given the inclusion of issue
of shares, by a company to another
resident, at a price in excess of FMV
in the definition of income under
the ITL, the HC noted that, there is
conscious intention of the Parliament
to not tax amounts received from a
nonresident for issue of shares, as it
would discourage capital inflow from
abroad.
For all the above reasons, the HC
held that in the present facts, issue
of shares at a premium by the
Taxpayer to its nonresident AE does
not give rise to any income from an
admitted international transaction
and thus, Indian TP provisions are
not applicable in such a case.
Implications
A recent controversy faced by some
taxpayers in India has been on
whether TP provisions are attracted
when shares are issued by an Indian
company to its AE and whether
issuance of shares at a price lower
than the fair market value can result
in a TP adjustment. The approach
of the Tax Authorities in making
TP adjustments on transactions
involving issue of shares to AEs has
been one of the concerns expressed
by several foreign investors.
In general, Indian TP provisions
apply to income arising from an
international transaction. Even if
allotment of shares is regarded
as an international transaction,
as consideration received is not
regarded as income subject to tax,
TP provisions may not apply to such
transactions. Further, the HC ruling
acknowledges that mere reporting
of an international transaction
on abundant caution would not
make the same taxable as there
is no income arising from such
international transaction.
The HCs ruling upholding this
view may be welcomed by foreign
investors as it is expected to
address one of the TP challenges
they were facing in India in
recent times. The HC in its ruling
recognizes there is a conscious
intention of the Parliament not
to tax amounts received from a
nonresident for issue of shares
as it would discourage capital
inflow from abroad. This ruling,
which comes in the backdrop of
the Governments initiatives for
encouraging foreign investment,
can play a significant role in
providing certainty to foreign
investors.
For additional information with respect to this Alert, please contact the following:

Ernst & Young LLP (India), New Delhi

Vijay Iyer +91 11 6623 3240 vijay.iyer@in.ey.com

Ernst & Young LLP (India), Bangalore

Rajendra Nayak +91 80 6727 5454 rajendra.nayak@in.ey.com

Global Tax Alert Transfer pricing 5

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