Friday, 31 January 2014

Suresh Koushal vs. Naz Foundation - Why it is poorly reasoned

Alright then, this marks my first non-tax post! The Supreme Court delivered its verdict on the constitutional validity of Section 377 a few months ago, in the case of Suresh Koushal vs. Naz Foundation. It drew outrage and approval in almost equal measure. Personally, I was quite disappointed with the decision primarily because I could hardly believe that it was authored by Justice G. S. Singhvi. I still respect and admire him; he has always been utterly unafraid, candid and fair in his judgments, many of which have been hailed as landmark (cancellation of 2G spectrum allocation, making land acquisition more stringent, restricting usage of red beacons to people holding constitutional posts only, protecting the safety of sewage workers). Whether or not one agreed with the outcome of Justice Singhvi's judgments, it was beyond doubt that they were well reasoned and reflected due application of mind. Except for the one upholding constitutionality of Section 377 of the IPC, criminalizing homosexuality. Speaking purely from a legal point of view, I believe the judgment is very poorly reasoned and I have attempted to outline the reasons in this post. 

I am not sure why I have chosen this subject as my first non-tax post; I haven't been particularly vocal about the rights of the LGBT community. I suppose it is because I was in the Supreme Court on the day of pronouncement, which also happened to be Justice Singhvi's last day as a Judge. '377' was the only topic of discussion and the atmosphere was emotionally charged. Every single person I met that day had something to say about it. The judgment was vehemently criticized from the moment it was pronounced but I decided to refrain from commenting on it before reading it, because it was authored by Justice Singhvi. I read it carefully, realizing that it had left out various important aspects which should have been adequately addressed. Though this post comes quite late, after the review petition has been dismissed, I am putting up my thoughts anyway because I rarely scrutinize non-tax issues with such interest! So here goes.

Locus Standi

The Supreme Court has failed to address whether the interveners before the Delhi High Court had any locus standi to file an appeal before the Supreme Court. While upholding the constitutional validity of Section 377, the SC observed that it was upto the Legislature to amend the provision as it deemed fit and that it was not for the Court to interfere and read it down. However, at the same time, it failed to attribute importance to the fact that the State had not appealed against the High Court's verdict and that the appeal was filed in the SC by non-State entities. The proceedings before the SC were appellate proceedings, and not writ proceedings in the nature of a PIL. The scope of appellate proceedings is limited compared to PIL proceedings. Undoubtedly, the SC has wide powers under Article 136 of the Constitution to admit an appeal if it involves a substantial question of general importance. However, in line with established principles of judicial practice and propriety, the SC ought to have addressed the issue of locus before proceeding to answer the substantial question of law raised before it. 

The Delhi High Court had not struck down Section 377, but merely read it down to make it inapplicable to actions of consenting adults within private confines. Before ruling on the merits, the SC ought to have clarified how the High Court’s judgment had prejudiced or aggrieved the non-State entities so as to enable them to have a sufficient cause of action to file an appeal before the SC. In fact, those non-State entities who can be said to have a legitimate stake in the outcome of the proceedings i.e. parents of the LGBT individuals, too supported the judgment of the Delhi High Court. Viewed in this light, the SC failed to address an important issue, the answer to which could have resulted in dismissal of the appeal at the outset.

Right to Privacy

The Supreme Court has not entirely addressed the violation of the right to privacy. Paragraph 45 onwards, the SC has only reproduced the ratios of various other Indian decisions which deal with the right to privacy under Article 21. These decisions lay down that the right is not absolute, there are no fixed parameters for defining the essence and scope of the right and it can be curtailed in larger public interest by imposing reasonable restrictions. It appears as if the SC has merely reiterated the judicial position on the approach to the right to privacy. There are no reasons that reflect what the essence and scope of the right is in this case, how it is not being violated, how its curtailment is in larger “public interest” or how criminalizing consensual acts between consenting adults in private confines counts as a “reasonable restriction.”

The High Court had extensively relied on judgments of other jurisdictions while decriminalizing homosexuality. The SC has taken the view that these judgments cannot be applied blindfolded for deciding the constitutionality of an Indian law. Though this view is undoubtedly correct, the SC has not explained how such reliance is wrong or blindfolded or how the judgments depart from Indian jurisprudence and Indian judicial approach when it comes to testing the constitutionality of a legal provision, especially where an issue of human rights is involved.

Rational Nexus

The Supreme Court has held that the classification sought to be made between persons who have intercourse in line with and against the ordinary course of nature, in the context of Article 14, is reasonable. However, the Supreme Court has only considered intelligible differentia without considering 'rational nexus.' Though the classification by itself may be reasonable, it has to achieve a rational nexus as well. The SC has not addressed what rational objective is sought to be achieved by treating homosexuality as a crime. Infact, it has brushed aside the submission of Naz Foundation that due to laws like Section 377, it is not possible to prevent HIV / AIDS or other sexually transmitted diseases. In paragraph 40, the SC has noted that: 

“Only in the affidavit filed before this Court on behalf of the Ministry of Health and Family Welfare, Department of AIDS Control it has been averred that estimated HIV prevalence among FSW (female sex workers) is 4.60% to 4.94%, among MSM (men who have sex with men) is 6.54% to 7.23% and IDU (injecting drug users) is 9.42% to 10.30%. The total population of MSM as in 2006 was estimated to be 25,00,000 and 10% of them are at risk of HIV. The State-wise break up of estimated size of high risk men who have sex with men has been given in paragraphs 13 and 14 of the affidavit. In paragraph 19, the State-wise details of total adult population, estimated adult HIV prevalence and estimated number of HIV infections as in 2009 has been given. These details are wholly insufficient for recording a finding that homosexuals, gays, etc., are being subjected to discriminatory treatment either by State or its agencies or the society.”

It is not clear why these details are insufficient, or which details will be considered to be sufficient. Not only has it failed to answer what rational objective is sought to be achieved, the SC has also failed to elaborate on how the ‘irrationality’ perpetrated by Section 377 is ‘insufficient’ to hold that homosexuals are being accorded discriminatory treatment.  

Article 15

The Supreme Court has ignored Article 15 while arriving at its decision. Naz Foundation had advanced detailed arguments on how Section 377 in its present form violates Article 15, as enumerated below:
  • Section 377 violates Article 15 by discriminating on the ground of sexual orientation as although facially neutral, it treats homosexual men unequally compared to heterosexuals and imposes an unequal burden on them. 
  • The general purport of Article 15 is to prohibit discrimination on the grounds enumerated therein. As Article 15(3) uses the expression “women” the word sex in Article 15(1) must partake the same character. However Article 15(3) must not be allowed to limit the understanding of Article 15(1) and reduce it to a binary norm of man and woman only. This becomes clear when Article 15(2) is applied to transgendered persons who identify as a third gender (for example, as reflected in the application form for the 'Aadhar' card).
  • The underlying purpose against sex discrimination is to prevent differential treatment for the reasons of non conformity with normal or natural sexual or gender roles. Sexual relations are intricately tied to gender stereotypes. Accordingly discrimination on the ground of sex necessarily includes discrimination on the basis of sexual orientation. Like gender discrimination, discrimination on the basis of sexual orientation is directed against an immutable and core characteristic of human personality. Even international law recognises sexual orientation as being included in the ground “sex”.
The Supreme Court has not commented at all, on how Section 377 does not violate Article 15. 

Sexual intimacy

It appears that the Supreme Court has also failed to recognize that consensual sexual intimacy is an important part of adult life for both physical and mental well-being and a law denying consenting adults of the same sex the right to indulge in sexual intimacy is a violation of Article 21. In this context, it is not out of place to cite a judgment of the Supreme Court where it has been categorically held that sex plays an important role in married life and cannot be separated from other factors which lend to matrimony a sense of fruition and fulfilment.  This judgment has been relied on by various High Courts (Delhi, Bombay and Madras) while granting divorce on the ground of wilful denial of sex amounting to mental cruelty. 

Though not directly relevant to the issue at hand, these instances serve to highlight the fact that Indian Courts have recognized sexual intimacy and sexual intercourse to be a fundamental part of adult life. So fundamental, that its wilful denial is a ground for heterosexual individuals to seek divorce. Consenting LGBT individuals have to forego this fundamental part of adult life (or face punishment under Section 377), merely because they indulge in intercourse ‘against the order of nature.’ In the present case, the Supreme Court recognizes that the theory that sexual intercourse is only meant for the purpose of conception is out-dated. While consenting heterosexual individuals are legally permitted to experience and indulge in sexual intercourse purely for pleasure, LGBT individuals are penalized for doing so. Not only is this a violation of their right to life and personal liberty under Article 21 but is also a violation of Article 15 because Section 377 discriminates between the two instances of indulging in sexual intimacy only on the basis of sex.

I close by noting that the Supreme Court has reserved judgment in a case involving rights of transgenders. It will be (legally) interesting to see what will be the outcome in this case; whether it follows Naz or takes a different view.

Friday, 12 October 2012

“I'm the Parliamentary Draftsman, I compose the country's laws. And of half the litigation, I'm undoubtedly the cause.”


Pranab Mukherjee proved THAT right. Introducing retrospective amendments through the Budget wasn’t a smart move, which is what anyone with a rational mind has been screaming since March. The result was evident – the investor community was outraged, the Rupee took a sharp fall. The moment Mukherjee got elected as President, the Government almost fell over itself in a haste to soothe investor sentiment. The Prime Minister appointed a Committee to review GAAR and the retro tax policies (with respect to indirect transfers). And in a lot of press conferences, Chidambaram has been advocating a ‘non-adversarial tax regime’ (whatever that means).

And oh, Justice S.H. Kapadia retired. :( Not that this has any specific relevance, it is just sad. In this regime of flip-flops, he was truly a shining beacon of steadfastness. 

Despite having a SUPREME COURT ruling in its favour, it absolutely flabbergasts me to see that there still remains a doubt as to whether Vodafone could be made liable to tax. IT BLOODY WELL CANNOT. And I do hope it doesn’t cave and ‘settle.’ Incidentally, the Committee appointed to review the retrospective amendments in relation to indirect transfers (the Shome Committee) has recommended that the amendments be made applicable ‘prospectively.’ 

The Committee’s Report, made public on October 9, states, “The Committee concluded that retrospective application of tax law should occur in exceptional or rarest of rare cases, and with particular objectives: first, to correct apparent mistakes/anomalies in the statute; second, to apply to matters that are genuinely clarificatory in nature, i.e. to remove technical defects, particularly in procedure, which have vitiated the substantive law; or, third, to ‘protect’ the tax base from highly abusive tax planning schemes that have the main purpose of avoiding tax, without economic substance, but not to ‘expand’ the tax base.” This is an interesting point. An amendment seeking to ‘widen’ or ‘increase’ the tax base cannot be considered as ‘clarificatory.’ 

The Supreme Court said “Sec 9(1)(i) is not a ‘look through provision’ and cannot, by a process of interpretation be extended to cover indirect transfers of capital assets/property situate in India. To do so, would amount to changing the content and ambit of Section 9(1)(i). We cannot re-write Section 9(1)(i). … The question of providing ‘look through’ in the statute or in the treaty is a matter of policy. It is to be expressly provided for in the statute or in the treaty.”

Does this lead to a not-so-merry go round?


Who the hell would want to invest in such a climate? Please, Parliamentary Draftsman, ACCEPT the recommendations, end the confusion and establish some certainty. You’re already the cause for half the litigation, don’t become the SOLE cause.

Friday, 23 March 2012

Boohoo, we didn't get to tax the Zoozoo - In other words, Union Budget 2012

So, the Government has decided to recover its $ 2 bn by acting like Paris Hilton - "I WANT IT, I WANT IT!!" The Budget for 2012-13 was announced a few days ago and it brought with it some a lot of stuff that qualifies as 'Braking News.' Although I have never had the pleasure of listening to Palkhivala's post-Budget speeches, I am sure he'd have quite a lot to say if he was still with us. Here goes:

1. Retrospective amendment to Section 9(1)(i) with effect from 1962 for bringing indirect transfers within its ambit

After IN-DEPTH analysis of the jurisprudence surrounding Section 9 (taxing income 'deemed' to accrue or arise in India), the Supreme Court categorically held that in its present form, it DOES NOT cover indirect transfers of a capital asset situated in India. The Supreme Court also said that if the Government wants to tax indirect transfers, it should enact a provision to that effect first. This is how the Government heard it - "So, all we need to do is get a time machine, go back to 1962 and insert suitable Explanations in order to bring indirect transfers within the ambit of Section 9. Easy-peasy! Thanks, Supreme Court, wonder why WE didn't think of this UNTIL NOW."

So, through Finance Bill 2012, not only did they enact a retrospective amendment, COMPLETELY disregarding what the highest judicial authority of the country has held (after extensive deliberation), but they also introduced a Validation Clause to tell the Supreme Court that its exercise was totally in vain. By way of this clause, any Court ruling can be nullified if it was pronounced on basis of the 'mistake in the law' which has now been 'corrected' by way of the retrospective amendment.

How ethical is this? While no one's challenging the Government's authority to amend law retrospectively, it ought to keep in mind that it has to play by its own rules. I recollect a statement made by the Supreme Court while staying the 27% OBC reservations in 2007 - "You cannot play the game first and devise the rules later." Instead of heeding the Court's advice, the Government has gone one step ahead this time. It has played by its rules, lost the game fair and square, gone back to the point before the game started and THEN changed the rules. While I'm not sure whether the retrospective nature of the amendment will be struck down, the Validation Clause definitely will be.

2. Retrospective amendment to Section 9(1)(vi) with effect from 1977 to bring within its ambit 'copyrighted articles.'

With the Delhi High Court upholding the distinction between a copyright and copyrighted article, and the Karnataka High Court rejecting it, a clarification in this respect was needed. But did it really have to be retrospective? I mean, common sense dictates that if you buy software when you walk into a store, you don't buy the COPYRIGHT in it, you just buy the damn software. You don't care how it works, as long as it serves its intended purpose. The amendment (in line with Karnataka HC) says that it doesn't matter whether you actually buy the copyright in it or not; for tax purposes, its royalty anyway. There's no distinction in paying for simply acquiring a software on a CD and paying for the right to OWN the copyright in that software. For tax purposes.

So wait, for COPYRIGHT purposes there's a distinction but for tax purposes, there isn't? *scratches head* B-but, shouldn't the definition of COPYRIGHT under the COPYRIGHT ACT supersede the definition under the Income tax Act, because you know, the former is where the CONCEPT actually COMES FROM? No such luck.

3. General Anti-Avoidance Rules:

While this doesn't affect Vodafone, it is another disrespectful piece of legislation. Only a few days before the Budget was to be announced, the Parliamentary Standing Committee on Direct Taxes Code submitted a detailed report to the Government. The report stated that the GAAR rules proposed in DTC needed substantial change. Again, COMPLETELY disregarding most of the Standing Committee's recommendations, Finance Bill 2012 has sought to introduce GAAR from April 2013, with an added insult to the Supreme Court.

CJI Kapadia in Vodafone's case had specifically stated that "every strategic foreign direct investment coming to India, as an investment destination, should be seen in a holistic manner. While doing so, the Revenue/Courts should keep in mind the following factors: the concept of participation in investment, the duration of time during which the Holding Structure exists; the period of business operations in India; the generation of taxable revenues in India; the timing of the exit; the continuity of business on such exit.”

Clearly displeased with this observation, the Finance Bill states that in determining whether a transaction lacks commercial substance, the following factors shall NOT be taken into account:

(i) the period or time for which the arrangement (including operations therein) exists;
(ii) the fact of payment of taxes, directly or indirectly, under the arrangement;
(iii) the fact that an exit route (including transfer of any activity or business or operations) is provided by the arrangement

Moreover, SC has clearly mentioned that "the onus will be on the Revenue to identify the scheme and its dominant purpose." As per the proposed GAAR rules however, the taxpayer carries the burden of proof. What constitutes 'dominant purpose' has not been defined either. There are no provisions to protect the transactions ALREADY structured, as per the existing law (is it stable, is it not, is it stable, is it not).

On one hand - such blatant disrespect for the SUPREME Court (there's a reason why its called the SUPREME Court). On the other hand - Kapil Sibbal wants to censor social media. Are we moving towards anarchy?

4. Negative List for Service Tax:

I guess this isn't that bad a move. Except for the 2% hike. Only thing I'm wondering is, whether renting of immovable property could be considered a service. The matter is still pending before the Supreme Court. It would be interesting to see what would happen if the Supreme Court says it isn't...

One positive thing for salaried individuals is that the exemption limit is proposed to be raised to Rs. 2 lakhs.

While there are a horde of other changes, discussing all of them here isn't feasible. This article stemmed mainly from the outrage I felt at the Government's obstinacy. And I have spoken about that in detail. All in all, it is certainly a good time to be a tax lawyer, no matter whose side you're on. In the words of Palkhivala (what can I say, the man is a source of endless charm) - "To preach the virtue of stability to our Finance ministry is like seeking to preach the value of peaceful coexistence to Genghis Khan. Who has benefited from the chronic tinkering with the (Income tax) law, except lawyers and chartered accountants?"


Sunday, 22 January 2012

Vodafone is out of coverage area. Literally.

"FDI flows towards location with a strong governance infrastructure which includes enactment of laws and how well the legal system works. ... Tax policy certainty is crucial for taxpayers (including foreign investors) to make rational economic choices in the most efficient manner." - CJI Kapadia

"We will continue to grow our Indian business - including making significant investments in rural areas and in 3G network coverage - for the benefit of Indian consumers" - Vittorio Colao, Vodafone CEO

"The damage to the economy of our country and the welfare of our people, arising from the maddening instability of our laws, is truly incalculable." - Nani Palkhivala

Vodafone International Holdings vs. UOI. Awaited with bated breath and received with jubilation. Undoubtedly a landmark judgment, not only because of the high stakes (a $ 2bn tax liability) and the legal intricacies involved, but because it welcomes foreign investment into India. (LOL, this brings to mind a statement made by Anna Hazare not so long ago - "FDI in retail will enslave India." Tell that to the Supreme Court, Mr. Hazare). How I dearly wish Palkhivala were alive today.

The moment it became clear that Vodafone (based in Netherlands) has no liability to pay any capital gains tax on the purchase of a Cayman Island company (CGP Investments Ltd), sold to it by Hutch (HTIL, based in Hong Kong), I simply sat there, grinning from ear to ear like a Zoozoo. I have all along been thoroughly opposed to the tax liability imposed on Vodafone. I always thought that in the glaring absence of a specific provision, it will be unfair to tax Vodafone on an 'indirect' transfer of assets situated in India. And I am happy that the Supreme Court too thought so.

Few of the key legal conclusions laid down by the SC are:

1. Section 9, taxing non-residents on income deemed to accrue or arise on transfer of capital assets situated in India, does NOT cover indirect transfers and is not a 'look-through' provision. A legal fiction, a deeming provision, has to be literally interpreted. It is only a capital asset 'situated in India' whose transfer will attract capital gains, and not transfer of an foreign company who happens to own this asset. If the Government wants to tax indirect transfers, a separate enactment will be required (which the DTC happens to incorporate).

2. Section 195 (TDS) is applicable only to payments made by an Indian resident to a non-resident. Justice Radhakrishnan in his judgment, made this expressly clear. "A literal construction of the words 'any person responsible for paying' as including non-residents would lead to absurd consequences. A reading of Sections 191A, 194B, 194C, 194D, 194E, 194I, 194J read with Sections 115BBA, 194I, 194J would show that the intention of the Parliament was first to apply Section 195 only to the residents who have a tax presence in India. ... The expression 'any person', in our view, looking at the context in which Section 195 has been placed, would mean any person who is a resident in India." Hence, Vodafone was not obliged to deduct any tax while making payments to Hutch. (The original tax liability is on Hutch, being the seller)

3. Azadi Bachao Andolan and McDowell are not in conflict with each other and Ramsay does not override Westminster. Upholding the correctness of the decision given in Azadi, SC held that "it cannot be said that all tax planning is illegal/illegitimate/impermissible." SC finally put to rest the debate, whether Azadi had correctly interpreted McDowell. McDowell, while relying on Ramsay, had laid down that colourable devices cannot be a part of tax planning and it is wrong to encourage the belief that it is honourable to avoid payment of tax by resorting to dubious methods. The key word is 'dubious.' Unless the transaction is clearly a case of tax 'evasion,' its structure cannot be disregarded and as laid down in Westminster, "given that a document or transaction is genuine, the court cannot go behind it to some supposed underlying substance."

An important thing to be noted here is that the Supreme Court accepted the genuineness of the purchase of CGP Investments Ltd (Cayman Island), because purchasing this company enabled Vodafone to derive certain additional advantages that it would not have derived had it purchased Array Holdings (Mauritius), rejecting the Department's contention that the Mauritius route was not open to it. The additional advantage was obtaining (indirectly) call option rights held by 3GSPL in the companies that held a 15% stake in HEL, which was beneficially owned by HTIL. Had Vodafone opted for the Mauritius route, it would not have obtained these rights. Hence, the taxpayer should be able to SHOW why he opted for a particular transaction structure. If the ONLY purpose is avoiding tax, the transaction will not be bondafide. There has to be a commercial reason behind its structure, other than  saving tax. This will prove to be a major factual difference, while applying the principles of this judgment to other cases.

Lastly, why do I care so much about this judgment, people have asked. I care because it not only carries academic interest but because I am now a taxpayer myself. If I can save tax, I will. Through this judgment, the Supreme Court has reaffirmed that there is indeed a difference between tax avoidance and tax evasion and that the former is legitimate. If I can legally opt to pay lesser tax, then I will choose that option. Especially when I see how the Government chooses to spend the money *I* earn. I work hard to earn it and if I give some part of it to the Government, I don't want to see it wasted on salaries paid to MPs who merely rant, rave and tear papers in the Parliament, taking inordinate amounts of time to actually come to a conclusion about anything. You want my money, you give me good governance.

Sunday, 21 August 2011

Methods of computing Arm's Length Price

I dealt with the basic concept of transfer pricing in an earlier post. As promised (to myself), I will now deal with the methods of computing arm’s length price (ALP).

ALP, crudely, is the fair market value at which transactions take place in the open market. Section 92C names the methods and Rule 10B elaborates on their application. There are primarily 5 methods of ALP computation:

1. Comparable Uncontrolled Transaction Method - CUP Method
2. Cost Plus Method - CPM
3. Resale Price Method - RPM
4. Profit Split Method - PSM
5. Transactional Net Margin Method - TNMM

The most complicated of these (and probably the most popular) is TNMM, I think. PSM has hardly ever been used in Indian cases. CUP is the simplest and most preferred one.

In this post however, I have discussed only the first three methods. I shall discuss PSM and TNMM in the next post.

CUP METHOD:

Under CUP method, the transacting enterprise has to:
  • Identify the price paid for goods or services provided in a (or a number of) comparable uncontrolled transaction(s).
  • Adjust such price to account for differences, which could materially affect it in the open market, between:
    • Transaction with AE and comparable uncontrolled transaction, or
    • The enterprises entering into such transaction



Sale price in uncontrolled transaction: 100

Add (in proportion to better quality goods sold to AE): 25

ALP = 125

In the above scenario, the transaction between the TE and Unrelated Enterprise 2 would be an ‘internal comparable.’ The transaction between the two unrelated enterprises would be an ‘external comparable.’ This is true for all methods of ALP computation; transactions of the TE with third parties would be termed as internal comparables. It is to be noted that internal comparables are preferred over external comparables, since they provide a greater degree of comparability.

CUP Method is generally preferred in all situations, where suitable uncontrolled transactions are available. The uncontrolled transactions can be considered comparable in terms of the goods sold, services rendered, prices charged, qualitative and quantitative comparability, etc.

COST PLUS METHOD:

Under CPM, the transacting enterprise has to:
  • Determine the costs of production (direct and indirect)
  • Determine the normal gross profit mark-up on such costs, incurred by an unrelated enterprise
  • Adjust this mark-up to account for functional or other differences that could materially affect it in the open market
  • Add the adjusted profit mark-up to the costs of production.







ALP = 150 + 10 + 2 = 162

CPM is most suitable for:
  • Sale of semi-finished goods
  • Provision of services
  • Long-term buy and supply arrangements

RESALE PRICE METHOD:

Under RPM, the transacting enterprise has to:
  • Identify price at which goods / services obtained from AE are re-sold to unrelated enterprise
  • Reduce such price by:
    • normal GP margin accruing to assessee / unrelated enterprise from similar uncontrolled transaction
    • expenses incurred by assessee for obtaining goods / services
  • Adjust the price on account of functional differences that could materially affect it in the open market






    Price of sale: 120
    Less: 15 (normal GP margin)
              10 (freight charges)
    Add:    5 (packaging expenses)
    ALP = 100


    RPM  is most suitable for:
    • Chain of distribution of goods through an intermediate company
    • Marketing operations


    Wednesday, 17 August 2011

    The Vodafone Controversy

    The hottest issue of the tax world right now is the Vodafone case. There has already been enough discussion on the structure of the deal so I won't go into the details. Vodafone (Netherlands) paid 11 billion dollars to Hutch (Hong Kong), for purchasing Hutch’s wholly-owned subsidiary in Cayman Islands (HCI). HCI owned a company in Mauritius which directly and indirectly (through various companies) held a controlling stake of 67% in Hutchison Essar Ltd, India (HEL). By purchasing HCI, Vodafone acquired a controlling stake in HEL.

    The Department cried foul and sought to tax Vodafone on the deal, conducted and concluded outside India. The Department’s claim rested on the fact that the underlying purpose of the transfer of HCI was to acquire Indian operations of HEL and therefore, such transfer had a sufficient nexus with India to attract tax. And we’re not talking peanuts here; the tax liability is 2 billion dollars.

    The Bombay HC ruled against Vodafone and the case is currently in the Supreme Court. There has been enough debate on the applicability of section 9(1), whether there is ‘transfer’ of a ‘capital asset’ ‘situated in India.’ While it is true that Vodafone’s intention was to acquire Indian operations, the ultimate question that arises is, whether the IT Department can tax an ‘indirect’ transfer of a capital asset situated in India, effected through intermediary companies.

    My take is, no they cannot do that until the DTC is introduced or the present Section 9 is amended. Section 9 of the IT Act says that income accruing or arising, directly or indirectly, through the transfer of a capital asset in India is liable to tax in the hands of the non-resident. It is section 5 of the DTC, however that lays down that such ‘transfer’ can be ‘direct or indirect.’ The DTC is not an amendment to the current Income Tax Act, but is a whole new legislation, which will repeal and replace the Act. In my view, bringing indirect transfers into the ambit of taxation is possible only after DTC comes into effect or after Section 9 is amended to that effect.

    Moreover, other countries like China, Australia and Peru have specifically enacted provisions making indirect transfers taxable. Can India tax such transfers without a specific provision in place? Not unless there is clear tax evasion, in the garb of a colourable device (lawyers simply love to use this phrase). In my opinion, Vodafone has not evaded tax, it has merely structured an indirect transfer as a part of some creative tax planning, which is legal. In the glaring absence of a specific provision, it will be unfair to tax Vodafone.

    The outcome of the case is keenly awaited by foreign investors and MNCs who are waiting for settlement of the issue before structuring any deals involving Indian assets/operations.

    Tuesday, 7 June 2011

    Oh, let them just evade taxes!

    That isn't really the kind of statement you'd expect to hear from a tax-law student in India. I'm supposed to hold the law of the land in the highest regard and I come from a high-tax jurisdiction (a corporate taxpayer's nightmare). But you try and study Transfer Pricing regulations and that's all you can exclaim. Atleast I did.

    At the outset, let me state that I'm not sure what this article (?) is about. I guess that's what blogs are for. The purpose of this "blog entry" is mainly to ascertain if I understand what I'm writing. And if I can write enough about Transfer Pricing to call it an article (?).

    Transfer Pricing is probably one of the most complex computations a tax officer can come across and ironically, it has very little to do with tax. It is more about market conditions, economic scenarios, product knowledge and of course the glue that holds this all together; sister concerns. These regulations concern only international transactions (as of now) between associated enterprises, atleast one of which is a non-resident. The general idea behind these provisions is to ensure that cross-border transactions between them are at arm's length i.e. valued at the same price as such transactions would have been, had they taken place between unrelated parties. The transactions cover sale of both goods and services.

    Why do international transactions between AEs make tax authorities wary? Apparently because the money exchanging hands in these cases may be a fishy business, designed to attract lower tax. As is well known, Indian tax authorities love to tax foreign corporate entities. The Vodafone case highlighted it enough. Textbook-like as it may sound, an example should help illustrate this.

    Z is an Indian company which is a subsidiary of Y, an American company. Y sells certain goods to Z for Rs. 100 but makes an entry in its books of accounts, showing this amount to be 125. Z claims Rs. 125, instead of Rs. 100, as deduction from income on account of business expenditure. This lowers Z's income, thereby attracting lower tax. Since Z is ultimately the subsidiary of the American company, Y too derives indirect benefit from this arrangement. The Transfer Pricing regime dictates that the authorities will have to make sure that the amount of Rs. 125 is a reasonable price for the goods sold and in line with prevailing market trends.

    All is dandy so far, but now arises the question as to HOW? There are so many things to be considered. The quality of the goods, the quantity of the goods, whether the value of the goods changes with different geographical locations, the cost of labor, etc. There are different methods to ascertain all this and compare the transaction with other independent and uncontrolled transactions. The factors to be considered while determining arm's length price differ from method to method and therefore, I will deal with them when I deal with the methods. For some reason, our lawmakers thought that these methods (enumerated in Section 92C of the Income Tax Act) would make the task 'simple.' (that totally backfired, I might add). These methods are essentially based on the internationally accepted OECD Transfer Pricing Guidelines. They are:

    1. Comparable Uncontrolled Price (CUP) Method
    2. Cost Plus Method
    3. Resale Price Method
    4. Profit Split Method
    5. Transactional Net Margin Method

    I wont discuss the methods in this post. They deserve a separate post of their own.

    Moving on, the concept of an AE is fairly clear and comprehensively defined in Section 92A of the Income Tax Act. As far as I know, there has not been any litigation in this aspect. The concept of a Permanent Establishment has been the subject matter of many cases, the most important one being that of Morgan Stanley.
    What constitutes an international transaction has also been discussed somewhat. An important case with regard to 'international transaction' is that of Tianjin Tianshi Pvt Ltd, a Chinese PE in India. A Delhi ITAT Bench held in this case, that international does not necessarily mean cross-border. A Indian company dealing with a foreign company's PE in India is subject to Transfer Pricing regulations.
    Most of the Transfer Pricing litigation is only at Tribunal level right now, so I'm sure there will be much discussion on the basic aspects as the cases go to the High Court and Supreme Court level.

    I'm not sure yet, whether I agree with the principles behind this regime. I'll need a much deeper knowledge of the subject. Not that my agreement/disagreement makes a shred of difference at this stage, but atleast it will clear things up for me. And who knows, perhaps the Finance Minister will ask for my opinion someday. Erm, anyhow.

    This was a very basic article (?) with regard to the idea and purpose of Transfer Pricing. The next one will probably be more formal, with technical details and caselaws. By then, hopefully, I shall have a much better understanding of the subject.