By Mayur B. Nayak | Tarunkumar G. Singhal | Anil D. Doshi
Chartered Accountants
1. INTRODUCTION
Benchmarking of
financial transactions is an integral part of the Transfer Pricing Regulations
of India (TPR). The Finance Act, 2012 inserted an Explanation to section 92B of
the Income-tax, Act 1961 (the ‘Act’) with retrospective effect from 1st
April, 2002 dealing with the meaning of international transactions. Interestingly,
the Notes on Clauses of the Finance Bill, 2012 is silent on the intent and
purpose of inclusion of such transactions within the definition of
‘international transaction’. Clause (i)(c) of the said Explanation reads as
follows:
‘Explanation. –
For the removal of doubts, it is hereby clarified that –
(i) the
expression “international transaction” shall include –
(a) ….
(b) ….
(c) capital
financing, including any type of long-term or short-term borrowing, lending or
guarantee, purchase or sale of marketable securities or any type of advance,
payments or deferred payment or receivable or any other debt arising during the
course of business;
(d) ….
(e) ….’
Since financial
transactions are peculiar between two enterprises, it is hard to find comparables
in many cases. In this article we shall deal with some of the possible options
to benchmark some of these transactions to arrive at an arm’s length pricing
and / or discuss controversies surrounding them.
It may be noted
that Clause 16 of the Annexure to Form 3CEB requires the reporting of
particulars in respect of the purchase or sale of marketable securities, issue
and buyback of equity shares, optionally convertible / partially convertible /
compulsorily convertible debentures / preference shares. A relevant extract of
the Clause is reproduced herein below:
Particulars in respect of international
transactions of purchase or sale of marketable securities, issue and buyback of
equity shares, optionally convertible / partially convertible / compulsorily
convertible debentures / preference shares:
Has the
assessee entered into any international transaction(s) in respect of purchase
or sale of marketable securities or issue of equity shares including
transactions specified in Explanation (i)(c) below section 92B(2)?
If ‘yes’, provide the following details
(i) Name and address of the associated
enterprise with whom the international transaction has been entered into
(ii) Nature of the transaction
(a) Currency in which the transaction was
undertaken
(b) Consideration charged / paid in
respect of the transaction
(c) Method used for determining the arm’s
length price [See section 92C(1)]
It may be noted
that the Bombay High Court in the case of Vodafone India Services Pvt.
Ltd. vs. UOI [2014] 361 ITR 531 (Bom.) clearly stated that the issue of
shares at a premium is on capital account and gives rise to no income and,
therefore, Chapter X of the Act dealing with Transfer Pricing provisions do not
apply. (Please refer to detailed discussion in subsequent paragraphs.)
However, even after
the acceptance of the Bombay High Court judgment by the Government of India,
international transactions relating to marketable securities are still required
to be reported / justified in Form 3CEB. And therefore, we need to study this
aspect.
Of the various
financial transactions, this article focuses on Capital Investments and
Outstanding Receivables (Debtors). Other types of transactions will be covered
in due course.
2. Benchmarking of capital
instruments under Transfer Pricing Regulations
2.1 Investments in share capital and CCDs
Cross-border
investment in capital instruments of an Associated Enterprise (AE), such as
equity shares, compulsory convertible debentures (CCDs), compulsory convertible
preference shares (CCPs) and other types of convertible instruments are covered
here.
Since CCDs and CCPs
are quasi-capital in nature, the same are grouped with capital
instruments. Even under FEMA, they are recognised as capital instruments.
Collectively, they are referred to as ‘Equity / Capital Instruments’ hereafter.
2.2. FEMA Regulations
(i) Inbound investments – FDI or foreign
investments
Inbound investment
in India is regulated by the Foreign Exchange Management (Non-Debt Instruments)
Rules, 2019. The said Rules define ‘Capital Instruments’ as equity shares,
debentures, preference shares and share warrants issued by an Indian company.
‘FDI’ or
‘Foreign Direct Investment’ means investment through equity instruments by a
person resident outside India in an unlisted Indian company; or in ten per cent
or more of the post-issue paid-up equity capital on a fully-diluted basis of a
listed Indian company;
‘foreign
investment’ means any investment made by a person resident outside India on a
repatriable basis in equity instruments of an Indian company or to the capital
of an LLP;’
The NDI Rules define Foreign Portfolio Investment (FPI) as any investment
made by a person resident outside India through equity instruments where such
investment is less than 10% of the post-issue paid-up share capital on a
fully-diluted basis of a listed Indian company, or less than 10% of the paid-up value of each series of equity
instruments of a listed Indian company.
Since cross-border
investment of 26% or more in an entity would trigger the TPR [section 92
A(2)(a)], investments under FPI would not be subjected to benchmarking under
TPR. However, FDI and Foreign Investments in India would be required to be
benchmarked under TPR.
(ii) Pricing guidelines for inbound investments
Rule 21 of the NDI
Rules provides pricing or valuation guidelines for FDI / foreign investments as
follows:
(a) For issue of equity instruments by a company to
a non-resident or transfer of shares from a resident person to a non-resident
person, it shall not be less than the price worked out as
follows:
For listed
securities ? the price at which a preferential allotment of shares can be made
under the Securities and Exchange Board of India (SEBI) Guidelines, as
applicable, in case of a listed Indian company, or in case of a company going
through a delisting process as per the Securities and Exchange Board of India
(Delisting of Equity Shares) Regulations, 2009;
For unlisted
securities ? the valuation of
equity instruments done as per any internationally-accepted pricing methodology
for valuation on an arm’s length basis duly certified by a Chartered
Accountant or a merchant banker registered with SEBI or a practising Cost
Accountant.
(b) For transfer of equity instruments from a
non-resident person to a person resident in India,it shall not exceed the
price worked out as mentioned in (a) above. The emphasis is on valuation as
per the provisions of the relevant SEBI guidelines and provisions of the
Companies Act, 2013 wherever applicable.
The interesting
point here is that the pricing guidelines under NDI rules emphasise on the
valuation of equity instruments based on an arm’s length principle.
The Rule provides
the guiding principle as ‘the person resident outside India is not
guaranteed any assured exit price at the time of making such investment or
agreement and shall exit at the price prevailing at the time of exit.’
(c) In case of swap of equity
instruments, irrespective of the amount, valuation involved in the swap
arrangement shall have to be made by a merchant banker registered with SEBI or
an investment banker outside India registered with the appropriate regulatory
authority in the host country.
(d) Where shares in an Indian company are issued to
a person resident outside India in compliance with the provisions of the
Companies Act, 2013, by way of subscription to Memorandum of Association,
such investments shall be made at face value subject to entry route and
sectoral caps.
(e) In case of share warrants, their pricing and
the price or conversion formula shall be determined upfront, provided that
these pricing guidelines shall not be applicable for investment in equity
instruments by a person resident outside India on a non-repatriation basis.
(iii) Outbound investments
Valuation norms for
outbound investments are as follows:
In case of partial
/ full acquisition of an existing foreign company where the investment is more
than USD five million, share valuation of the company has to be done by a
Category I merchant banker registered with SEBI or an investment banker /
merchant banker outside India registered with the appropriate regulatory
authority in the host country, and in all other cases by a Chartered Accountant
/ Certified Public Accountant.
However, in the
case of investment by acquisition of shares where the consideration is to be
paid fully or partly by issue of the Indian party’s shares (swap of shares),
irrespective of the amount, the valuation will have to be done by a Category I
merchant banker registered with SEBI or an investment banker/ merchant banker
outside India registered with the appropriate regulatory authority in the host
country.
In case of
additional overseas direct investments by the Indian party in its JV / WOS,
whether at premium or discount or face value, the concept of valuation, as
indicated above, shall be applicable.
As far as the
actual pricing is concerned, one must follow the guidelines mentioned at
paragraph (ii)(b) above, i.e., the transaction price should not exceed the
valuation arrived at by the valuer concerned.
2.3. Benchmarking of equity
instruments under transfer pricing
From the above discussion it is clear that for any cross-border capital
investments one has to follow the pricing guidelines under FEMA. However, as
mentioned in the NDI Rules, the valuation of equity / capital instruments must
be at arm’s length. Thus, the person valuing such investments has to bear in
mind the principles of arm’s length.
One more aspect that one has to bear in mind while doing valuation is to
use the internationally accepted pricing methodology. Pricing of an equity /
capital instrument is a subjective exercise and would depend upon a number of
assumptions and projections as to the future growth, cash flow, investments by
the company, etc. Therefore, the traditional methods of benchmarking as
prescribed in the TPR may not be appropriate for benchmarking investments in
equity / capital instruments.
2.4. Whether investments in
equity instruments require Benchmarking under TPR?
In this connection,
it would be interesting to examine the Bombay High Court’s decision in the case
of Vodafone India Services Pvt. Ltd. vs. Union of India(Supra).
Brief facts of the
case are as follows:
VISPL is a wholly-owned subsidiary of a non-resident company, Vodafone
Tele-Services (India) Holdings Limited (the holding company). VISPL required
funds for its telecommunication services project in India from its holding
company during the financial year 2008-09, i.e., A.Y. 2009-10. On 21st
August, 2008, VISPL issued 2,89,224 equity shares of the face value of Rs. 10
each at a premium of Rs. 8,509 per share to its holding company. This resulted
in VISPL receiving a total consideration of Rs. 246.38 crores from its holding
company on issue of shares between August and November, 2008. The fair market
value of the issue of equity shares at Rs. 8,519 per share was determined by
VISPL in accordance with the methodology prescribed by the Government of India
under the Capital Issues (Control) Act, 1947. However, according to the A.O.
and the Transfer Pricing Officer (TPO), VISPL ought to have valued each equity
share at Rs. 53,775 (based on Net Asset Value), as against the aforesaid
valuation done under the Capital Issues (Control) Act, 1947 at Rs. 8,519, and
on that basis the shortfall in premium to the extent of Rs. 45,256 per share
resulted in a total shortfall of Rs. 1,308.91 crores. Both the A.O. and the TPO
on application of the Transfer Pricing provisions in Chapter X of the Act held
that this amount of Rs. 1,308.91 crores is income. Further, as a consequence of
the above, this amount of Rs. 1,308.91 crores is required to be treated as a
deemed loan given by VISPL to its holding company and periodical interest
thereon is to be charged to tax as interest income of Rs. 88.35 crores in the
financial year 2008-09, i.e., A.Y. 2009-10.
The Bombay High
Court,while ruling on the petition filed by VISPL, among other things observed
as follows:
‘(i) The tax can be charged only on income and in
the absence of any income arising, the issue of applying the measure of arm’s
length pricing to transactional value / consideration itself does not arise.
(ii) If it’s income which is chargeable to tax,
under the normal provisions of the Act, then alone Chapter X of the Act could
be invoked. Sections 4 and 5 of the Act brings / charges to tax total income of
the previous year. This would take us to the meaning of the word income under
the Act as defined in section 2(24) of the Act. The amount received on issue of
shares is admittedly a capital account transaction not separately brought
within the definition of income, except in cases covered by section 56(2)(viib)
of the Act. Thus, such capital account cannot be brought to tax as already
discussed herein above while considering the challenge to the grounds as
mentioned in impugned order.
(iii) The issue of shares at a premium is on capital
account and gives rise to no income. The submission on behalf of the Revenue
that the shortfall in the ALP as computed for the purposes of Chapter X of the
Act is misplaced. The ALP is meant to determine the real value of the
transaction entered into between AEs. 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.’
In an interesting
development thereafter, on 28th January, 2015, the Ministry of
Finance, Government of India, issued a press release through the Press
Information Bureau accepting the order of the Bombay High Court. Relevant
excerpts of the said press release are as follows:
‘Based on the
opinion of Chief Commissioner of Income-tax (International Taxation),
Chairperson (CBDT) and the Attorney-General of India, the Cabinet decided to:
i.) accept the order of the High Court of Bombay
in WP No. 871 of 2014, dated 10th October, 2014 and not to file SLP
against it before the Supreme Court of India;
ii.) accept orders of Courts / IT AT / DRP in cases
of other taxpayers where similar transfer pricing adjustments have been made
and the Courts / IT AT / DRP have decided /decide in favour of the taxpayer.
The Cabinet
decision will bring greater clarity and predictability for taxpayers as well as
tax authorities, thereby facilitating tax compliance and reducing litigation on
similar issues. This will also set at rest the uncertainty prevailing in the
minds of foreign investors and taxpayers in respect of possible transfer pricing
adjustments in India on transactions related to issuance of shares and thereby
improve the investment climate in the country. The Cabinet came to this view as
this is a transaction on the capital account and there is no income to be
chargeable to tax. So, applying any pricing formula is irrelevant.’
CBDT has also
issued Instruction No. 2/2015 dated 29th January, 2015 clarifying
that premium on shares issued was on account of capital account transaction and
does not give rise to income. The Board’s instruction is reproduced as follows:
‘Subject
Acceptance of the Order of the Hon’ble High Court of Bombay in the case of
Vodafone India Services Pvt. Ltd.-reg.
In reference to
the above cited subject, I am directed to draw your attention to the decision
of the High Court of Bombay in the case of Vodafone India Services Pvt. Ltd.
for AY 2009-10 (WP No. 871/2014), wherein the Court has held, inter alia, that the premium on share issue was on account of a
capital account transaction and does not give rise to income and, hence, not
liable to transfer pricing adjustment.
2. lt is hereby informed that the Board has
accepted the decision of the High Court of Bombay in the above-mentioned writ
petition. In view of the acceptance of the above judgment, it is directed that the
ratio decidendi of
the judgment must be adhered to by the field officers in all cases where this
issue is involved. This may also be brought to the notice of the ITAT, DRPs and
CslT(Appeals).’
The above decision
has been referred to in the following decisions:
On different facts,
the Supreme Court in case of G.S. Homes and Hotels P. Ltd. vs. DCIT
[Civil Appeal Nos. 7379-7380 of 2016 dated 9th August, 2016]
ruled that ‘we modify the order of the High Court by holding that the amount
(Rs. 45,84,000) on account of share capital received from the various
shareholders ought not to have been treated as business income.’ Thus, the Apex
Court reversed the order of the Karnataka High Court.
In ITO vs. Singhal General Traders Private Limited [ITA No.
4197/Mum/2017 (A.Y. 2012-13) dated 24th February, 2020],
following the decisions of the Bombay High Court in the case of VSIPL
(Supra) and the Apex Court in the case of G.S. Homes and
Hotels Ltd. (Supra), the Tribunal upheld the decision of the CIT(A) of
treating the receipt of share capital / premium as capital in nature and that
it cannot be brought to tax u/s 68 of the Act.
In light of the above discussion, the question arises, is it necessary to
benchmark the transactions of investments in capital / equity instruments? As
Form 3CEB still carries the reporting requirement, it is advisable to report
such transactions. One can use the valuation report to benchmark the
transaction under the category of ‘any other method’. This is out of abundant
precaution to avoid litigation. Ideally, the Form 3CEB should be amended to
bring it on par with the CBDT’s Instruction 2/2015 dated 29th
January, 2015 and the Government’s intention expressed through the press
release dated 28th January, 2015.
3. Benchmarking of
outstanding receivables (debtors)
Debtors are
recorded in the books in respect of outstanding receivables for the exports
made to an AE. The underlying export transactions would have been benchmarked
in the relevant period and, therefore, is there any need to benchmark the
receivables arising out of the same transaction?
As mentioned in paragraph 1, the Explanation to section 92B dealing with
the meaning of international transactions was inserted, inter alia, to
include ‘receivable or any other debt arising during the course of business’
with retrospective effect from 1st
April, 2002. Therefore, apparently even the receivables need to be reported and
benchmarked.
However, recently
in the case of Bharti Airtel Services Ltd. vs. DCIT, the Delhi
ITAT [ITA No. 161/Del/2017 (A.Y. 2011-12) dated 6th October,
2020] ruled that outstanding debtors beyond an agreed period is a
separate international transaction of providing funds to its associated
enterprise for which the assessee must have been compensated at an arm’s
length. In the instant case there was a service agreement between Bharti Airtel
Services Ltd. and its overseas AE for payment of invoices within 15 days of
their receipt. However, the same remained outstanding beyond the stipulated
time of 15 days. The working capital adjustment was denied to the assessee in
the absence of any reliable data and therefore the same was not taken into
account while determining the arm’s length price of the international transaction
of provision of the services. On the facts and circumstances of the case, the
Tribunal held that outstanding debtors beyond an agreed period is a separate
international transaction of providing funds to its associated enterprise for
which the assessee must have been compensated in the form of interest at LIBOR
+ 300 BPS as held by CIT(A).
In this context the
Tribunal held as under:
‘9. Coming to the various decisions relied upon by
the learned authorised representative, we find that they are on different
facts. The decision of the honourable Delhi High Court in ITA number 765/2016
dated 24th April, 2017 in case of Kusum Healthcare Private Limited
(Supra), para number eight clearly shows that assessee has undertaken working
capital adjustment for the comparable companies selected in its transfer
pricing report which has not been disputed by the learned transfer pricing
officer and therefore the differential impact of working capital of the
assessee vis-à-vis
is comparable had already been factored in pricing profitability and therefore
the honourable High Court held that adjustment proposed by the learned TPO
deleted by the ITAT is proper. In the present case there is no working capital
adjustment made by the assessee as well as granted by the learned TPO. The
facts in the present case are distinguishable. Further, same are the facts in
case of Bechtel India where working capital adjustment was already granted. In
case of 91 taxmann.com 443 Motherson Sumi Infotech and Design Limited non-charging
of interest was due to business and commercial reasons and no interest was also
charged against outstanding beyond a specified period from non-related parties.
No such commercial or business reasons were shown before us. The facts of the
other decisions cited before us are also distinguishable. Therefore, reliance
on them is rejected.’
From the above
ruling it is clear that one must ensure the receipt of outstandings within a
stipulated time, else it would call for transfer pricing adjustment.
Benchmarking
Once it is
established that the receivables are beyond due date, the benchmarking has to
be done as if it is a loan transaction. Such a transaction needs to be
benchmarked using the Libor rate of the same currency in which the export
invoice is raised.
3.1. FEMA provisions for
receipt of outstanding receivables
It may be noted
that the time limit for realisation of export proceeds is the same for export
of goods as well as services.
The normal time
limit for realisation of exports is nine months from the date of exports.
However, it was extended to 15 months for exports made up to 31st
July, 2020 due to the Covid-19 pandemic [RBI/2019-20/206 A.P. (DIR Series)
Circular No. 27, dated 1st April, 2020].
Thus, ideally,
parties can provide mutual time limit for settlement of export invoices within
the overall time limit prescribed by RBI under FEMA.
4. CONCLUSION
Benchmarking of financial transactions is an important aspect of
transfer pricing practice in India. Not much judicial / administrative guidance
is available for the two types of financial transactions referred to in this
article.
However,
detailed jurisprudence and guidance is available for benchmarking of financial
transactions in the nature of loans and guarantees. Readers may refer to the detailed articles published in the May, 2014 and June, 2014 issues of the BCAJ dealing with benchmarking of
loans and guarantees, respectively.
