Justice delivered

Transfer pricing has been a key area of dispute between MNCs operating in India and the Indian Revenue Department. This is clearly evident from the fact that the amount of transfer pricing adjustment has increased manifold from ₹1,220 crore in financial year 2005-06 to ₹70,016 crore in 2012-13 (57 times in seven years), according to the Annual Report of the Ministry of Finance.

While such disputes have increased litigation, recent measures taken by the Government — such as advance pricing agreements, safe harbour rules and the introduction of a roll-back mechanism in Budget 2014 — can be considered genuine attempts in the direction of reducing litigation.

The recent ruling by the Bombay High Court in the Vodafone India case will further reduce scope for dispute. India needs foreign investment, particularly in the infrastructure sector, and therefore cannot spurn foreign investors. The judgement of Bombay HC, therefore, needs to be lauded and should soothe nerves of foreign investors.

In this case, the tax department alleged that Vodafone India undervalued the price of shares issued to its overseas holding company. The tax department valued the shares at ₹53,775 per share as against ₹8,519-per-share valuation of Vodafone India, resulting in a difference of ₹45,256 per share.

The tax department alleged that such difference has resulted in a benefit being accrued or given to the overseas parent from the transaction. The differential valuation or shortfall of ₹1,308 crore was considered as a transfer pricing adjustment in the hands of Vodafone India.

Further, such shortfall was considered as a deemed loan by Vodafone India to its holding company and interest amounting to ₹88 crore was also added to the transfer pricing adjustment.

Vodafone argued that for application of the transfer pricing provisions, income should arise from the international transaction. Further, it said the term ‘income’ has to be understood as defined in section 2(24) of the Income-tax Act 1961 and there cannot be a separate definition for transfer pricing purposes.

The receipt of consideration on issue of shares is a capital receipt which cannot be brought to tax. An issue of shares was argued as a process of creation of shares and not a transfer of shares.

The High Court held that when the capital receipt on issue of shares is not taxable in India, the alleged short-fall in the value of shares issued cannot be considered as taxable income as defined in the Income-tax Act, 1961.

The Court also held that only when an ‘income’ arises from an international transaction, the transfer pricing provisions can be invoked to measure the arm’s length price of such transaction.

However, in cases of capital receipts such as issuance of shares where such receipt itself is not taxable as ‘income’, the provisions of transfer pricing cannot be invoked. On international transactions such as business restructuring or capital financing, the Court said such transactions are taxable only to the extent it impacts income, that is the interest or depreciation arising from transactions.

In the case of issue of shares, transfer pricing should not apply since such receipts are in the nature of capital receipts not taxable in India.

Importantly, it was held that the transfer pricing provisions do not create a ‘charge’ of tax under the Income-tax Act, 1961; the provisions are applied only to measure the arm’s length price of a transaction which is otherwise taxable in India.

The writers are with EY. The views are personal