The Bombay High Court’s ruling in the Vodafone taxation matter strikes at the tax administration’s adventurism.

Source: The Financial Express

In a landmark verdict rendered on October 10, the Bombay High Court has held that issuance of shares by an Indian company to its overseas parent is not exigible to arm’s-length price (ALP) test under Chapter X of the Income Tax Act, which houses the transfer-pricing (TP) law. The HC, allowing Vodafone’s writ, declared the order null and void and decided the question of ‘jurisdiction’ against the tax administration, holding that shares issuance at premium (or inadequate premium) is merely tantamount to capital account transaction and didn’t warrant the rigours of transfer pricing adjustment, a position that has shaken investor confidence in the past few years. The HC’s verdict scores 2-0 in favour of Vodafone, following its earlier order (in November 2013) directing the tax administration to determine the preliminary question of jurisdiction. The ruling was pronounced in the wake of Vodafone’s challenge (round 2) to the Dispute Resolution Panel’s (DRP) directions upholding the tax administration’s alleged jurisdiction in the issue.

Whilst the tax administration could consider seeking remedy under Article 32 in a Special Leave Petition, the HC ruling is a significant outcome not just for Vodafone but a group of multinationals facing similar disputes emerging from indiscreet ‘tax adventurism’ in transfer-pricing matters.

Largely, disputes in the Vodafone case and others had emerged on the account of retrospective amendments brought in by the Finance Act 2012 to the definitional aspects of the 2001 law, which had the effect of bringing ‘capital financing’ and ‘business restructuring’ transactions within the fold of ‘international transactions’. Setting aside the debate on retrospective law, the amendment, though intended to bring with in its ambit certain specified transactions, surely gave a handle to the administration to apply it indiscreetly. The HC unequivocally held that even in relation to such transactions, transfer-pricing rigours can be applied only if the transaction yields income to the associated enterprises (AEs), e.g., interest income on a loan transaction, etc, and if its applicability to share capital transaction was in abstract. The ruling assumes significance given the manner in which the HC has comprehensively refuted the tax administration’s allegations insofar as applicability of the law to capital account transaction, even though the administration in its pleadings oscillated between a range of allegations to argue taxability of shortfall in premium. In a well-crafted ruling, the court has chronicled key milestones in the multi-million dispute, on the question of whether shortfall in premium on share issuance could be brought to tax as notional income under Chapter X even though the alleged notional income failed to pass the litmus test of the ‘income’ definition, thereby failing the charging provision. The court found the tax administration’s arguments on taxing such notional income entirely unfounded as the latter was trying to recharacterise ‘measure’ of tax as ‘charge’ of tax; to allege shortfall of share premium as being liable for transfer-pricing adjustment.

Intent of TP law reinforced

The ruling reinforces the fundamental principles for interpretation of fiscal statutes which ought to be read practically by resolving ambiguities of legal construction in favour of taxpayers. The ruling underlines another trite law in construing taxing statutes, requiring the literal interpretation of words employed without permitting such interpretation to be extended beyond the clear import of the language used.

Transfer-pricing legislation, in its present comprehensive form, was ushered in by the Finance Act 2001; the legislature, then, was amply articulate in stating that it was intended to provide a detail statutory framework which can lead to computation of reasonable, fair and equitable income on international transactions, such that profits/incomes are not understated and don’t lead to erosion of tax base of the country. The adventurism of tax administration, however, has since led to dilution of the law’s chief motive and, contrary to its intent, it has created a fear psychosis in minds of investors facing multi-million adjustment for FDI they bring into India.

The ruling is significant insofar as debate on the nature of transfer pricing provisions is concerned—for long, tax administration has disputed that Chapter X operates as a comprehensive independent tax code , and therefore, measure of income derived by applying ALP test could be brought to tax, even if such income was not explicitly recognised as taxable income under the charging provisions of the statue. The HC has set to order the confusion by holding that Chapter X is a machinery provision in the statute, as envisioned in the Memorandum to the Finance Act 2001, and hence couldn’t be permitted to usurp the jurisdiction of the charging provision in the Act, thereby reiterating the decades-old principles enshrined in several judgments of the Supreme Court.

Comprehensive victory for the investors

The Bombay HC’s ruling is a huge reprieve, undoubtedly for Vodafone, and no less to other multinational investors who had to bear the brunt of ‘innovative’ avenues of the tax administration in raising tax demands since the past two successive transfer-pricing audits. To a large extent, the outcome of the judicial intervention vindicates taxpayers’ confidence in bona fide understanding of the legislation and shores up the larger investing community’s confidence in the Indian judicial system. Moreover, the timing of the court’s verdict is important, given the Prime Minister’s recent visits to the US and Japan where he reiterated his government’s commitment to reign in ‘tax adventurism’ and to rolling out the red carpet for investors.

In hindsight, I hope that the tax administration acknowledges and gracefully accepts the judiciary’s verdict, which is in line with the legislative intent and is pragmatic too in its approach and reasoning. Should the government choose to pursue the path of constitutional remedy under Article 32, it remains to be seen if the Supreme Court shall deem this a fit case for intervention, without losing sight of a well-reasoned judgment. If so, Vodafone will have to brace up for another battle in the apex court. Till then, there is certainly reason to rejoice the outcome!