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?"

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.

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

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.

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. 

Point(less) of Taxation Rules, 2011

As expected, the Union Budget 2011 has brought with it a horde of changes to be made to the existing tax system. Some of the changes are welcome while others are plain ridiculous. One of these is the 'Point of Taxation Rules,' pertaining to taxability of services, brought in vide Notification 18/2011-ST, dated 1-3-2011. Set to come into force on 1-4-2011, these rules fix the point of time of 'when' a service is said to be provided. The more important of these rules are discussed below.

Rule 3 lays down that a service will be deemed to be provided on the earliest of the following dates:

i) The date on which the service is actually provided

ii) The date on which the invoice is issued

iii) The date on which payment is made

Rule 4 (notwithstanding Rule 3), regarding determination of point of taxation in case of change of rate of tax, is a fantastic means of creating utter chaos. This rule lays down that in case a taxable service has been provided before any change in the rate of tax, the point of taxation will be:

i)  the date of payment or issuing of invoice, whichever is earlier, where invoice has been issued and payment has been received after change of rate

ii) the date of issue of invoice, where the invoice has been issued prior to change in tax rate but the payment is received after the change of rate.

iii) the date of payment, where the payment is received before the change of rate, but the invoice has been issued after the change of rate.

The rule also goes on to state that in case a taxable service has been provided after any change in the rate of tax, the point of taxation will be:

i) the date of payment, where the invoice has been issued prior to change of rate but the payment is made after change of rate.

ii) the date payment or issuing of invoice, whichever is earlier, where both events have occurred after change of rate.

iii) the date of issue of invoice, where invoice is issued after the change of rate but payment has been received before the change of rate.

Rule 6 lays down that in case of a continuous supply of service, every instance of periodical billing will determine the point of taxation of such service provided during such period, if such period is specified in the contract.

As of today, collection of tax is on cash basis. Service tax is payable once the payment is received by the service provider. These rules will make the service provider liable to pay tax once the service is provided, whether or not payment has been received. Though the intention of the rules is to ensure that tax is paid at the earliest, this is certainly not a smart move because of the following reasons:

1. Undue pressure to make payment will be created on the service receiver. The service receiver may not necessarily make immediate payment after the service is provided to him, owing to personal / financial constraints. Depending upon the requirement of the receiver, the service may need to be quantified first before any payment is made.

2. Moreover, the payment may very well be in instalments. The entire payment need not be made at once. If the payment is made in instalments, what will be the point of taxation; the date of the first instalment or the date of the last instalment? Also, what will happen if some instalments are paid before the change in rate and some are paid after?

3. As is the accepted norm, the service is provided first and payment is made later. However, if the rules come into effect, service providers will start demanding payment before actual provision of any service. The quality of service provided thereafter may not be up to the mark, since the payment is already received by them.

4. The service receiver will be left with no means to ensure that the service is wholly and satisfactorily provided to him. Litigation will certainly increase in such cases, increasing the existing burden on the administrative machinery.

5. What about that invoices that are raised before 1-4-2011 but the payment is received after this date? Will the Rules be applicable to such invoices?

6. Where a service is continuously provided, it often happens that the invoices issued and payments made are based on the requirement and convenience of parties. How will the point of taxation be determined where no specific agreement with regard to period of billing exists?

7. The accounting norms will be turned upside down. There may be several attempts to change the dates of payments / issuance of invoices / provision of services in order to escape any higher rates of tax prescribed after the taxable service has been provided. The balance sheets in such cases may not tally with the returns, leading to further confusion.

Looking at the kind of hardship that will be caused to the service providers as well as service receivers, these rules are bound to be a source of much debate. Whether or not the rules come into force, the intense discussion on their implementation will certainly uphold the debating tradition followed every year after the announcement of the Budget.