Vodafone share pricing case: Why Bombay High Court may be wrong in its judgment

The Bombay High Court, on 10 October, ruled in favour of Vodafone India Services and said it need not pay Rs 3,200 crore - the amount demanded by the income-tax department on the purported concession with reference to the fair value of shares allotted by it to its parent company in the UK in 2011. The court tersely pointed out that allotment of shares involved a transaction on capital account and did not impinge on the income of the Indian company.

It is true that the raising of capital normally does not impinge on the income of a company raising capital. To wit, companies in India charge mind-boggling premiums on IPOs but the legal position is they are not liable to pay income tax on such premiums because they are capital receipts, period.

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But an international transaction coming within the purview of transfer pricing mechanism is a different kettle of fish. Section 92B of the Income-Tax Act, 1961, germane to the discussion on hand, is reproduced below for ready reference:

“For the purposes of this section and sections 92, 92C, 92D and 92E, “international transaction” means a transaction between two or more associated enterprises, either or both of whom are non-residents, in the nature of purchase, sale or lease of tangible or intangible property, or provision of services, or lending or borrowing money, or any other transaction having a bearing on the profits, income, losses or assets of such enterprises and shall include a mutual agreement or arrangement between two or more associated enterprises for the allocation or apportionment of, or any contribution to, any cost or expense incurred or to be incurred in connection with a benefit, service or facility provided or to be provided to any one or more of such enterprises.”

The law cited above is open-ended enough to accommodate the income-tax department’s point of view that when shares are allotted at less than their fair value to a non-resident parent pro tanto, it suffers diminution in the value of its assets with a corresponding benefit for the non-resident parent. The alleged bee in the bonnet of the tax administration is precisely this issue, which is not only logical but also fortified by the legal provision cited above. In other words, had an Indian company allotted shares to an Indian resident, the department’s hands would have been tied but section 92B gives it the latitude even to reach out to what are ostensibly capital transactions.

The department has a sneaking suspicion that foreign companies are resorting to convoluted procedures to get round the Indian income tax law - heavy royalty instead of dividend, given the lower rate of tax on royalties vis–vis dividend distribution tax and allotment of shares at huge discounts vis–vis their fair price. Ironically the same Bombay High Court had a few years ago sustained the Rs 8,500 crore tax liability on Vodafone India on its failure to collect tax at source relating to capital gains made by Hutchchison Whampoa of Hong Kong while transferring the controlling interest in the Indian operating company through transfer of shares in a offshore company located in Camay Islands, a tax haven, on the ground that even though the shares related to an off shore company, in effect and substance they were about the Indian operating company.

The Supreme Court, of course, struck down the Bombay High Court verdict on the ground that the income-tax law did not specifically target such transactions. The then Finance Minister Pranab Mukherjee moved quickly to fill the breach - retrospective amendment to confer such power on the department - for which the Indian government has been pilloried by the pink media.

It is amazing that the same Bombay High Court which in the earlier case involving the same Vodafone, UK, chose to go out of its way to set store by the spirit of the law to sustain the department’s claim has now chosen to ignore the express provisions of the law as enshrined in section 92B. That section 92B turns the concept of income on its head is beside the point given the fact that transfer pricing regimes are after all a serious attempt to nail the multinational corporations in their attempts to circumvent tax laws. Section 92B seeks to reduce the wiggle room for MNCs.

Parenthetically, it may be mentioned that Sebi’s regulations on preferential allotment seeks to prevent favoritism in the matter of pricing of shares so that garden variety shareholders are not taken for a ride. While Vodafone India Services may not be a listed company coming under Sebi oversight the income tax department has a fair point - shares should be allotted at a fair price, i.e. arm’s length price, to a foreign company that is closely related to an Indian company whose shares are thus allotted. In support of this contention it has glibly cited section 92B with which the Bombay High Court has somehow not been impressed.