Is The Shell Case All Gas?

Shell is calling it a tax on FDI! The Indian tax department says it's a simple case of underselling Indian assets - a disguised loan that should be subject to transfer pricing rules. Here’s the back story

In 2009, Shell India issued 87.63 crore shares to two parent companies at the par value of Rs 10 each. The tax department found fault with the valuation of shares and computed their value through a revised DCF valuation at Rs 183. It alleged that the undervaluation amounted to underselling of an Indian asset which compromises the asset base of the country. That - ‘Shell has brought short receipt of capital and loss on share premium to itself and thereby diminished the wealth of an Indian company’. The TPO calculated this short receipt of Rs 15,200 crores as a loan or receivable extended by Shell to its parent and deemed the entire amount receivable as tax, adding to it tax on the annual interest that should have accrued to such a loan. Shell has contested that claim in the Bombay High Court in a writ that says -          the transaction is a capital receipt and not a revenue item and hence not taxable 
            under the income tax act
-          a transfer pricing adjustment cannot apply to an item in the balance sheet
-          even if a premium was received it could not have been brought to tax
-          the transfer pricing officer has no authority to recharacterise a ‘subscription’ into a
            ‘sale’
-          fresh issuance of shares is not an international transaction
-          the definition of international transaction envisages only an actual receivable and
            not a hypothetical one
-          TP provisions do not provide for making secondary adjustments - that is, first consider issue of shares as an international transaction and apply arms length pricing and then treat the difference between the alp and actual price as debt accruing interest
  The past few years have been littered with high-pitched transfer pricing cases. But this one is not just the most unusual; it could also potentially cost Shell Rs 15000 crore in tax. The single largest TP case ever in India! Does the government have a legitimate case or is it creating an artificial tax event? To discuss that I have with me Rahul Mitra of PwC, BM Singh, Former CBDT Chairman and Rupak Saha of GE. Doshi: Does an ‘international transaction’ include share capital received from a foreign parent by a wholly owned subsidiary in India, on the issuance of fresh shares and not a sale of shares to a third party? Shell says had they sold the shares at Rs 183 in the first place, the subscription would still not have been a taxable event; so issuing them at Rs 10 should not make them a taxable event either. What do you make of that? Singh: You summed it up correctly. This is on capital account, it is the sale of a share, it is an FDI and if there was a capital gain involved in sale of some shares, one would have thought that yes we could step in with a TP adjustment. However speaking firstly whether it is an international transaction, that itself appears to be slightly stretching the definition of 92 (b). Sec 92(b)
….“international transaction” means a transaction between two or more AEs…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… However let us for one moment say that it is covered by section 92 (b) as it covers just about every transaction- be it on capital account or on revenue account. Having done that then you go to the charging section of section 92 (1) which says any transaction which has an effect of reducing the income of an assessee can be brought to a transfer pricing scrutiny and adjustment. Sec 92(1)
..any income arising from an international transaction shall be computed having regard to the arm’s length price. In this case even if they are charged at Rs 183 a share, the amount would not have been taxable in India in the sense that it would have been a share premium which would have gone to their capital account. So I don't think that the department has done the right thing to invoke the provisions of transfer pricing in such a case. It is a matter of other authorities to ascertain whether the amount paid was correct, the RBI guidelines, the Controller of Capital Issues and all that. But not for the Department to step in and say that this would have amounted to an underselling of an asset therefore it is an income. Okay even if it is an underselling of an asset is it an income? That is what the point is. Is it income in the hands of assessee that is Shell India, I don't think so. Doshi: Is it an income? Can a capital receipt be recharacterised as an income? Is it an international transaction based on the expanded definition of international transaction emanating from last years Budget?  Mitra: Coming to the question on the principal amount of undervaluation of shares, there is no question of it being brought to tax. I don't think it is required to go into the definition of international transaction because transfer pricing is all about valuation of the income or the expense but not to say as to whether a capital receipt can be revenue receipt. So any receipt first needs to have the insignia of an income in the first instance and then say whether you have received more or less. So if I have received less than what I should have for issue of shares, maximum my share account, my capital account, would have been increased without any impact on the profit and loss account. So under no stretch of imagination, whether under any definition of international transaction, can the shortfall be ever taxed in the hands of the Indian company who is issuing the shares as a revenue income.  Doshi: Mr. Saha, how are you looking at this case given that at the very heart of it is the question - that by expanding the definition of international transaction, can you say the undervalued portion is a receivable?
 
Saha: I tried to look into this for quite some time and honestly I cannot find any reason which can support why the tax authority has done what it has. So yes there is a capital versus revenue debate. The other issue is that is there any benefit to either the Indian company to which the tax is levied or for that matter even to the investee entity? Who is getting any benefit from this entire transaction at all? The Indian company, if at all it has perhaps received less money than it should have and therefore if at all, it has suffered and for its sufferance it is getting taxed - that is unbelievable. Let us talk about the foreign company- the foreign company never got a tax bill to start with. But even if it is argued that the foreign company made a benefit because it invested less amount of money than what it should have, the question is that the foreign company, it was a 100 percent shareholder and it remains a 100 percent shareholder. Now if there were two-three shareholders and if one shareholder received value in an Indian company for less than fair market, then perhaps one can argue that the value from the other shareholders in the Indian company passed on to the shareholder who received shares at less than fair market value. Here that is not the case. Here, the shareholder in the Indian entities is a 100 percent shareholder. So he stays at the same position before the share issue as well as after the share issue.  Doshi: It struck me as fairly ingenious that the tax department may have seen all these share transactions take place over 2008-2009-2010, thought that they were taking place at values less than they ought to but did not have any way to be able to tax them. So what they do last year is pass a clarificatory retroactive amendment that expands the definition of ‘international transaction’ to include ‘receivable’. Then they go back to all of these companies and raise demands saying the undervalued portion is in fact a receivable and this new amendment allows us to bring receivables under transfer pricing provisions. Does this give them an arguable case? Mitra: Now we are coming to the second question on the imputed interest and what we typically call as ‘secondary adjustment’. If you have made a primary adjustment and thereafter since there is an imbalance between the taxable event and your account you see as to how you can recharacterize the amount to say that now it is either a receivable or it is a dividend, depending upon how you look at it. Now the question is you do not need to have an amended definition of ‘international transaction’ because as such loans, financial transactions were anyway an international transaction. The question here is different. The question is could the Indian revenue have recharacterised an amount to say that now this amount should have been received by you and having not received it, now it is a receivable on which you need to pay an interest. This is something called a secondary adjustment- whether you can make a further taxation on the primary adjustment? Based upon significant research, which we have done, secondary adjustment is something which is not uncommon in the world. There are several countries, about 12, which I can remember off-hand who do secondary adjustments but only where their domestic transfer pricing laws specifically or expressly permit them to do. Even the OECD has stated very clearly that the issue of secondary adjustment is best left to the domestic laws of the country. In India unfortunately we do not have an express law for making a secondary adjustment. So in absence of an express law for making a secondary adjustment, I do not think that it is legally permissible within the framework of our transfer pricing regulations. Singh: Yes, it is a good thing that Rahul Mitra brought this up because in my discussions I was told that earlier the tax department had – what is being done as a secondary adjustment - they had done as the primary adjustment. Where the shares were sold at an extensively lower price, they considered this to be a loan to the AE and at a notional interest, which they were charging, bringing to tax under the TP regulation. The secondary adjustment - it is not expressly given there but they can stretch their argument saying that this does affect the income of the Indian entity and could be brought to tax. It is not so easily tenable for them to succeed and appeal in this case also because like I was saying earlier, the shareholder is distinct, the company is distinct, they are two distinct entities. Now whose asset is diluted, is the company’s asset diluted, who has taken the loan, is it a shareholder or is it a company, one has to see about that also. Doshi: Are we missing something in this, why aren’t we able to see why revenue is pursuing, not just Shell, but several other similar demands with such fervor?
 
Saha: I agree with that. At least none of us in the panel seem to understand what the Revenue’s case is or for that matter to be fair to the Revenue, if press reports are to be believed, the law ministry as well as the AG seems to suggest that there is a case.
But honestly, at least I have not been able to understand that. Even before we go to the issue of the secondary adjustment, I think your initial question was that they expanded the definition of international transaction. I would say that by their own admission they never expanded, they said that look all these transactions were within the ambit of international transaction. So therefore it was almost a clarification if you will. If you see the definition of international transaction, the essential definition of the international transaction under 92B(1), it clearly says that those transaction which have an impact on the taxpayer’s profit, loss or assets right… Therefore even if there is a retroactive expansion of the list of illustration, that entire list of illustration still gets circumscribed by this condition, which is that - international transaction must impact either the taxpayer’s profit, income, loss or assets. Finance Act, 2012 amended definition of ‘international transaction’ Amended definition includes 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….   Doshi: Would you say the usage of the word asset there might give them some case in this situation? Saha: The question is how? This was an issuance of share capital. How would the transaction have an impact on the company’s assets. I do not understand that. Doshi: I am not the tax expert here but to stretch the argument, if they are saying that the asset has been undersold, does that give them then transfer pricing jurisdiction to look at this, revalue the asset and find a way to tax the undersold part?
 
Saha: As BM Singh correctly pointed out, the company and the shareholder are two distinct legal entities. It is nobody’s case that the company is underselling its assets. The company is issuing shares; the company is not selling its property to its shareholder so that one can argue about valuation etc. Doshi: Mr. Singh can you see any grounds at all for revenues to proceed with this case or any chance  at all for revenue winning this case and making this a taxable situation? Singh: I have a lot of sympathy with my Former Department, but in this matter I don’t think they have a chance to win it at a judicial level, at the High Court or the Supreme Court level. The shareholder is distinct, the asset is distinct, and it has no impact on the income of the company. How they could get away with this, I am not sure how they were allowed to do it. Doshi: Rahul, I am still going to try and look at this from the tax department’s point of view. They are looking at a series of transactions, which they think seriously undervalue Indian assets. Is there any case for them to be able to tax or prevent those kinds of transactions or create taxable events out of them?
 
Mitra: It is difficult, particularly for a transaction like this. And if you extend little further - the company has received, what you are saying is, less than what it should have on issue of shares. So what happens in the hands of the shareholder - the cost of acquisition of the shares becomes depleted to that extent. So, let’s say at a future date if he sells those shares to a third party and makes a capital gain, so anyways he is going to disclose a higher capital gains in India because his cost of acquisition would be less.
So in all cases Indian revenue will never be a loser. But at the end, by taking any recourse whatsoever you cannot just bring the capital receipt to tax by saying that there has been undervaluation.  Doshi: The other thing that I didn’t understand in this is how they say that the full Rs 15,200 crore is the tax amount and they did not restrict just to, if this is a receivable, the interest that could have accrued on it, notional interest. So, they have not restricted themselves on the tax or notional interest. They have counted the full Rs 15,200 crore as the tax amount that ought to be paid to them. Saha: Again, let’s take a reverse situation- if, for example, the Indian company had let’s say two shareholders and let’s say two separate independent shareholders. Now if the company, in its own wisdom, chooses to issue a fresh tranche of shares to one of the shareholders at significantly less than fair market value or even less than book, then what is happening is the second shareholder he loses out to that extent. So, therefore, in that case, the entire amount of undervaluation would arguably be a gain to the first shareholder’s hand and, if you see the definition of income under Section 2(24), that could bring the entire undervaluation arguably in the scope of income. But then, in the hands of the shareholder who benefited from that valuation. There is no way how the Indian company can gain. And again in this case that situation which I just described a few moments back does not really arise because here there are no two or multiple independent shareholders. Here it is all a 100 percent subsidiary of the same Shell entity.  Doshi: So what Mr. Saha is saying Rahul, is that even if they had restricted themselves to taxing just the notional interest on that undervaluation of Rs 15,200 crore, they would have had no case? Mitra: That’s correct. So, you had to have an express law for it and that I would say the accepted jurisprudence in the various countries that you do not do it as a matter of practice. It is only when you are empowered specifically by a law. Saha: But regardless of that whether the issue of secondary adjustment is brought into the rule book or not- the point is that on one hand you are saying that this is a constructive loan and on the other hand you are saying no I am going to tax that; you can’t have the cake and eat it too. So whatever is the undervaluation they are added back to the tax bill that’s the bigger number. Then on the other hand they are saying no, while that is an income, simultaneously I am saying that that is also an asset and therefore you should have earned interest on it. That is something which sounds a little strange and one other point which I am going to add is that, there have been significant comments by people that in absence of General Anti-Avoidance Rules (GAAR) could they have done this or could they have recharacterised this? I was looking at the GAAR provision and if you see the definition of impermissible avoidance arrangement, this particular transaction does not even fit that bill. So even if GAAR was to be there, I don’t think they could have done this because GAAR starts by saying - an impermissible avoidance arrangement has to have a tax benefit to the tax payer. What tax benefit was the tax payer Shell India trying to get in this transaction? It was just simply trying to get some equity capital. So there is no question of any tax benefit even if GAAR was there in the rule book and they wanted to recharacterise this on the basis of GAAR. So, any which way you look it is very difficult to understand the logic. Doshi: So what I am going to draw from your comments and the comments of the other panelists Mr. Saha is that this is a slam-dunk case for Shell? Saha: I will not immediately rush to that because in the past the tax office has come up with amazing kind of positions, which finally even if they have found no joy in the courts some of them they have managed to get entrenched in the rule book. Doshi: We are already facing one retroactive amendment in this case, which is the clarificatory expansion to the definition of international transaction. So, I don’t know if there can be any other further changes to the rule book to make this a taxable event. Mitra: Talking about the retroactive amendments on account of international transactions - those were clarificatory and if they want to bring this to tax- that will be a substantive amendment…for bringing in a new burden of tax and not just clarificatory. So, I don’t think it will be as easy as just trying to make a retroactive amendment going forward.