A long-standing debate that continues to hold its ground even today is whether investment in a company's shares can be construed as income and thus liable to tax in the hands of the investee company? Ideally, investment in shares of a company is a capital account transaction and thus, is a capital receipt, which is not taxable under the provisions of the Income-tax Act, 1961 (IT Act), unless specifically made liable to tax.
This debate arose due to the transfer pricing related issue in the case of Vodafone India Services Pvt. Ltd vs. ACIT[ᶦ] before the Hon’ble High Court of Bombay. Even though this debate was put to rest when the Indian Income-tax Department (IITD) did not contest the Order of the High Court, the IITD time and again raises this issue during the assessment proceedings. The most recent being the order passed by the Hon’ble High Court of Delhi in the case of Angelantoni Test Technologies Srl[ᶦᶦ] and others.
Transfer pricing adjustment on account of receipt of share premium
When Vodafone India issued shares to its holding company for a premium, it was contended by the IITD that the premium charged by the Indian subsidiary ought to have been a much higher amount and therefore, the (notional) shortfall in the premium received should be construed as income. It would be interesting to observe that even though the premium was valued in accordance with the method prescribed under applicable law, such valuation was questioned by IITD.
The Hon’ble High Court of Bombay was of the view that issuance of shares is undoubtedly on capital account and thus, cannot be construed as income and therefore not subject to transfer pricing provisions[ᶦᶦᶦ]. The High Court also discussed provisions relating to taxation of share premium and observed that “Share premium have been made taxable by a legal fiction under Section 56(2)(viib) of the Act and the same is enumerated as income in Section 2(24)(xvi) of the Act. However, what is sought to be brought into the ambit of income is the premium received from a resident in excess of the fair market value of the shares. In this case what is being sought to be taxed is capital not received from a non-resident i.e. premium allegedly not received on application of ALP”. Section 56(2)(viib) is an exception to the general rule and is applicable only if the share premium received exceeds Fair Market Value (FMV). Thus, unless the issuance of shares at a premium fall within the exception, the transaction cannot be brought to tax.
This decision of the High Court was accepted by the IITD by not filing a Special Leave Petition before the Hon’ble Supreme Court of India and an Instruction[ᶦᵛ] was issued by the Central Board of Direct Taxes (CBDT) in this regard.
Recent controversy
The Hon’ble High Court of Delhi in Angelantoni and various other taxpayers (where a common order was passed) was faced with the issue of whether investment made by a foreign holding company in its subsidiary tantamount to income? In this case, with regard to all the taxpayers, notices were issued under Section 148 and 148A of the Act (for initiation of re-assessment proceedings) on the ground that these non-resident taxpayers have remitted funds for the purpose of investment in their Indian subsidiaries and as no return of income was filed, there was no avenue for the IITD to verify these transactions. When the taxpayers objected to the initiation of the proceedings on the ground that the transaction was on capital account, incapable of generating any income, the IITD stated it intended to verify the source of the transaction. Interestingly, the IITD did not specify under which provision they intended to tax the investment made in India by these non-resident taxpayers.
On these facts, the Hon’ble High Court of Delhi following its earlier ruling in the case of Nestle[ᵛ] held that “It is settled law that investment in shares in an Indian subsidiary cannot be treated as ‘income’ as the same is in the nature of “capital account transaction” not giving rise to any income”. The High Court also observed that the action of the IITD is in contravention of its earlier instruction reiterating the views expressed in the case of Vodafone (supra). The High Court also set aside the order passed under Section 148A(d) of the IT Act, as there was no tangible material to allege escapement of income.
Re-affirmation by the Hon’ble High Court of Delhi is certainly a relief to all non-resident companies investing into India, sending a positive signal to the investor community on the tax-friendly environment in the country.
Variation in the manner of taxability by IITD
Despite it being a settled law that investment in shares is on capital account and incapable of generating any income, the issue was raised by IITD, and surprisingly, there was a variation in the manner of taxability by IITD. Firstly, it was contended that there is a shortfall in the premium charged and thus, the difference should be construed as income chargeable to tax. Secondly, mere remittance for the purpose of investment has been alleged as income escaped from assessment, though no provision has been indicated under which it was intended to be taxed. Thirdly, if the share premium is received above FMV, then the difference is taxable in the hands of the domestic company receiving it[ᵛᶦ].
Under the provisions of the IT Act, only the third situation as contemplated above has a statutory recognition and certainly the IITD had no basis to contest the first two issues, mainly when the remittance has been received in a transaction that is regulated under the exchange control regulations, unless a violation of any law can be demonstrated.
Issue concerning fresh issuance of shares
The last aspect of this transaction involves taxability on fresh issuance of shares, if issued below FMV while interpreting Section 56(2)(x) from 01 April 2017 and Section 56(2)(viia) until 31 March 2017. This issue has been a subject matter of extensive debate, wherein the CBDT had issued a Circular[ᵛᶦᶦ] clarifying that Section 56(2)(viia) was never intended to apply to fresh issue of shares. However, this Circular was later withdrawn, and it was clarified that this view was never expressed. The judiciary has also held that the provision is not applicable in the context of rights issue.
Certainly, no clarity is available on this issue. Section 56(2)(x) of the IT Act (which is the extant provision), mentions the following term - “where any person receives … from any person”. The term “receive” implies that there is an act of giving on the other side. Thus, there should be a giver or receiver in the transaction, thereby indicating existence of the property in order to fall within the ambit of Section 56(2)(x). In the context of issuance of rights share, the Hon’ble Supreme Court of India in the case of Khoday Distilleries Ltd[ᵛᶦᶦᶦ], held that there is a difference between creation and transfer of shares and shares come into existence only upon allotment. Thus, in light of the above, what is contemplated under Section 56(2)(x) is only transfer of shares, as in that case the property is already in existence and thus, the provision cannot be extended to issuance of shares, wherein the property is not in existence.
Practically, this issue should not arise in situations where the pricing is determined as per the exchange control regulations (which recommends internationally accepted methods), since in such a case, the transaction cannot be undertaken for a value which is less than FMV.
Conclusion
Taxability of investment (through shares) in an Indian subsidiary has become a bone of contention between IITD and the taxpayers, which has led to unwarranted consequences. Concerns have arisen, primarily because the IITD is applying varied methodologies to tax these transactions such as taxing shortfall in premium, taxing the entire investment, etc., which certainly has no statutory recognition. Non-resident entities have been burdened with the enquiry on their investment in India by way of initiation of re-assessment proceedings without there being any support of tax provisions in the hands of IITD with respect to escapement of income. The term “information” for initiation of re-assessment proceedings has certainly been interpreted widely by IITD, granting itself wide powers on the basis of mere facts.
The recent order of the Hon’ble High Court of Delhi certainly will assist taxpayers on twin grounds – firstly on the procedural aspect – that re-assessment proceedings cannot be initiated on the basis of a fact termed as “information”, unless there is tangible material on record and secondly on the substantive aspect - investment into Indian subsidiary cannot be construed as income, which is a capital account transaction, unless it fulfils the conditions of Section 56(2)(viib).
Author: Vidushi Maheshwari, Partner – Direct Tax
This Article was published by Taxsutra on 16-01-2024
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[i] Writ Petition No 871 OF 2014
[ii] Angelantoni Test Technologies Srl vs ACIT (TS-804-HC-2023DEL)
[iii] Section 92 of the IT Act, directs that any income arising from an International Transaction should be computed, having regard to the ALP. Thus, the sine-qua-non, for application of Section 92(1) of the IT Act is that income should arise from an International Transaction.
[iv] Instruction No 2 dated 29-01-2015
[v] Nestle SA vs ACIT (W.P.(C) 12643/2018 & and CM APPL. 49097/2019)
[vi] Finance Act, 2023, extended the applicability of Section 56(2)(viib) for receipt of consideration from non-residents as well.
[vii] Circular No 10 of 2018, Circular No 2 of 2019 and Circular No 3 of 2019.
[viii] Khoday Distilleries Ltd vs. CIT [(2008) 220 CTR SC (228)]