- Delhi Tribunal rejects addition of arm's length notional interest by re-characterization of redeemable preference shares into loan
- Hybrid instruments such as RPS should constitute 'securities' for the purposes of Companies Act, SCRA and SEBI Act.
- Powers of re-characterization should be used sparingly and only in exceptional circumstances.
- Tax authorities should not deviate from the 'Real Income' theory as per which only actual profits arrived at on commercial principles should be chargeable to tax.
Recently, in the case of Cairn India Ltd. v. ACIT,1 the Delhi tribunal ("Tribunal") held that redeemable preference shares (RPS) cannot be re-characterized into loans on account of arm's length adjustment. In doing so, the Tribunal rejected addition of notional interest with respect to the RPS based on an arm's length computation.
In the said case, Cairn India Ltd., a company located in India ("Taxpayer") had preferred two separate appeals to the Tribunal against two separate orders pertaining to financial years ("FY") 2010-11 ("FY11") and 2011-12 ("FY12"). The grievance in both the appeals, being related to addition of arm's length interest by re-characterization of RPS into loans, was common. Accordingly, the Tribunal clubbed both the appeals and rendered this consolidated order.
Brief facts are such that during FY 2009-10 ("FY10"), the Taxpayer had invested INR 1343, 76,37,000 in Cairn India Holding Private Limited, located in Jersey ("CIHL") by way of subscribing to RPS. However, while determining the arm's length price ("ALP") of the international transactions for FY10, the Transfer Pricing Officer ("TPO") re-characterized the RPS as unsecured loan and added an arm's length interest. This order of the TPO was appealed to the CIT (A), which was pending disposal ("Pending Appeal")
Consistent with its view for FY10, the TPO did the same re-characterization for FY11 as well. When the same was eventually appealed before the Tribunal, it was remanded back to the assessing officer ("AO") / TPO for fresh adjudication depending on the outcome of the Pending Appeal. The Tribunal noted that the instant transfer pricing addition has its foundation in the immediately preceding FY10 in which a similar re-characterization was done, and until the disposal of the Pending Appeal, the Tribunal is handicapped to independently decide the issue for the subsequent FY11.
The Taxpayer however took the matter to the Delhi High Court to obtain necessary orders directing the Tribunal to decide the matter pertaining to FY11 without waiting for disposal the Pending Appeal. The Delhi High Court was of the opinion that the Tribunal need not have felt constrained by Pending Appeal and could have proceeded to decide the issue on merits since it did not involve elaborate fact finding. Accordingly, it directed the Tribunal to rule on the issue without waiting for disposal of the Pending Appeal. During this time, the TPO pronounced a similar order for FY12, against which also the Taxpayer filed an appeal. Finally, both the appeals, pertaining to FY11 and FY12 were clubbed for adjudication by the Tribunal.
Ruling of the Tribunal
To begin with, the Tribunal summarized the TPO order as follows: the TPO held that although the investment was made in the form of subscribing to RPS, in substance it was a deemed loan. It was structured in this manner merely to avoid taxes on the interest income earned in India. Such a conclusion was reached by the TPO based on certains terms of the RPS including but not limited to (i) The RPS were eligible for NIL preference dividend (0% Coupon Rate); (ii) the amount was invested on October 28, 2009, but the corresponding RPS were allotted on November 5, 2009; (iii) redemption of some RPS were done prior to the minimum period contemplated in the terms; (iv) the Taxpayer had obtained a loan of a similar amount from SBI Bank on the same date it invested it into CIHL etc.
Further, in coming to this conclusion, the TPO relied on the OECD guidelines, 2010 pertaining to ALP adjustment ("OECD Guidelines"). The relevant excerpt from the said OECD Guidelines which was relied upon provides that there are two circumstances under which tax authorities should be able to re-characterize structures, namely (i) where the economic substance of a transaction differs from its form; and (ii) where the form and substance of a transaction viewed in their totality would differ from those which would have been adopted by independent enterprises behaving in a commercially rationale manner.
After perusing the TPO order, the Tribunal noted that Companies Act, 1956 ("Companies Act") provides for two kinds of share capital, namely preference and equity share capital.2 Further, it provides that no such share capital shall be redeemed except out of profits of the company which would otherwise be available for dividends or out of proceeds of a fresh issue of share capital made for the purpose of redemption.3 In referring to these provisions, the Tribunal implied that as per the provisions dealing with RPS, it has attributes of share capital only and cannot therefore be classified as loans.
In addition to the aforementioned, the Tribunal relied on the following judgments to rule in favour of the taxpayer, i.e. RPS cannot be re-characterized into loans for the purposes of arm's length adjustment.
- Delhi High Court judgment of EKL Appliances4 where it was noted that the significance of the OECD Guidelines that deal with re-characterization lies in the fact that it should be done sparingly and only in exceptional cases. The court also noted that it is of further significance that the OECD Guidelines discourage re-structuring of legitimate business. This judgment also referred to several Supreme Court judgments which held that the test of commercial expediency should be examined from the point of view of the businessman and not the Revenue.5
- Delhi High Court Judgment of Globe Engineering and Foundry Co Ltd. v. Industrial Finance Corporation of India6 wherein it was categorically held that: "The Preference Shares are really part of the company's share capital, they are not loans."
- Sahara India Real Estate Corporation Limited & Ors. v. SEBI7, the Supreme Court was faced with the question of whether 'hybrid' instruments such as Optional Fully Convertible Debentures ("OFCDs") should constitute 'securities' as per the provisions of the Companies Act and SEBI Act, 1992 ("SEBI Act") for them to be governed by the relevant provisions of these statutes. With respect to the Companies Act, the definition of 'securities'8 includes 'hybrids.' As regards the SEBI Act, the term 'securities' is not defined and terms undefined under SEBI Act but defined under the Securities Contracts Regulation Act,1956 ("SCRA") would be attributed the meaning given under SCRA.9 Under SCRA, section 2(h) defines 'securities' to include 'shares, scrips, stocks, bonds, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporate'. The Supreme Court held that since the term 'hybrids' has been defined10 to mean 'any security having the character of more than one type of security' and since they are transferable and hence 'marketable', they should fall within the ambit of 'other marketable securities of a like nature'. Based on the above, the Supreme Court noted that 'hybrid' instruments constitutes 'securities' for the purposes of the Companies Act, SCRA and hence the SEBI Act. By relying on this judgment, the Tribunal concluded that RPS, being 'hybrid' instruments should constitute 'securities' and should hence not be characterized as loans / advances.
- Pune Electricity Supply Co. Ltd. v. CIT.11 In this judgement, the Supreme Court relied on the 'Real Income' theory which means 'profits arrived at on commercial principles subject to provisions of the Income Tax Act'. It held that profits and gains should be true and correct profits and gains, neither understated nor overstated. In doing so, it placed a limitation on addition of notional income. It specified that ALP adjustment which results in addition of notional income should only take place in exceptional circumstances to correct distortion and shifting of profits to tax the actual income earned by a resident / domestic AE. The Tribunal also relied on other similar judgments12 to highlight that the rationale of the transfer pricing provisions13 is not to tax any notional income but to ensure that the real income is brought to tax.
This is certainly a welcome ruling in several aspects. It strikes at the principle that Specific Anti-Avoidance Rules ("SAAR") such as transfer pricing should be only applied sparingly and should not deviate from the 'real income' theory which provides that only actual profits and gains should be considered income chargeable to tax. Tax authorities tend to exercise wide powers by using SAAR without carefully analyzing the thin line between prevention of tax avoidance and violation of the real income theory.
The ruling also reiterates, based on precedents, that tax authorities cannot interfere with legitimate business decisions which have commercial objectives. It specifies that arm's length adjustment / re-characterization of income should be done sparingly and in exceptional circumstances where avoidance of tax is glaring. It also clarifies that 'hybrid' instruments such as OFCDs, RPS, CCDs etc are all securities and cannot be categorized or considered as a loan. The tribunal appears to have taken an approach that since it was possible for such instruments to be issued without being considered a loan, it would be incorrect to re-characterize them.
With the newly introduced GAAR, this ruling has come about as a much needed reminder to the tax authorities on the restrictions placed on their powers, especially from the viewpoint of respecting business decisions and the form of the transaction. GAAR is usually considered a wide power, almost akin to a residual clause, to question the form of any transaction. However, tax authorities should look closely at the powers to re-characterise transactions under the GAAR provisions before exercising the same. The powers to re-characterise transactions is allowed only in limited circumstances and as pointed out in this case, questions in relation to what can be considered debt or equity remains unclear, which may further limit the power of the tax authorities. While the specific facts of this case may have convinced the court to rule in the taxpayer's favour, since the initial redemption was allowed by the tax authorities without question, in future cases even minor differences in the factual situation could potentially lead to a different outcome. Further, when SAAR is applicable, there is inadequate clarity on to what extent GAAR could also be applied, for instance in the present case, if the court has ruled that SAAR would not apply, could the tax authorities resort to GAAR in the alternative?
Taxpayers need to be vigilant since the one thing that is clear is that tax authorities would be seeking to exercise larger powers vested in them under the GAAR provisions. All commercial rationale for a transaction should be documented on the assumption that the matter may be picked up for scrutiny by the tax authorities and litigated in the future. Such questions are likely to come up more in the near future, atleast till such time that the law is settled by the Supreme Court.
1 ITA No. 1459/DEL/2016 & ITA No. 263/DEL/2016
2 Companies Act, 1956. Section 80
3 Companies Act, 1956. Clause (a) of proviso to section 80(1).
4 345 ITR 241
5 CIT v. Walchand & Co.[(1967) 65 ITR]
6 44 Comp. Cases 347
7 Civil Appeal no. 9813 of 2011 with Civil Appeal No. 9833 of 2011 (SC)
8 Section 2(45AA)
9 Securities Contracts Regulations Act, 1956. Section 2(2).
10 Companies Act, 1956. Section 2(19AA)
11 CIT 57 ITR 521.
12 Ramgreen Solutions Pvt. Ltd. v. CIT, 377 ITR 533
13 Income Tax Act, 1961. Sections 92 to 92F
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