THE Bombay High court in its landmark judgements in Vodafone India & its sequel in Shell India (both emanating from Writ Petitions) held in unequivocal terms that the transaction of issuance of equity shares cannot be subject to transfer pricing adjustments as enshrined in Chapter X of the Income tax Act, 1961 (Act), in the absence of an element of income present in the said capital transactions. Observations of the court relevant for the purpose of this article are summarised below:

•  Chapter X does not replace the concept of income or expenditure.

•  The object of the chapter is to ensure that the profits or losses from an international transaction are appropriately 'computed' as per arm's length principles.

•  Equity financing is a 'capital receipt' and not taxable even under the inclusive definition of 'income' under the Act. Share premium on equity financing has been made taxable only w.e.f. 01.04.2013 by the Finance Act, 2012 and therefore cannot be construed as income in the absence of a charge.

•  Chapter X is a machinery provision. Measurement of income is undertaken on application of Chapter X. But it must be remembered that measurement or re-computation can be carried out only when income arises from an 'international transaction'.

The Court was examining two international transactions which were identified by the Transfer Pricing Officer - (i) Deemed loan on account of subscription of equity shares below a fair price quantified to the extent of the shortfall in the subscription price (Deemed loan); and (ii) Imputation of interest income on such deemed loan (Imputed interest). While both the decisions discussed the first issue at length, the second issue was decided in favour of the assessee, more as a consequence rather than on an independent analysis. Moreover, the High Court did not categorically hold that the transaction is NOT an international transaction. The High Court did not completely examine the implications subsequent to the introduction of section 56(2)(viib) in the statute. This article proceeds to examine these open issues with reference to a very recent decision of the Tribunal in case of First Blue Home Finance Ltd. v. DCIT 2015-TII-378-ITAT-DEL-TP.

1. Interest on deemed loan

Section 92(1) of the Act applies the transfer pricing provisions with the primary objective to determine the 'income arising' from international transactions having regard to the arm's length price. The phrase income arising has been italicised by the author in view of the emphasis it warrants in the said provision.This is in view of the pre-requisite of a charge/ taxable event necessary for application of machinery provisions - section 5 requires that income should 'accrue or arise or be received' for income tax to be payable on any income. Once the charge is triggered, the income should be computed (i.e. the measure for income tax) in accordance with the provisions of the Act, which includes the transfer pricing provisions under Chapter X. The other point that requires attention is that the Act clearly distinguishes between an 'international transaction' and the 'income that arises' from the international transaction. While a transaction may be classifiable as an international transaction, it is not always necessary that an income will accrue or arise from such an international transaction.

With this background, let us examine whether the High Court delved into these aspects while examining the facts or the issue is still res integra. The High Court rightly set aside the transfer pricing adjustment on the Deemed loan on the basis that the transaction was a capital receipt by itself and hence cannot be termed as 'income' u/s 2(24) of the Act. On the imputed interest, the High Court in Shell India stated that as a consequence, the deemed interest 'not received' would also not be subject to ALP determination. With due respect, can one say that the High Court has been slightly complacent by making the issue on deemed interest sound so simple.

Admittedly the deemed loan cannot be subjected to transfer pricing. The High Court did not state that the transaction is not an 'international transaction'. The High Court did not also state that the transaction is not a deemed loan (or a loan in substance). Assuming for the sake of clarity that the High Court, on facts held that the transaction is a deemed loan, the question that would arise is whether the imputed deemed interest can still escape transfer pricing? In the author's view there the answer is not as simple as portrayed by the Hon'ble Court.

An International transaction should be distinguished from the income that arises from such international transaction. While a transaction may get classified as an international transaction, having a bearing on assets of an enterprise, it may not always have the feature of resulting in an income chargeable to tax under the Act. Equity financing is a classic example of such a transaction. On the other hand, where the deficit in equity financing is held to be in the nature of a debt advanced to the shareholder, the deemed loan could necessarily have an element of income arising to the assessee (in the form of an interest) for transfer pricing purposes. Revenue can take the argument that the deemed loan rightly entitles the assessee for an imputed interest,which should be computed with reference to the arm's length price.

The Tribunal in Blue finance case (supra) was faced with such a situation and made an observation, which could have repercussions on taxability of the imputed interest, though the Tribunal ultimately followed the Shell India case. The Tribunal observed that:

"9. On going through the above extracted observations of the Hon'ble Bombay High Court, the overall ratio of the entire judgment can be culled out that though the international transaction on capital account itself would not lead to generation of any income because of the transfer pricing adjustment, but the international transaction on capital account, which impacts income, such as, under reporting of interest or over reporting of interest paid or claiming of depreciation etc. is required to be adjusted to the ALP price, which is not a tax on the capital receipts. The effect of this judgment on a holistic basis is that though the international transaction on capital account per se cannot call for any addition on account of transfer pricing adjustment because of the absence of any provision under the Act charging income from such transactions, but the transactions flowing out of such original transaction on capital account, having impact on the profitability of the assessee, would be required to pass the mandate of Chapter-X of the Act."

The Tribunal, as an obiter, went ahead to give an example of an import of a capital asset, which after a transfer pricing adjustment, would result in the re-computation of the depreciation claim on purchase of the capital asset. Applying this analogy, while the transaction by itself may not result in the income to the assessee, the natural consequence (such as interest to the assessee) of such a transaction would have an impact on the income of the assessee and result in invocation of transfer pricing provisions to such income. This aspect of the transaction was not addressed and hence there is every risk of this being subject to the rigours of transfer pricing provisions even after the High Court's decision.

2. Introduction of section 56(2)(viib)

The allegation of the Revenue in the aforesaid cases is that the assessee had under-priced the equity share issue. The High Court was examining a period prior to the introduction of section 56(2)(viib). Would the answer be different had the provisions of section 56(2)(viib) come under consideration by the High Court? Section 56(2)(viib) was introduced only for specific cases of issuance of shares to residents by closely held companies. More importantly, the section seeks to tax issuance of shares at a price in excess of fair market value rather than below the fair price. Therefore the presence of section 56(2)(viib) should not have an impact on such equity financing transactions.

3. Consequence of non-reporting equity/ capital financing transactions

As stated above, the High Court did not categorically state that the transaction is not an international transaction - understandably in view of the retrospective insertion of capital financing in the definition of 'international transaction' by Finance Act, 2012. Therefore by implication, the transaction of equity financing continues to be an international transaction having a bearing on the assets of an enterprise (as observed by the Tribunal in First Blue Home Finance Case). Does this mean that even though an international transaction may not result in any income to the assessee, it requires reporting under the provisions of section 92D and 92E of the Act. In the Shell India case,the revenue did raise this factual point of non-reporting of international transactions. The High Court held that the fact the assessee chose not to declare the share issue in the Form 3CEB on the understanding that it falls outside the scope of Chapter X (a stand now vindicated in the Vodafone case). This would not give jurisdiction to the revenue to tax a transaction, which is otherwise outside its jurisdiction. But the consequence of non-reporting as provided in the Act would follow.

Does this imply that the assessee is amenable to the risk of penalty proceedings under the provisions of section 271AA and 271BA for non-reporting or failure to maintain documentation or non-certification of international transactions?One view would be that the Act should be given a purposive interpretation and not a literal interpretation especially where literal interpretation leads to absurd results - i.e. when a transaction itself is outside the ambit of Chapter X, the application procedural requirements would serve no purpose and no mala-fide could be present where the entire exercise is revenue neutral. The other view is that the obligation of reporting is distinct from the taxability of a transaction. The legislature is not bound to limit its scope of examination to taxable transaction only. The legislature have wide powers to place an obligation for reporting non-taxable transaction in the overall interest of revenue and the assessee would be restrained from challenging such obligations on the grounds of legality or constitutionality. Both views are plausible and we have to wait for a resolution from the Courts for a firm view on this to emerge.

In summary, though the High Court has settled the dust on the applicability of transfer pricing on equity financing transaction, the surrounding issues on application of transfer pricing provisions to certain natural consequences of such transaction would still face scrutiny and debate in legal fora. Moreover, non-applicability of transfer pricing does not automatically relieve the assessee from the burden of reporting and documenting this transaction and it is always advisable to adopt the approach of proactive reporting to establish bonafides at higher judicial fora.

(The author is Principal Associate, Lakshmikumaran & Sridharan, Attorneys)