Preventing tax erosion

Transfer Pricing provisions (Sections 92 to 92F) were inserted in the Income Tax Act, 1961 (Act) to curb avoidance of tax so that profits chargeable to tax in India do not get diverted elsewhere leading to erosion of Indian tax revenue by providing that income arising from an international transaction shall be computed having regard to Arm's Length Price (ALP).

For applying such law, the transaction has to be between two ‘associated enterprises.' Transaction has been said generally to include an arrangement, understanding or action in concert.

The word ‘enterprise' has been exhaustively defined in s.92F (iii), which, inter-alia, includes any activity relating to product, storage, supply, distribution, acquisition or control of articles or goods, provision of services, etc.

An ‘enterprise' is to be regarded as an ‘associate enterprise' if it is, amongst others, in control of capital of the other enterprise.

Holding and 100 per cent subsidiary company would be ‘associated enterprises' coming technically within the purview of transfer pricing provisions. This view has also been judicially confirmed. The issue that is proposed to be examined in later discussion is whether this is fair and should continue and would not amount to excessive taxation of oneself.

Holding and subsidiary companies

Though the holding and wholly-owned subsidiary companies have separate legal entities, the importance of their relationship lies mainly in preserving operational identity, shareholders' control over each other and in the obligation to attach subsidiary's balance sheet, profit and loss account, Directors' and Auditors' report and statement showing holding company's interest in the subsidiary company to the balance sheet of the holding company.

Subsidiaries of holding companies are generally managed as if they are the departments of holding companies though in law these are treated as independent legal entities.

However, for certain purposes, the Companies Act treats the holding and subsidiary companies as though they are single companies (see Sections 229, 230, 236, 239 & 741 of the Companies Act, 1956). Thus, where a company has pervasive control over the other company, the subsidiary company is nothing but an instrumentality, rather part of the holding company. The two, in such an event, have to be treated as one enterprise. Obviously, it would be wrong to apply transfer pricing provisions in such situations as being between two separate entities.

Under the I-T Act, in the taxation of capital gains, vide Section 47(iv) & (v) of the Act, the oneness of holding and subsidiary companies has been recognised. These provisions stipulate that there would be no charge of tax on capital gain arising on transfer of capital assets between holding and subsidiary companies in the following circumstances:-

47(iv) [a] The parent company or its nominees hold the whole of the share capital of the subsidiary company; and

[b] the subsidiary company is an Indian company

47(v) Any gain arising on transfer of a capital asset by a subsidiary to the holding company will be exempt from tax if

[a] The whole of the share capital of the subsidiary company is held by the holding company; and

[b] the holding company is an Indian company.

Thus, in principle, the identities of holding and wholly-owned subsidiary companies have been considered to be identical. There seems to be no obvious ground for differentiation in such a matter between the Indian and foreign companies and providing for exemption in the cases of only Indian companies.

No tax avoidance

In the cases of holding and wholly owned subsidiary companies, the issue of tax avoidance, the menace for which transfer pricing provisions have been enacted, is also not there as the whole of the distributed profits (dividends) of the subsidiary company come to the Indian holding company and do not get diverted to any outside assessee.

Hence, according to the legislative intent also, such companies need to be kept outside the purview of transfer pricing provisions.

A mere mechanical interpretation of the words devoid of concept of purpose cause unintended hardship. As stated by Mr Iyer J., to be literal in meaning is to see the skin and miss the soul.

The judicial key to construction is the composite perception of deha and dehi of the provision [AIR 1979 SC 1802]. A literal and mechanical construction needs to be disregarded if it conflicts with requirement of justice and fairplay.

Hence, the policy of application of the transfer pricing provisions in the cases of holding and wholly owned subsidiary companies needs re-consideration.

(The author is a former chairman of CBDT.)

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