Share valuation: Foreign investors step into taxing times

Developments in the Indian tax landscape over the last couple of years are sure to leave anyone confused. While the Vodafone ruling brought cheer to investors, the subsequent retrospective amendment and tax authorities’ insistence on recovering demand created a huge furore. However, the Shome Committee’s report and assurances by the Prime Minister and Finance Minister signalled steps towards restoring investor confidence.

Another measure was the introduction of the Advance Pricing Agreement (APA) regime for transfer pricing issues. The tax authorities’ positive and open approach vis-à-vis APAs has encouraged taxpayers to explore this route. However, there follows a reality check, challenging the optimistic outlook towards tax policy and the general investment climate.

The case in point is the recent transfer pricing adjustment suffered by many taxpayers, including Shell and Vodafone. Besides being high-stake adjustments, the nature of the issue and the approach of tax officers have evoked sharp reactions from taxpayers and tax practitioners.

The tax authority questioned the valuation of shares issued by taxpayers to associated companies. The share price was alleged to be below arm’s length price. Normally, that would not warrant adjustment to the income of the taxpayer. However, the authority went a step further to treat the under-valued part of the share price as an unsecured loan, extended by the taxpayer to its associated company, and imputed interest on the same. The income of the taxpayer is then adjusted upwards to reflect notional interest income.

In essence, money not brought in is being treated as money lent to an associated company — without an actual loan extended. The authority used transfer pricing provisions to tax income which is in the realm of fiction.

Furthermore, from media reports it appears that in some cases the entire amount of alleged undervaluation is being taxed. From an income tax standpoint, the undervalued share capital should not have any impact on the income, and adjustment on that count seems highly unlikely. It would be interesting to see the reasoning behind this seemingly absurd adjustment.

From a taxpayer’s perspective these adjustments would have a recurring impact. Once the undervalued capital is treated as a loan, the imputation of interest would continue. With no recourse to square off the alleged loan, the hardship gets compounded. On the other hand, there is no corresponding cost adjustment as far as the shareholder is concerned. From a group’s standpoint, it is a double whammy.

Besides the merits of the adjustment, the manner in which such issues are presented to the taxpayers is also disappointing. There has been a spurt of notices, making this an issue with wide ramifications. An issue such as this should have been raised and discussed with all stakeholders, and guidance provided. Though not a mandate of law, it is a desired practice. Instead, the adjustments seem motivated by a need to meet revenue targets. Although appellate proceedings may ultimately vindicate the taxpayer’s position, they can be costly and time-consuming. This does not bode well for the investment climate, especially when the leadership is inviting investments.

It is the tax administration’s job to implement the policy, and it has every right to collect taxes and protect the tax base. However, the process needs to be more inclusive in order to be sensitive to the concerns of the business community. This will help bridge the trust deficit between authorities and the business community, and build investor confidence.

Arun Chhabra is a chartered accountant

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