Foreigners must be in awe of the abilities of the Indian government, particularly its uncanny ability to identify transactions that it believes it must tax. In recent weeks, several controversial transfer pricing tax assessments have hit the headlines. Transfer pricing orders have hitherto concentrated on revenue items such as advertising and marketing expenses. Last year, however, one of the key items was differentials in the interest rates of inter-corporate loans. Reportedly, that has this year led to additional trouble. For, if some equity transfers are “mispriced”, then they can be treated essentially as a combination of equity transferred at the correct price and a mispriced loan — with a completely different tax structure that’s then applicable.
That’s what lies behind the tax authorities’ sudden interest in the pricing of share subscriptions. It appears that while bringing in investments, many foreign parents have issued shares at tiny premiums. In a listed entity, such share subscriptions by promoters are governed by pricing norms prescribed by the Securities and Exchange Board of India, which are based on the prevailing market price. But how to value unlisted companies? It must, after all, be done; across the world there is settled law on the subject, with the United States using an Internal Revenue Service memo more than half a century old as a guide. But in India, this process of valuation is what’s being thrashed out at the moment, with multinational corporations pushing back hard. Revenue officials insist they’ve used the discounted cash flow (DCF) method, plugging in variables from the directors’ letters to the firm under consideration — and that’s the method they have used to tell the Indian arms of foreign companies that they have sold shares well below their market value. The difference is being considered as a loan extended to the foreign arm, and their income subject to tax is adjusted to take into account interest that would have been chargeable. Companies complain the valuations at which they have subscribed to the shares have been certified by an “independent” valuer and the tax department has no grounds to challenge these. The problem, of course, is that a small variation in any DCF variable can lead to a huge swing in valuations; dispute resolution panel and tribunals will have to go into these assumptions on a case-by-case basis, since it is almost impossible to prescribe a universally applicable formula to determine these factors. This is, in fact, how valuations are managed across the world, so it wouldn’t be a worry — were tribunals not overpopulated with revenue service officers, unsympathetic to companies’ arguments.
The government, thus, claims it is taxing mispriced, hidden loans, not equity transfers. But how come it is interfering in transfers between two wholly owned companies, anyway? This is a product of tax laws that introduce an artificial difference between debt and equity financing even in such cases. This forces regulators (including the Reserve Bank of India) into determining the specific character of such transfers for tax or regulatory purposes. The 2012 Budget introduced an amendment specifically saying that “capital financing” was taxable by transfer pricing assessors — and the tax department officials now believe that share subscriptions are being tweaked to hide capital financing. It is, however, not clear why this specific amendment should also cover transactions between two wholly owned companies and why these companies did not seek an advance ruling from the revenue department with regard to their tax liability on account of such transactions. On its part, the government too should perhaps extend its credibility and capability when it comes to pricing complex transactions before becoming quite so ambitious.
