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Taxing foreign investment- the final straw for multinationals?


This article was also published in Thomson Reuters' Practical International Tax Strategies, 31 August 2013

The recently ended fiscal year saw the Indian Revenue hand out tax bills, ranging from a modest million dollars to over a billion dollars. Taxand India investigates these developments and their impact on the way India is viewed in the global market.

These bills were distributed to a selection of multinationals’ Indian subsidiaries for alleged tax avoidance through undervaluing shares issued to their foreign parent entities. The aggressive stance of the Indian tax authorities once again drew the attention of the international business community, with impacted MNCs reacting strongly to the tax audits by taking legal action, as well as by approaching senior government officials.

The Indian Revenue has alleged that Indian subsidiaries of the MNCs are avoiding taxes by undervaluing shares issued to overseas parent/group entities. Invoking transfer pricing provisions, the tax authorities have disputed the methodology used and/or earnings estimated by the Indian subsidiaries to price the issuance of shares which historically complied with Indian foreign exchange laws. Substituting their own earnings estimates and assumptions for valuing shares, the officers have computed significantly higher values than the one computed by the taxpayers in question; such differences have been considered a “receivable” from the foreign entity. A notional interest computed on such alleged receivable was deemed taxable by the Tax Authorities. Even more surprisingly, in many cases, the alleged receivable itself has been added to taxable income in the hands of the Indian entity.  

The transfer pricing provisions have also been invoked in case of buy-backs by Indian subsidiaries of existing shares from overseas parent companies. In the case of a buy-back, the Revenue authorities have alleged overvaluation of shares and held that the excess amount paid to shareholders is refundable to the Indian subsidiary. Interest on such excess amount, allegedly refundable, has been added to the taxable income of the Indian subsidiary.

Impact on MNCs
Discounted cash flow valuation, being a matter of subjective opinion, is highly dependent upon estimated future earnings, growth perceptions and discounting factors used. The aggressive approach from the tax authorities creates an enormous potential for disputes on share pricing resulting in effectively taxing the investment itself (ie bringing into the tax net an item that is capital by nature). In fact, the tax impact is on a fictional investment amount never even received by the Indian subsidiary. Since the alleged ‘short receipt’ of these share prices cannot be provided, the interest adjustments become perpetually recurring. This is similar to the case with excess amounts alleged to be paid on buy-back of shares.

The Revenue’s action has not only alarmed the impacted MNCs, but also created a feeling of uncertainty in other organisations with new investments in India. Several MNCs have placed caution on fresh equity injections to Indian subsidiaries and many are adopting a “wait and watch” approach. The actions of the tax office, in the already stressed investment environment, are being illustrated as another instance of extreme tax adversity and reckless hostility.

The audits have been challenged by the taxpayers in the ordinary tax dispute manner, and also in the form of direct writs to higher courts, a remedy available under the Constitution of India. 

Your Taxand contacts for further queries are:
Abhishek Goenka
T. +91 80 4032 0000

Anurag Jain
T. +91 124 339 5254

This article was also published in Thomson Reuters' Practical International Tax Strategies, 31 August 2013

Taxand's Take

The Revenue’s stand is blatantly misplaced. The domestic tax laws do not permit capital receipts to be taxed as income (other than some specific exceptions). Bringing to tax such capital receipts in the garb of transfer pricing is certainly legally unsustainable with the law as it presently stands. In the absence of enabling provisions in domestic transfer pricing law to make secondary adjustments, the addition of notional interest on a hypothetical receivable is also beyond the competence of the Indian tax authorities. It is hoped that the Indian judiciary, which reinforced belief in its independence with the 2012 Vodafone verdict, will again have to come to the rescue of the shocked taxpayers against the unwarranted action of the tax collector.

Meanwhile, MNCs should have robust valuation reports supporting the issuance price of shares. These should be supported by strongly defensible projections and sustainable valuation parameters and factors, to help keep the adjustments to the minimum, should the Revenue choose to investigate.

Taxand India is currently involved in defending the largest transfer pricing adjustment in this context that has been triggered in India so far. 

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