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In safe harbour, at long last
The Central Board of Direct Taxes recently issued final rules on transfer pricing
The Central Board of Direct Taxes recently issued final rules on transfer pricing 'safe harbours'. These are optional for a taxpayer and contain conditions and circumstances under which the transfer price adopted by the taxpayer would be accepted by the tax authority. The CBDT had earlier released draft safe harbour rules for public comments. The final rules were issued after considering stakeholder comments and addressing some of the concerns raised. The transfer price contained in the safe harbour rules will apply for five years from financial year 2012-13 and taxpayers may elect to be governed by the rules for all or any of the five years.
Taxpayers would need to evaluate the impact of these rules on their inter-company pricing arrangements and consider options for transfer pricing risk management.
'Subvention' payments are not taxable
In the case of the Handicrafts and Handlooms Export Corporation of India Ltd, the Delhi High Court ruled that "subvention" payments received from its holding company were not taxable.
The court held that the amount received was meant to recoup losses and not supplement its trading receipts. Accordingly, relying on the "purpose" test espoused by the Supreme Court in earlier rulings to determine whether a receipt is on capital or revenue account, the court held that the receipt was capital in nature and not taxable.
This decision reiterates that sums received voluntarily, enabling the ailing subsidiary to restore its net worth, recoup losses or protect the parent's investments in the subsidiary may be capital in nature and, accordingly, may not be taxable. However, taxpayers would need to separately evaluate the impact of such payments in computing book profits for Minimum Alternate Tax.
India-Australia tax treaty recast
The Government recently issued a notification bringing into force the protocol to amend the tax treaty between India and Australia, which was signed in December 2011. While the protocol comes into force from April 2, 2013, the notification mentions various dates on which specific articles of the protocol would be effective in India.
The protocol brings significant changes to the Australia DTAA (double taxation avoidance agreement), including an expanded definition of permanent establishment to cover furnishing of services, provisions related to exchange of information and assistance in collection of taxes. The protocol also introduces an article on non-discrimination in the tax treaty to prevent discrimination in tax treatment on a reciprocal basis under circumstances described.
The protocol is significant, given the large volume of trade between the two countries.
Is it royalty?
The Mumbai Income Tax Appellate Tribunal recently ruled on whether consideration for software payments was taxable as royalty. It held that payment for software licence under a standalone agreement, which was not integral to equipment purchase, would constitute transfer/ use of copyright and consequently taxable as royalty. While the tribunal agreed with the principles of earlier court rulings that payment for software embedded in equipment/ hardware may not be taxable as royalty, it distinguished these rulings on facts.
Characterisation of software payments as royalty or business profits assumes significance as royalty is subject to withholding tax, whereas business profits are typically not taxable in the absence of a business presence/ permanent establishment of the foreign enterprise in India. The contentious "software issue" is currently pending before the Supreme Court.
Service tax exemption for SEZs
The Government recently issued a new notification prescribing the conditions and procedures under which a Special Economic Zone (SEZ) unit/ developer can claim exemption/ seek refund/ claim credit of service tax paid on specified services received for their authorised operations.
Earlier, the concept of "wholly consumed" services under the Place of Provision of Service Rules 2012 was prescribed for claiming service tax exemption. It was incumbent on the SEZ unit/ developer to demonstrate that the services were wholly consumed within the SEZ. However, now the exemption is provided to specified services used "exclusively" for authorised operations of the SEZ. While the term 'exclusively' is still open to interpretation and remains untested, the substantive conditions for claiming the exemption appear to have been simplified. The onus of claiming exemption continues to be on the SEZ unit/ developer.
— EY
(This article was published on September 29, 2013)
ook at' or 'look through'?
Recent developments appear to suggest that tax authorities are going beyond conventional approaches in assessing taxpayers.
Recent developments appear to suggest that tax authorities are going beyond conventional approaches in assessing taxpayers.
Can a strategic sale of shares be classified as a sale of business because the sellers also handed over management responsibilities to the buyer? Can the inclusion of a non-compete clause from the sellers in the share purchase agreement (SPA) re-characterise the consideration as a business income, instead of capital gains? These questions arise subsequent to a recent judgement of the Punjab and Haryana High Court. This is expected to step up the level of controversy/ litigation between taxpayers and authorities.
Recently, the HC in the case of Sumeet Taneja, Supneet Kaur affirmed the ruling of the Income Tax Appellate Tribunal that sale of equity shares is effectively a sale of business and taxable as business income. The taxpayers, in this case, were promoters and directors of an Indian company, and they had, as part of the share transfer, agreed to (a) relinquish supervision and management of the Indian company; (b) hand over product database, customer support contracts, new client proposals, and so on; and (c) enter a two-year non-compete covenant restraining themselves from engaging in a similar activity. The HC eventually held such a transfer of shares as transfer of a business that resulted in business income. Generally, the domestic base tax rate for business income is 30 per cent, which is higher than the 20 per cent applicable to long-term capital gains.
The ruling seems at variance with several others, leading to uncertainty over the correct position in law. To begin with, it's a settled position that company and shareholders are distinct from each other. Secondly, the HC ruling seems to have overlooked the general principles laid down by the Supreme Court in Vodafone's case, which held that in the absence of abuse of corporate form, the Revenue Department/ Court should 'look at' the entire transaction as a whole and not adopt a 'look through' approach when ascertaining the legal nature of the transaction.
The apex court also held that, as a general rule, a transaction involving transfer of shares cannot be split into individual components, assets or rights such as the right to vote, right to participate in company meetings, management rights, controlling rights, control premium, brand licences and so on, as shares constitute a bundle of rights. The HC ruling does not seem to provide strong reasons for ignoring the legal form of the transaction (that is, transfer of shares). Lastly, even assuming that the transfer was business, it could be classified only as a capital asset resulting only in capital gains. But here the share sale has been re-characterised as business income.
The ruling also seems to have arisen from the inclusion of the non-compete element. A couple of Mumbai ITAT judgements involving similar transfer of shares together with a non-compete clause did not allow splitting the composite consideration between sale and non-compete covenant. However, the HC seems to hold the entire consideration towards non-compete.
Strategic share transfer deals are generally likely to have covenants in their agreements similar to those listed in the HC ruling. Hence, the ruling (unless reversed by the Supreme Court) could increase the controversy/ litigation between taxpayers and authorities.
Several tax controversies related to merger-and-acquisition deals have been making headlines in recent times. These developments appear to suggest that the tax authorities are going beyond conventional approaches in assessing taxpayers. As laws in India undergo reforms, it is imperative that clarity, consistency and certainty emerge in the overall tax regime.
Sriram Krishna senior tax professionalcontributed to the article
(The author is Tax Partner, EY)
A landmark in Indian corporate history
There are close to one million registered companies in India and, therefore, strong company legislation is imperative. Picture: Bloomberg
As corporations increasingly access global pools of financial and human capital, partner with vendors on mega collaborations, and are required to function in harmony with the community, corporate governance becomes imperative.
India is close to having one million registered companies, and the need for a strong company legislation is even greater. The new Companies Act intends to bring governance standards on par with those in developed nations through several key provisions, such as composition and function of Board of directors, code for independent directors, performance evaluation of independent directors, class action suits, auditor rotation and independence, and establishment of Serious Fraud Investigation Office.
Board of directors
The Act recognises the Board as a key component and entrusts it with significant responsibilities for strong internal controls and risk management.
Besides the audit committee, listed and prescribed class of companies should constitute the nomination and remuneration committee and stakeholder relationship committee. The Act stipulates appointing at least one woman director in listed and prescribed class of companies.
Independent directors
The concept of independent directors has been introduced for the first time in the Companies Act.
The Act lays down the qualification, code of professional conduct (includes assisting companies in implementing best corporate governance practices), performance evaluation mechanism, and duties of independent directors. Independent directors will now have greater responsibility to ensure a vigilant and active board.
While this is a welcome step, there may be an element of subjectivity when enforcing compliance.
Class action suits
The concept of class action suits is prevalent in countries like the US and the UK. The Companies Act now allows a requisite number of members or depositors or any class of them to file an application before the National Company Law Tribunal (NCLT), if they feel that the company's affairs are being conducted in a manner prejudicial to the interests of the company, its members or depositors.
The average value of a settlement in the US in the first half of 2012 was $71 million — a sharp rise from $46 million during 2005–2011. Major allegations in the suits included operational shortcomings/ product defects (45 per cent), followed by accounting, breach of fiduciary duty, and customer/ vendor issues.
Audit and auditors
Auditor rotation has been made mandatory for listed and prescribed class of companies. Severe penal provisions have been introduced to enforce compliance. Most countries do not have mandatory rotation of audit firms, even as they mandate the rotation of audit partners. Regulators in the UK, the US, and Germany have discussed the topic in the past, but concluded that the potential benefits of mandatory rotation do not outweigh the risks and costs.
Fraud Investigation
The Government shall establish a Serious Fraud Investigation Office (SFIO) for companies, and stringent penal provisions have been defined for fraud-related offences.
In summary, the Act is a landmark development in the Indian corporate landscape. The impact of the new pronouncement should not be underestimated, and companies and other stakeholders should start evaluating the implications and act swiftly.
The Ministry of Corporate Affairs will have to proactively issue circulars and clarifications to ensure the act is implemented in the right spirit.
(The author is Partner and Leader – Risk Advisory Services, EY)
Capital gains vs. interest
The characterisation of additional payments received as interest or capital gains has been a vexed issue.
Open offers and buybacks have been an integral part of capital market activity. Often, there are delays in the completion of open offer formalities, resulting in payment of additional consideration, which is computed as 'interest' under Securities and Exchange Board of India regulations.
Should the additional compensation be treated similar to the original consideration (that is, capital gains/ business income, depending on whether the security is held as investment/ business asset), or should it be treated as interest and taxed accordingly?
Interest income is typically taxed at a base rate of 30 per cent for Indians and 40 per cent for foreign companies, whereas long-term capital gains are taxed at 10 per cent or 20 per cent depending on the class of investors and the type of transaction, that is, off-market transaction. For foreign investors, capital gains on sale of Indian securities may be exempt from tax in India under the relevant tax treaty.
Recently, the Mumbai Income Tax Appellate Tribunal, in the case of Genesis Indian Investment Co Ltd, dealt with this issue. The SEBI-registered foreign institutional investor had made portfolio investments in Indian capital markets. It, inter alia, held shares of Castrol India Ltd.
Following British Petroleum's announcement to acquire Burmah Castrol Plc (which held shares in Castrol UK), under Indian regulations BP had to make an open offer to acquire 20 per cent of Castrol India's share capital. BP sought exemption from SEBI, but subsequently withdrew its application. Due to this, and other litigation, the public offer to buy back Castrol India's share capital was delayed. Eventually, Castrol UK was held liable to pay 15 per cent interest on the offer price, from the date on which the offer was made to the date of actual payment to shareholders.
Genesis Indian Investment tendered its shareholding in Castrol India under the open offer and received additional compensation (above the offer price/ sale consideration). Indian revenue authorities characterised this compensation as 'interest' and taxed it accordingly.
The Mumbai tribunal observed that the compensation was a part of the sale consideration and, relying on the Supreme Court's decision in the case of Govinda Choudhary, held that it should be taxed as capital gains. The tribunal further observed that the key differentiating factor is whether the interest is paid for delayed payment after the debt has crystallised, or for the period before that.
Genesis Indian Investment received additional compensation for the delay in completing the open offer formalities prior to the date of tender/ acceptance of shares. As it was not for paying the determined consideration after the purchase/ sale transaction, it constituted a part of the sale consideration.
The characterisation of additional payments received as interest or capital gains has been a vexed issue, with divergent judicial decisions. The Mumbai tribunal's decision is a welcome one — it is driven by the facts of the case, and analyses the issue in the correct perspective, without merely looking at the nomenclature of the payment.
(The article uses base tax rates; surcharge and education cess apply)
Jesal Mody, senior tax professional contributed to the article.
(The author is Associate Director – Tax and Regulatory Services, EY)
A new chapter in M&A accounting
BL The new company law prohibits the creation of treasury shares in a merger and acquisition scheme.
The new company law prohibits the creation of treasury shares in a merger and acquisition scheme.
Many companies use merger-and-acquisition schemes to restructure business for reasons ranging from unlocking valuation, rationalising operations and tax benefits to splitting the family wealth. Historically, companies have also used them to clean up balance sheets.
Some companies, for example, have used them to write off expenses or impairment loss directly against the securities premium or other reserves, instead of charging them to profit and loss. This helped present a better P&L and EPS (earnings per share).
To address these anomalies and ensure compliance with accounting standards, listed companies since April 2010 are required to submit an auditor's certificate stating that the treatment in an M&A scheme complies with accounting standards.
For non-listed companies, the responsibility to ensure compliance rested with the Regional Directors/ Registrar of Companies. Under the new Companies Act, the National Company Law Tribunal will not sanction any M&A scheme unless the company's auditor certifies compliance with accounting standards.
Hence, all companies, including non-listed, should comply. This will significantly reduce the opportunities for balance sheet clean-up available to non-listed companies.
However, some opportunities may still be available. For example, no standard prohibits adjustment of debit balance in P&L against the securities premium, if the adjustment is directly through balance sheet transfer.
Certain schemes, previously sanctioned by courts, allow departures from accounting standards not only at the appointed date, but also going forward. For example, a court scheme may have permitted write-off of goodwill impairment/ amortisation for the next 10 years directly against reserves rather than through P&L. It may be argued that the new Act applies only to new schemes approved after its enactment and not earlier.
Another area where the new Act may significantly impact M&A accounting is treasury shares. Under the old Act, companies have used M&A schemes to invest in own shares (treasury shares).
Some companies with treasury shares recognise the dividend income and gain/ loss arising on sale of these shares in P&L. The new Act prohibits the creation of treasury shares in an M&A scheme and, hence, these practices will cease. As the new Act is silent on treasury shares previously held by companies, the restriction will seemingly apply only to new treasury shares.
Currently, no notified accounting standard deals with demerger accounting. The draft rules uploaded online by the Ministry of Corporate Affairs on September 20, 2013, contain specific guidance on such accounting.
The draft rules propose that accounting will follow the conditions stipulated in section 2(19AA) of the Income-tax Act. The demerged company will transfer assets and liabilities at book value. It will recognise the difference between the value of assets and liabilities as capital reserve/ goodwill. The resulting company will recognise assets and liabilities at book value. Shares issued will be credited to share capital account. The excess or deficit will be recognised as capital reserve/ goodwill.
While one appreciates the concern arising from the absence of specific guidance on demerger accounting, it is incorrect to prescribe accounting based on the Income-tax Act requirements.
Accounting treatment should be governed by accounting standards. Also, the draft rules assume a very simple example of demerger to prescribe accounting. In practice, it may involve complex structures. Moreover, the accounting proposed is restrictive and limited.
To illustrate, for a demerged company, treating the difference as goodwill/ capital reserve is one option.
Other possibilities not discussed include treating it as investment in the resulting company or as substance distribution to shareholders. Similarly, for the resulting company, it may be possible to use AS-14 analogy and apply the pooling of interest method. This results in adjustment of surplus or deficit to reserves. The Corporate Affairs Ministry should revisit the matter.
(The author is a senior professional in a member firm of Ernst & Young Global)
(This article was published on September 29, 2013)
A fine balance
The notified GAAR strikes a fine balance between the need for foreign investment flows and the legitimate demands of the Indian exchequer.
The Government has taken the right step in postponing the enforcement of the General Anti Avoidance Rules to 2015-16. Foreign investment flows are critical at this juncture given the precarious state of the country's external account. India's current account deficit of $21.8 billion in the June quarter was partially bridged with the help of increased foreign direct investment inflows. The currency too slid to record lows as sentiment towards the entire emerging market equity and debt assets is dampened by fears that reduced liquidity — when the Federal Reserve begins tapering its quantitative easing program — will erode the value of assets. Against this backdrop, this is hardly the time to stir the hornet's nest by implementing the anti-avoidance rules.
That said, the rules notified do not sacrifice the interest of the Indian exchequer. The fine print reveals that the days when foreign investors were allowed to get away without paying any tax on profits made in India are over. Despite GAAR taking effect only from April 2015, all tax benefits earned after August 2010 will come under scrutiny. As a result, so will foreign institutional investors who are already routing their investments in Indian equity through off-shore tax havens. The government has also not back-tracked from its stance on tax residency certificates being 'essential but not sufficient'. Brass-plate firms will now have to provide evidence regarding the ultimate owner of the funds. FIIs using tax havens will now have to find an alternate (read: legitimate) investment route to Indian assets.
Leaving a large swathe of foreign investors outside the ambit of GAAR will avoid undue turbulence when the rules are enforced. Transactions where the tax benefit is less than Rs 3 crore in an assessment year are beyond the purview of the law. Again, foreign investors not availing themselves of tax benefits under double tax treaties and foreign residents investing in India through registered FIIs will not be subject to this scrutiny. The Government has also done well to leave investments through participatory notes outside the radar of GAAR since flows through this route have whittled down in recent years. All in all, the amended rules strike a fine balance between the need for foreign investment flows and the legitimate demands of the Indian exchequer.
(This article was published on October 1, 2013)
When auditors keep bad company
SEBI can act as an agent of change
Lessons from NSEL, Satyam — managements should not appoint their own auditors.
October 1, 2013:
When scams break out in the private sector, auditors, too, end up on the firing line, and rightly so. This was evident in the Enron scam in 2001, the Satyam scam in 2009 and the NSEL episode now.
The massive Enron scam in the US, where future sales were booked as current, predictably took its toll on its auditor, Arthur Andersen.
In the case of Satyam, the management booked fictitious sales in order to project financial and profit muscle that it did not possess. Its auditor, Price Waterhouse Coopers, got away with a rap on its knuckles.
Now, Financial Tech, the holding company of NSEL that has defaulted on paying a whopping Rs 5,500 crore to its investors is in the news --- its auditor Deloitte has withdrawn its report pending revision. Withdrawing an audit report smacks of abdication of responsibility.
These are high profile cases, and have therefore come to light. There are many cases of auditors' negligence or complicity that do not hit headlines because the companies are not listed or are low profile.
CAG, AN EXCEPTION
In this depressing scenario of gloom and doom, one set of auditors stands tall, though its detractors are shrugging away its reports as exaggerated ----the Comptroller and Auditor General of India (CAG) and its nominees. The 2G and coal scams are examples. What sets apart the CAG and its private nominees who audit the accounts of public sector companies from auditors of private sector companies is their independence.
The CAG is a constitutional office enjoying considerable freedom. He or she can be removed only through the arduous process of impeachment. And private auditors nominated by the CAG do not have to fear anybody; they are not at the tender mercies of the managements of the companies concerned. They get some audit assignment or the other on a rotational basis, that eschews development of cosy relationship with the management.
The new Companies Act, 2012, has done quite a bit to restore the credibility of auditors in the eyes of the company stakeholders. Rotation of auditors, heavy penalties for mistakes, and assignment of the whistleblower role are commendable initiatives in reviving public confidence. But they fall short of the deep surgery the doctor has ordered.
AUDITORS' INDEPENDENCE
Nothing short of insulating the auditor from the management would bring about the desired results. Even under the proposed regime of auditor rotation, it would effectively be the management at the helm that would choose the auditor and make the appointment, as well as fix the fees.
This arrangement has lowered the dignity of the office of the auditor the world over and fostered the perception that he is the handmaiden of the management; he simply cannot be counted upon to give a fearless and frank report. The only way to end this justified cynicism is to delink his appointment from the management.
Research papers, articles or theses are blind referenced to ensure freedom from bias. But accounts cannot be blind referenced to auditors, as the identity of the client would be known in the course of auditing. Yet, a device must be found that insulates the auditor from the management of the auditee --- while an accused can be seen hobnobbing with his lawyer and a patient can choose his own doctor, there is no way an auditee can be seen hobnobbing with the auditor. Auditing is the only profession that casts the professional in an adversarial role vis-à-vis his client.
LEAVE IT TO sebi
In the event, there is no escape from the CAG-like regime in place for public sector audit. An independent body should be mandated to appoint an auditor every five years for a listed company. That body should not be the ICAI because there would be a lingering suspicion that a powerful member wangled a plum audit. It must necessarily be the market watchdog, SEBI. If SEBI were to conduct the allotment of audit as a transparent exercise once in five years, in full public view, like the allotment of flats by the Delhi Development Authority, it would restore some credibility to the auditing profession.
This could be done by a draw of lots, with the names of the companies in one container and names of auditors meeting the qualifying norms in another. The two can be dipped into at random and displayed in full public view.
Appointment by an independent agency is only the first step in restoring the credibility of the profession. Internal audit has turned out to be at best audit of the efficacy of the system, including internal controls, and at worst, spying of divisional heads and profit centre heads. It would be futile for a statutory auditor to repose faith in and take shelter behind an internal auditor's work.
A meaningful system of peer review, even if it has the effect of pitting one professional against another, must be put in place, if the system of dual audit --- simultaneous audit of the same accounts by two firms of auditors --- is found to be an expensive duplication.
(The author is a Delhi-based chartered accountant.)
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