By accepting the Bombay high court judgment on the Vodafone India Services Private Ltd, the Union government has quietly pushed through a major tax reform last week. Shorn of the technicalities of legal argument and references to numerous sections and definitions, the nub of the dispute is quite simple which, the high court, has clearly expressed in its award.

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Possibly out of overzealousness, some officials had slapped tax on deemed income from mere issue of shares from the Indian subsidiary to the parent company. Vodafone Mauritius had subscribed to shares of Vodafone India Services at a premium of Rs8,509 per share. The Indian company thus received Rs246 crore. Since this was a transaction with its overseas parent, the Indian company reported this as an “International Transaction” and also stated it did not in any way affect its income. This was a capital receipt. 

However, the department applied a curious logic for claiming tax. It computed that on Arms’ Length Pricing, a formula assuming as if some totally unrelated entities had concluded the deal in a free market, the price for the shares of Vodafone India should have been Rs53,775 per share. On that basis of Arms’ Length pricing, Vodafone India should have received Rs1,309 crore from the transaction. However, both the companies agreed and the deal was done at Rs246 crore. Thereafter, the department concluded that the difference between Arms’ Length Pricing and the actual pricing should be construed as a loan from the Indian company to the overseas parent, and an interest on that sum — to a tune of Rs88.35 crore — should also be added as income. Thus, in total, transfer pricing amount as well as due deemed interest should be taxed. 

The fact, however, was that the funds were sent by the overseas company as fresh foreign direct investment in the shares of its fully owned subsidiary. The fund could have been for extending its operations or to tide over shortage of resources or for covering loss. It was a plain case of foreign investment. How can you invite FDI and tax it too, before it earns any income? The high court too has observed the same.

Income tax should have been valid if the overseas company had sold off its shares at a higher price (for instance, at the Arms’ Length Price as computed by the department) and the income had accrued to the company. It would then have been liable to pay tax the moment it earned a sum of money above what it had paid. But without that realised income, imposing deemed income penalty is like taxing notional and fictitious income. That is what the tax demand in this case had achieved. 

Terms like ‘transfer pricing’ are immensely appealing to tax authorities. If you can attach transfer-pricing description to any transaction, it would immediately be fit for the stiffest of tax laws. Transfer pricing means when two related firms clinch a deal in which the price for the goods or services have been kept artificially low to create scope for out-of-market benefits. 

However, when a company invests in the share capital of its subsidiary and when the premium, so computed, has not been, in effect, realised, it is inappropriate to slap deemed income on it. This kind of attitude towards taxation results in creation of uncertainty about the tax regime of a country. The government has done well to have cleared the mess following the tax notice.