Wednesday, April 28, 2010

The ULIPs controversy and a Delhi High Court decision

The ULIPs SEBI/IRDA tussle takes new turns practically every week and would not warrant further posts to my last one, (which was also followed by another post by a learned contributor) till either the Court decides the issue or the law is amended. However, I stumbled across a recent decision of the Delhi High Court (Chanchal Jain vs. SEBI (95 SCL 31 (2009)) dated July 24, 2009) on a related matter that is worth a quick mention here for several reasons.

Firstly, it apparently goes back to what is said to be the root of the current controversy and that is the ban on entry load/commission payment by mutual funds. Secondly, it also, albeit indirectly, considers mutual funds schemes vis-à-vis insurance policies and the fact that insurance policies command a higher commission. Finally, though not specifically on ULIPs, it is perhaps the only other recent decision (as far as I know) that deals to some extent directly with the current controversy.

Curiously, as will be seen later, on one hand the initial statements of the Court specifically state that SEBI has no power over life insurance policies and thus on first impression may appear to go against the recent SEBI Order on ULIPs. On the other hand, the reasoning given for distinguishing insurance policies and mutual fund units actually support the SEBI decision.

I have focused here on just one point of this decision but readers may find it generally worth reading the decision for other points.

Readers may recollect SEBI had issued a circular on June 30, 2009 whereby entry load on mutual fund schemes was banned and certain further disclosure requirements made. A writ petition was filed against this circular before the Delhi High Court.

While various contentions were raised, one relevant point made was that Article 14 of the Constitution was infringed since the petitioners have been discriminated. It was submitted that, “LIC agents are entitled to commission, which can go upto 40 per cent”.

The Court rejected this submission and it is interesting to read the reasoning of the Court:-

“The said contention has no merit. Life Insurance policies serve a different purpose and object. Life Insurance policies form a separate class and cannot be clubbed with mutual funds. SEBI does not control and regulate life insurance policies. It is well known that rate of return in an LIC policy is substantially lower. The primary object of a life insurance policy is to secure and benefit beneficiaries on death of the insured. The rate of return in mutual funds is market driven. It is not possible to accept the contention of the petitioner that insurance policies and their agents and mutual funds, agents and distributors form the same class and must have same rules of trade and charges. Article 14 does not prevent classification but ensures that there is no discrimination by treating two equals differently. Role of a distributor of a mutual fund is distinct and separate from the role of a life insurance agent.”. (emphasis supplied)

To reiterate, the first part makes it clear that SEBI has no jurisdiction over life insurance policies. However, the Court quickly followed this by briefly explaining what is a life insurance policy and how it is different from mutual funds.

Unfortunately, the peculiar concept of ULIPs which, as SEBI has shown with calculations, are often 98% mutual fund units, was not placed before the Court. Thus, while one cannot apply this decision directly to ULIPs, this decision should provide one more piece in the unraveling of the complex legal jigsaw concerning ULIPs and the powers of the two regulators.

- Jayant Thakur, CA.

Tuesday, April 27, 2010

Changes to Minimum Pricing Norms for FDI in Unlisted Companies

(The following post is from Tanmay Amar, senior associate at Luthra & Luthra. Tanmay discusses a significant change to the minimum pricing norms for issue of shares by Indian companies to foreign investors. This change is bound to affect the manner in which valuations are to be arrived at, especially for investments by financial investors such as private equity funds. It is not clear as to what the motivation behind this change is, but it is likely to place restrictions on the flow of foreign investment into unlisted companies)

The Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000 (the “FEMA Regulations”) have been recently amended to include a significant change regarding minimum pricing norms. The Reserve Bank of India (“RBI”) has altered the mechanism for computing the base price for issue of shares by an Indian unlisted company to a non-resident. The same was notified in the Official Gazette on April 21, 2010, although the Gazette notification or the amendment itself is apparently yet to be made available on the RBI website.

Until now, the price for issue of shares of unlisted Indian companies to a non-resident could not be less than the price computed by a chartered accountant (“CA”) in accordance with the guidelines issued by the erstwhile Controller of Capital Issues (“CCI value”). As the CCI value was based on historical performance parameters, it often tended to be relatively moderate.

Post this amendment, for a new issue by an unlisted Indian company to non-residents, the base price would be the higher of (i) the fair value computed by a CA/ Merchant Banker, as per the discounted free cash flow method (“DCF Value”), and (ii) (where the issue of shares is on a preferential allotment basis) the price applicable to transfer of shares from a resident to a non-resident, as per guidelines notified by RBI. The relevant provision is as follows:

In Schedule 1 [of the FEMA Regulations], for paragraph 5, the following paragraph shall be substituted, namely:--

“5. Issue price

Price of shares issued to persons resident outside India under this Schedule, shall not be less than—

(a) the price worked out in accordance with the SEBI guidelines, as applicable, where the shares of the company [are] listed on any recognised stock exchange in India;

(b) the fair valuation of shares done by a SEBI registered Category-I Merchant Banker or a Chartered Accountant as per the discounted free cash flow method, where the shares of the company [are] not listed on any recognised stock exchange in India; and

(c) the price as applicable to transfer of shares from resident to non-resident as per the pricing guidelines laid down by the Reserve Bank from time to time, where the issue of shares is on preferential allotment.”
Since the base price for issue of shares is linked to the price for transfers, it is necessary to note that currently the price applicable to transfer of shares (for unlisted companies) from a resident to a non-resident is the CCI Value. As yet, no amendments seem to have been announced to such pricing guidelines for transfers, and even assuming any amendments have been effected, they have not been widely publicized.

Till such time that RBI amends the pricing guidelines for transfer of shares of an Indian company from a resident to a non-resident, an anomaly will remain, whereby the issue of shares to a non-resident will be subject to a base price which is the higher of CCI Value and DCF Value. However, it may be possible for an Indian company to issue shares to a resident entity, which entity may immediately thereafter transfer the shares to the non-resident, at a price which is subject only to the CCI Value and not the DCF Value, and therefore frustrate the intention behind this amendment.

While the CCI Value was computed as per a given set of regulator-issued guidelines which were fairly detailed, I believe that there is much scope for ambiguity in computing the DCF Value. Perhaps an accounting professional may be able to elaborate.

DCF Value is generally likely to be higher than CCI Value and could challenge private equity valuations in on-going deals, as well as closed private equity deals or joint ventures, which provide for multiple investment tranches or other scenarios where a non-resident is to be issued further shares at a subsequent point of time.

Certain news reports speculating on the amendment seem to indicate that it may have been RBI’s intention to replace the base price for issue of shares from CCI Value to DCF Value. However, going by the drafting, it appears that (in all cases involving preferential allotments) two separate computations for the CCI Value and DCF Value will be required and the higher of the two will be the base price. Perhaps this may be to guard against the ambiguity in DCF Value computation, which could possibly be exploited, in certain cases, to obtain a DCF Value which is lower than CCI Value.

- Tanmay Amar

(Update: Please see further developments in this subsequent post)

Monday, April 26, 2010

Porrits & Spencer: Form over Substance Reaffirmed

We have extensively discussed issues around tax avoidance previously; and one of the questions in this regard is the exact relationship between the 5-Judge Bench decision in McDowell and the subsequent 2-Judge Bench decision Azadi. To briefly recapitulate, in McDowell, Justice Chinappa Reddy took a strong stance against tax avoidance and effectively equated avoidance with evasion. Under Justice Chinappa Reddy’s reading, tax avoidance was also illegal. In Azadi, the Bench held that Justice Chinappa Reddy’s opinion was a “far cry” from the view of the majority; and cited some paragraphs from McDowells’s majority opinion (per Justice Ranganath Mishra) to support this view. What creates some confusion is that the majority however also states that on the issue of transactions planned because of a tax-saving motive, “one of us, Chinnappa Reddy, J., has proposed a separate and detailed opinion with which we agree.” This opens the door for the Revenue to try to circumvent Azadi. I have discussed these issues previously here. (What is also noteworthy is that a petition for review of the judgment in Azadi has been dismissed, and a curative petition against that dismissal has also been rejected by a 5-Judge Bench. The order dismissing the curative petition can be found here.)

Some subsequent decisions – including Akshay Textiles of the Bombay High Court and E*Trade Mauritius of the AAR (discussed here) – suggest that the Revenue’s argument of following McDowell over Azadi is incorrect. The clearest and most recent indication of this comes in a recent decision of the Punjab & Haryana High Court in Porrits & Spencer v. CIT.

The assessee had purchased certain units of ‘US64’ of the Unit Trust of India at the market rate from ANZ Grindlays Bank in May 1990. In June, dividend was declared on those units, and the assessee claimed deduction on the dividend under the then-existing Section 80-M of the Income Tax Act, 1961. The assessee sold the units back to ANZ Grindlays Bank in July. In the course of this transaction, the assessee incurred a loss of Rs. 51,61,875. This sum of loss represented the difference between the purchase price and the sale price plus transaction costs.

The Tribunal had held that these transactions (on which losses had been incurred) would have to be ignored, as they were entered into only because of a tax-saving motive. The Tribunal found that the assessee had planned to purchase the shares in May and then sell them after 60 days in July. Furthermore, a finding was made that the reason why the assessee took such a step was that the assessee was well aware that dividend was to be declared in the month of June. As noted above, this dividend was indeed declared, and the assessee claimed deduction under Section 80-M of the Income-tax Act. Furthermore, the Tribunal also found that “the assessee (knew) that there will be a loss on account of sale in the month of July and there was a loss of Rs. 51 lakh and odd, which it claimed against its business income. In this way, the assessee claimed deduction u/s 80-M and then he claimed deduction on account of loss against business income also.” Taking a negative view of this series of transactions, the Tribunal concluded, This planning, in our considered view, cannot be approved, as the same was clear cut planning to reduce the tax effect, which is not permissible in the eyes of law…

This holding was reversed on appeal to the High Court. After considering both McDowell and Azadi, the Court observed, “The argument of the learned counsel for the revenue-respondent based on the judgment rendered in the case of McDowell & Co. Ltd. (supra) cannot be accepted because the judgment rendered by Hon’ble Mr. Justice O. Chinnappa Reddy in McDowell’s case has been explained in detail by the later judgment of Hon’ble the Supreme Court in the case of Azadi Bachao Andolan (supra). It is well settled that if a smaller Bench of Hon’ble the Supreme Court has later on explained its earlier larger Bench then the later judgment is binding on the High Court. In that regard reliance may be placed on a Full Bench judgment of this Court rendered in the case of State of Punjab v. Teja Singh, (1971) 78 PLR 433… once the transaction is genuine merely because it has been entered into with a motive to avoid tax, it would not become a colourable devise and consequently earn any disqualification…

The decision strongly reaffirms the form-over-substance approach of the judiciary towards tax planning; and it appears that arguments based purely on McDowell will not persuade Courts easily.

Meaning of 'work' under section 194C

In a decision last delivered last month, the Bombay High Court once again visited the debate over the meaning of ‘sale’, in the process of clarifying the scope of the obligation to deduct tax at source under section 194C of the Income Tax Act.

The factual matrix before the Court involved a unique business model adopted by pharmaceutical companies. Pharmaceutical companies adopt three methods for their products- certain products are manufactured by the company at its factory; the company gets some products manufactured on a license from third parties; and for some products, the company enters into agreements under which pharmaceutical products are manufactured by third parties to specifications and standards provided by the company under the trade-mark of the assessee. The issue was whether the third of these business models created an obligation to deduct tax on the pharmaceutical company under section 194C.

Section 194C provides that any person responsible for paying any sum to any resident for carrying out any work has an obligation to deduct tax at source on such payment. Thus, the crux of the issue was whether the supply of products by third parties to the pharmaceutical company constituted ‘work’ for the purposes of section 194C. The contention of the pharmaceutical companies was that these agreements were clear instances of sale, and given the well accepted distinction between sales contracts and works contracts, a sale could not be covered by the meaning of work. However, matters were complicated by the decision of the Supreme Court in Associated Cement Co. Ltd. v. CIT, [1993] 201 ITR 435. This case held that the term ‘work’ used in section 194C is wider than the phrase ‘works contract’. Hence, the first question before the Court was whether this widened meaning of the term ‘work’, would also include sales where some work was done on the product by the seller. In other words, the question posed to the Court was whether in cases like the one at hand, where the product which is sold is manufactured according to the specifications of the purchaser, can the process of manufacture according to specifications be considered to be ‘work’. The Court relied on a series of CBDT circulars, and came to the conclusion that even if the term ‘work’ was wider than the term ‘works contract’, it could not include sales within its ambit. Hence, it answered the first question against the Revenue.

The next issue that required to be considered then, was whether the transaction here was a sale. The Revenue contended that manufacture according to the purchaser’s specifications and the use of the purchaser’s trademarks on the product rendered the transaction something different from a sale. Rejecting both these contentions, Justice Chandrachud, speaking for the Bench, laid down the test as follows-

A contract for sale has hence to be distinguished from a contract of work. Whether a particular agreement falls within one or the other category depends upon the object and intent of the parties, as evidenced by the terms of the contract, the circumstances in which it was entered into and the custom of the trade. The substance of the matter and not the form is what is of importance. If a contract involves the sale of movable property as movable property, it would constitute a contract for sale. On the other hand, if the contract primarily involves carrying on of work involving labour and service and the use of materials is incidental to the execution of the work, the contract would constitute a contract of work and labour. One of the circumstances which is of relevance is whether the article which has to be delivered has an identifiable existence prior to its delivery to the purchaser upon the payment of a price. If the article has an identifiable existence prior to its delivery to the purchaser, and when the title to the property vests with the purchaser only upon delivery, that is an important indicator to suggest that the contract is a contract for sale and not a contract for work.

On this basis, the Court concluded that the transactions in questions were cases of sale, and did not amount to work for the purposes of section 194C. While these arguments were sufficiently persuasive, another factor that weighed heavily with the Court was the amendment made to the Explanation of section 194C by the 2009 Finance Act. Explanation II to section 194C gave an provided an inclusive list of activities that would considered ‘work’ . By the 2009 amendment, an addition was made to this list, which read-

For the purposes of this section, the expression, "work" shall also include –


(e) manufacturing or supplying a product according to the requirement or specification of a customer by using material, purchased from such customer, but does not include manufacturing or supplying a product according to the requirement or specification of a customer by using material purchased from a person, other than such customer. [emphasis supplied]

Relying on the Memorandum of Explanation of the 2009 Finance Bill, the Court came to the conclusion that this amendment was clarificatory, and hence should be given retrospective effect. In the case of the assessee pharmaceutical companies, the raw materials for production were not being provided by the pharmaceutical company. Thus, it clearly fell within the exclusion provided by the amended Explanation. Thus, for legislative and judicial reasons, the Court concluded, it is submitted rightly, that there was no obligation to deduct tax on amounts paid for the transactions in question.

One final issue that arises out of the present language of the amended Explanation needs to be addressed here. Though it was briefly touched on during oral arguments, this issue did not need to be considered by the Court, and finds no place in the judgment. The newly amended Explanation provides that, in cases where a product is manufactured according to the specifications of the purchaser, the tie-breaker for deciding whether it is work is the party from whom the raw material is ‘purchased’. While this term is apposite when referring to the transaction between the manufacturer and a third party, it seems highly erroneous to use it in relation to the manufacturer and the purchaser of the finished product. Surely, the intent of the legislature was that when specifications and raw materials are ‘provided’ by the purchaser, the return of the finished product to the purchaser does not constitute a sale. However, given the language of the section, it would be ‘work’ only if the manufacturer ‘purchases’ the raw material from the purchaser. Further, in such a case, where the manufacturer purchases the raw material, the title in the finished product will vest in the manufacturer, and when it is handed over to the purchaser, title will pass again. Applying the test laid down by the Bombay High Court in Glenmark, this passing of title would make that transaction a sale. As was suggested before the Court, the only solution is to read the term ‘purchased’ loosely; however, this is yet another instance of poor legislative drafting that could very easily have been avoided.

Saturday, April 24, 2010

Substance over Form in Taxation: The Recent English Approach

We have at several times on this blog discussed issues around the legality of tax avoidance. In debates around avoidance/evasion distinction, reference is often made to the classic English cases - Duke of Westminster, Ramsay, Furniss, Macniven and others. In this background, it might be useful to consider the latest approach of the English Courts to tax planning activities. The latest case on the point appears to be Commissioners for HM Revenue & Customs v. Tower MCashback LLP. This case however relies on the statement of the law on the point in the judgment of Arden LJ in John Astall v. HM Revenue & Customs, [2009] EWCA Civ 1010. Justice Arden analysed the recent case law carefully, and discussed in detail the recent judicial approach.

It was stressed in the judgment that the question is to be answered not by beginning with pre-conceived ideas about the legitimacy or illegitimacy of tax avoidance, but rather by beginning with the rules of statutory interpretation. “The essence of the new approach was to give the statutory provision a purposive construction in order to determine the nature of the transaction to which it was intended to apply and then to decide whether the actual transaction (which might involve considering the overall effect of a number of elements intended to operate together) answered to the statutory description. Of course this does not mean that the courts have to put their reasoning into the straitjacket of first construing the statute in the abstract and then looking at the facts. It might be more convenient to analyse the facts and then ask whether they satisfy the requirements of the statute. But however one approaches the matter, the question is always whether the relevant provision of the statute, upon its true construction, applies to the facts as found.

The Court then explained cases such as Inland Revenue v. Burmah Oil Co Ltd., 1982 SC (HL) 114, Furniss v. Dawson [1984] AC 474, and Carreras Group Ltd v. Stamp Commissioner, [2004] STC 1377. Broadly speaking, in these cases, it had been held that tax-saving steps inserted into a transaction without any other commercial purpose do not prevent the composite transaction from falling within a charge to tax. In the words of the Court (which I quote extensively as the Court offers a very useful summary of the leading decisions), “ the Burmah case, a series of circular payments which left the taxpayer company in exactly the same financial position as before was not regarded as giving rise to a "loss" within the meaning of the legislation. In Furniss, the transfer of shares to a subsidiary as part of a planned scheme immediately to transfer them to an outside purchaser was regarded as a taxable disposition to the outside purchaser rather than an exempt transfer to a group company. In Carreras the transfer of shares in exchange for a debenture with a view to its redemption a fortnight later was not regarded as an exempt transfer in exchange for the debenture but rather as an exchange for money. In each case the court looked at the overall effect of the composite transactions by which the taxpayer company in Burmah suffered no loss, the shares in Furniss passed into the hands of the outside purchaser and the vendors in Carreras received cash. On the true construction of the relevant provisions of the statute, the elements inserted into the transactions without any commercial purpose were treated as having no significance...” Importantly, the Court then went on to clarify, “Cases such as these gave rise to a view that, in the application of any taxing statute, transactions or elements of transactions which had no commercial purpose were to be disregarded. But that is going too far.” 

Thus, merely because in Furniss a certain form was disregarded does not mean that Furniss is authority for a general substance-over-form view. In sum, the question is not so much about whether Courts should adopt a substance-over-form approach or a form-over-substance approach – the real question to ask is what approach the particular statutory provision at issue requires. And this is to be answered not by reference to judicial anti-avoidance techniques, but by reference to the rules of statutory interpretation.

Friday, April 23, 2010

SEBI’s “Advisory Instructions” to BSE

In a somewhat unconventional order, SEBI has on April 20, 2010 issued “advisory instructions” in a matter involving the Bombay Stock Exchange Limited (“BSE”).

It arises out of a letter by the BSE to SEBI dated July 2, 2004 containing a proposal to introduce a market making scheme in the derivatives segment of the exchange. A unique feature of the scheme proposed by BSE was that it would reimburse any losses sustained by market makers indulging in market making in the derivatives segment. This was with a view to generate greater liquidity in the derivatives segment. SEBI advised BSE by letter dated September 29, 2004 that “such a scheme would expose it to the risks of market making and therefore, had not allowed BSE from taking ‘commercial risks as an insurance agency’”.

SEBI later noticed that the BSE had implemented a ‘Market Development Scheme’ engaging two market makers and that the market making activity had occurred between December 2006 and May 2008. It was therefore alleged that by introducing such market making scheme without the permission of SEBI, BSE had acted in contravention of the SEBI letter dated September 29, 2004.

A number of arguments were made by the BSE in defending its position. First, it was stated that the market making schemes operated by BSE were routine in nature and did not involve compensating the market makers for losses suffered by them. It was due to this unique compensation mechanism that BSE decided to approach SEBI in the first place. Second, it was argued that “there are no specific rules/regulations/circulars issued by SEBI which prohibit or otherwise seek to regulate the manner in which a stock exchange would implement market making in the derivatives segment”. In other words, if there was no requirement to obtain the approval of SEBI to carry out such activity, then BSE cannot be faulted for carrying on the same without such approval.

Although SEBI did not attempt to rebut each of BSE’s arguments, it made the following observations which are in the nature of “advisory instructions”:

BSE’s contention is that there are no explicit provisions that SEBI has mandated which required it to seek prior permission for launching the impugned market making schemes in the derivatives segment. However I am constrained to observe that since SEBI had issued a letter in a closely related matter, notwithstanding the stand of BSE that the subject matter in this instant case was different, it would have been in the fitness of things and would have been proper for BSE to have brought its new market development scheme to the attention of SEBI. For a market infrastructure institution of long standing like BSE, it should have seen that as a regulator for the securities market, SEBI has been and is at all times sensitive to the potential of any such activity or market making scheme jeopardizing the system and eroding the integrity of the securities market. I therefore, at this juncture, would advise BSE and remind it of its duty to bring such schemes which have wide and far reaching implications for the securities market, in future, to the attention of SEBI and seek guidance or approval wherever required. I however, stop short of prescribing what exactly a scheme would be or laying down yardsticks that would set apart schemes with far reaching consequences for the securities market, as I would still prefer to leave it to the better judgment of an Exchange.
On the one hand, it may be argued that since no violations of legal provisions by BSE have been established, no order ought to have been passed against it. On the other hand, this case demonstrates an increasing trend on the part of securities regulators (even worldwide) to resort to softer measures, for example censure (both private and public), where other legal remedies are either unavailable or inappropriate. Whether this trend will catch on in a more widespread fashion in India is hard to speculate. Whether the validity of such orders will be subject to reexamination at an appellate level is an even harder question because it may not usually be worthwhile for affected parties to appeal against such orders.

Tuesday, April 20, 2010


The Securities and Exchange Board of India (“SEBI”) has issued a circular dated April 15, 2010 clarifying its stand on broad-based criteria for registration as foreign institutional investors (“FIIs”). See:

SEBI has clarified that if an entity has a feature of its structure, multiple classes of investors and multiple pools of investments within the same entity, each such pool ought to comply with broad-based criteria prescribed by SEBI in its regulations for registration of FIIs. Existing FIIs have been given time to become compliant with such a requirement by September 30, 2010.

The move is yet another step towards to ensuring that the FII framework in India is available only for genuinely institutional investors and not for individuals and entities that are not genuinely institutional in character.

To be considered as being broad-based, SEBI has prescribes a minimum number of investors with no investor exceeding a specified percentage of the assets under management. These parameters have been revised from time to time, and currently a single investor is allowed to account for upto 49% of the assets (earlier the requirement was to have at least 20 investors with no investor accounting for more than 10% of the assets).

With a multi-class vehicle it was possible for an entity that had one class of shares that featured a broad-based character, but other classes of investors that were not broad-based. An assessment of the assets of a multi-class entity claiming to be broad-based could result in the real picture not in fact being broad-based, with individuals and their companies riding piggyback on one class of shares that could be regarded as being broad based. The latest move addresses the possibility for such a sham.

The development could lead to privately-banked Indian money being routed back into India having to struggle a bit more in its entry to the Indian market. Such money would have to find company to make itself broad-based - therefore, even if this move will not prevent such money flowing in, it would make it more difficult for it to flow back into India.

Monday, April 19, 2010

Characterising a Joint Venture

A joint venture, perhaps one of the most widely used vehicles of commerce, is principally of two types – an incorporated joint venture [“IJV”] and an unincorporated joint venture [“UJV”]. The shares of the IJV are held by the members of the joint venture, in proportions that typically reflect their respective contributions to the enterprise. As a matter of law, therefore, an IJV is treated as any other incorporated company. A UJV, on the other hand, is a creature of contract, and has no separate legal existence. Members of the joint venture create rights and obligations through a consortium agreement that defines the role that each member plays in the enterprise. The considerations that affect this choice are many, and the obvious benefit of an IJV’s separate legal existence is often offset by the tax obligations it generates, and by company legislation to which it becomes subject.

A UJV, however, raises many legal questions that have not yet been fully answered in India. For example, there are doubts over the validity of a shareholder’s agreement that restricts the right of a joint venture member to a third party, although such agreements essential to a joint venture. It was likewise with qualifying criteria such as experience, until the Supreme Court settled the question in New Horizon.

In this connection, an interesting question arose last week before the Authority for Advance Rulings [“AAR”], in the context of the Income Tax Act, 1961 [“ITA”]. The decision is Hyundai Rotem Co. v. DIT, and is available here. The Delhi Metro Rail Corporation [“DMRC”] had invited bids for design, supply and manufacture of Electrical Multiple Units. The winning bid was submitted by a consortium that comprised four members – Mitsubishi Corporation (Japan), Hyundai Rotem (Korea), Mitsubishi Electric (Japan) and BEML Ltd. (India). The relationship between the consortium members was governed by two agreements, known as the Consortium Agreement [“CA”] and the Supplementary Consortium Agreement [“SCA”], and a single contract was entered into with the DMRC.

Rotem filed an application before the AAR asking whether the members of the consortium would be assessed as “individual” companies, or as an “association of persons”. An association of persons is considered a taxable entity under s. 2(31) of the ITA. The expression, however, is not defined in the ITA, and tests to determine its existence have been evolved judicially. Some decisions held that an association of persons must have as its object the sharing of profit or gain. In 2002, however, an Explanation was inserted to s. 2(31) stating that an association of persons shall be deemed to be a person “whether or not such person or body or authority or juridical person was formed or established or incorporated with the object of deriving income, profits and gains”. Two decisions of the AAR – Van Oord Acz BV and GeoConsult ZT GmbH – added to the difficulty. In Van Oord, the AAR held that the UJV in question was not an association of persons, while it held in GeoConsult that it is, since the sharing of profit is not an essential ingredient of an association of persons. In Hyundai Rotem, the AAR had to decide whether the UJV structure in the case was closer to Van Oord or to GeoConsult. For three reasons, the AAR decided that the UJV structure in Rotem did not constitute an association of persons.

First, the nature of the work or function assigned to each UJV member under the CA and the SCA was substantially different. Mitsubishi Corporation was appointed, for example, as the Consortium Leader and charged with overall responsibility, legal concerns, collecting payments etc. Mitsubishi Electric was charged with the electrical component of the project, Rotem with the mechanical component, and so on. The AAR held that this prevents the “interchangeability” or “re-assignment” of work, which it considered a useful test to distinguish between an association of persons and a collection or group of individuals falling short of it. Secondly, the SCA specifically provided that “nothing in the Agreement is intended or shall be construed as creating a partnership, joint venture or any other legal entity among the parties”. Thirdly, the UJV members individually presented invoices to DMRC, and incurred no common expenditure. None of these factors had existed in GeoConsult. The Agreement had provided specifically that its object was to create an unincorporated association, and the function of each member was entirely interchangeable with the function of another. In particular, a breach of the agreement by one member could lead to the reassignment of that member’s role in the agreement to another, and members were jointly and severally responsible for each other in the event of insolvency.

It is clear that analysing the nature of a UJV is no easy task. Hyundai Rotem, however, demonstrates that the most useful method of approaching this question is likely to be a careful analysis of the particular agreement, and a comparison of that agreement with other cases.

Friday, April 16, 2010

More Controversy over Forex Derivatives

Over the past two years, forex derivatives have generated substantial legal controversy in India, perhaps because of the relatively recent rise in the use of these instruments in India. We have discussed the challenge to the legality of derivatives as wagering agreements, their regulation, taxability and other related issues.

The latest addition to this chapter of uncertainty is a report that the Central Board of Direct Taxes [“CBDT”] has issued an internal instruction directing Income Tax Officers to disallow forex derivatives losses incurred on account of currency fluctuations. The basis for this decision is reported to be that these losses are “unrealised” and present only in the books of accounts. The legal provision governing this question is s. 37 of the Income Tax Act, 1961. S. 37 is a “residuary” provision that allows assessees to deduct from their profits and gains from business certain expenses that do not fall within the other deduction provisions. The requirement, however, is that the expenditure must be “laid out or expended” wholly and exclusively for the business of the assessee.

An example illustrates the point. Suppose an Indian company deals in forex derivatives at a particular date in a particular currency and finds that the currency has become more expensive two months later, it will record the loss arising at the future date as a result of currency fluctuation in its Profit and Loss [“P&L”] account, and will show a correspondingly lower figure of net profit. The CBDT’s view would imply that the Indian company cannot deduct the currency fluctuation loss under s. 37, because it is “unrealised”. While this view has some force at first sight, it seems that it is misconceived, for several reasons.

First, it is possible to contend that s. 37 speaks of an “expenditure” and not a “loss” and consequently that a loss is by definition excluded from s. 37, whether incurred on account of currency fluctuation or otherwise. The legal position in this respect is not clear, and there are decisions that support both views. However, as Mr. Palkhivala points out in his commentary, the reason “loss” is not expressly mentioned in s. 37 is that it is in any case deductible under ordinary principles of accounting. Secondly, these ordinary principles of accounting are recognised in s. 145 of the ITA, which provides that an assessee may follow either the cash or mercantile system of accounting, and the Supreme Court has held that the books of accounts of an assessee cannot be ignored or disregarded unless there is clear evidence of mala fide.

Thirdly, it is surprising that the CBDT has rested its circular less on the scope of s. 37 and more on the proposition that an “unrealised” loss cannot be deducted. This seems, with respect, at odds with a basic assumption of the mercantile system of accounting – that a gain or a loss is accounted not when it is actually received or incurred, but when the legal right or liability arises. Indeed, there appears no reason in principle to confine the CBDT’s view to forex derivatives – if this view is correct, the corollary is that any unrealised loss or gain is excluded from the ambit of the ITA, which is not the case.

Fourthly, the ITA has in the past subjected gains from currency fluctuation to tax, on the basis that the mercantile system of accounting does not require actual receipt. While this is not a reason, as a matter of law, to question the CBDT’s view, it is interesting to note that the circular is at odds with the position the Department has consistently taken in the past.

These principles had been approved by the Supreme Court in 2009, in CIT v. Woodward Governor India P. Ltd., (2009) 13 SCC 1. In that case, an assessee debited approximately Rs. 29 lakh to the P&L account as a result of currency fluctuation. The Department disallowed the expenditure, on the basis that it represented a “contingent” liability. The Supreme Court rejected this contention, holding that s. 145 “recognizes the rights of a trader to adopt either the cash system or the mercantile system of accounting”, and further noted that “[a]ccounts regularly maintained in the course of business are to be taken as correct unless there are strong and sufficient reasons to indicate that they are unreliable.”

However, the CBDT will derive comfort from the Supreme Court’s express observation in Woodward Governor that these “ordinary principles of commercial accounting… may stand superseded or modified by legislative enactments”. Indeed, Justice Kapadia, who decided Woodward, observed in the more recent Southern Technologies decision, which we have discussed here, that the “real income” principle does not assist an assessee in contravention of statutory language. More ominously for assessees, the Court had held in Southern Technologies that a provision for bad debts is only a “notional expense” and must be added back to determine “real taxable” income. Thus, it is difficult to conclude that the CBDT instruction is ultra vires the Act, but this is an issue that requires adjudication.