April 24, 2012
Buy-Back by Indian Subsidiary results in Taxable Capital Gains
Transfer of a capital asset from a parent company (including a foreign parent company) to its Indian wholly owned subsidiary is not treated as a taxable transfer as per section 47(iv) of the Indian Income Tax Act, 1961 (“ITA”). Hence, such transfers are exempt from capital gains1 tax in India. However, the Authority for Advance Ruling (“AAR”), in its recent ruling2, denied the benefit of the above exemption in a transaction involving buy-back of shares by an Indian subsidiary from its parent company i.e. RST (“Applicant”) which held 100% shares of the Indian subsidiary, directly, and through its nominees.
Provided below is a summary and our analysis of the AAR ruling.
The Applicant, a company incorporated in Germany, held 99.99986% shares in an Indian public limited company (“Indian Subsidiary”). The remaining shares were held by six nominees of the Applicant, since the Indian Companies Act, 1956 (“Companies Act”) requires a public company to have a minimum of seven shareholders. When the Indian subsidiary proposed to buy-back certain portion of the share capital from its shareholders, the Applicant approached the AAR to ascertain its tax liability in India upon tendering its shares in the buy-back offer.
SUBMISSIONS AND CONTENTIONS
The Applicant submitted before the AAR that by virtue of the exemption under section 47(iv) of ITA, the gains arising from transfer of shares held by it in the Indian Subsidiary, pursuant to its proposed buy-back offer, should not be treated as a taxable transfer. The Applicant further contended that section 46A of the ITA, which deals with capital gains in case of buyback of shares, is not a charging section3, and that section 45 is the applicable charging section in the instant case and that exemption from section 45 provided under section 47 should be applicable in case of buy back of shares.
On the other hand, the tax department contended that the income from a buy-back was to be taxed under the specific provisions of section 46A of the ITA, (as opposed to the general provisions of section 45 of the ITA) which provide that any consideration received in a buy-back offer by a shareholder, less the cost of acquisition of shares, was to be deemed as capital gains. Thus, the revenue submitted that section 45 and exemptions therefrom provided under section 47 is not applicable in case of buy back of shares.
In any case, the tax department submitted that the exemption under section 47(iv) of ITA covers only such situations where “the parent company or its nominees hold the whole of the share capital of the subsidiary company”, but not a situation where the parent company partly holds the shares through a nominee. Since the Indian Subsidiary was a public company, it was required to have at least 7 members. It could not be treated as a wholly owned subsidiary of the Applicant since a small percentage of shares in the Indian Subsidiary were held through the Applicant’s nominees. Hence, the tax department argued that the Applicant’s case was not covered under the exemption provided under section 47(iv) of the ITA.
The AAR accepted the arguments of the revenue department on both the counts. On the first point, the AAR held that the exemption under section 47(iv) is available only where the parent company itself holds, or its nominees separately hold 100% shares of the shares of the subsidiary. The AAR also noted that it was legally not possible for the Applicant to hold 100% shares of the Indian Subsidiary and that the benefit of section 47(iv) would be available only in cases where the entire of the shareholding of a parent is held through its nominees. As regards the argument of the Applicant that it effectively held all of the shares of the Indian Subsidiary since all other shareholders were its nominees, the AAR observed that a nominee shareholder has the same rights in the company as any other shareholder viz. voting rights, right to receive dividends, allotment rights under section 81 of Companies Act etc. and hence the shareholding by the nominees is not to be equated with the shareholding by the Applicant. The AAR also held that it was not possible to accept the argument of the Applicant that the phrase “the parent company or its nominees hold the whole of the share capital of the subsidiary company” should be read as “the parent company and its nominees hold the whole of the share capital of the subsidiary company”, since the section would be workable even without such reading albeit in limited cases.
In connection to the second argument of the Applicant, the AAR observed that section 46A of the ITA was a specific provision that deems gains arising pursuant to buy-back of shares as capital gains. Holding that section 45 is a general provision dealing with transfer of all capital assets and placing reliance on the principle that a specific provision prevails over a general provision, the AAR held that section 46A has to prevail over section 45. The AAR referred to the speech of the Finance Minister at the time of introduction of section 46A wherein the Finance Minister clarified that the intent behind the section was to clarify that income earned on buy back of shares would be deemed to be capital gains and not dividend income. On that basis, the AAR concluded that section 47, which exempts certain transfers only from the applicability of section 45, had no bearing on the capital gains taxable under section 46A and hence the income received by the Applicant was taxable in India. The AAR further stated that it was not relevant to go into an enquiry as to whether section 46A of the ITA was in the nature of a charging provision of tax or not in coming to such a conclusion.
Section 46A was introduced to address the issue of whether proceeds from buyback of shares would give rise to deemed dividend or capital gains in the hands of the shareholder. The Explanatory Notes to the Finance Act, 1999 state as follows:
“The two principal issues are whether it would give rise to deemed dividend under section 2(22) of the Income-tax Act and whether any capital gains would arise in the hands of the shareholder. The legal position on both the issues were far from clear and settled and there was apprehension that there will be unnecessary litigation unless the issues are clarified with finality.”
From the above, section 46A appears to be a deeming provision of law inserted to clarify that the income from tendering shares in a buy-back process would be deemed to be capital gains. A deeming provision need not always create a charge. It would be important to examine whether section 46A is merely clarificatory in nature and whether the charging section for such income continues to be section 45. In such a case, one would have to consider any relevant exemptions under section 47 even in case of buy back. Hence, the refusal of the AAR to go into this issue is perplexing, since the determination of this issue was a critical first step, in determining whether the subject benefits extend to buy backs.
The conclusion of the AAR, that for the purposes of section 47(iv) of the ITA a parent company should hold 100% shares of the shares of the subsidiary, seems to be hyper technical view, since such an interpretation would lead to the benefit under section 47(iv) being rendered largely redundant. As stated earlier, a single shareholder company is not legally permissible in India per the provisions of the Companies Act, and thus it is a legal necessity for parent entities to appoint nominees of their shareholdings in subsidiaries. The interpretation adopted by the AAR would restrict the benefit of section 47(iv) only to cases where entire shareholding is held by the nominees of a parent company, with the parent company not actually owing a single share in its own name. Such an interpretation seems patently absurd and is also inconsistent with the accepted principles of interpretation that (a) beneficial provisions should be read liberally, more so in case of exemption provisions in tax laws4and (b) a provision should not be read in a manner that renders part of it or any word/(s) therein redundant5.
It would be interesting to see if the Applicant chooses to appeal against the decision of the AAR, since in our view the decision of the AAR seems contentious and based on a hyper technical interpretation of the law which seemingly defeats the intent of legislature in enacting the provision in the first place.
1 Section 45 of ITA deals with capital gains, and brings under the ambit of tax any capital gains arising from the transfer of a capital asset including shares. Section 47 of the ITA exempts certain types of “transfers” from the purview of the aforesaid section 45. Section 47(iv) specifically exempts any transfer of a capital asset by a company to its subsidiary company, if: (a) the parent company or its nominees hold the whole of the share capital of the subsidiary company, and (b) the subsidiary company is an Indian company.
5 Ashwini Kumar Ghose v. Arabinda Bose, AIR 1952 SC 369; Reserve Bank of India v. Peerless General Finance and Investment Co. Ltd., AIR 1987 SC 1023; Rao Shiv Bahadur Singh v. State of Uttar Pradesh, AIR 1953 SC 394; Shri Mohammad Alikhan v. The Commissioner of Wealth Tax, AIR 1997 SC 1165.