Transfer Pricing on Issue of Equity Shares to Foreign Investors

The
financial newspapers have covered this (here and here) and The Firm has an interesting
discussion on this. The income tax
authorities have sought to challenge the valuation on which certain Indian
companies have issued shares to their foreign parents. While the shares were
previously issued based on the erstwhile formulation adopted by the Controller
of Capital Issues (CCI) that was applicable in the past, the tax authorities
appear to have challenged that and instead imposed a higher valuation on the
basis of the discounted cash flow (DCF) method that is now applicable to
unlisted companies. The difference between the notional value and the actual value
is treated as a loan by the foreign parent to the Indian subsidiary on which
tax is now levied.
It is
understood that the amounts involved are quite substantial, and this issue
could lead to prolonged litigation. It might also possibly have an adverse
impact on the sentiment pertaining to foreign direct investment (FDI) in India.
The
phenomenon of recharacterising equity into debt poses some concerns from a
legal perspective. Such a recharacterisation is not novel in the India context.
The FDI policy treats any optionally convertible instrument as debt and
therefore outside the purview of FDI and consequently within the external
commercial borrowings (ECB) regime. Similarly, the Reserve Bank of India (RBI)
had been treating foreign equity investments accompanied by put or call options
as debt under the ECB policy. The regulator’s role has only been further
enhanced in bringing about such a recharacterisation.

Generally, it is courts
that exercise the power to recharacterise commercial transactions. But, this
power is usually exercised in limited circumstances and with considerable
restraint. The basic premise is always to give effect to the
stated intention of the parties. However, in India, especially in the foreign
investment arena, we find extensive recharacterisation of investment securities
by the regulators. In some cases, such recharacterisation is expressly stated
in policy, but in others it is effected merely by a “view” adopted by the regulators
in individual cases rather than as a matter of general policy pronouncements.
While powers of recharacterisation are useful in certain circumstances to avoid
blatant abuse of policy, its extensive and unbridled use by the regulators
gives rise to uncertainty and would affect the investment climate in the
country. 

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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